Oilsands Quest: Anatomy of a Potential Short Squeeze

As of mid-July, Oilsands Quest’s (BQI) short interest has increased to the highest it has been in recent history. Specifically, BQI’s short interest has increased by 133% to 12.4 million shares from 5.3 million shares at mid-June.

Undoubtedly, some of the investors shorting the stock were betting against the prospects of a bullish management update of the company's resource estimate and resource commerciality in July (when the company was widely expected to provide the update).

In particular, Bears on BQI were betting that the lack of shale cap rock on its acreage would preclude its bitumen resources from being recovered via in-situ processes since there wouldn’t be a barrier to contain the high pressure steam from some in-situ recovery processes.

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That said, on July 12th, BQI management came out with a resource estimate of 10 billion barrels, a better-than-expected number. Perhaps more importantly, management stated that…

The Axe Lake bitumen resource is characterized by thick, continuous, coarse-grained oil sands in reservoirs at depths from 185 to 205 metres. Studies to date suggest that grain size distribution of the coarse sands, which ranges from smaller particles at the top of the pay zone to larger particles at the bottom, will enhance drainage, thereby improving production and economics. The clay-rich layer overlying the reservoir is expected to provide an effective seal for anticipated recovery processes.

The fact that management believes that its Axe Lake project is suitable for in-situ recovery was a monumental statement. Moreover, BQI’s studies showed recoverability rates of 54% to 83% (for an average of 69%), much higher than the industry average of about 40%. Those two pieces of information sent BQI shares soaring by about 25% to end the day at the highest level the stock has been since around March 2007.

What’s interesting is that one might expect some significant short covering to occur (and the short interest to decline) by mid-July, given management’s July 12th statements which have contradicted the key short-investment thesis point. However, the opposite occurred. In mid-July, BQI’s short interest soared to its high. As of mid-July, BQI’s short interest equated to about 8% of the company’s total shares outstanding of about 158.6 million shares.

Of note, anyone who shorted BQI from about mid-February (as indicated by the dotted red vertical line) and who did not cover his/her short position would be losing money (and possible significantly so) since the stock’s recent price of $4.00 (as indicated by the black dashed line) was higher than anytime since mid-February.

That leads me to my current hypothesis that the spike in the short interest through mid-July is attributable to prior Shorters increasing (and possibly doubling-down) on their short positions to recoup their losses. In other words, the recent build in the short interest is due to loss aversion psychology rather than sound fundamental shorting rationale. It’s the same mentality that prompts a losing blackjack player at a casino to continue to reach into his wallet in an attempt to leave the table “even”. In my mind, that would be the most likely explanation as new Shorts would probably not put on their short positions immediately after a bullish press release from the company’s management.

What makes the situation that much more interesting is the fact that BQI management plans another resource update around the September-October timeframe. Especially notable is the fact that this update will contain the opinion of a 3rd party oilsands assessor, which will likely confirm management’s internal resource estimate and the commerciality of its acreage. That should open BQI’s management to the next step in its plan for the company; the establishing of a joint venture with a deep-pocketed, Big Oil partner who would provide the bulk of the financing for developing BQI's oilsands resource.

A sale of part of a project would immediately make transparent the value of the bitumen on BQI’s property. For example, if a Big Oil company came and bid $5 billion for 60% of the company’s 7 billion of recoverable resource (equaling an estimated 10 billion barrels of resource x 70% recoverability), that would imply that the entire 7 billion barrels is worth $8.33 billion. On a fully-diluted per share basis (assuming 250 million fully-diluted shares), that would imply that each share of BQI is worth $33.33 (=$8.33 billion value / 250 million shares). I would think that an explicit valuation of the company would, at the least, cause the stock price to approach that valuation relatively rapidly as do most similar joint venture announcements. Of course, those are just hypothetical numbers.

From the two most recent Seeking Alpha articles on BQI’s valuation, “Oilsands Quest Inc.: Undervalued Canadian Oilsands Play” and “Three More Compelling Reasons To Like Oilsands Quest”, it appears some investors believe the stock is worth between $18 and $26 per share. Using the mid-point of those two estimates, I arrive at a valuation of $22 per share, or about 424% higher than the current price of $4.20 per share.

I believe that, upon the company’s September-October update, BQI’s stock will be propelled upwards towards $22 per share as investors speculate on the potential economics of a joint venture with a Big Oil company. I’m sure many of today’s current Shorters are cognizant of BQI’s potential upside and are well aware of the timing of the September-October update and the potential repercussions of a very bullish update. That, coupled with the fact that the current short position is large ( 12.4mm shares and 8% of the float) and likely predicated on loss aversion psychology rather than fundamental issues with Oilsands Quest, should prompt a short squeeze over the next couple months before the September-October update. And that is my take of the anatomy of a BQI short squeeze.

BQI 1-yr chart

Disclosure: none