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Following the Money Trail to Undervalued, Unconventional Plays

If you look very closely, you'll find some big players in the energy market sinking a lot of dollars into some very unconventional plays. Mat Wilson, an analyst with Pinetree Capital in Toronto, is following a trail of billion-dollar shale exploration and development investments from Canada to Texas and South America. Wilson tells The Energy Report which small-cap names are linked with hefty, large-cap investments and why they stand to benefit.

The Energy Report: What do you expect will be the hot themes affecting energy commodities in 2013?

Mat Wilson: Many of the same themes that drove energy commodities in 2012 will continue to affect them in 2013. There's instability in the Middle East, a bottleneck of infrastructure in North America, the Keystone Pipeline and the continuing development of shale wet gas that's occurring throughout the Western Hemisphere.

TER: Tell us about your thesis and how it interacts with some of these themes.

MW: My thesis is to follow the money. There's a lot of high-profile activity in some very interesting unconventional plays. In a world of declining conventional reserves, there's some big spending in North America and internationally in unconventional exploration and development.

Exxon Mobil Corp.'s (XOM:NYSE) takeover of Celtic Exploration Ltd. (CLT:TSX) is an example of a super major entering a liquid-rich shale gas formation in Canada. There will be billions of dollars spent over the next 24 months in the Wolfcamp and Cline shales in the Permian Basin of West Texas.

There is also huge spending on ongoing activity in Argentina, despite the recent political activity.

TER: As of November, Pinetree had about 40 positions in the oil and gas space accounting for about 9% of the total value of the portfolio. Are you seeking to grow those numbers?

MW: We're definitely excited about a few different opportunities that are out there in the market and plan on taking advantage of those. We believe we currently hold some of the best names in the small-cap space, but will add accordingly if the right opportunity surfaces.

TER: Is there such a thing as a "low-risk" asset when it comes to small-cap E&Ps?

MW: Definitely not. In the small-cap space, everything is very high risk as the asset, no matter how strong, always faces significant operational and financing risk. Small-cap companies are always going to face small problems and delays, which can be the difference between an economic well and an uneconomic well and can therefore determine the ability for that company to access future financing in the market. By finding plays with large companies completing large drilling programs, assets within small-cap companies become "less risky" as the drill density in the region increases.

TER: What's an example of a less risky asset?

MW: Two companies that are starting to see a solid de-risking to their asset base are the two that I'm most bullish on in 2013: Lynden Energy Corp. (LVL:TSX.V), which is operating in the Cline and Wolfcamp shales of West Texas, and Americas Petrogas Inc. (BOE:TSX.V) in Argentina.

Lynden is listed on the Toronto Venture Exchange, based in Vancouver, and exploring in Texas, which has kept the story relatively unknown to many investors despite its strong performance in 2012.

Lynden has exposure to more than 100,000 gross acres in the Wolfcamp and Cline shale formation in the Midland Basin of West Texas. We expect the company to report a 2012 exit production rate of about 1,000 barrels of oil equivalent per day (1,000 boe/d) from 7,000 net acres in the middle of the Wolfcamp basin. This land package and production underpins its current valuation of $100 million ($100M) as it recently sold 660 net acres for $25M.

What's more exciting here is that the company holds 50% of 68,000 gross acres in Mitchell County. This property is in the middle of Devon Energy Corp.'s (DVN:NYSE) 560,000-acre Cline shale package, which is only beginning to be explored.

Following the money, Sumitomo Metal Mining Co. Ltd. (STMNF:OTCPK) recently paid Devon $340M in cash and is committed to spend more than $1 billion ($1B) for just 30% of the ground in the basin. The majority of that is going to this Cline package, which Lynden's ground is right in the middle of.

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Just south of this area, Sinochem International Corp. just paid Pioneer Natural Resources Co. (PXD:NYSE) $500M in cash and is spending $1.2B to drill 86 horizontal wells in the Wolfcamp. This is adding fuel to the fire in what is turning out to be one of the more exciting American domestic oil plays.

Lynden's plan for the year is to continue to push its Wolfcamp production and probably drill a well on its Mitchell property to prove the Cline shale extends through its ground.

TER: What was Lynden's production last year and what's its production guidance for this year?

MW: Lynden came into 2012 producing 300–400 boe/d and its guidance throughout the year was to exit 2012 with 1,000 boe/d. Lynden will be reporting soon and we expect its exit production to be in line with its guidance.

TER: What's the plan to expand that production in 2013?

MW: These are not very expensive wells, so Lynden will continue to rely on its $30M borrowing base to expand production as it has been doing for the last year.

TER: It sold roughly $25M worth of acreage. What are the plans for that cash?

MW: That cash brought down the borrowing base to essentially zero to allow the company to continue pushing forward on its production expansion.

TER: What about Americas Petrogas?

MW: Americas Petrogas is a bit of a different story. It's a little bigger than Lynden but is located in a much less stable jurisdiction in Argentina. The Vaca Muerta is the shale formation they are exploring and it is getting a lot of attention from several different super majors.

Argentina has been in the news lately for all the wrong reasons after it decided to nationalize the Repsol (REPYY:OTCPK) stake of the oil and gas company YPF SA (YPF:NYSE). The situation is proving to be something of a disaster. The case is in front of the World Bank and YPF is being sued by its American shareholders.

But if you look beyond that, you see companies like Exxon, Chevron Corp. (CVX:NYSE), Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) and many others starting to push hard again into this play.

If we follow the money, there are billions of dollars going into earn-in agreements and spending that will go into the ground over the next 12–24 months. Americas Petrogas holds the largest land package of any small-cap name down there. It has earn-in deals with Exxon and Apache Corp. (APA:NYSE).

Petrogas has four blocks in the northern area of the Vaca Muerta that it has farmed out to Exxon. The first results have been absolutely fantastic from vertical wells with small frack programs—and there is room for upside. Realistically, one of those blocks alone could prove to justify the majority of the market cap of Americas Petrogas. Furthermore, it has a very large land package in the southern end of the basin, where it holds a 90% interest, from which we should see results soon. This could also justify a large percentage of its current valuation.

There isn't much reason to be worried about financing either. Petrogas has just under $70M in cash and exited 2012 with about 3,000 boe/d of production and is going to push that toward 4,000–5,000 boe/d this year. That can generate a solid stream of cash flow that it can recycle into its Vaca Muerta land package.

TER: Is there any pressure on a company like that to provide a dividend?

MW: I don't think so because it's such a high-growth area.

One thing that's been an interesting development in the oil and gas space is that many companies that are starting to provide dividends are forsaking several growth opportunities.

TER: It's a shortsighted plan.

MW: A little bit. I understand the need for investors to have cash flow returned to them, but these companies need to push toward growth if they have the finances to do so. In my opinion, this is the only way the reward can outweigh the risk.

TER: Nationalization isn't the only risk in Argentina. Companies there also have to buy all of their supplies, for example, in Argentina. It has to be Argentinean equipment. The contractors have to be Argentinean. How is that affecting this company?

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MW: I think that's a little misunderstood. There is definitely equipment being brought in from abroad. Petrogas is drilling wells in seven days. Its rigs are first class and its crews are doing a great job, so I think that's a bit of a misconstrued notion.

TER: So Argentina, because of these big blocks, is worth the risk?

MW: I think so. It's a great entry point into the market because Argentina has been such a disaster, making this an ideal contrarian play. The market is so down on the country despite the fact that it still has super majors coming in and spending such large sums of money. A company like Petrogas would be worth multiples of where it is today if it were in almost any other jurisdiction.

TER: The margins in natural gas production are very tight in North America, but remain quite healthy elsewhere. Are you actively seeking companies with exposure to markets with healthier natural gas margins?

MW: We're always looking for a good international gas play, but they are generally tough to come by. There have been some interesting developments in Europe that we continue to keep our eye on. However, there are still many interesting opportunities in Canada where liquids-rich gas allows for strong margins despite weak gas prices in North America.

TER: Do you have any plays there?

MW: A company worth keeping your eye on is Donnycreek Energy Inc. (DCK:TSX.V). It has a substantial position in the Montney deep basin where there's been some very interesting developments to date. It's very early stage, but it has released results to date that are in line with the very strong liquids-rich gas wells that are currently being drilled in the area. The issue with this area of the Montney is that the amount of success has caused a bit of a bottleneck in the ability to process the vast amount of liquids found in each well, causing the story to move a little slower than initially expected. However, we feel this is a solid long-term play and the infrastructure will be worked out in due time.

TER: Are there any other companies in South America that are interesting to you?

MW: Sintana Energy Inc. (SNN:TSX.V) has some interesting ground with exposure to the La Luna formation in the Middle Magdalena basin of Colombia, another up-and-coming shale play. This is much earlier days and the spend is definitely not nearly what it is in West Texas or Argentina, but there are a few wells being drilled this year that will prove very telling to the future of this play.

Exxon, Shell and Ecopetrol S.A. (EC:NYSE; ECP:TSX) are starting to push into this area. Sintana farmed out 70% of its VMM-37 block to Exxon for a three-well carry and cash. Sintana is a bit of a long-term story because there won't be any drilling on its grounds by Exxon until the end of the year or 2014, but there will be some drill density developing in the region.

Historical results that have been published from the La Luna formation are very strong. Exxon is also doing deals with other companies in the area that could lead to some interesting results in 2013 and create some excitement for the story.

Sintana is run by a very strong team, has $10M in cash and a market cap of only $45M. The company has conventional and unconventional prospects and should be in a position to cash in, should this play heat up. In a sense, the success of these stories is about diversifying reliance on a single source of success. By farming out a portion of ground, establishing cash flow and pushing forward on separate exploration programs, a company is able to avoid being at the mercy of its farm-out partner, the market or a single asset. Donnycreek and Lynden don't have big partnerships with companies, but have large land packages and are able to self-finance production growth to explore those packages. Petrogas has its joint venture with Exxon, but also has substantial cash flow and a 90%-owned block in the south of the basin, as well as a phosphate and potash asset that could end up proving value.

When all of the pieces are put together, it allows for development in oil and gas, which is certainly a challenging thing for a small-cap company.

TER: Thanks for speaking with us, Mathew.

Mat Wilson is the special situations analyst at Pinetree Capital Ltd. Wilson has spent the last several years covering a diverse range of small-cap stocks mainly focused in the commodities and technology spaces. Wilson received his Master of Finance from Queen's University in 2012 and graduated cum laude with a degree in economics and philosophy from Bucknell University in 2008. Wilson has also served as a director of TSX Venture-listed companies.

By. Brian Sylvester of The Energy Report

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