Connacher: Big Upside Potential, But Little Room For Error

| About: Connacher Oil (CLLZF)

Connacher Oil and Gas (OTCPK:CLLZF) has $3.71 per share in net assets at just a $0.56 share price.

Expecting a catch? Of course, there is one: All of those assets are attached to an ugly, overleveraged balance sheet.

I’ve looked at a lot of oil producers in the past couple of years, and there are certainly some nice assets trapped within companies that do not have the financial means to exploit them on a timely basis. Usually that is because the companies have taken on projects that are too much for them to handle.

This works great if everything works out; it ends badly if some unforeseen hiccups arise. Check out Oilexco (OTC:OILXF), which was a deer caught in the headlights needing cash in the fall of 2008 when the credit and equity markets were completely paralyzed. The needed cash never arrived, and the company filed for bankruptcy.

When I look at companies like Connacher Oil and Gas or ATP Oil and Gas (ATPG) and see that oil reserves are being discounted enormously because of the balance sheets they are attached to, I start thinking about is what I would do if I ran a large, well-capitalized oil company.

My plan would look something like this:

  1. Stop all exploration spending where the rewards for the spending are uncertain;
  2. Instead, start hunting for oil reserves on Wall Street or Bay Street;
  3. Target reserves that are heavily discounted because they are attached to overleveraged balance sheets;
  4. Start using my reasonably valued shares and cash not spent on exploration to add these reserves at bargain prices by buying smaller, overleveraged companies.

And I might start with Connacher Oil and Gas.

The cash flow statement and balance sheet for Connacher are ugly. A quick look at the most recent cash flow statement reveals that the company is spending virtually all incoming cash on paying the interest expense on its debt. That means there is little cash left over for funding capital spending. The company has dug a big hole for itself to get out of.

But what Connacher does have is an asset base that is valuable in a world of high oil prices to a company with the cash to develop it. And that asset base at a fair (not an attached to an overleveraged balance sheet) price is far in excess of what the current share price implies.

Here is the value of what Connacher has:

  • PV10 of proven and probable oil reserves - $3.1 billion
  • Best estimate value of contingent reserves - $570 million
  • Other assets - $140 million
  • Total assets - $3.8 billion
  • Less net debt - ($880 million)
  • Net asset value, pre-tax - $2.9 billion

Value On a Per Share Basis:

On a pre-tax, per-share basis, this equals $6.54 per share.

On an after-tax, per-share basis, this equals $4.98 per share.

Excluding the contingent resources, this equals $3.71 per share.

Did I mention the current share price is $0.56 ?

How To Get Out From Under the Debt Load

The oil business is a fascinating one. The most interesting part of it is watching the smaller companies scramble to raise cash and develop properties that are too big for them.

Finding a small company with a big project can result in a very successful investment. It can also result in the loss of a lot of money.

Connacher has a plan to work through this heavy debt load and retain as much value per share as possible. Note that I said as much as possible, because when you have no free cash to develop anything, you are going to be taking a haircut should you start trying alternative financing means.

Right now Connacher is looking for a joint venture partner to fund a production expansion of 24,000 boe per day. The partner would pay the cost of development and receive an ownership in the property. This would obviously dilute the reserve value per share for Connacher shareholders, but would work towards deleveraging the balance sheet. Production and cash flow would increase, but the debt wouldn’t.

I think Connacher could be a very successful investment at current prices. What frightens me is if oil prices were to suddenly drop, the value of oil reserves drops as well. If that were to happen, potential joint venture partners would either walk away or dramatically drop their offer price.

Obviously completion of a joint venture on reasonable terms could be a major catalyst for the stock price.

I’m watching this one, not buying. There is little room for error for Connacher, and that doesn’t appeal to me. But that said, the upside could also be large, especially if oil prices were to take off.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.