A Summary of the News
My interest in Canacol Energy (OTCQX:CNNEF, or CNE on the Toronto Stock Exchange) has been piqued for quite some time, but the company released news from its shale-oil JV with Exxon Mobil today that has put me "over the edge" in terms of my conviction on the value proposition in the company's shares.
To be brief, Canacol has released news that the vertical Mono Arana-1 well (La Luna shale oil, 80% Exxon (NYSE:XOM), 20% CNE) tested up to 590 bopd of 22-degree API oil with a 0.4% water cut. The well was not fracture stimulated (though it is naturally fractured), nor was it horizontal. The well was acidized to improve flow rates, which is a fairly standard practice to clean up near-wellbore formation damage in a carbonate-rich interval. The shale encountered in the MA-1 well is believed to be amongst the thickest oil-shale intervals encountered anywhere in the world and it also appears to have porosities that rival the best shale plays (the thicker and more porous a resource play is, the more oil that can be packed into it on a per acre basis). With a pump, the test rate would likely have been even higher, though I won't speculate on how high, given that I don't have enough information to accurately evaluate that. In addition to likely having a very high OOIP (original oil in place) per acre, the La Luna formation is overpressured, which may bode well for production potential and recovery factors. For completeness, the flow rate I am quoting above is on a 24/64ths-inch choke with a final bottom hole flowing pressure of 4,081 pounds per square inch achieved under natural flow conditions during the last hour of the 24-hour test (as per the CNE press release, linked above).
What It Means
CNE is up 15c on record 52-week volume at the time of writing and is trading at C$7.17. With only ~90 million shares outstanding, the market cap has increased roughly $14 million on the MA-1 news. For perspective, I would point out that if any company in the now-famous Bakken or Eagle Ford got a 590 bopd test rate from an unfractured, vertical well, without the use of a pump (and where Exxon was the partner), I think it's fair to say that the market would be "less muted" to say the least. It is worth noting that CNE has 545,000 net acres of exposure to oil-shale in Colombia and that Conoco and Shell are partnered with the company on blocks proximal to the MA-1 well announced today. Given the above, I would characterize the market reaction to Canacol's news as "underwhelming." I am not a stranger to being baffled by the market reaction from time to time on smaller-cap companies, but this one is particularly interesting, particularly in light of the fact that I had viewed CNE as undervalued even prior to today.
Figure 1: Map of Closest CNE Blocks (with partners noted) Relative to MA-1 Well
(source: company reports)
To use a recent domestic "shale-oil success story" from my own investing universe, I would point to BNK Petroleum (OTCPK:BNKPF) (BKX on Toronto). Since October 2013, BKX has consistently had a market cap in the $200mm range based solely on its Caney project in Oklahoma (BKX's market cap is now ~$300mm). BKX is surrounded by XTO Energy, which coincidentally happens to be a subsidiary of Exxon now. Without going into a full summary of BKX's asset base, I will summarize it in these few words: BKX has 14,700 net acres of oil-shale that demonstrates good flow rates from horizontal multistage-frac'd wells in Oklahoma's Caney shale oil play. An unfrac'd vertical well in BKX's acreage would naturally flow very little, if anything at all, and I seriously doubt that it would flow oil to surface, unassisted, at 590 barrels per day like CNE's well just did. This is not to take anything away from BKX's results, but it is meant to point out how outstanding the CNE result appears to be.
For perspective, recall that CNE has 545,000 net acres of Colombian shale exposure. Not only is CNE's shale substantially thicker than what BKX is drilling, but it's also more porous… both of those things mean one thing; higher OOIP (oil in place) per section. Again, I won't speculate on the resource upside net to CNE, other than to say it is probably in the 10's to 100's of millions of barrels. If one were to assume that only 3% of CNE's acreage was prospective, that would still be more net acreage than all of BKX's holdings in Oklahoma. Of course, BKX and CNE are different in many ways, but I use the comparison to give some appreciation for scale and value potential as I see it. In a low case, I think it is not at all unreasonable to see $2-3/sh of incremental value for CNE's La Luna oil shale.
So what is the market paying for this option? I would argue right now that it is paying zero. In fact, based on my initial analysis, I think that it's easy to make a case for CNE having a base NAV, excluding the shale, of around $1.25B, which would mean it is valued at about 0.6x NAV and the shale oil exposure comes for free (this is discussed further below).
Reasons that I have heard for the muted market response range from "investors think a financing is coming," to "it looks like there is a large seller out in the market," to "investors were hoping to see 1,000-5,000 bopd from this test." While the first two reasons are not worth much discussion in my view (as they have nothing to do with the fundamental value proposition), the lattermost is just verging on the ludicrous.
Where in the world can I get a shale play that flows 1,000-5,000 bopd unassisted to surface from an unfrac'd vertical well? There is simply nothing fitting that description in my universe. In short, I haven't heard a good fundamental reason for the discounted valuation yet, which leads me to what I believe the reason is, which is simply the market's consistent inefficiency in pricing small cap energy stocks. Such is the market. Perhaps as a result of writing this article someone will be able to point to a reason that I have not considered, or perhaps this is the very reason why I believe that contributing to (and reading) Seeking Alpha is a worthwhile endeavor. In either case, in a way, writing articles such as these is part of my continuous due diligence process.
I could be wrong, but in my eyes, CNE just got a lot cheaper today. The blue sky is immense. Arguably, at the low end, I believe the shale has the potential to double the value of the company if it proves out over time. If I was paying even close to $200-300mm for that option value (as per the BKX discussion above), I might think about it a little harder, but with the stock trading at what I view as 0.6x of a very defensible current NAV (with zero value attributed to the shale), I believe that the risk-reward is verging on exceptional.
How I Get to 0.6x NAV
In the interest of keeping this article short enough to be digestible, I will make my NAV argument very quickly.
In Canacol's corporate presentation (link to the presentation download page here), the company states that its current 2P NAV (+ deemed volumes) is $846 million. I will not go through the detailed breakdown of that NAV here, but it was recently updated to include an announced reserves increase in the company's Colombian gas project.
In addition to that $846 million NAV, two important NAV-relevant events have transpired since the last reserve report (June 30, 2013), which I don't believe investors are accounting for. These form the basis for my view of where I believe NAV is today:
1. The discovery of the 80%-owned Leono oil field in late 2013 (press release here) and subsequent successful appraisal, showing combined flow rates of approximately 6,700 bopd from three separate tests.
2. The announcement in January 2014 that the Mono Arana-2 well result suggests that the "shallow" Lisama field is, in the company's words, "larger than we had anticipated based only on the Mono Arana 1 well results." (a link to that press release can be found here)
So what are the impacts of these two events to NAV? That is the question that, even before the shale test news, had me excited about the value proposition in CNE. Fortunately, I don't have to stretch too far to get to the $1.25B extrapolated NAV that I mentioned above. In CNE's corporate presentation, the company now suggests 10 mmboe of net recoverable resource potential in the conventional shallow Mono Arana field, which sits over top of the shale play. I know that before the MA-2 well result, the company was targeting 4 mmbbls net recoverable there (in total) and I strongly doubt that the company's reserves auditors had booked 100% of what was then viewed as the total potential volume. Given those points, I think that it is very safe to assume that the MA-2 well result may point to at least an incremental 6 mmbbls of net recoverable resources in the Mono Arana conventional discovery. If I assume that Leono is a 4 mmbbl (net) discovery (i.e., 5 mmbbls gross with an 80% working interest), I think that is also conservative. I base that statement on my experience in the oil industry, the data released by the company, analyst reports, and my experience in investing in this sector.
Combining the above assumptions of additional net resources, I believe I can feel quite comfortable with saying that CNE will add 10 mmbbls of reserves from those two assets alone. To use a market reference, Gran Tierra Energy's (NYSEMKT:GTE) unit value per barrel of comparable 2P reserves in Colombia is about $45/bbl as per that company's most recent reserve report. If I assume even just $40/bbl for Canacol's high netback adds at Mono Arana shallow and Leono, that's an incremental $400mm in NAV. If I add that to the $846 million above, you arrive at my extrapolated $1.25B NAV with lots of room for upside from additional success at Leono and/or Mono Arana shallow. Recall that I have not included ANY value for the shale in my calculations.
CNE has roughly 90 million shares out and about $125 million in debt, giving it an EV of about $770 million. Divide $770 million by $1.25B and you get to my ~0.6x extrapolated NAV number.
Putting It All Together
If I'm right about my analysis above, CNE is trading at 0.6x of what I view as a conservative NAV (again, with zero shale value) and offers upside of ~200 million net risked boe (that's resource potential adjusted for the chance of success for the exploration/upside portfolio, as per the last slide of the company's corporate presentation). Given what was just disclosed about the MA-1 shale test result, the company's valuation became even more attractive to me today.
I can't think of a lot of companies that are firing on so many cylinders at once in this sector. I haven't discussed the exploration and development plans for the 2014 calendar year here, but it's there for anyone to read in the corporate materials. In light of the planned drilling program and the current production of about 12,500 boepd, an exit rate of 15,000 bopd doesn't seem to be a stretch to me. If I use last quarter's netback of ~$40/boe on 15,000 boepd, I get a gross cash flow number of over $200 million per year; which gives me comfort on a cash flow valuation basis as well. It's probably also worth pointing out that the company appears to be targeting 24,000 boepd of average production in 2016, so investors may have good future growth to look forward to from the Leono and Mono Arana fields for quite some time.
I would encourage readers to go through the data I have linked here and the corporate materials to get a handle on the 2014 drilling program.
Next up in terms of news flow is a well test from the shallow reservoir section in the MA-2 well, which is a follow up to the MA-1 well shallow discovery that tested 1,043 bopd early in late 2013. Given the logs and commentary regarding the potential field size in the Lisama (see below, MA-1 on the left and MA-2 on the right), I'm feeling pretty good about the look of that well, but (as always) time will tell. Well log results from a new well in the shallow Mono Arana field (MA-5) are also expected soon.
Figure 2: Shallow Zones in MA-1 (left) Compared with MA-2 (right) Showing Significantly Thicker Pay in MA-2
(source: company reports)
The balance of the year will see additional development, appraisal, and exploration drilling in all of the areas discussed above, as well as some new ones. One thing that all investors will quickly see is that Canacol is not a one-trick pony.
Additional disclaimers: This is not investment advice, nor is it a recommendation to buy or sell shares in the company/companies mentioned. The information contained herein is accurate to the best of the author's knowledge, but the presented information should be verified by any party using this information as part of any decision making process. This view represents the author's opinion only, and as such readers should come to their own conclusions if they are using the opinions contained herein as part of any larger due diligence process. Prospective resources and extrapolated metrics are, by their nature, subjective and interpretation dependent.
Disclosure: I am long CNNEF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.