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Introduction

After writing two articles about both the major and the junior heavy oil producers of North America, I decided to write a third one about Rock Energy (OTCPK:RENFF). Rock is a heavy oil junior producer with production from Plains and Southwest Saskatchewan in Canada. It also trades at the main Toronto board under the ticker (RE).

Rock Energy has shallow, low decline, low cost wells ($750K-$850K per well) with an average IP rate ~60 bopd. The funds from operations in conjunction with some accretive acquisitions will fuel the company's growth according to the corporate website.

Rock Valuation Metrics

To prove Rock's current undervaluation, let's find first the Enterprise value of the company:

Share Price (as of the closing price on Dec 10th) = $1.08

Fully Diluted Shares Outstanding = 41,900,000

Bank debt = Zero

Enterprise Value = (41,900,000 x $1.08) + $0 = $45,252,000

1) Based on Production

Current production = 2,600 boepd (74% oil and liquids)

2012 Forecast Average Production = 2,300 boepd (79% oil and liquids)

2012 Forecast Exit Production = 2,900 boepd (85% oil and liquids)

Enterprise Value / Current Production = $17,404 per boepd

Enterprise Value / 2012 Average Production = $45,252,000 / 2,300 = $19,674 per boepd

Enterprise Value / 2012 Exit Production - $45,252,000 / 2,900 = $15,604 per boepd

2) Based on Reserves

Total Proved Plus Probable Reserves = 8.3 MMboe (79% oil and liquids) as of Dec 2011

PV10 (Pre-tax) of 2P Reserves = $136,500,000

Enterprise Value / Proved and Probable Barrels = $45,252,000 / 8.3 = $5.45 per Mboe (79% oil and liquids)

Enterprise Value / Pre-tax PV10 = $45,252,000 / $136,500,000 = .33x

Rock has an inventory of over 120 drilling locations and it also explores new technology to increase recovery factors from known pools (radial drilling, water flooding, SP flooding, High Volume Lift). The company has currently 5 High Volume Lift projects that would provide up to 50 reactivation candidates. It has also a new oil pool discovery at Mantario at the early stages of development and numerous exploration prospects identified on its 85,000 net acres of undeveloped land.

3) Based on Funds From Operations

2012 Forecast Funds Flow From Operations = $15M

Q4 2012 Forecast Funds Flow From Operations (Annualized) = $14.84M

Enterprise Value / 2012 forecast cash flow = $45,252,000 / $15,000,000 = 3.01x

Enterprise Value / Q4 2012 forecast cash flow = $45,252,000 / $14,840,000 = 3.04x

All the multiples above ($15,604 per flowing barrel, $5.45 per Mboe and 3.01x per EV/FFO) are definitely very appealing.

Rock has also Working Capital = $2.6M (Sept 30, 2012) and an undrawn bank line of $45M to fund its growth for the remainder of 2012 and in 2013.

The Heavy Oil Acquisitions

The gross undervaluation of Rock Energy is also obvious, if we check the recent heavy oil-focused acquisitions of Twin Butte (OTCPK:TBTEF) in Lloydminster area right where Rock operates. Here are these 3 acquisitions of Twin Butte during the last 10 months:

1) It acquired the privately held heavy oil producer Waseca for $127M. The transaction metrics were $32,114 per boepd and $14.14 per Proven plus Probable boe.

2) It acquired the privately held heavy oil producer Avalon for almost $89M. The transaction metrics were $32,506 per boepd and $12.02 per Proven plus Probable boe.

3) It acquired the heavy oil producer Emerge Oil and Gas for $170M. The transaction metrics were $29,250 per boepd and $13.05 per Proven plus Probable boe.

So the average acquisition metrics were $31,290 per flowing barrel and $13.07 per Proven and Probable boe. If I apply these metrics to Rock, the value per share is as below:

1) Current production from Rock = 2,600 boepd

Estimate of value = $31,290 x 2,600 = $81,354,000

Bank Debt or Convertibles as of Sep 2011 = Zero

Working Capital as of Sep 2011 = +$2,600,000

Market Cap = $81,354,000 + $2,600,000 = $83,954,000

Shares Outstanding = 39.1M

Estimate of value per share = $2.15

Current share price = $1.08

2) Proven and Probable Reserves of Rock = 8.3 MMboe

Estimate of value = $13.07 x 8.3 = $108,480,000

Bank Debt or Convertibles as of Sep 2011 = Zero

Working Capital as of Sep 2011 = +$2,600,000

Market Cap = $108,480,000 + $2,600,000 = $111,080,000

Shares Outstanding = 39.1M

Estimate of value per share = $2.84

Current share price = $1.08

The Valuation Gap

It is clear that there is a valuation gap here. Two factors may be the reason for this:

1) The company is not widely known.

2) Those investors who know the company are in a "wait and see" mode. Rock has been in a transformational period during the last 10 months after selling part of its natural gas assets to pay off its bank debt in early 2012. So the company has to deliver first to be rewarded later by the market.

The Production Target

The company notes in the corporate website that it has a production target higher than 5,000 boepd during the next 3 years in order to become a dividend payer. I believe that the company can achieve this target primarily through the organic growth. Let's see how:

The heavy oil wells have low decline rates. The average decline rate for them is around 20% annually.

The company has currently $15M annual funds from operations which gives it room to drill at least 15 new heavy oil wells. If we multiply this with the average IP rate of 60 bopd, we get 900 bopd new production in 2013.

The current 2012 exit target of 2900 boepd reduced by 20% gives 2320 boepd in 2013 from the existing production.

So the production by the end of 2013 can be:

2320 + 900 = 3220 boepd.

This does not capture any use of the undrawn bank line ($45M) and any production benefits from Rock's optimization techniques. With an horizon of 3 years, it is clear that the 5000 boepd target by the end of 2015 is achievable if the company decides to use the credit facility to drill an additional 50 new wells and if it gets a decent 30% production increase from its ongoing waterflood initiatives.

Insiders' Ownership

The management team has a 12.4% (f.d.) stake and the ARC Financial fund holds 17.1% of Rock. This fund is owned by ARC Resources (OTCPK:AETUF) which is a major natural gas weighted producer from Canada. There is also a new shareholder who took a sizable position recently. I talk for Bissett Investment Management who bought 10.85% of the company in Oct 2012.

Conclusion

I can not know how long Rock Energy is going to stay around as an independent company but I do know for sure that it is a grossly undervalued company currently. My thorough analysis above suggests the company is worth from $2.15 up to $2.84 per share. I don't know if it ever gets acquired as this is insiders' information. However it is apparent that the current share price leaves a lot of upside which can be realized in the near future.

Source: The Time Will Come For Rock Energy To Rock