The Long Case for Canada's Petrobank

| About: Petrobank Energy (PBEGF)

In a recent edition of Value Investor Insight, Passport Capital's Laurance Narbut described why he sees unrecognized value in Petrobank (OTCPK:PBEGF).

Why is Canada’s Petrobank [PBG:CN] one of your favorite energy bets?

Laurance Narbut: The company is based in Calgary and has three primary areas of operation. The first is in the Bakken oil formation in Saskatchewan, the second an 80% ownership of oil-and-gas company Petrominerales [TSE:PMG] in Colombia and the third is an oil-sands project in Calgary, called Whitesands. At Whitesands, they’re trying to use an innovative new technology called the “THAI” process to extract oil from the bitumen at about half the capital cost and half the operating cost of traditional methods. They own the THAI technology outright, which provides significant upside from licensing if they can prove that it works.

One of the key criteria we use to invest in oil and gas companies is to look for the best risk-adjusted well economics, and the Bakken is one of the best reservoirs we know of in North America. If you drill a well there it typically pays back in six to seven months – versus a more normal two years – and internal rates of return on those wells are around 180%. The net present value per well, at $80-per-barrel oil and given a $1.8 million cost, is very high at around $4.6 million.

We also look for investments that have low geologic risk. The Bakken field is largely a blanket formation, in which hundreds of wells have been drilled across the formation and the geologic characteristics have been found to be relatively similar. Based on that and using 3-D seismic imaging, you can see pretty clearly where the boundaries of the formation are, which limits the risk of dry holes. For Petrobank's Bakken wells, the drilling success rate is 95%-plus. We think the stock is so attractively priced because the initial story for Petrobank emphasized the oil-sands project, and given that the THAI technology is high-risk and unproven, people are ignoring the value in the rest of the company.

Walk through the value you see.

LN: We look at the company's value in a variety of ways, but the most straightforward is through a sum of the parts. First let's look at the company's Canadian conventional production. At year-end 2007, existing production was valued at a PV-10 figure of $468 million. Since then Petrobank has drilled approximately 80 wells, to which we give an NPV of $4.6 million each, yielding an additional $368 million in value. Turning to the Bakken acreage, if we assume 100,000 of the 141,000 acres there are prospective and that they develop it with 160-acre spacing over four years, you get a PV-10 of approximately $2.3 billion with $80 oil. Petrominerales is publicly traded and at its current valuation is worth $940 million. That then leaves the Whitesands project. We've taken the view that the new technology is more likely to work than not, but even if it's a flop Whitesands has considerable value as a traditional developmental oil-sands asset. Petrobank has an estimated 2.6 billion barrels of oil in place in Whitesands.

Assuming a 30% recovery factor on those 2.6 billion barrels and – because it’s a developmental field – valuing those recovered barrels at only 75 cents per barrel, that still provides a worst-case Whitesands value of about $600 million All in, that gives us a low-case, sum-of-the-parts value of nearly $4.7 billion, vs. the current market value [at a C$47 share price] of $3.9 billion.

What’s the high case?

LN: The delta in our high case is mostly in the Whitesands valuation. If THAI works, it is a complete game-changer for the oil-sands industry and for Petrobank. In addition to the cost savings, we believe it would increase the recovery factor from 30% to 70%-plus. It also upgrades the oil to a much higher-quality grade, with API gravity from their pilot already in the 12-14 degree range, as opposed to typical 8-degree bitumen.

With a higher recovery factor, that would yield 1.8 billion barrels of potential reserves from Whitesands. Premium Canadian oil sands players that are producing high API oil attract acquirors in the $3.50-4.50 per recoverable barrel range. Canadian Oil Sands Trust currently trades around $6.50 per barrel of recoverable reserves. Multiplying $3.50 per barrel times 1.8 billion barrels would give us a Whitesands value as a producing project of $6.3 billion. Applying the higher $6.50 per barrel number yields an $11.7 billion value. Either way, we see the upside scenario as multiples of the current valuation.

Another upside option that's not in our valuation is the value of joint ventures arising from licensing the THAI technology. Their strategy would be to swap the technology in return for a piece of a resource asset and the capital spending dollars needed to develop that asset. Again, if THAI works, that could be worth a lot. Also not in our valuation, of course, is the potentially considerable upside if oil prices end up being higher than $80 per barrel.

Are there regulatory or political concerns?

LN: There’s some perceived political risk in Colombia, but the current administration is very pro-business and the FARC’s influence is waning. The bigger issue in Colombia is the geologic risk in the higher-decline wells they are drilling. The last quarter saw a fall in daily production, but they are bringing new wells on line that much more than compensate.

There is some government risk in Alberta, where Whitesands is located. The recent royalty increase there is already in the stock, but there is limited risk that royalties could continue to rise.

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