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Industry experts are all over the map on short- and long-term projections, but producers are still pumping and there's money to be made in oil and gas. In this exclusive interview with The Energy Report, Kim Pacanovsky, managing director in research at MLV & Co., discusses some sweet spots in energy markets, including some companies that are enjoying success at the well.

The Energy Report: In the past few weeks, commentators have expressed more varied sentiment on oil markets, with some pretty astute analysts now turning bearish. What do you see on the horizon?

Kim Pacanovsky: You're asking the question at the right time because the U.S. Energy Information Administration [EIA] inventories came out today, and they were up 8½ million barrels. That was an extremely bearish number, putting oil down over $3 per barrel [bbl]. But what oil does in the longer term is a complicated projection. First and foremost, "it's the economy, stupid," right? If it continues to weaken, we're going to be using less oil. A few days ago, the Organisation for Economic Co-operation and Development forecast the G7 to have growth of about 0.3% in the third quarter. That's a pretty weak number. The Japanese have been helping the market by buying a lot of oil to make up for their off-line nuclear reactors, but that purchasing may slow down.

We have a price range between $90-100/bbl to the end of 2013. I would be reluctant to change that right now. Once the election is over and some of the stimulus measures take effect, I think we'll get back to that higher number. It's politically very bad for Saudi Arabia to see very low oil prices. They have a vested interest in keeping prices where they are.

TER: The other side of the coin is natural gas, which has been good for consumers and not so good for producers. What do you think its prospects are in the near term?

KP: The rig count has been consistently coming down, with 448 rigs drilling for gas as of last Friday. The EIA noted last week that gas drilling in Pennsylvania has declined sharply in the last few months, yet production is up. That's not surprising because these wells come on at very high rates and it takes time to see a response in the market. The high gas liquids prices early in the year supported active gas drilling in places like the Marcellus, while low gas prices caused a big decline in dry gas Marcellus drilling. But as we see from Lower-48 statistics, there is a time lag between dropping rigs and supply. The Lower-48 gas rig count has been sliding since the high in late 2008, but we are just now seeing U.S. marketed production finally leveling out. This year, average injections have been below the five-year average for all but three weeks. So we have made a lot of progress in rebalancing the gas markets and I think the lows are behind us even though storage is still above the five-year average.

TER: Are a lot of these companies surviving on the liquids portion of the gas production?

KP: They're absolutely surviving on the liquids. Also, while we are seeing a little bit of weakness in the oil price right now, gas pricing has actually been quite strong compared to where it's been over the past year. We're dancing above the $3 per thousand cubic feet [Mcf] mark again. The other consideration is that the costs are coming down, particularly frack costs.

TER: Have we seen the bottom in natural gas?

KP: I do think we've seen the bottom. Right now we're entering the shoulder months, with low gas demand. If we have a colder-than-normal winter, which is what a lot of the longer-term models are predicting, that will be very positive for the gas market.

TER: MLV & Co. covers quite a few companies for a smaller firm. How do you choose which companies to include in your coverage universe?

KP: We cover companies where we can add value through research. I look to cover companies that have promise, that have very clear catalysts on the horizon. Because we're a small firm, we need to deploy our resources very carefully. We cover about 16 companies in oil and gas, and we have an analyst who covers MLPs.

TER: Do you see M&A activity on the horizon for a lot of these smaller companies?

KP: I think that's the exit strategy for a lot of small companies. Cash flow multiples are one of the valuation metrics we look at very closely. If you look at the industry group of companies under $2 billion [$2B], they're trading at 6.5 times cash flow for 2012 and 2.8 times cash flow for 2013. That's a huge difference. Larger companies in the $2-10 billion range are trading at 6.5 times for 2012 and 5.4 times for 2013. The $10B+ companies are 6.8 times cash flow for 2012 and 5.7 for 2013. So, if you're one of those big guys and you see some attractive assets that the little guys hold, why wouldn't you look at a company that's being valued under three times its assets and capture your higher multiple by rolling those assets into your company?

TER: Let's talk about some of your favorite names.

KP: I like Magnum Hunter Resources Corp. (NYSE:MHR), which has been successfully building a base in the Bakken, the Eagle Ford and in Appalachia. What's so impressive about this company is how the oil cut has been growing, which is important because of the weak gas market. Its average oil production in 2011 was about 2,000 barrels a day [bblpd]. In 2012, it will average almost 7,000 bblpd, and, we're looking at over 10,000 bblpd in the fourth quarter.

TER: Is the market recognizing this huge jump in production?

KP: The stock had actually been surprisingly weak, but it's had some strength in the past few weeks, hitting $5 again. I think that there is now some recognition of the growth. It has been outspending its cash flow, which in 2012 should be a little over $120M, growing to over $260M in 2013. This will be a pivotal year for it because, unless it has a huge budget increase, it will, for the first time, be able to spend within its cash flow.

TER: So there's some reasonable upside to look forward to. What else do you like that you're currently covering?

KP: Evolution Petroleum Corp. (NYSEMKT:EPM) is a buy-rated stock and it's very oily. Evolution is a non-operator. It's the only company I cover that is a purely non-op company. Most analysts try to stay away from non-operators because they're not in control of their own destiny. That's the disadvantage. But Evolution has a very unique situation where it has a royalty interest in the Delhi field, which is operated by Denbury Resources Inc. (NYSE:DNR), the expert in CO2 floods. Evolution's growth has been due to great success in this tertiary recovery oil field where it has no capex or operating expense on a 7.4% royalty interest. Anybody on earth would love to take that deal.

TER: So all it has to do is accounting.

KP: That's right. It can back in for about a 24% reversionary interest after payout, which should happen sometime in 2013. Then it'll have its operating expense with respect to that 24% interest. That field is going to produce oil for a very long time and it's basically an annuity for Evolution. The company has also acquired acreage and a 45% share of a joint venture in the Mississippi Lime, where it will be drilling three wells. The first is waiting on completion right now.

TER: What are your projections for that one?

KP: On the revenue side, we are at just shy of $18M for 2012, going up to $33M, and cash flow is $10M going up to $20.7M. There's no credit in those numbers for anything coming out of the Mississippi. So that would be a nice catalyst for the stock if that works out.

TER: What other picks are looking good?

KP: GreenHunter Energy Inc. (NYSEMKT:GRH) is an exciting, early-stage company in what I call the cradle-to-grave water handling business. Unconventional drilling uses a lot of water, which has to be sourced and transported to the well site to frack the well. A lot of that water comes back nearly immediately, and it's contaminated. It then has to be transported to an injection well and either injected into the ground or recycled. But recycling is very expensive.

The chairman of Magnum Hunter is also the chairman of GreenHunter. The company looks at the business from the producer point of view. It has six disposal wells on-line and about 100 tanks and 30 trucks. But one of the things investors should look for is its new tank design, called the "MAG Tank." Traditional tanks that are used at the well site are small 50,000 gallon steel tanks that have to be transported, necessitating a lot of back-and-forth trips [and this creates more pollution and noise from trucks]. The other alternative is to store fluid in a pit called a frack pond, which creates a whole array of other environmental issues.

The industry would like to see the water and fluids become more contained, with a more portable tank that could better fit on well site spaces in constrained locations. GreenHunter decided to redesign a tank, and its design is now being fabricated and should be tested in October. If it passes muster, it's an extremely high-margin business, and we think there's great demand for it. That's a catalyst to watch. There's absolutely nothing in our numbers for the tank, but it could be a very substantial boost in 2013 if the design works.

TER: What would take the stock from a hold to a buy, in your estimation?

KP: There are many potential acquisition targets out there and GreenHunter has a lot of competition in the water-handling industry. I would like to see it make some smart acquisitions. It made a few previously and I'd like to see that continue. I'd like to see some growth in the Bakken, which has the best economics for handling water. And I'd like to see the MAG Tank roll out with contracts from producers to purchase the tanks, hopefully by the end of the year.

TER: Can you summarize your thinking at this point in regard to the oil and gas markets and where you think people should be looking to hopefully maximize their returns?

KP: From a retail investor perspective, I think that companies that have growing crude production with large acreage positions in gas plays are very attractive now because the market is placing little to no value on the gas, and that gas will have great value in the coming years. The fundamentals for gas are changing. Look at a company like Comstock Resources Inc. (NYSE:CRK) or Goodrich Petroleum Corp. (NYSE:GDP), which have large positions in the Haynesville shale and transitioned into oil when gas prices weakened. These companies are not getting any credit for that Haynesville acreage. Once you see gas prices turn around, those companies will do quite well. Magnum Hunter also has very large gas exposure through its acreage in Appalachia. Its Bakken and Eagle Ford are pretty much all oil, but Appalachia gives it a big call on gas. Those are the types of companies that investors should look for.

TER: And there are a number of those all over the map as far as size and potential.

KP: Absolutely.

TER: You've given us a good overall view of the industry and some pretty interesting names to look at. Thanks for joining us today.

KP: Thanks for the opportunity.

Kim Pacanovsky, Ph.D. joined MLV & Co. as a managing director in research in May 2010. Pacanovsky concentrates on small- to mid-cap independent exploration and production companies within the oil and gas sector. Prior to joining MLV, she co-initiated the oil and gas research practice at Collins Stewart LLC, the U.S.-based full service investment banking arm of U.K.-based Collins Stewart Plc. She was also an explorer and producer [E&P] analyst at Ferris, Baker Watts Inc. and KeyBank Capital Markets. Dr. Pacanovsky has also worked as a consultant for Superior Well Services, an oilfield services firm. She has over 15 years of E&P equity research experience and holds a Ph.D. in geophysics from Stony Brook University. She also holds a Bachelor of Science in physics from Fairleigh Dickinson University.

DISCLOSURE:
1) Zig Lambo of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: None. Interviews are edited for clarity.
3) Kim Pacanovsky: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview.
4) MLV or any affiliates in the past 12 months [a] managed or co-managed a public offering of securities for Magnum Hunter Resources Corp., GreenHunter Energy Inc., Evolution Petroleum Corp.; [b] received compensation for investment banking services from Magnum Hunter Resources Corp., GreenHunter Energy Inc., Evolution Petroleum Corp.; [d] MLV or any affiliate expects to receive or intends to seek compensation for investment banking services from Magnum Hunter Resources Corp., GreenHunter Energy Inc., Evolution Petroleum Corp., Comstock Resources Inc. and Goodrich Petroleum Corp. in the next three months.

Source: Who's Winning Big In Lopsided Energy Markets? An Interview With Kim Pacanovsky