Penn West's Growth Prospects Look Compelling

In 1979, the founder and CEO of Mesa Petroleum, T. Boone Pickens, faced a serious problem. Although he had built his company from a small Texas operator into one of the world's largest global oil producers, it was becoming increasingly difficult to expand the company's oil reserves.

Mesa's once-prolific Texas oilfields were now mature. These fields produced safe, reliable cash flows with little need for investment, but it was nearly impossible to grow production or boost reserves. And without growth, Wall Street just wasn't interested in the stock. Mesa desperately needed to unlock the value of those mature fields and raise cash for exploration and expansion to appease investors.

Enter the energy trust. Simply put, a trust is a unique kind of organization that is designed to pay out large distributions to its unitholders (in trust lingo, shares are known as "units" and dividends are dubbed "distributions"). Trusts allow income and cash flows to be passed directly to investors as distributions, without corporate taxes. Not only did this raise capital for Mesa, it also provided a steady stream of income for investors.

Today there a number of energy trusts trading on the market. At StreetAuthority.com, we prefer to look toward Canadian trusts. Due to legislation, energy trusts based in Canada have more freedom to undertake debt and fund new exploration activities. This usually leads to more sustainable share prices and distributions. While picking the right trust can be tricky, there is one that I feel could provide stable income and decent returns in the future: Penn West (PWE).

After operating for years as an exploration and production (E&P) firm, Penn West converted into a Canadian royalty trust in 2005 in an effort to take advantage of the numerous tax benefits. It now ranks near the top of trusts in North America in terms of average daily production. And thanks to its mid-2006 acquisition of Petrofund, PWE has strengthened its status, increasing its daily production by nearly +40% to around 140,000 barrels of oil equivalent per day.

PWE produces a near-even balance of oil and gas. It also has some 500 million barrels of oil equivalent in oil and natural gas reserves (this includes proven and probable), including the reserves it acquired via the Petrofund deal.

Growth Drivers
The prime consideration for buying a trust is stability and predictability of production; stable income is what allows the payment of strong distributions to shareholders. As a result, trusts usually own mature and well-explored oil and gas reserves. Meanwhile, traditional E&P firms tend to focus more on new, unexplored opportunities.

In the past, Penn West operated primarily as a traditional E&P company. As part of its growth strategy, PWE would buy up promising but somewhat unexplored acreage all over Canada and would conduct additional development on these lands. After converting to a trust in 2005, PWE was left holding more than 4 million acres of this undeveloped land.

Although not a typical asset for a trust, this undeveloped land has huge strategic value for Penn West. The company has been able to negotiate deals with E&P firms to develop this land while taking little or no capital risk. Specifically, Penn West allows E&P firms to explore and drill on this virgin land in exchange for a royalty interest in any future production. These farm-in partners take on all the expense of drilling, development, and production processing. Meanwhile, PWE still gets a piece of any future oil and gas revenues from this land. This is an excellent low-risk growth strategy.

In addition, PWE has a history of success with enhanced recovery techniques. Enhanced recovery techniques include a process known as carbon dioxide (CO2) flooding. Contrary to popular belief, oil in a reserve is not trapped in a giant underground pool, but is instead held in tiny holes, cracks, and pores of rock. Because oil is under pressure underground due to geologic forces, it will flow easily to a newly spudded well. But over time, that geologic pressure drops and production falls. When that happens, 60% to 70% of the total oil in the field can be left trapped underground.

In CO2 flooding, a company pumps carbon dioxide gas through injection wells into the edge of an oilfield. The gas is literally absorbed by the oil and helps to re-pressurize the field. As anyone who has ever opened a can of shaken Coca-Cola can attest, carbon dioxide bubbles will force the soda through the top of the container, creating quite a mess. Similarly, carbon dioxide bubbles in oil help push the oil up a well. PWE uses carbon dioxide flooding to push more oil out of its existing wells. The result is both increased recovery and a greatly enhanced reserve life.

For example, one of Penn West's key properties, the Weyburn field, currently accounts for a large chunk of the firm's production. This field was discovered in the 1950s and has already been peppered with 600 wells. But by using a carbon dioxide flood to enhance recovery, PWE estimates that Weyburn will deliver almost two decades of additional reserve life.

PWE also garners around 40% of its total production from mature light oil fields in central Canada. Light oil is easier to refine than other forms of crude and earns a premium price on the global market. Although these fields are mature, PWE expects to garner steady production from the region using its enhanced recovery techniques.

Distributions and Outlook
PWE has maintained a conservative dividend policy throughout its short history as a trust. The trust aims to pay out just 60% of its cash flows as distributions. Meanwhile, PWE has been using its excess cash flows wisely.

For example, the firm's 2006 acquisition of Petrofund has greatly enhanced Penn West's growth prospects. PWE is also spending heavily to roll out its CO2 enhanced recovery program across more of its reserve base. Both of these investments will ultimately lead to higher production. This means Penn West is in good shape to deliver consistent distributions in the coming years -- something which all income investors should take note of.

Disclosure: Author has no position in PWE

Comments

[DavidNeubert]

Nice description. Worth a look, thanks.