The Energy Report's  Instablog

Source: Alec Gimurtu of The Energy Report (5/16/13)

www.theenergyreport.com/pub/na/15280

Not all the shale plays are created equal, and one in particular is bucking the trend with robust economics and company share prices that show it. But is it too late to buy in? Fund Manager Josh Young doesn't think so, and he sat down with The Energy Report to discuss the hottest (and coldest) North American shale plays. Read on to find out where he's finding bargains that could pay off handsomely.

The Energy Report: Last week in The Energy Report, Bill Powers, author of "Cold, Hungry and in the Dark," argued that energy reserves from U.S. shale deposits are far smaller than the U.S. Energy Information Administration (EIA) estimates. The difference is significant-approximately seven years compared to 100. Where do you come in on this debate? Is the production growth rate from non-conventional shale plays sustainable?

Josh Young: Making really broad predictions like this is challenging, but I can address a shorter time horizon. It looks to me like there is quite a bit of supply available to come onto the market, with a year or more lead time. Outside the most mature shale plays like the Barnett, there appears to be significant inventory available. In the current market conditions, the Marcellus has lots of inventory, but infrastructure is constrained. At higher price points, much more incremental supply is available from the Haynesville, the Woodford, the Eagle Ford and other plays. In aggregate, there is probably more than five to seven years of incremental inventory. One point that "Cold, Hungry and in the Dark" has right is that higher gas prices are needed to make much of that inventory economic. That is one of the reasons I am bullish on gas prices. I was early, but prices are now rising. Gas prices have some upside bias here, partly driven by shale economics.

TER: What sustained pricing is needed to stimulate investment in the marginal projects?

"The southwestern core of the Marcellus might be one of the most economic places to drill."

JY: I had a long conversation with senior management at Chesapeake Energy Corp. (CHK:NYSE) about this a few months ago, around the time Encana Corp. (ECA:TSX; ECA:NYSE) restarted its drill program in the Haynesville. From Chesapeake's perspective, a reasonable rate of return for these projects is 20%. To get that rate of return in the Haynesville requires a natural gas price of approximately $4.75 per thousand cubic feet ($4.75/Mcf). It looks like the Haynesville will probably be the tipping point-the marginal producing play that's able to balance gas demand and supply. It has a large inventory that can be delivered to the market when the project economics support it. In the medium term, the market price for natural gas may exceed the $4.75/Mcf because there is an upside bias due to rising service costs and project risk over time. From a medium-term price perspective, I'd expect a reasonable balancing point in the $5-6/Mcf price range.

TER: With $5/Mcf required to bring on marginal deposits, what shale plays would be solidly profitable at that price?

JY: The northeastern core of the Marcellus. Potentially even more economic is the southwestern core of the Marcellus, which is liquids rich. I think that might be one of the most economic places to drill. If you look at the different charts that investment banks put out showing the different economics for shale plays [see below], particularly for the shale gas plays, they typically show the southwestern core of the Marcellus as the most economical of the gas shale plays.

(click to enlarge)

TER: As far as non-conventional fields in North America go, is the Marcellus fairly mature? Is there a long enough track record to have a comfort level with the decline rate and the sustainability of the production?

"It looks like the Haynesville will probably be the tipping point."

JY: In "Cold, Hungry and in the Dark," Bill Powers cites Geologist Art Berman, who listed the Marcellus as one of the exceptions to his view that shale gas production was falling short of expectations. Berman noted that the Marcellus had less steep declines than the Barnett, Haynesville and Fayetteville wells, with quicker production leveling off sooner. Compared to other non-conventional plays, the Marcellus seems to have a longer economic life with higher recoverable reserves.

TER: Some of the companies within a given play are more successful than the others for a variety of reasons. What's your take on success factors for companies in the Marcellus?

"From a geologic, political risk and regulatory perspective, West Virginia seems like the place to be."

JY: Considering that the most economic area is in the southwestern core, from both a geologic perspective and a political risk and regulatory perspective, West Virginia seems like the place to be. West Virginia is friendly to natural resources companies. It has a long history of natural resource extraction. It is conservative and pro-business. If you had the same rock in West Virginia versus Pennsylvania, Ohio or New York, you would prefer to be drilling in West Virginia just purely because of the political, tax and regulatory environment.

Given all that, it makes sense to focus on companies with more West Virginia exposure. Of those companies, I find Gastar Exploration Ltd. (GST:NYSE) the most interesting. It stands out because of its leverage to the Marcellus as well as its superb economics. Gastar's valuation on per-share production, reserves and acreage push it to the top of the list. High rates of return on capital expenditures and liquids-rich incremental production are added benefits.

Other companies active in the sweet spot in northwestern West Virginia include Magnum Hunter Resources Corp. (MHR:NYSE.MKT), Chesapeake, and EQT Corp. (EQT:NYSE). Magnum Hunter has drilled a number of excellent wells, but is challenged right now with deleveraging. While Magnum Hunter has had great results in the Marcellus, the company is not a pure play in that area, and has had mixed results in its Bakken area. Chesapeake has a position in West Virginia as does EQT and a few other majors.

TER: You mentioned Gastar during your last interview. At that time, the stock was choppy and trending down. Since then, it has shifted into overdrive. What accounts for the turnaround?

JY: Gastar's turnaround is driven in large part by its exposure to the Marcellus. It's not contrarian for me to say that the Marcellus is an interesting place to invest. Most of the stocks of the Marcellus-focused companies have skyrocketed in the last two years. Range Resources Corp. (RRC:NYSE), Rex Energy Corp. (REXX:NASDAQ), EQT and Cabot Oil & Gas Corp. (COG:NYSE)-these companies have significant exposure to the Marcellus and are up at least 50% in the last two years. Cabot is up 150%. Gastar, which is still down 40%, has a lot of catching up to do. However, when we last spoke, Gastar was trading at approximately a third of its current price.

"As a value investor, I'm interested in buying the best companies, assets and management teams-but the price is what seals the deal."

As a value investor, I'm interested in buying the best companies, assets and management teams-but price is the most important factor. The price is what seals the deal. As an example, let's compare Rex Energy and Gastar. These are similar companies with excellent management, excellent assets and growing production. Note that Rex trades at more than twice the valuation based on earnings, reserves or production. So buying Rex at $16.50 is the equivalent of buying Gastar for $9/share, roughly three times the current price on a relative estimated value/earnings before interest, tax, depreciation and amortization deductions (EV/EBITDA) basis. So, while I like Rex and think Rex is doing an excellent job developing its assets, the value investor in me would love to buy Rex at a lower valuation. If Rex were at $8 and Gastar were at $3, it would be a much more difficult decision, but at current prices, it's a lot easier to identify the value play.

TER: Gastar is in the midst of a large transaction with Chesapeake. Can you explain the dynamic in the industry behind it?

JY: Chesapeake has activist shareholders and they have been pushing for leadership changes for several years. They eventually succeeded in bringing on a new CEO, a new board and a new strategy. Chesapeake's strategy had been to aggregate land, delineate it through exploratory drilling and then resell a portion and get development capital from joint venture partners. Profit expectations didn't match results, partly due to low natural gas prices, and shareholders demanded change.

Chesapeake is now in the process of unwinding the former corporate strategy. Chesapeake used to accumulate speculative land with the hope of being able to resell it into a joint venture. Without former CEO Aubrey McClendon-a brilliant salesperson-leading the process, finding joint venture partners has been more difficult, and deal prices have been less favorable for Chesapeake. One example of the deleveraging is a deal Chesapeake did with Sinopec Shanghai Petrochemical Company Ltd. (SHI:NYSE) in the Mississippi Lime. That deal should have been a high-priced joint venture but it ended up looking more like a liquidation sale. Since that deal, Chesapeake has sold a number of other assets in deals where the previous strategy and management would likely have yielded higher land prices. Rather than spend the capital to drill in order to get high land prices, the company chose to exit the positions and refocus capital on its core areas. The new strategy makes sense, but it is a big change. Chesapeake has a lot of off-balance sheet obligations because of its joint ventures, drilling trusts, midstream agreements and service agreements, so it has a lot of obligations to meet and needs cash and a streamlined asset base to meet those obligations. I understand the strategy, but it has created a buyer's market for Chesapeake's assets, and buyers of Chesapeake's assets like Gastar have benefitted tremendously from that.

TER: This transaction allows Chesapeake to refocus on its core. Is that an industry theme?

"Most of the stocks of the Marcellus-focused companies have skyrocketed in the last two years."

JY: Yes, it is. For example, Gastar announced that it is selling its East Texas field for $46 million ($46M) in order to redeploy the cash into its core areas. Management had previously estimated that it was generating about $4M/year in cash flow from the asset. Call that about 10 times cash flow. The company right now is trading for about 6.5x EV/EBITDA, so it's an accretive sale. In the same way that Gastar is buying this acreage from Chesapeake that's highly prospective for Hunton Lime, the people that are buying Gastar's acreage in East Texas are buying it in part because they want to have exposure to this Eagle Ford/Woodbine oil play, which Gastar has unsuccessfully tried to develop. It's unclear whether that's a geologic, engineering or a drilling issue. Regardless, successful companies focus on what they do best, and refocusing on core assets is an industry trend.

TER: Are there any other less mature, emerging plays that an investor might want to take a look at? How about the Mississippi Lime?

JY: There's one that I'm in with a client called Petro River Oil Corp. (PTRC:OTCBB). It built up a 100,000-acre position in the Mississippi Lime in Kansas along the Nemaha Uplift. It has a tremendous amount of acreage relative to the size of the company. It looks likely that it will bring in either a joint venture partner at a high value per acre or that it will get some other kind of deal so it can get some drilling done on its land. It just did a reverse merger, and that closed relatively recently. Because of that, the stock is not very widely traded. The potential to go from very small to large is there. Petro River is earlier on in its path but with a large land position in a very promising area, it looks like a good opportunity. And Petro River is one of the highest-performing energy stocks in the past 12 months, going from less than $0.03/share to a recent $0.33/share.

TER: Are there any factors you look for besides the geography and geology as key differentiators for an investment decision?

JY: As a value investor, price is very important to me, so price relative to resource in the ground and price relative to cash flow. Management is very important, too. I don't necessarily need to invest with the next Warren Buffett or the next rock star CEO; I just need to invest with competent management that's aligned with my interests. I look for management that is going to take the steps that are necessary to create value for the company in the near to medium term. That's important. The lower the cash flow multiple I'm paying, the less I'm dependent on future growth of the company in order to justify the value of the shares that I'm buying.

TER: You've identified the Marcellus as the hottest shale play. Do you have other companies in the area that you think are noteworthy?

JY: Yes, Gale Force Petroleum Inc. (GFP:CVE). It is active in the liquids-rich Marcellus, right next to Gastar. It is a very small company that appears to potentially be an acquisition candidate rather than an organic growth story given its small size and limited exposure to different large resource plays. But it does have a nice position in the Marcellus, which has increased substantially in value since it got involved.

TER: The stock price has trended sideways since we talked last-very little seems to be happening. Is there any news coming from the company?

"I don't necessarily need to invest with the next Warren Buffett or the next rock star CEO; I just need to invest with competent management that's aligned with my interests."

JY: It is an unusual situation. The largest shareholder wrote a public letter to the board of the company, saying the stock is undervalued. The letter goes on to question the leadership of the company. As a response, the company put out a letter, also highlighting how undervalued the company is and clarified the value in the company. Generally speaking, when an activist shareholder gets involved in a company, the stock does something, and there's some amount of volume. This hasn't been the case with Gale Force. There's been no volume, and apparently no one seems to care, or perhaps, few investors are following the stock.

The activist shareholders and the company both point to a value of more than $60M in proved and probable reserves. The last reserve report of the company showed over $40M Proved reserves. This compares to an enterprise value of around $20M. Between the liquids-rich Marcellus assets and the oil production in Texas, there is embedded value, but what is unclear is exactly what it will take for the market to realize it. It surprises me that nobody seems to notice or care.

TER: Let's summarize the hottest shale play out there in North America.

JY: The hottest place to be in shale development right now is in the Marcellus. The best area is the liquids-rich spot, particularly in West Virginia given some of the political developments in Pennsylvania. There are lots of choices for investment, but a value investing approach will lead an investor to Gastar and Gale Force. Taken as a whole, shale plays may disappoint investors, with the exception of a few key plays like the Marcellus, the Eagle Ford and a few others. Rates of return may not meet expectations and some companies are going to struggle to recycle capital because of challenging deposit economics. Compared to the other shale plays, the Marcellus is a standout. Last, it's beneficial to have exposure to commodities like natural gas that are currently trading at a discount to replacement cost. That provides a tailwind that could potentially help over time in increasing intrinsic value.

TER: As always, it has been great to talk to you.

JY: Likewise; thanks for having me.

Josh Young is the founder and portfolio manager of Young Capital Management, LLC. He is also a board member of Lucas Energy Inc. He previously served as an analyst at a multibillion-dollar single-family office in Los Angeles. Prior to that, he was an investment analyst at Triton Pacific Capital Partners. He was also a corporate strategy consultant at Mercer Management Consulting and DiamondCluster. He holds a Bachelor of Arts in economics from the University of Chicago.

Want to read more Energy Report interviews like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Interviews page.

DISCLOSURE:
1) Alec Gimurtu conducted this interview for The Energy Report and provides services to The Energy Report as an independent contractor. He 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: Chesapeake Energy Corp. Streetwise Reports does not accept stock in exchange for its services or as sponsorship payment.
3) Josh Young: I or my family own shares of the following companies mentioned in this interview: GST, Gale Force Petroleum Inc. and Petro River Oil Corp. I personally am or my family is paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
4) Interviews are edited for clarity. Streetwise Reports does not make editorial comments or change experts' statements without their consent.
5) The interview does not constitute investment advice. Each reader is encouraged to consult with his or her individual financial professional and any action a reader takes as a result of information presented here is his or her own responsibility. By opening this page, each reader accepts and agrees to Streetwise Reports' terms of use and full legal disclaimer.
6) From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles and interviews on the site, may have a long or short position in securities mentioned and may make purchases and/or sales of those securities in the open market or otherwise.

Streetwise - The Energy Report is Copyright © 2013 by Streetwise Reports LLC. All rights are reserved. Streetwise Reports LLC hereby grants an unrestricted license to use or disseminate this copyrighted material (i) only in whole (and always including this disclaimer), but (ii) never in part.

Streetwise Reports LLC does not guarantee the accuracy or thoroughness of the information reported.

Streetwise Reports LLC receives a fee from companies that are listed on the home page in the In This Issue section. Their sponsor pages may be considered advertising for the purposes of 18 U.S.C. 1734.

Participating companies provide the logos used in The Energy Report. These logos are trademarks and are the property of the individual companies.

101 Second St., Suite 110
Petaluma, CA 94952

Tel.: (707) 981-8204
Fax: (707) 981-8998
Email: jluther@streetwisereports.com

Source: Tom Armistead of The Energy Report (5/14/13)

http://www.theenergyreport.com/pub/na/15264

Let's make one thing clear: There is no magic formula to determine which company will be the next big buyout story. But if there were a formula, it would include variables like asset value, management skill level, risk profile and location, location, location. Today, C. K. Cooper & Co. Analyst Daren Oddenino joins The Energy Report to discuss M&A trends and help us solve for X. One caveat-a company that tempts an international player might leave domestic majors cold.

COMPANIES MENTIONED : APPROACH RESOURCES INC. : BHP BILLITON LTD. : COMSTOCK RESOURCES INC. : CONCHO RESOURCES INC. : DIAMONDBACK ENERGY INC. : MAGELLAN PETROLEUM CORP. : MCMORAN EXPLORATION CO. : PIONEER NATURAL RESOURCES CO. : ROSETTA RESOURCES INC. : SARATOGA RESOURCES INC. : STATOIL ASA

The Energy Report: Interest in merger and acquisition (M&A) deals in the oil and gas space seems to be picking up. Pioneer Pioneer Natural Resources Co. (PXD:NYSE) made headlines last January when it sold 207,000 net acres of its Wolfcamp shale leases to Sinochem Group (00817:HK) for $1.7 billion. Does this signal a trend of international companies investing in North American shale plays at a premium?

"International players have a lot to gain by establishing a foothold in North America."

Daren Oddenino: For an international company acquiring a U.S. domestic asset, the valuation is high, but it's not out of line with some past transactions. It would seem high if it were another domestic player acquiring those assets at that price, but International players pay a premium because they want entrance to the U.S. market and access to advanced horizontal drilling technology. International players have a lot to gain by establishing a foothold here.Horizontal completion technology in the U.S. is leading the way.

TER: Would you expect more of this kind of deal to occur?

DO: We'll, I don't think we'll be seeing them frequently, but we'll definitely continue to see an international interest in U.S. assets. For example, in 2011 Statoil ASA (STO:NYSE; STL:OSE) bought Brigham Exploration Co. and BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK) bought Petrohawk Energy Corp. International entities are actively participating in both asset and corporate transactions. It's a general trend that we expect to continue.

TER: How can investors identify a company in the oil and gas industry that is ripe for merger or acquisition? What are the signs?

"Look at companies with big asset bases-big enough to create a lot of running room while stilling providing low-risk development upside."

DO: Investors should look at a company that has a big asset base-big enough to create a lot of running room while stilling providing a low-risk development upside. There has to be a gap between the value the Street is placing on a company and the ultimate, fully developed value of that targeted company's asset base. If that gap is big enough, a buyer can come in and acquire a company at a premium to where it is currently trading and still have additional value to develop those assets in an accretive manner. That'swhen a company could be viewed as a good acquisition candidate.

Another factor to consider is all the regulatory- and legal-related expenses associated with corporate acquisitions. It makes more sense for international companies to defray those costs over a bigger asset base. They want something they can sink their teeth into. But it's not as cost-intensive for domestic exploration and production companies (E&Ps) to buy other domestic E&Ps. Domestic strategic acquirers can also appear when the deal size is a little smaller.

TER: What are the defining criteria for assessment of an M&A target in oil and gas? Should investors look at the resource base? Proved reserves? Production rates and costs? Access to infrastructure? Management?

"Another factor to consider is all the regulatory- and legal-related expenses associated with corporate acquisitions. It makes more sense for international companies to defray those costs over a bigger asset base."

DO: It's different for every entity. Some entities want to make bolt-on acquisitions and acquire assets where they are already operating that would provide additional low-risk development upside. For example, when Concho Resources Inc. (CXO:NYSE) bought Three Rivers Operating Co. last year for $1B in cash, Three Rivers had a lot of acreage very close to where Concho was already operating in the Midland and Delaware basins. From Concho's standpoint, it made a lot of sense to acquire those assets as a strategic bolt-on. When domestic E&P companies are looking to expand their footprint, those bolt-on opportunities are extremely attractive. However, juxtaposed to that is the acquisition Rosetta Resources Inc. (ROSE:NASDAQ) recently made. The company wanted to expand beyond its Eagle Ford acreage and establish another core area in the Permian Basin, so it acquired Comstock Resources Inc. (CRK:NYSE) assets in that area.

TER: Saratoga Resources Inc. (SARA:NYSE.MKT) has a joint venture with McMoRan Exploration Co. (MMR:NYSE); does that partnership make it a possible acquisition target?

DO: At current trading levels, I think a lot of companies could be looking at Saratoga. The company is trading well below its proved value and carries a lot of upside. Saratoga has a plan to develop some of its lower-risk proven undeveloped reserves this year, and there's a big opportunity there.

TER: What advice would you have for investors concerned about weathering volatility?

DO: In the oil and gas space, stock performance is always going to be highly correlated to commodity prices. As such, investors will always be subject to the whims of commodity prices. But when it comes to evaluating an individual company, we look at the worth of its current asset base. What has the management team done in the past and has it executed according to plan? How much additional running room does the company have? Our research strategy or thesis is to follow undervalued micro- and small-cap companies until they get taken out by an industry player, or we follow them through their growth cycles until they become mid-cap players that are able to execute their plans and continue to grow with fiscal discipline. We tend to stay away from companies with really complicated balance sheets and "exotic" financing products in their capital structures.

TER: Magellan Petroleum Corp. (MPET:NYSE) stock price is in the $1 range right now. Has that changed significantly? You have recommended it as Buy.

"We tend to stay away from companies with really complicated balance sheets and 'exotic' financing products in their capital structures."

DO: The company has some producing Poplar field assets in Montana and some producing Australian natural gas assets, as well as large exploratory acreage positions in offshore Australia and onshore in the U.K. There could be a lot of upside potential to those Australian and U.K. assets, but capturing additional value would require exploratory success. But Magellan has a lot of optionality too-it can sell some of its international assets and take some profit off the table. The exciting catalyst for Magellan is the opportunity to test its CO₂-Enhanced Recovery project in the Poplar field's Charles formation. If that proves successful, Magellan should be headed for a lot of growth.

TER: Your buy target for Approach Resources Inc. (AREX:NASDAQ) is $43, but over the long term the stock has seldom exceeded $35. Is $43 realistic?

DO: There's definitely a lot of running room associated with Approach Resources. Approach Resources has almost 150,000 (150K) net acres in the Permian Basin. The company has evolved from a tight gas sands producer to a horizontal Wolfcamp player. It started developing Wolfcamp in 2010/2011 and it has 2K unbooked potential well locations as it develops the A, B and C benches of the Wolfcamp.

Approach has just built some additional infrastructure allowing it to reduce its water hauling and trucking costs, so its costs and price realizations are going to get better and well results continue to meet or exceed expectations. It's tough to find a position where you have 150K nearly contiguous net acres, so there's definitely a lot of upside associated with their asset base and development program. Approach has been very methodical about developing its assets and investors may have wanted the company to go a little faster than it has, but this cautious methodology will ultimately benefit Approach and allow it to most efficiently develop its assets and maximize the potential recoveries. We're big fans of the Approach story.

TER: You recently bumped the target for Diamondback Energy Inc. (NASDAQ:FANG) up from $26 to $30. What was your thinking behind that?

DO: Diamondback is another Wolfcamp player that went public in October of last year. It was drilling some shorter lateral lengths and now it looks like it is going drill more of its wells on longer, 7K-foot lateral lengths. With those increased laterals, we expect better estimated ultimate recoveries. The change in target price was adjusted based on our development scenario accounting for the better estimated ultimate recoveries associated with those longer lateral lengths. Diamondback has been very aggressive and had some good well results in its Wolfcamp program. We're seeing increased horizontal activity right in Diamondback's area, and Diamondback is well positioned to capitalize on its transition from a vertical Wolfberry player to a horizontal Wolfcamp player.

TER: Any final thoughts about the O&G space in general?

DO: The trend we expect to see is further advancements in horizontal drilling. A lot of companies are now focused on stacked lateral development with multi-horizon potential and increasing their well pads as much as five-fold, which is allowing for more efficient asset development. This seems to be the next phase of horizontal drilling and completion technology. Also, we're continuing to see E&Ps test the limits of horizontal well density with increased down-spacing. That's a positive trend as it boosts recoveries and increases potential recoverable resources over a fixed acreage position.

TER: Daren, thank you very much for your time and sharing your thoughts with us today.

Daren Oddenino is a senior analyst in the research group for C. K. Cooper & Co., a full-service investment bank. Oddenino has focused on the oil and gas sector since 2005, when he began his career at a middle-market M&A advisory firm working with privately held oil service companies. Oddenino also focused on small and mid-cap exploration and production companies while working at KeyBanc Capital Markets' oil and gas group as well as in the corporate finance group at Canaccord Genuity. During his career, he has participated in the execution and closing of over $8B in transactions, including equity and debt offerings, mergers, fairness opinions, PIPEs and arranging of senior credit facilities. Oddenino graduated from the University of Utah in Salt Lake City with a bachelor of science in Economics. He is a licensed FINRA broker and maintains Series 7, 66, 86,87, and 24 licenses.

Want to read more Energy Report interviews like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Streetwise Interviews page.

DISCLOSURE:
1) Tom Armistead conducted this interview for The Energy Report and provides services to The Energy Report as an independent contractor. He 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. Streetwise Reports does not accept stock in exchange for its services or as sponsorship payment.
3) Daren Oddenino: I or my family own shares of the following companies mentioned in this interview: None. I personally am or my family is paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: Magellan Petroleum Corp., Diamondback Energy Inc. and Saratoga Resources Inc. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
4) Interviews are edited for clarity. Streetwise Reports does not make editorial comments or change experts' statements without their consent.
5) The interview does not constitute investment advice. Each reader is encouraged to consult with his or her individual financial professional and any action a reader takes as a result of information presented here is his or her own responsibility. By opening this page, each reader accepts and agrees to Streetwise Reports' terms of use and full legal disclaimer.
6) From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles and interviews on the site, may have a long or short position in securities mentioned and may make purchases and/or sales of those securities in the open market or otherwise.

Streetwise - The Energy Report is Copyright © 2013 by Streetwise Reports LLC. All rights are reserved. Streetwise Reports LLC hereby grants an unrestricted license to use or disseminate this copyrighted material (i) only in whole (and always including this disclaimer), but (ii) never in part.

Streetwise Reports LLC does not guarantee the accuracy or thoroughness of the information reported.

Streetwise Reports LLC receives a fee from companies that are listed on the home page in the In This Issue section. Their sponsor pages may be considered advertising for the purposes of 18 U.S.C. 1734.

Participating companies provide the logos used in The Energy Report. These logos are trademarks and are the property of the individual companies.

101 Second St., Suite 110
Petaluma, CA 94952

Tel.: (707) 981-8204
Fax: (707) 981-8998
Email: jluther@streetwisereports.com

Source: Peter Byrne of The Energy Report (5/9/13)

http://www.theenergyreport.com/pub/na/15246

Shale oil has been North America's great experiment, says Oil & Gas Investments Bulletin Editor Keith Schaefer. But in this interview with The Energy Report, he questions the experiment's success and predicts steep declines ahead, with just a few formations left to supply the market. The question is what shale play will last the longest? Read on to find out how-and when-to get positioned for the end of the shale revolution.

The Energy Report: A number of experts say North American gas supply is peaking. Where do you weigh in?

Keith Schaefer: During the last three years, the mantra has been, "Drill, baby, drill," for a number of reasons. The price of gas was never one of those reasons. Companies drilled because the technology kept improving. They drilled because they were able to get cheap foreign capital to partner in joint ventures. The market situation was not based upon economic "truth." It was based on securing the land position and, "Economics be damned, let's go!" But we are now returning to a real gas market based upon economic fundamentals. Where that's going to shake out, nobody knows; the market is betting on higher prices.

"We are now returning to a real gas market based upon economic fundamentals. Where that's going to shake out, nobody knows; the market is betting on higher prices."

The reality is, Peter, there is only one true gas formation in the U.S. that is increasing production, and that's the Marcellus. Every other single shale gas play is now in decline. The industry is now much more disciplined in producing gas, as the rig count has gone way down. But I suggest that the price rise is a year or two away because there is so much gas drilling going on in the Marcellus and Eagle Ford. These two formations are making up the shortfall in other regions. At some point in time-nobody really knows when-the scales are going to tip: Gas production in North America will seriously decline. The gas bulls think it's going to happen quickly, because the hydraulic fracking wells come in like gangbusters and then rapidly decline. An overall decline in supply could drive up the price.

TER: Are there undeveloped or undiscovered shale gas plays still out there?

KS: The short answer is that we do not know. Explorers are testing new areas. Just outside the Bakken, there is activity in Bowman County. There is play in the Heath Shale. It looks like the Utica will be mostly gas, not oil. But I don't see any more Marcellus Shales out there.

TER: Is there a limit to exploration?

KS: All of the easy fruit has been picked. Remember, most of the shale plays were already well known geology, so everybody knew where the oil and gas was. We just did not have the technology to get the stuff out of the ground. As the technology has improved, bit by bit, and the politics has improved, bit by bit, the known shale plays are being developed to capacity. Is there another undiscovered giant like the Marcellus lurking somewhere? Realistically, I doubt it. The industry has very good tools for looking underground. A big monster shale play that would keep the gas glut going for another two or three years is a bit of a stretch.

TER: Will we go back to importing gas?

KS: I do not see the U.S. importing much gas for at least three years, and maybe longer, depending on existing wells' decline rates. Right now, drillers are doing maybe four wells per square mile. With downspacing, they can get down to 8, 16 or even 32 wells per square mile. There is still a lot more domestic gas to be pumped before we need to import a lot of gas again.

TER: Let's talk about the role of Canadian penny stocks in your portfolio. How is the shale experiment with the oil juniors going in Canada?

"All across North America and especially in Canada, the rush into shale oil has been a great experiment."

KS: All across North America and especially in Canada, the rush into shale oil has been a great experiment. But it really doesn't work in a junior company. The place for juniors in an investor's portfolio right now is getting smaller and smaller. The shale, or tight wells cost a lot of money to drill, and the juniors just do not possess the capital necessary to develop many of these plays. The wells will pay out in 12-24 months, and that is simply not fast enough for the junior companies to recycle the cash and drill another well. A junior might have a big land position, but it cannot develop it, particularly on the gas side, without continually raising equity. Many of these companies have stopped or dramatically reduced drilling. It's a bad spiral: You drill less, you produce less and your declines are high. These smaller energy firms are in a really tough spot-for oil or gas.

TER: Is it reasonable for the management of these struggling companies to hope the price will go up and make staying the course worthwhile?

KS: Well, yes, they have no choice other than shutting down all of their production. It's just a question of how long the wait is. I was talking with a producer the other day, and he indicated that there will be no new capital available for pure dry gas until it is hedged at $4.50/thousand cubic feet ($4.50/Mcf). Gas has to be at $5/Mcf for a couple of weeks for them to do that. So gas prices have to be $5/Mcf for the market to realistically think about putting more money into dry gas wells.

Could that happen this year? It could, but the Marcellus is still coming on strong. Next year is quite possible. The other thing is that the gas wells with lots of natural gas liquids (NGL) like condensate, propane, butane and ethane have better economics than simple dry gas wells. With NGLs, more production can come on-line at $3.50/Mcf. There is hope; prices are moving higher than most people expected at this time of year, thanks to a very cold early spring. But to say that prices will go much higher from here would be a bit of a stretch.

TER: Which junior names are doing well in Canada?

KS: In no particular order, NuVista Energy Ltd. (NVA:TSX), Advantage Oil and Gas Ltd. (AAV:NYSE; AAV:TSX) and Delphi Energy Corp. (DEE:TSX) are doing well. The market is watching these companies to see which has leverage to gas, and which can really show a huge improvement in its numbers if gas does go up. These companies are heavily gas weighted. So, if gas does turn and stay higher, they have the most torque.

TER: What about old school oil and gas production? Not everybody is fracking-how are the standard vertical wells doing?

KS: That industry has been on hold for three years while the market experimented with the shale plays. On the junior side, it's very rare to find conventional plays. The one that I like the most on the conventional side is a company called Manitok Energy Inc. (MEI:TSX). It has done a great job of putting together a land package in the Cardium Formation in the Alberta foothills and hitting on all its wells for both gas and oil in regular conventional formations. So the old-style industry is still alive. . .a bit.

TER: Is it more efficacious to do vertical wells in the Cardium than to frack?

"When you hit a regular, old-style conventional pool with a vertical well, you can book a lot of reserves."

KS: Well, where Manitok is, yes. The old-style pools are not in shale, tight rock or tight sandstone, so you can put a regular, old-style vertical hole down. If you hit the pool, splash! That's a great well. Manitok hit a monster well two years ago and it did 5 million cubic feet per day (5 MMcf/d) gas. Two years later, it's still doing over 3 MMcf/d. The well has declined less than 40% in two years. A lot of producers would give their eye-teeth for a well like that. The unconventional wells typically deplete 65-85% in the first year, and another 20% during the next couple of years. When you hit a regular, old-style conventional pool with a vertical well, you can book a lot of reserves.

TER: Is the Street being realistic about the depletion rate of the unconventional wells, or do people believe the reserves will last forever?

KS: The Street is acutely aware of what the decline rates are now. At the same time, some of these plays take a long time to peak, and some of them do not. The Haynesville peaked quickly, but plays like the Barnett took more than 10 years to peak. The Marcellus is still growing, with lots of new wells coming onstream. The Street is very aware of the decline rates, and I think that's why natural gas prices have doubled in a year despite production not going down. But I think the Street is also aware of the amount of wells that can still come on in these plays, and it is sitting back and waiting to see some kind of supply drop before bidding gas up any higher.

TER: What is the science behind the rapid depletion rate with the hydraulic fracking?

KS: Basically, with fracking, once you pump the water, steam, or sand into the formation, only the oil and gas that is sitting right inside those particular fracks surfaces. The shale formation is super oil charged, so there are still huge amounts of oil and gas left in the rock after the first go-round. One can either refrack it multiple times, or perform a water flood to liberate a little bit more oil and gas. But drillers have to be close to the fracks to get the product out. The trick is to plan the optimal size and strength of the initial frack. After the well has depleted for two to three years it might be worthwhile to refrack.

TER: Is it more expensive to frack the second time around?

KS: Remember, the well has already been drilled. If the company has drilled a $3 million (M) well, probably $1M of that is the frack. You don't have to spend $3M again-only $1M. If the well is doing 10 barrels per day (10 bbl/d), and a refrack gets it back up to 30 bbl/d for a while, there can be substantial payback.

TER: How important is jurisdiction in assessing what companies to buy?

KS: It is very important because prior to the shale revolution, the market searched the world for new sources of oil and gas. We were getting deeper and more remote with all of our exploratory work. We had to; the thinking was that all the easy pickings in North America were long gone. Then along came the shale revolution. Everybody refocused their budgets on North America. And there have been so many discoveries in the last three or four years. Enough to keep the market excited, enough that it has not bothered going back to the international locations. The Street is saying, "Why would I take any political risks when we're getting great discoveries with fantastic returns in the Texas, North Dakota and Alberta shale plays?"

"Investors are paying more attention to the international plays even though there are some drawbacks, such as the rise of resource nationalism."

But now investors are paying more attention to the international plays even though there are some drawbacks, such as the rise of resource nationalism. It's becoming more difficult for free enterprise to get business done in the rest of the world. All the big discoveries are now in gas. That's why the majors likeRoyal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) andExxon Mobil Corp. (XOM:NYSE) are moving toward gas. They report in barrels of oil equivalents (boe), as opposed to barrels of oil (bbl), because to keep up their reserve base, they have to book gas reserves. Given the situation, it is very difficult for a junior to enter a new jurisdiction. Two things have to happen. A firm has to a) make sure that the geology is good; and then, b) hit a good well; and c) get the market to realize that. However, in Africa for example, a lot of juniors are having fantastic success, such as Africa Oil Corp. (AOI:TSX.V). There are a lot of ongoing junior African plays that are very high-risk, high-reward plays that can see big lifts with a discovery.

TER: Is North Africa a safe place to do business?

KS: It depends where you are in North Africa. The Street tends to wipe an entire area with one brush, and sometimes that's justified. There are pockets in North Africa that one can operate in, though. Tunisia seems to be fairly safe for business. Obviously, Libya and Algeria are currently fraught with danger, and the Street does not want to go there. Morocco looks relatively safe. Despite the political disruptions, however, some business is done.

TER: Are there juniors in North Africa that investors should look at?

KS: The satellite juniors in the African risk play- Taipan Resources Inc. (TPN:TSX.V) and Vanoil Energy Ltd. (VEL:TSX.V) -are both funded and set to start drilling in the next six months. In Tunisia, there isAfrica Hydrocarbons Inc. (NFK:TSX.V) as well as DualEx Energy International Inc. (DXE:TSX.V), which is going to be drilling its big well within 30-60 days. In Angola, there are a couple of drill plays getting funded.

TER: Are North American investors funding African plays?

KS: Most of the money comes from London. The Europeans are much more comfortable drilling in Africa than North Americans are. North Americans are very risk averse on the international scene. They are myopic, in fact.

TER: You also follow refinery stocks. Are the risks lower there than for the producers?

"For refinery stocks to move higher, we'll to need to see the WTI-Brent spread widen again. And that could happen."

KS: The refinery stocks had a great run over the last year. But in early March, they started to run into a bit of trouble. The stock charts are now consolidating. Even though the refiners are showing great earnings for the last quarter, the market looks forward. And the Street sees a very tight West Texas Intermediate (WTI)-Brent spread. So the refiner stocks are now in full retrenchment mode and not moving forward. They are consolidating the gains they've had over the last 9-12 months. For those stocks to move higher, we're going to need to see the WTI-Brent spread widen again. And that could happen. As light oil production in the U.S. continues to increase, it will overwhelm the refinery complex on light oil, and we will see a drop in light oil prices here in North America.

TER: Are there any companies that you like in that space?

KS: I am watching Valero Energy Corp. (VLO:NYSE) because it has so many refineries. It has a lot of torque to any turnaround. It exports a lot of product, which is very important, and it's the largest independent refiner.

The other refiner that I follow quite closely is called Northern Tier Energy LP (NTI:NYSE). It has been hit, like everybody else, pretty hard on the tight spreads. So I am watching it from the sidelines as the whole refinery game shakes out. But the sector certainly did give investors a great run for 9-15 months.

TER: What advice do you have for new and veteran investors in the oil and gas space?

KS: Investors need to be very patient. There are lots of good stories out there that are starting to look very cheap. But, it is not wise to run out and buy stuff just because it's cheap, particularly in Q2/13. The second quarter is generally the weakest for the industry. As we get close to June, there's a very good chance industry share prices will go lower. The Street wants to see if the rally in natural gas is real. If it is, and we start to see production decline, then making money in this sector should be quite easy, because there are lots of gas stocks with good teams and good assets that are trading dirt cheap. But we are at the seasonal high for gas now. So be careful. Come June and July, though, everybody wants to have their checkbooks open and take another good look at the overall scene.

TER: I appreciate your time.

KS: Thank you, Peter.

Keith Schaefer is editor and publisher of Oil & Gas Investments Bulletin, which finds, researches and profiles growing oil and gas companies that Schaefer buys himself, so subscribers know he has his own money on the line. He identifies oil and gas companies that have high or potentially high growth rates and that are covered by several research analysts. He has a degree in journalism and has worked for several Canadian dailies but has spent over 15 years assisting public resource companies in raising exploration and expansion capital. Schaefer will be speaking at the upcoming World Resource Investment Conference 2013.

Want to read more Energy Report interviews like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Interviews page.

DISCLOSURE:
1) Peter Byrne conducted this interview for The Energy Report and provides services to The Energy Report as an independent contractor. He 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: Royal Dutch Shell Plc. Streetwise Reports does not accept stock in exchange for its services or as sponsorship payment.
3) Keith Schaeffer: I or my family own shares of the following companies mentioned in this interview: Vanoil Energy Ltd. I personally am or my family is paid by the following companies mentioned in this interview: Taipan Resources Inc. and African Hydrocarbons Inc. My company has a financial relationship with the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
4) Interviews are edited for clarity. Streetwise Reports does not make editorial comments or change experts' statements without their consent.
5) The interview does not constitute investment advice. Each reader is encouraged to consult with his or her individual financial professional and any action a reader takes as a result of information presented here is his or her own responsibility. By opening this page, each reader accepts and agrees to Streetwise Reports' terms of use and full legal disclaimer.
6) From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles and interviews on the site, may have a long or short position in securities mentioned and may make purchases and/or sales of those securities in the open market or otherwise.

Streetwise - The Energy Report is Copyright © 2013 by Streetwise Reports LLC. All rights are reserved. Streetwise Reports LLC hereby grants an unrestricted license to use or disseminate this copyrighted material (i) only in whole (and always including this disclaimer), but (ii) never in part.

Streetwise Reports LLC does not guarantee the accuracy or thoroughness of the information reported.

Streetwise Reports LLC receives a fee from companies that are listed on the home page in the In This Issue section. Their sponsor pages may be considered advertising for the purposes of 18 U.S.C. 1734.

Participating companies provide the logos used in The Energy Report. These logos are trademarks and are the property of the individual companies.

101 Second St., Suite 110
Petaluma, CA 94952

Tel.: (707) 981-8204
Fax: (707) 981-8998
Email: jluther@streetwisereports.com