In Part 1 of this series, posted on my Instablog, Canadian oil and gas research analysts Josef Schachter and Martin Pelletier explained one of the key strategies to make money in the junior oil sector -- trade the volatility, and learn how to read the swings.
Here, they share some of their best money-making strategies moving forward.
To me, it's intriguing that Schachter says the future for juniors is not so much in big resource plays in the near term. These are the tight oil plays like the Bakken, the Cardium, the Alberta Bakken, etc. that have a much larger size and lower risk than conventional, old-style pools of oil/gas. They have been the bread and butter of the junior energy sector in North America for the last three years. Companies couldn't get financed without one.
"There is a future for the juniors, but it's in lower cost plays," according to Schachter. He says stock valuations are so low now that financing with new equity (issuing shares) is too expensive and dilutive. And these resource plays have voracious appetites for capital.
New technology is really making a difference. (High cost) horizontal wells have increased the "ante" of playing in the fairway. The main plays are not entry level plays for the juniors anymore. It's now a science play, and who pays for that?
When well costs in the Montney (a high-profile, liquid-rich gas play on the BC Alberta border -- ks) are $6-$10 million, and these juniors have market caps of $30 million, they can't do it. One bad well and you're hurting, and two bad wells and you're done.
You need to find lower cost plays, where well costs are $2 million all in, that produce 75-100 barrels of oil a day.
It's a treadmill, slow process now; it's not a home run game anymore. (Management teams should be saying) let's spend 70% of budget for conventional slow production build and take 10-15% for the home run swing.
Here are his four top junior stock picks, and he warns they could get cheaper before they get expensive:
Delphi Energy Corp (OTCPK:DPGYF): "It's liquid rich, and has new Montney wells this month, and lots of runway (large area of undeveloped land with low-risk drill locations -- ks), and new (production) facilities they've put in. They'll exit 2012 at 9500 bopd exit, maybe 10,000. DEE will have 28% of their production in Natural Gas Liquids."
Guide Exploration Ltd (OTC:GLNNF): "They have 30% oil and Natural Gas Liquids, heading to 40%."
Niko Resources (OTCPK:NKRSF): "Niko has a big Indonesian portfolio (they're starting to drill) now, and a chance for resolution of some issues in India, and they're financed for two years. The wells, if successful, could be worth more than stock price. Everyone hates India, and they're excessively negative. To me, it has low downside and upside into the $70s in a good market."
Western Zagros (OTCPK:WZGRF): "They're drilling the TLM zone. They'll test it through the summer. I'm pessimistic on the market short term, but this could outperform. It has already doubled this year. The politics are still up in the air, but pipelines in Kurdistan Regional Government will be built to Turkey, and they're protected by Turkey. All that is helpful to the story."
Pelletier offers a different tack for investors to consider.
He says the first movers in the energy sector will be the beaten-up large cap stocks. Small caps likely have another 6-12 months of living within their means -- which means slower growth, because they can't raise money to fund expansion.
He likes to actively manage his risk in energy stocks, and suggests that there are two fairly simple way for retail investors to create a profitable trade, based on their own beliefs:
At times, oil and gas stocks will factor in a premium or discount to their commodity. For example, we calculate that oil companies are factoring in a $20 to $30 per barrel discount to current oil prices.
So if you believe that the oil market is set for a recovery, then the cheaper buy is clearly Canadian oil stocks rather than owning oil itself.
But if you're worried about the broader market -- and in particular oil prices -- then you can short the spread. That means owning oil focused companies while shorting crude oil prices through an ETF. In a falling market, both oil prices and oil stocks will fall, BUT oil prices will fall faster than oil stocks. This will give you some downside protection to your portfolio.
So if you want to own oil, it's cheaper to own the stocks. You can do this trade by using ETFs -- on the Toronto Stock Exchange, you would buy symbols XEG (a basket of senior energy producers that mirror the TSX index -- ks) or COS (Canadian OilSands), which pays a very attractive 6% dividend, and buy HOD (that's double levered).
Investors can also do this exercise for natural gas versus natural gas focused companies. For example, Encana is now trading at a 15-20% premium to the forward curve on gas prices.
So if want to play a recovery in gas prices, it's better to own the winter gas ETF on the Toronto Stock Exchange-HUN. Then you could short Encana to play the spread.
I asked Pelletier to give readers one junior energy stock they should go do some of their own research on, and he recommended Surge Energy (OTCPK:ZPTAF).
According to Pelletier:
Whenever we look at a company, we break it out into 3 categories People, Assets and Value.
This is a very technical team with strong track record of growth. This year, they are estimating to increase production over 40%. Their assets are moving beyond exploration stage, so there's more predictability going forward. And they've got a big incremental upside from waterflood at some properties.
We estimate that it is trading at roughly a 25% discount to its oily peers on a cash flow multiple basis, and 20% discount on 2P reserve basis.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.