My investment criteria is to buy value which has been overlooked and eventually discounted by the market. I am a value type investor whose strategy is primarily driven by the fundamentals of a company. I do not buy stocks on the sole basis of it being bought. If one invests in good companies, his portfolio will grow and produce decent returns. The companies that produce good returns have a better chance of being bought and this adds upside.
There has been a lot of talk about the Bakken formation in North Dakota and Montana during the last 2 years and numerous articles have been released about the companies which operate there like Kodiak (NYSE:KOG), Northern Oil (NYSEMKT:NOG), Oasis (NYSE:OAS), Continental Resources (NYSE:CLR), Whiting (NYSE:WLL), and Halcon Resources (NYSE:HK). That being said, I decided to dig for overlooked value on another prolific formation with similarly strong upside potential as the IP of the wells has indicated thus far. This formation is the Beaverhill Lake in Alberta.
The Beaverhill Lake formation
"The Beaverhill Lake formation in the Swan Hills region is a Devonian aged carbonate reservoir. It covers a wide variety of limestones and dolostones that were deposited during the Middle Devonian, some 375 million years ago, when a large carbonate platform was situated in central Alberta. Since the 1950s, conventional oil and gas has been produced from the tall reef build-ups which represent some of the largest oil and gas pools ever discovered in western Canada.
The Swan Hills Field had an estimated 2.9 billion barrels of oil originally in place and had produced 0.9 billion barrels from its discovery to year-end 2010. BMO estimates that there are an additional 2.5 billion barrels of oil in place in these potential unconventional developments around the Swan Hills Field.
Source: National Energy Board of Canada (neb-one.gc.ca)
Among the juniors of this formation, I picked Second Wave Petroleum (OTC:SCSZF) which trades at the Toronto main board. Second Wave operates in the Beaverhill Lake formation which has attracted significant M&A activity lately as:
1) Midway Energy (Toronto main board: MEL) was acquired by WhiteCap Resources (SPGYF.PK) for $96,000/boepd in Feb 2012. Midway's production weighting is 67% oil and liquids and it was one of the juniors of the Beaverhill Lake. It appeared on the Beaverhill Lake scene in mid 2011 and it had 23,000 net acres in Inverness and Swan Hills South.
2) Sure Energy (OTC:SUGYF) sold its Beaverhill Lake assets back in June 2012 for $150,000/boepd to invest it on its other areas, its heavy oil assets in Saskatchewan primarily. Sure Energy land was near the Virginia Hills reef (16 sections) along with one section in Swan Hills South. It is worth mentioning that Sure Energy hit rates as high as 1,100 boepd in one of its horizontal wells back in 2011.
Second Wave Petroleum is a "single and ready to mingle" junior of the Canadian oil patch. According to the company, Second Wave received some unsolicited proposals in late Feb 2012. Not surprisingly, it sits on some of the best Beaver Hill Lake oil acreage at Swan Hills. It holds 50,000 acres with a 60% working interest and another 10,300 net acres with a 100% WI in Beaverhill Lake in Judy Creek. It also holds 92,000 net acres with 100% WI in Judy Creek in the Pekisko formation.
Few may know the TOP-30 oil wells drilled up to Feb 2012 in Western Canada. Even fewer folks know that 4 out of the TOP-16 oil wells in Western Canada belong to Second Wave Petroleum. The link of this source is here.
The company has slightly over 3,000 boepd production currently (80% oil and liquids) and it trades just 2x the funds from operations annualized. It also trades for only $65,000 per flowing barrel currently. Its book value is well below 1 at the current market cap of C$100M. The production and reserves growth yoy is strong and this is obvious both at the top and at the bottom line.
Second Wave has the ability to almost double its production (85% oil and liquids) within a year according to its latest presentation. Second Wave estimates that it has a drilling inventory of 130 Beaverhill Lake oil wells and an additional 650 wells in the Pekisko.
The long term debt/funds from operations annualized ratio is slightly higher than 2 but this is very manageable as:
1) The funds from operations are strong currently due to the rising price of oil in Q3 2012. The upcoming winter in conjunction with QE3 will provide a floor for the oil price for the next 12 months to say the least.
2) Few people have noticed that Edmonton price surpassed WTI lately by $3-5 which indicates the first positive results from the Seaway pipeline reversal. Seaway has more room to grow in the future as the capacity is expected to rise up to 400,000 barrels by early 2013. So the Edmonton positive differential looks more than sustainable to keep fueling the funds from operations. Actually this fact provides a major advantage to all the Canadian oil weighted companies versus their US-based peers. To realize this event at its full extent, we need to know that Edmonton light sweet crude oil was averaging a discount of $10 per barrel less than WTI during Q2 2012 according to the Pengrowth Q2 2012 report. It seems that Penn West was right when it projected in its Q2 2012 report that "We anticipate Canadian crude oil prices strengthening over the next 12 months as slow and steady demand increases are amplified by improvements in North American pipeline infrastructure pushing Canadian crude into closer alignment with world oil pricing and lead to stronger netbacks for our industry."
3) The company has several non core assets to sell if needed.
4) Brookfield Asset Management can act as a safety net and provide a loan for the reduction of the bank debt if needed. Brookfield is the largest shareholder with a 47,5% stake in the company. The source is here.
The spring drop
Some will wonder why the price dropped in late spring from C$3 down to C$1. It was a combination of 3 factors which caused a domino effect. Firstly Brookfield Asset Management, the biggest shareholder, did not accept to sell. Nobody knows the premium Brookfield wanted to receive. So all the traders left and they did not get that quick 40-50% premium they expected to get based on the peers' valuations. This rejection of the unsolicited proposals coincided with the severe correction of the stock exchanges and the steep decline of the oil price. All of these events took place in Q2 2012. However an experienced investor will observe that:
1) Second Wave was trading at C$3 in Q1 2012 even before the arrival of the unsolicited proposals in very late Feb 2012. Actually the pps has never dropped below C$2 since the company has been public although it had a very low production 1-2 years ago when the Beaverhill Lake play was at its infancy.
2) Second Wave received unsolicited proposals and it was not the company which initiated a strategic review to sell itself. In other words, the suitors came first and made an offer. This shows that the company is a very attractive target even when it was trading at C$3.
The core thing is that nothing has changed fundamentally since Feb 2012. Actually the company is better than it was in Feb 2012. It was producing 3,000 boepd (80% oil and liquids) in Feb 2012 according to the corporate press release of 13 Feb 2012 which described the big success on the Judy Creek drilling program. This success was also confirmed once again in June 2012 through another press release. It produces a bit more than 3,000 boepd (80% oil and liquids) currently and the production will ramp up by year end.
The Beaverhill Lake Majors/Suitors
The notable major players in this formation which has been greatly de-risked are Apache (NYSE:APA), Arc Resources (AETUF.PK), Pengrowth (NYSE:PGH), Penn West (NYSE:PWE), Crescent Point (CSCTF.PK) and Devon (NYSE:DVN).
1) Apache has been one of the most active drillers on this trend since 2010 although it holds a relatively small land position of 55 sections in the House Mountain area to the North. Apache's well results here have been consistent with the industry average, however interestingly enough, the company has been using horizontal laterals that are shorter than the norm.
2) Arc Resources (OTCPK:AETUF) carries a legacy position on this play in the Inverness/Swan Hills where it is the 100% WI owner and operator. The company owns 66 sections here. It has experienced stable, high quality light crude oil volumes thus far. Arc completed a financing of approximately $345 million and a debt issuance of $400 million in late Aug 2012. The total gives a cash pool of $745 million and its use remains to be seen.
3) Pengrowth holds a solid 260 net sections of land here and it is one of the largest area landholders with exposure as far north as House Mountain and extending to the south to Carson Creek. It has been one of the most active drillers and it plans to spend 40% of its total budget of 2012 on the Beaverhill Lake program. Pengrowth has been diligent in testing the horizontal multi-stage fracture stimulation concept in several different areas of the play, garnering industry average results. Two operated wells which were drilled and completed in Q1 2012 showed an average IP-5 rate of over 800 boepd per well according to the Pengrowth Q2 2012 report.
4) Penn West has a dominant position in the Beaverhill Lake play. The management team currently estimate that the company's 203 net sections of land hold 100 net drilling locations. The drilling activity of Penn West has been concentrated on the east side of Swan Hills East and Swan Hills South regions with results aligning well with industry averages.
5) Crescent Point has one of the largest land exposures to the Beaverhill Lake with 280 net sections. It completed a financing of $633M just few days ago which is another indication that this giant is about to hit again soon. Crescent Point has made a conscious decision to ramp up operations in 2012. Since January, the firm has struck just over $1.7 billion in takeovers, the latest of which was announced last May 2012. Under the latest agreement, Crescent Point bought the private oil and gas player Cutpick Energy, whose assets are in the Viking light oil resource play near Provost, Alberta. In exchange for the $425 million it is doling out, Crescent Point Energy will pick up production of 5,600 boepd, weighted approximately 65% to light oil.
Crescent Point says the new assets will "complement and consolidate" its existing position in the Alberta and Saskatchewan Viking light oil resource play. Now that the deal is public, it means Crescent Point has announced a takeover in every month this year, except for April. They may not seem like much because the largest was $625 million, but if combined they total $1.7 billion. Here is a brief run down of what Crescent Point has acquired in 2012:
January: Bought Wild Stream (TSX Venture: WSX) for $611 million, adding production of approximately 5,400 boepd. The deal solidified Crescent Point's dominance in the Shaunavon resource play in southwest Saskatchewan.
January: Increased its Beaverhill Lake light oil land positions at a total cost of $38 million and it holds 280 net sections there currently. It has already a JV with Second Wave for its 50,000 net acres in the Judy Creek area.
February: Bought assets in the Viewfield Bakken light oil resource play in southeast Saskatchewan from PetroBakken (PBKEF.PK) for $427 million in cash, adding 2,900 boepd in production. Crescent Point also acquired Manitoba light oil assets with production of just 940 boepd for $130 million.
March: Acquired the majority stake in Reliable Energy that it didn't already own for about $99 million. The deal added production of approximately 1,000 boepd from the Bakken light oil play.
May: Announces Cutpick transaction worth $425 million.
So after the aforementioned acquisitions on Bakken, Viking and Shaunavon formations, which core formation of Crescent Point has stayed without a top dollar acquisition? Yes, it is the Beaverhill Lake formation in Alberta. Consequently I expect Crescent Point to roll up the Beaverhill Lake formation and consolidate it sooner or later.
Now that we know the fundamentals and the current valuation of Second Wave, let's check the current valuations of some other oil weighted Canadian juniors based on their Q2 2012 reports. So:
Spartan Oil (OTC:SRTNF) (83% oil and liquids) trades for about $150,000 per flowing barrel and the market cap is 8x the funds from operations annualized.
Raging River (OTC:RRENF) (97% oil and liquids) trades for $150,000 per flowing barrel and the market cap is 8x the funds from operations annualized.
Pinecrest (OTCPK:PNCGF) (99% oil and liquids) trades for about $100,000 per flowing barrel and the market cap is 6x the funds from operations annualized.
Renegade Petroleum (OTC:RPTTF) (97% oil and liquids) trades for about $100,000 per flowing barrel and the market cap is 5x the funds from operations annualized.
Whitecap Resources (OTC:SPGYF) (67% oil and liquids) trades for about $100,000 per flowing barrel and the market cap is 6x the funds from operations annualized.
DeeThree Exploration (OTCQX:DTHRF) (70% oil and liquids) trades for about $90,000 per flowing barrel and the market cap is 10x the funds from operations annualized.
Surge Energy (OTCPK:ZPTAF) (71% oil and liquids) trades for about $85,000 per flowing barrel and the market cap is 6x the funds from operations annualized.
I think these numbers above speak volumes and prove why Second Wave is grossly undervalued at the current levels of C$1,10. In case Crescent Point does not buy Second Wave, then in my opinion look for Penn West or Pengrowth or Arc Resources or the recently arrived Whitecap Resources to be the big fish that swallows it. The longer the big boys wait, the more expensive the price will be.