As I wrote last week, I’m on the hunt for exposure to undervalued oil reserves. And I think the best place to look for them right now is North American oil companies with unappreciated unconventional acreage.
One company that I think fits the bill perfectly is mid-sized Canadian light oil producer Petrobakken (PBKEF.PK).
Now I don’t actually own much of Petrobakken directly. But I do own a significant position through its parent company Petrobank (PEGF.PK).
As the title suggests, Petrobakken has a nice dividend yield and I think it is undervalued by at least 30%, likely more. I will get to my valuation thinking later. But first I’d like to explain what has caused the stock market to not appreciate the true intrinsic value of the company.
Petrobakken – Why Is It Cheap ? (current stock price is $22.15)
Of course trying to answer why the stock market prices a stock in a certain way is more than a little bit of guesswork. But I’ll take a shot at it.
Here are my 2 reasons why I think the market doesn’t recognize the true intrinsic value of Petrobakken:
- The company was formed as a pure play on the Bakken. Investors who bought shares for this exposure sold when Petrobakken moved aggressively into the Cardium play in Alberta.
- Production has not grown over the past year, and Petrobakken is supposed produce a steady 10% to 15% per year of production growth.
Unexpected and Large Move to the Cardium
Petrobakken was formed in October 2009 when Canadian company Petrobank merged its Canadian light oil assets with Tristar Oil and Gas. This created a company focused mainly on the very popular Saskatchewan Bakken unconventional oil play.
It started trading at $35 per share.
However, if investors held Petrobakken because it was a pure play on the Bakken, they were quickly disappointed, as in early 2010 Petrobakken spent $1 billion acquiring non-producing land in the burgeoning Cardium play in Alberta.
- Berens Energy on January 4, 2010 for $336 million cash
- Result Energy on January 28, 2010 for $480 million ($200 million cash, remainder in shares of Petrobakken at $32.25 per share)
- Private Cardium focused company on March 2, 2010 for $270 million ($90 million cash, remainder in shares of Petrobakken at $32 per share)
To fund these acquisitions Petrobakken also issued $750 million of convertible notes. The notes are convertible at $39.61 per share and pay $39.61 per share.
Investors did not seem to take kindly to these transactions. The share price of Petrobakken fell from $35 at inception of the company in October 2009 down to $20 in June 2010 where it basically still remains.
Quite frankly I understand the concern. Petrobakken already had plenty of drilling locations to grow production for the next decade just with their Bakken and conventional Saskatchewan assets. For a $5 billion company to go out and spend $1 billion on unproducing land in a new resource play changed the entire fundamentals of the company.
Lack of Production Growth in 2010
The large amount spend on acquiring a position in the Cardium seems to have been the main reason behind the move in the Petrobakken share price from $35 down to $20.
The reason that the share price still remains near $20 is that Petrobakken ended 2010 with basically the same level of production it entered the year. And for this company that is a disappointment.
Upon the founding of Petrobakken in late 2009 the basic story behind the company was that it would be a nice blend of yield for investors from its dividend and growth. The company basically expected roughly 10% to 15% annual production growth from its large inventory of drilling locations.
So what happened to the growth ? Two things I think.
The first and largest was the horrible weather in Western Canada. Normally the oil producers in Western Canada have a few weeks in the spring that is known as "spring breakup" where the snow melts and the ground is just too wet to get out with trucks to move drilling crews and equipment around.
In 2010 "spring breakup" basically did not end until mid October because of an incredibly wet spring, summer and fall in Alberta. This meant that Petrobakken simply couldn’t get out and drill and complete enough wells to create the kind of production growth anticipated.
The second reason for the lack of production growth related to growing pains for a new company. Petrobank’s light oil unit merged with Tristar late in 2009. This new entity then acquired not one, not two but three additional companies within its first 6 months of existence. With that kind of upheaval it has to take a while to get everything up and running smoothly.
Why Do I Think Petrobakken Is An Attractive Investment at $22.15?
I’ll summarize what I like about Petrobakken and then go into a little more detail.
- The valuation. Trading around $22 I think the value of the company assets is at least $28 and you get paid a 4% plus dividend to wait for the market to figure this out.
- The management team. I think John Wright and group have a great track record of creating shareholder value.
- Upside. I think there are a few free options that I haven’t factored into my valuation that could make it far too conservative.
How Do I Get to $28 Per Share?
I’ve looked at the various reports from analysts who cover Petrobakken. They uniformly use a multiple of EBITA or cash flow to value the business. Here are the analyst targets:
Mean Target: 27.87
Median Target: 27.00
High Target: 38.00
Low Target: 23.00
No. of Brokers: 19
I don’t really like the multiple of cash flow approach when valuing an oil and gas producer. I find it far too subjective.
I prefer to look at the value of the reserves that a company owns both on a present value basis after tax and by comparing what the company owns to recent sales of similar acreage.
Petrobakken has 4 Main Properties
- Unconventional Bakken acreage/reserves in Saskatchewan
- Conventional Mississipian acreage/reserves in Saskatchewan
- Unconventional Cardium acreage/reserves in Alberta
- Unconventional shale gas in the Horn River and Montney in Northeastern British Columbia
One of my approachs to valuing the company is to take the PV10 valuation and to that add an estimate of value for the unbooked locations that we know exist but have yet to be drilled (thus no reserves booked).
Bakken – Over 950 locations, 350 of which have proven or probable reserves assigned.
Mississippian – Over 350 locations, 150 of which have proven or probable reserves assigned.
Cardium – Over 650 locations, 200 of which have proven or probable reserves assigned.
Horn River / Montney – Over 400 locations, none of which have proven or probable reserves assigned.
Step 1 is the easy part – the reserve engineers have updated 2010 PV10 of proven and probable reserves and the PV10 figure is $4.1 billion.
Step 2 is the hard part – we need to value 600 unbooked Bakken locations, 450 unbooked Cardium locations, 200 unbooked Mississippian locations and 400 unbooked Horn River/Montney locations.
An approach I have adopted is to take the PV10 per drilling location suggested for each property by Petrobakken (assuming only $75 oil) and give it a 40% haircut to account to provide a margin of safety.
Bakken 600 locations x $3.6mil x 60% = $1.30 billion
Cardium 400 locations x $4.7mil x 60% = $1.12 billion
Mississippian 200 locations x $1.9mil x 60% = $220 million
Horn River/Montney = $100 million (not enough info)
Total step 1 = $4.14 billion
Total step 2 = $2.74 billion
Total estimate of asset value = $6.88 billion
Less net debt – ($1.6 billion)
Value for shareholders = $6.88 billion less $1.6 billion = $5.28 billion
Value per share = $5.28 billion / 187 million shares = $28.24
My approach is different than that of the analysts who assign a multiple based on expected cash flows. The result is the same though and that is that Petrobakken is attractively valued at $22 per share.
A Little History on John Wright as a Creator of Shareholder Value
I wouldn’t be interested in Petrobakken if I didn’t think that it was undervalued. But undervaluation alone isn’t enough on its own at this point to get me to buy a stock. I also need a good management team that is aligned with shareholders.
And I think Petrobakken has that and then some.
In 2000 John Wright (current CEO of Petrobakken and Petrobank) approached the then chairman and CEO of Petrobank about Wright and his team taking over and taking the company in a new direction. At that time Petrobank was natural gas focused and had a market capitalization of about $50 million.
In the 10 years since Wright took over he turned Petrobank into a company with a market capitalization of almost $5 billion when you include its interest in Petrominerales which was just spun out. From $50 million to $5 billion in a decade. That is quite a bit of value creation.
Prior to Petrobank Wright did the same thing with Pacalta Resources which went from being a small Alberta junior producer to being bought out by Encana for over $1 billion in a span of 3 years.
Wright and all his top deputies have the vast majority of their net worth in the Petrobank companies (Petrobank, Petrobakken and Petrominerales). So they are fully aligned.
Free Options That Could Make Petrobakken Even More Interesting
While I think getting a quality company like Petrobakken at a significant discount to intrinsic value and getting paid 4% per year to wait for the market to close the valuation gap is a great deal. I also think there are several other items that might make Petrobakken worth quite a bit more than I have suggested.
Option 1 – Technology and Enhanced Oil Recovery
What Petrobakken has done, and it was quite intentional is lock up vast acreage positions in two plays (Bakken and Cardium) with a huge amount of original oil in place. Horizontal drilling and multi-stage fracking have just in the past few years turned these pools of oil into recoverable pools of oil. We always knew there was a lot of oil there, just not how to produce it economically.
As technology continues developing and as companies like Petrobakken keep experimenting with the best ways to produce these fields they are going find ways to recover a higher percentage of the oil in place.
Crescent Point Energy (CSCTF.PK) which is the main competitor in the Bakken in Saskatchewan has been indicating that it has tested a waterflooding technique that believe will double its reserves. If true, then every company in the play will adopt the best practice.
Petrobakken themselves have just started talking about initial success they are having with an EOR technique that involves injecting natural gas into their wells.
And just this year each Bakken location added 30,000 barrels of oil (that is per location) thanks to the success Petrobakken had moving to bilateral drilling.
My point is they will recover more oil than anyone currently factors into their reserve figures. I have no doubt about that. And the additional amount recovered could be significant. What could be better for shareholders. The land is already bought and paid for. If they can extract more oil from the same land all of the incremental revenue turns into cash flow for shareholders.
Option 2 – Natural gas properties (Horn River and Montney)
I assigned a token $100 million to these 400 drilling locations in Northeastern British Columbia.
The reality is though, that Petrobakken has a lot of natural gas in place there. There reason I was so conservative is that with the high quality very light oil drilling that Petrobakken has these properties might not get developed for a while.
Here is an estimate of the natural gas that could be held by PBN:
BCF per section 40,000,000,000
Recoverable per section 12,000,000,000
Total recoverable gas - Montney 204,000,000,000
BCF per section 40,000,000,000
Recoverable per section 12,000,000,000
Total recoverable gas - Horn River 1,164,000,000,000
Looks like they could have over 1TCF of recoverable gas here. I feel confident that $100 million understates the eventual value to be realized here.
Option 3 – Petrobakken management will add value
One thing that I always find funny is that when people value an oil company they value only the existing reserves or production of the company. They don’t ever pay any sort of premium for the likelihood of the management team in question growing value per share.
And I believe that this management team will do just that. I don’t know when and I don’t know what it will be, but I bet in two years there will be an entirely new highly valuable play that is part of Petrobakken that is not there today.
Consider that four years ago neither the Bakken or the Cardium were known to Petrobank shareholders. Now both resource plays have values in the billions for Petrobakken shareholders.
One Last Thing
Both Petrobakken the company and most ever senior member of Petrobakken have bought shares of Petrobakken around this price or slightly lower. They believe that the company is considerably undervalued and my experience with Wright is that his timing on share repurchases has been pretty savvy.
I don’t look for the stock market to wake up tomorrow and decide Petrobakken is worth $30. But I do think that as 2011 rolls on with normal weather and no big corporate transactions to integrate into operations we will see production growth from Petrobakken and the stock market will reward them with a higher share price.