I am a sucker for a good story about a small energy company with a big exploration prospect. Who wouldn’t like to own a piece of a micro-cap company that hits it big and discovers an oil field worth multiples of the current share price?
And there are no shortages of small companies with stories like that to look at as an investor. The problem is that the success rate in investing in these companies is just too low for my taste.
What I really want is to accumulate a portfolio of companies that have a solid asset base, which more than supports the current share price and also provides me with home run potential on the upside.
And I think there is one group of companies that does exactly that. Energy companies focused on unconventional resource plays.
Where Does the Homerun Potential Come From?
The downside protection in these companies for me as an investor is the value of the third-party reservoir engineer approved proven and probable reserves. I try to make sure I pay less per share than the value of the recoverable oil (I’m avoiding natural gas for the most part) that I am certain the company has.
The home run potential comes from two parts:
- The fact that many of these companies have acreage within the boundaries of a resource play that has not yet been drilled and isn’t in the booked reserve numbers. While the value of this acreage isn’t reflected in the reserve figures or the stock price, it has considerable value to other energy companies
- Continuing evolution of the technology and techniques that have unlocked these unconventional plays. Small percentage increases in the amount of oil that can be recovered can mean changes in value for these companies
Petrobakken (PBKEF.PK) – Let’s Walk Through an Example
I’ve been touting Canadian unconventional producer Petrobakken and its parent company Petrobank for over a year. So far all that has gotten me are some large paper losses.
That’s ok, this isn’t the first time it has taken awhile for Mr. Market to come around to my way of thinking. I’m fully satisfied with the operating performance of the company.
There are several points I would like to make about Petrobakken that are worth being aware of when considering any unconventional resource focused company:
Point 1 – Reserve Bookings Tend to Increase Over Time
Reserve auditors are conservative by nature. The worst mistake a reserve auditor could make is to overstate the oil reserves of a company.
Unconventional resource plays are still relatively new. This makes reserve auditors even more cautious as they don’t have the same degree of historical data to draw from when evaluating unconventional reserves.
Because of this, if we as investors are buying an energy company at or below the value of its booked reserves there is a good chance those reserves are significantly understated.
Consider the proved plus probable reserves that have been assigned to the first six Bakken wells Petrobakken drilled:
December 2006 – 100,000 barrels
December 2007 – 142,000 barrels
December 2008 – 142,000 barrels
December 2009 – 150,000 barrels
December 2010 – 168,000 barrels
As the reserve auditors have gotten more data from these wells that were drilled in 2006 the amount of recoverable oil that the auditors estimate will be recovered has increased 68%.
Point 2 – Non-producing Acreage Holds Huge Hidden Value
The stock market tends to value energy companies based on a multiple of cash flow or a multiple of flowing barrels of production. What I think the market undervalues is the amount of growth that certain companies have before them.
In the technology sector the market now values Microsoft (NASDAQ:MSFT) at a very conservative multiple because its growth days are behind it. But a new technology company would be valued at a premium multiple because the market may see a decade of rapid growth ahead of it.
Petrobakken is a good example of where I think the stock market is not pricing in any sort of premium for future growth. At the current rate of drilling Petrobakken has over a decade of drilling locations in the Bakken and Cardium resource plays. That is virtually guaranteed production growth for the next 10 years.
Petrobakken isn’t drilling exploration wells. These are development locations where we know what the production additions from drilling will be.
On top of the Cardium and Bakken drilling locations Petrobakken has another 120,000 acres in four new emerging light oil plays in Alberta. These plays are being kept quiet as more land is being acquired, but there is little doubt they are going to add significantly to Petrobakken’s drilling inventory.
With all of this growth ahead of it, Petrobakken trades at an EBITA multiple well under 5. The stock market values current production and doesn’t seem to care that Petrobakken has years of growth ahead of it.
Point Number 3 – Enhanced Oil Recovery / Improved Unconventional Drilling Techniques
I think technology is going to create enormous value for shareholder of Petrobakken and other unconventional players.
Consider Petrobakken’s Bakken acreage:
- Petrobakken has 90 million barrels of proved and probable reserves recorded in the Bakken
- This assumes a 5% recovery of the original oil in place
- The original oil in place is estimated to be 1.8 billion barrels
- Petrobakken believes ultimate recoveries will be more than 25%
- 25% recovery on 1.8 billion barrels is 450 million barrels
- 450 million barrels is five times what Petrobakken currently has booked
I might be inclined to laugh at the idea that reserves could increase five times in the Bakken, except that Petrobakken’s main competitor in the region Crescent Point Energy (CSCTF.PK) actually thinks recoveries will be over 30%.
The key thing to remember is that for Petrobakken and many of these companies you don’t even pay a full price for the reserves that have currently been booked. You get a discount to the 5% assumed recovery factor.
Imagine how well you make out as an investor if ultimate recoveries are more than 5 times what the market is expecting.
I don’t expect to wake up tomorrow and see Petrobakken and my other unconventional players trading up by 100%. What I do think is that as time goes on and production keeps increasing stock prices will follow.
Petrobakken can keep plugging away for the next 10 years and grow production. Even if the multiple to cash flow that the company trades at doesn’t improve, the higher production numbers alone will drive the share price higher.
With every well drilled the industry gets more information on how to improve performance. The techniques involved in unconventional oil production are still young and improving by the month. The important part for oil companies is getting the real estate locked down so they can benefit from these technological advances.
Whether it is Chesapeake Energy (NYSE:CHK), EOG Resources (NYSE:EOG) or Sandridge Energy (NYSE:SD) that find technological improvements, it doesn’t matter. Every company that has land locked down benefits because the entire industry will adopt the best techniques.