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  • Small-Cap Energy Stocks Have Hit Bottom: Steve Palmer
    Small-Cap Energy Stocks Have Hit Bottom: Steve Palmer

    Source: Peter Byrne of The Energy Report (7/24/12)

    http://www.theenergyreport.com/pub/na/13960

    Don't panic, because things can't get much worse. Instead, hold your cards and scout out buying opportunities. This is the strategy Steve Palmer employs at AlphaNorth Asset Management, a small-cap powerhouse with a track record of solid returns. In this exclusive interview with The Energy Report, Palmer gives a quick-and-dirty assessment of resource markets and explains why he now favors energy stocks over precious metals in the current environment.

    The Energy Report: Steve, AlphaNorth created quite a stir when it returned 160% in 2009 and 113% in 2010. But this year's second quarter has seen negative returns. What do you attribute this to?

    Steve Palmer: It's hard to generate positive returns when stocks across the board are a no bid. The small-cap Canadian market has been hit pretty hard. There's zero investor interest right now, particularly in small-cap resource companies. I do expect things to get better, though, over the remainder of the year.

    TER: Is the current market downturn unusual?

    SP: The market is cyclical; every once in a while people head for the hills. The current downturn is related to concerns about Europe and the slowing of growth in China. My view is that concerns about Europe are overdone. There is a slowdown in Chinese growth, but it has been a policy-driven slowdown by the government to cool inflation and the housing market. That policy has been successful, but now investors are complaining about the slower growth. Going forward, the Chinese government will be implementing policies to reaccelerate the growth rate, now that inflation is not an issue. Meanwhile, China continues to increase its energy consumption. The latest data shows that the country's oil imports are up 11% year-to-date.

    TER: How do AlphaNorth funds weight the resource sector?

    SP: We take a balanced approach. The Partners Fund is 50/50 in resource stocks versus tech and healthcare stocks. Our Growth Fund has a higher resource weighting; it is currently above 70%. But that has not been good for performance in the short term, given that small-cap and midcap resource stocks have been hit the hardest over the last few months.

    TER: Why do you focus on small-cap equities?

    SP: Historically, small-cap equities are the best-performing asset class over the long term. They are more volatile than fixed-income investments or large-cap equities, but they generate far superior long-term returns. One reason for this is that small caps are often priced inefficiently. I try to buy companies that do not have any analyst coverage or institutional ownership. Getting in early can mean multiplying your money many times.

    TER: How does AlphaNorth exploit inefficiencies in small-cap firms?

    SP: It's based on risk versus reward. We try to identify situations that have limited downside with lots of leverage to the upside.

    TER: Why do you limit your portfolio to Canadian firms?

    SP: There are enough opportunities in Canada that we don't have to go looking internationally. I'm more familiar with the players in the Canadian market and how things work here, as compared to the U.S.

    TER: Do you favor investing in energy juniors over gold and other mining juniors in the current international economic environment?

    SP: In the current environment, I prefer energy to gold. Small- and midcap energy stocks currently offer better value than gold stocks. There's still some euphoria priced into gold by retail investors. Furthermore, energy is a finite resource. Once it's gone, it's gone. Gold, on the other hand, is not consumed; it sits around forever. However, I think both will do well over the balance of the year.

    TER: Steve, you have been a strong proponent of uranium stocks in the past. Given the current economic climate, what upside is there for uranium? Are there any uranium juniors that you like?

    SP: Uranium has been off the radar for a while because the situation in Japan has been a big negative for uranium companies. But I believe that the Japanese nuclear reactors will be restarted. In addition, China has a program to expand its nuclear energy infrastructure quite significantly. Over the longer term, uranium should do quite well. A micro-cap name we like is Athabasca Uranium Inc. (UAX:TSX.V; ATURF:OTCQX). It is one of the better small caps in terms of its potential to find an economic deposit in Canada. Denison Mines Corp. (DML:TSX; DNN:NYSE.A) is a larger-cap name that also has good prospects.

    TER: Shifting to oil and gas, what regions in Canada are the most promising for juniors?

    SP: Canada is a mature basin for energy. The most exciting opportunities are those companies that are exploiting new extraction techniques. New fracking technologies and horizontal wells have opened up areas that were previously uneconomic.

    TER: How do you assess takeover potential for energy juniors in Canada?

    SP: We look at the potential value of the company's asset relative to some of the larger companies nearby and whether or not it will be a strategic acquisition for them. Quite often, larger companies acquire land surrounding an area where a junior company already owns land. Therefore, land value can imply a significantly higher market cap for the junior company.

    TER: Do you have any advice for investors who are looking at junior equity stocks in Canada? Should they hold their cards, or go looking for cheap investments?

    SP: It is a tough market environment. The TSX Venture index is down over 50% since March of last year. There have been very few winners for anybody. I see a similar situation to 2008 in the small-cap environment, where investor sentiment is extremely negative. But that's also a positive sign because it can't really get much worse than it is. That's why I'm quite optimistic about the market going forward.

    Investors should not be panicking and selling. Generally, almost all of the junior resource companies are trading at attractive levels. If the market rallies, as I expect, everybody will benefit.

    The takeaway point is that it's been a very challenging market for investors in the junior energy space. This is not the time to abandon those investments. There may be some firms that are at risk of not getting further funding, and there's potential for some to go bankrupt. Stick with the good ones that are funded with strong management teams, and wait for the market environment to improve, as it surely will.

    TER: Thank you, Steve.

    SP: You are welcome.

    Steve Palmer, CFA, has served as president, CEO and a director of AlphaNorth Asset Management since founding the firm in 2007. AlphaNorth currently manages a long-biased, small-cap hedge fund. As VP of Canadian equities at one of the world's largest financial institutions, Steve managed assets of approximately $350M. He also previously managed a small-cap pooled fund, achieving returns ranked #1 by Morningstar Canada. He has a BA in economics from the University of Western Ontario.

    Want to read more exclusive 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 Exclusive Interviews page.

    DISCLOSURE:
    1) Peter Byrne 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: Athabasca Uranium Inc. Interviews are edited for clarity.
    3) Steve Palmer: From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles 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. I was not paid by Streetwise Reports for participating in this interview.

    Streetwise - The Energy Report is Copyright © 2012 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.

    The Energy Report does not render general or specific investment advice and does not endorse or recommend the business, products, services or securities of any industry or company mentioned in this report.

    From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles 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 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

    Jul 26 3:10 PM | Link | Comment!
  • Spot Uranium Sleeping Beauties Before The Market Wakes Up: Jeb Handwerger
    Spot Uranium Sleeping Beauties Before the Market Wakes Up: Jeb Handwerger

    Source: Peter Byrne of The Energy Report (7/19/12)

    http://www.theenergyreport.com/pub/na/13933

    Pundits may have closed the book on the so-called nuclear renaissance, but the story is far from over. In this exclusive interview with The Energy Report, Gold Stock Trades Editor Jeb Handwerger names the "sleeping beauties" quietly proving their worth. A new generation of nuclear energy must be part of a diversified happy ending, Handwerger says, but by that time, merger and acquisition activity may have already rewarded the investors who believed in a brighter future. Read on.

    The Energy Report: Jeb, at the turn of 2012 you were bullish on junior uranium mining stocks. It's halfway through the year and a lot of these stocks have still underperformed. Is this the result of continued economic fallout after the Fukushima nuclear disaster, or perhaps a consequence of the availability of cheap natural gas?

    Jeb Handwerger: We had a really difficult year for uranium equities in the aftermath of both Fukushima and the end of QE2. The whole resource sector went, and uranium was hit extra hard. Cameco Corp. (CCO:TSX; CCJ:NYSE) and Uranium One Inc. (UUU:TSX) declined more than 50%.

    However, we are beginning to see a notable improvement in the supply-and-demand fundamentals with more institutional investor interest in uranium. Year-to-date, Cameco is up close to 21%, making a higher low than in late 2011 and holding the 200-day moving average. It seems that the bottom we predicted in uranium miners in late 2011 is still holding. Compare that to the gold miners' ETF (GDX:NYSE), which is down 17% and to the rare earths ETF (NYSEARCA:REMX), which is down about 12%. The uranium ETF is down only 10%. That shows me that uranium miners are relatively strong in a weak, panic-driven natural resource market where investors are hoarding cash and treasuries.

    TER: So what's breathing life into the uranium sector now?

    JH: In 2011, nuclear energy had a lot of competitors from alternative energy sources such as solar, wind and natural gas. Since then, the challenges for each of these sources have become more apparent and the entire energy sector has undergone an outright selloff. A lot of articles have talked about cheap natural gas taking the place of nuclear. What the pundits don't say is that natural gas has plenty of its own issues, ranging from the environmental downsides of hydraulic fracturing to greenhouse gas emissions. Furthermore, service stations and natural gas liquefaction plants must be set up along the chain of supply from mine to consumer. Major costs are involved and there is no assurance that the price of natural gas will remain at these low levels. Plus, some parts of the world don't have abundant natural gas. The cost of liquefying it and shipping it can be extravagant. Japan, for instance, tried importing natural gas, but eventually gave up and recently reactivated nuclear plants amid growing fears of power outages affecting industry.

    The short position in nuclear miners has increased even as money is being directed toward construction of new nuclear power plants globally. The shorts use the stories of cheap natural gas to depress the uranium sector. This means uranium miners may even have additional upside because of the large short position that may soon have to run for cover in the event of a turnaround. We have seen short covering rallies before in the uranium miners. In the summer of 2010, after QE2 was announced, the sector experienced major gains. The same was true in 2007/2008 before the credit crisis. We saw a huge exponential move. These moves came out of nowhere and were very powerful, with miners moving up 10-20% a day.

    We must not tar nuclear energy with the broad brush of the entire resource sector malaise. Construction of new nuclear plants proceeds steadily and the media is not emphasizing that. The U.S., for the first time in three decades, announced the approval of plans for nuclear reactors in Georgia and South Carolina. Even Japan is reactivating nuclear reactors. India and China are moving full speed ahead, and this alone will require an additional 40 million pounds (40 Mlb) of uranium annually by the end of this decade. We must remember that the underperformance right now in junior uranium miners is transient. Nuclear power is here to stay. All energy sources have their own sets of cost and environmental issues. No one source can fulfill everyone's needs for the next 30 years. Nuclear will always be part of the long-term energy mix, and when the market turns, long-term uranium investors have the potential to experience exponential profits.

    TER: Japan's Fukushima Nuclear Accident Independent Investigation Commission published its report on the 2011 accident. It largely blamed the Tokyo Electric Power Co. operators for administration and operational failures. What did these findings mean for the future of nuclear power in Japan and around the world?

    JH: Many countries are still stuck with the old, 40-year-old nuclear reactors, which is what Fukushima was. A renaissance has since occurred in nuclear engineering. The next generation of reactors has a fraction of the risks involved with the old reactors. That is what is being built in China, India and Russia. Even Saudi Arabia has 16 plants under serious consideration. Four are in the works in the United States.

    TER: Given that more than 500 new reactors are in some phase of the building pipeline right now, how attractive are investments in the engineering and contracting firms that design and build reactors?

    JH: Investors are looking into the companies that build the reactors. The Shaw Group Inc. (SHAW:NYSE) is building the South Carolina reactors. Babcock & Wilcox Co. (BWC:NYSE) used to build nuclear submarines, but has also moved into small modular nuclear reactors. Fluor Corp. (FLR:NYSE) and General Electric Co. (GE:NYSE) are other names with exposure to nuclear power. One can also look at utilities like Exelon Corp. (EXC:NYSE) who are major players in nuclear power generation in the United States.

    TER: If this is where the increased demand for uranium will come from, what about the supply? The large producers will probably deliver, but will the explorers eventually benefit as they find the fuel for the future? From an investment point of view, what is the best way to capitalize on this coming trend? Is it through the big companies or the juniors?

    JH: To answer that, I think we need to take a look at what happened in 2011. One of the biggest deals was that Hathor Exploration, which owned the Roughrider deposit up in the Athabasca Basin, was bought up for multiples by the giant Rio Tinto Plc (RIO:NYSE; RIO:ASX; RIO:LSE; RTPPF:OTCPK). Rio Tinto's stock price did not move nearly as much as Hathor's price. Hathor received over $11/lb uranium. If you are looking to leverage the sector, a good way to play it might be to find a suitable candidate for the major uranium miners, many of which are trading at one-tenth of that value right now. Cameco and Rio Tinto have expressed ongoing interest in further acquisitions of juniors. That is why we are specifically looking at areas that are in mining-friendly jurisdictions where the majors are going to be looking to develop economic resources. The undervaluation of quality uranium miners is creating a possible once-in-a-lifetime buying opportunity.

    TER: Do you see other buying opportunities in the Athabasca Basin?

    JH: Following the Hathor buyout, we expect even more consolidation in the Athabasca Basin. When a company that large sinks $650 million into an area, we don't think that's the end. It is just the beginning. Rio Tinto will want to build resources and consolidate its position. We also think Cameco and possibly BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK) is going to try to build a larger position in the basin. Target candidates include Denison Mines Corp. (DML:TSX; DNN:NYSE.A). It has the Wheeler River deposit, which is one of the best undeveloped projects in the basin. UEX Corp. (UEX:TSX) has a large resource base in the basin and is already 22% owned by Cameco. Fission Energy Corp. (FIS:TSX.V; FSSIF:OTCQX) has the J Zone, which is pretty much a continuation of the Roughrider deposit.

    Athabasca Uranium Inc. (UAX:TSX.V; ATURF:OTCQX) is an early-stage company in the area, but it has some great prospects at Keefe Lake. Athabasca has an interesting team with Dr. Zoltan Hajnal from the University of Saskatchewan, who is an expert at using seismic data for uranium exploration. He did this successfully for Hathor. He is a world-class seismic expert and he has joined Athabasca's advisory board, along with Kim Goheen, who recently retired as CFO for Cameco. The company also came out with spring drilling program results that showed some very promising early-stage success using that seismic data. The second half of 2012/2013 may be interesting.

    TER: Could Athabasca Uranium or any of these be standalone projects, or are they mainly acquisitions targets?

    JH: In time, there won't be many juniors in the Athabasca Basin. The high-quality ones will be a part of Rio Tinto or Cameco. The same thing will happen in the U.S., where we follow three juniors who are currently very active. Uranium Energy Corp. (UEC:NYSE.A), Ur-Energy Inc. (URE:TSX; URG:NYSE.A) and Uranerz Energy Corp. (URZ:TSX; URZ:NYSE.A) are going to be U.S. producers who are part of the solution to the U.S. supply crisis. Just under 20% of U.S power comes from nuclear reactors, however more than 95% of the uranium is imported. The U.S. used to be one of the largest uranium exporters. Now it produces less than 4 Mlb of uranium.

    As part of a plan to meet that demand, in the near term Uranerz, could be a takeover target for Cameco or Uranium One. It already has a processing agreement with Cameco and an off-take agreement with Exelon Corp. Uranerz has an incredible land package right between the two majors in the Powder River Basin, which has been producing uranium for five decades. The company employs in-situ mining, which also has many benefits over conventional mining when it comes to environmental issues and costs.

    TER: How soon might a takeover happen? Is there some catalyst in the wings?

    JH: You just never know when it's going to happen, although I do know it will be sooner rather than later. I think as we get closer to 2013 there's going to be more pressure. Over the next 6-18 months a huge amount of consolidation could come to the industry.

    TER: Has the market already priced in these takeovers?

    JH: No, no, no. Uranerz is trading near three-year lows. Investors have a chance to get into these companies on historic lows.

    In South America, a company I like is U3O8 Corp. (UWE:TSX.V; OTCQX:UWEFF) in Colombia, Guyana and Argentina. The main project is Berlin in Colombia. The company has shown incredible resource growth during the past year. It has increased the Indicated and Inferred resource sevenfold, from 7.1 Mlb to 47.6 Mlb, and it has only documented the three southern kilometers (km) of a 10.5 km mineralized trend. The Berlin deposit is also home to phosphate and vanadium and has shown some very positive metallurgical recoveries. U3O8 is rapidly growing and derisking its resources in South American countries that are mining friendly. I understand the company will be completing a PEA in the second half of 2012. The company thinks it can potentially grow this asset in the near term to 40-50 Mlb uranium.

    U308 already has a strong cash position with institutional support. What is really interesting is that the phosphate, vanadium and rare earths may pay the way with the uranium as pure profit. That is what we are looking for in the second half of the year from this company.

    TER: U308 Corp is trading at $0.33 right now. How much could it go up from there?

    JH: Right now, U3O8 is priced at about $0.77/lb uranium; Hathor was bought out for $11/lb and Mantra for $10/lb. That is almost a potential tenfold increase. As the project is derisked in the second half of the year, the stock should get to at least a comparable value to some of its current competitors, at over $1/lb.

    TER: Are you looking at any uranium companies in Europe?

    JH: Yes. We have one that we really like in Slovakia called European Uranium Resources Ltd. (EUU:TSX.V; TGP:FSE). First of all, it has a great management team. Plus, Europe is the largest user of nuclear power per capita. There is only one operating uranium mine in Slovakia at the moment and that is rapidly depleting. European Uranium Resources is really Europe's next answer for uranium production. The deposit may be one of the lowest-cost uranium mines in the world. The prefeasibility study is very impressive from an environmental and economic perspective. The real momentous catalyst is if the company can sign an off-take agreement with the Slovakian government, with a surplus going to other EU nations.

    AREVA (AREVA:EPA), the third-largest uranium producer in the world, already took a 10% position at approximately $0.35 a share and is on the European Uranium board giving technical expertise. The company is now trading at three-year lows of $0.22 per share. This may be a real undervalued situation in Europe.

    Overall, Europe and the Americas are much better mining pictures than Africa and Australia right now. Rising resource nationalism in Africa and rising costs in Australia make these other stories much more attractive.

    TER: So, is the overarching story mergers and acquisitions?

    JH: I think so. There is going to be a dramatic change of landscape in the uranium sector. As the high-quality juniors come closer to production, they'll be taken over by the majors. We saw the beginnings of that in 2011 and we will see it continue. One needs patience and fortitude and the ability to go against the consensus.

    TER: Thank you for your time and your insights, Jeb.

    JH: Thank you.

    Gold Stock Trades Editor Jeb Handwerger is a stock analyst and best-selling writer who's syndicated internationally and known throughout the financial industry for accurate, in depth and timely analysis of the general markets, particularly as they relate to the rare earths, precious metals and, nuclear sectors. He studied engineering and mathematics and received his undergraduate degree from University of Buffalo and a masters degree from Nova Southeastern the University in Fort Lauderdale. Teaching technical analysis to professionals in South Florida for some seven years, Handwerger began a daily newsletter that grew to become Gold Stock Trades: Mining for Winners in Any Market, with thousands of readers from more than 40 nations who are interested in the North American resource markets. Click Here to subscribe to his free newsletter.

    Want to read more exclusive 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 Exclusive Interviews page.

    DISCLOSURE:
    1) Peter Byrne 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: Fission Energy Corp, Athabasca Uranium, Uranium Energy Corp., Ur-Energy, Uranerz and U308 Corp. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
    3) Jeb Handwerger: I personally and/or my family own shares of the following companies mentioned in this interview: Uranerz Energy Corp., Ur-Energy, Denison Mines Inc., Athabasca Uranium Inc., European Uranium Resources Ltd. and U3O8 Corp. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise for participating in this interview.

    Streetwise - The Energy Report is Copyright © 2012 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.

    The Energy Report does not render general or specific investment advice and does not endorse or recommend the business, products, services or securities of any industry or company mentioned in this report.

    From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles 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 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

    Jul 23 2:29 PM | Link | 1 Comment
  • Buy 'Discount Darling' Oil Stocks This Summer: Ray Kwan
    Buy 'Discount Darling' Oil Stocks This Summer: Ray Kwan

    Source: Zig Lambo of The Energy Report (7/17/12)

    http://www.theenergyreport.com/pub/na/13900

    Not every beaten-down oil stock is necessarily a bargain. Picking the true gems requires in-depth analysis of the type that Ray Kwan, professional engineer and oil and gas analyst, does at Macquarie Capital Markets. In this exclusive interview with The Energy Report, he explains what to look for and talks about several of his "discount darlings" and why he thinks they offer investors a good shot at above-average returns.

    The Energy Report: Oil prices have been bouncing around quite a bit. Where do you see them headed over the next year?

    Ray Kwan: As a firm, we're actually pretty constructive on the oil complex. There are three main reasons behind that. First, global refineries are exiting a large maintenance season. Second, we believe that there's going to be a slow but steady transport demand recovery in Asia as well as in the U.S. Finally, we're going to see stronger demand for power generation in emerging economies and throughout Asia. We expect the Organization of the Petroleum Exporting Countries (OPEC) to balance out excess supply by reducing production. The bottom line is that we think West Texas Intermediate (NYSE:WTI) prices will increase to the $90-100/barrel ($90-100/bbl) range by year-end.

    TER: Will China's economic growth-or lack thereof-have a significant influence on the market?

    RK: Macquarie has pretty good insight into the Asian markets, especially China. We expect a soft landing. That is going to bode well for a lot of the commodities, including oil.

    TER: On the other hand, low natural gas prices have been a problem for producers for a couple of years now, although consumers are benefiting from it. What do you see going on there?

    RK: We're not as positive on gas, unfortunately. The supply side continues to offer little help in rebalancing the market, and it's still flat-to-growing, despite the drop in the rig count. The only silver lining is the coal-to-gas switching on the demand side and the hot summer, which has improved U.S. storage levels. Unfortunately, it's just not enough, in our view. I think coal-to-gas switching is effectively tapped out, and it should set a ceiling for natural gas prices over 2012 and 2013. Interestingly, if natural gas comes close to the $3/thousand cubic feet ($3/Mcf) range, utilities could potentially start switching back to coal. Next year, we expect natural gas to stay in the $3.50-3.70/Mcf range.

    TER: You just mentioned strip pricing, and you talk about this in your research reports. Can you explain that concept in layman's terms?

    RK: Strip prices are the future prices for both oil and natural gas. Future contracts give buyers the right to purchase a set amount of a given commodity on a set day in the future. In the U.S., the most liquid futures contracts are Henry Hub as well as WTI. Both of those are found on the NYMEX. Futures contracts give investors a picture of what producers, as well as speculators, are willing to pay for the commodity to be delivered at that time.

    TER: What is the best valuation metric for determining which stocks are true bargains?

    RK: We look at two valuation tools: The first is enterprise value to debt-adjusted cash flow (EV/DACF). The second is net asset value (NYSE:NAV). EV/DACF is essentially enterprise value (NYSE:EV) divided by debt-adjusted cash flow. Debt-adjusted cash flow is funds from operations and adding back the interest costs. So it's somewhat equivalent to earnings before interest, taxes, depreciation and amortization (EBITDA). This figure will indicate a company's valuation based on near-term cash flow. With EV/DACF, the cheaper it is, the more it represents a true bargain. NAV, on the other hand, is simply the present value of the company's Proven and Probable (2P) reserves at a particular oil and gas price. You subtract the debt and add any option proceeds as well as the value of the company's land. If a company is trading below NAV, that naturally represents a bargain. In addition to that, if a company has a huge resource that's not accounted for in its 2P reserves, we add its risked-resource NAV to that equation so we can see the ultimate potential of the company.

    TER: Do you use different discount factors?

    RK: Yes. For the NAV, especially in the junior oil and gas space, we use a standard 10% discount rate. Sometimes we use sensitivities for an implied discount rate.

    TER: Your coverage list is fairly broad. Most of these stocks range between $3-12, and you have a couple of cheapies in there. How do you determine which companies to cover?

    RK: We look for high-growth exploration and production (E&P) names that are generating solid cash flow while growing their NAVs through the drill bit and/or through acquisitions. Our coverage universe is narrowly focused on names that have the capability of showing high growth potential or that have interesting asset bases.

    TER: Have your cheaper holdings simply depreciated, or do they have a lot of hidden value that the market isn't recognizing?

    RK: There are some gas names I picked up when we had a better gas environment, expecting that they were going to show quite a bit of growth in cash flow and NAV. With the recent volatility in both oil and natural gas prices, however, the junior oil and gas space has really fallen off. I think this represents a great time for investors to look at these specific names and see what hidden value and optionality these companies have. A lot of them fall in that category.

    TER: You call some of your holdings "discount darlings." Who are they?

    RK: The two oily names I like are Whitecap Resources Inc. (WCP:TSX.V) and Surge Energy Inc. (SGY:TSX). I like them despite volatile prices because they're still able to maintain a fairly profitable margin. Both are close to 70% light oil. They're the "growthy" mid-cap oil producers with operations in Western Canada. They're both recognized as having top-tier management teams. Both are growing their production on a per-share basis by well over 34% year-over-year (YOY) in 2012. By comparison, our mid-cap median group is only generating about 20% YOY growth in production volume. Whitecap and Surge are top-tier in these factors. They're generating operating netbacks well over $35/bbl at current levels and are well hedged. They have strong balance sheets and should do well in an oil price recovery.

    While we're not specifically bullish on gas, Celtic Exploration Ltd. (CLT:TSX) is one of my favorite gas-weighted stocks and, in my view, represents a prime takeout candidate. It has two sizable and contiguous land blocks, chasing the liquids-rich, gas-prone Kaybob Duvernay shales and Montney at Resthaven. For its Montney land base, Celtic has one of the largest land positions in Western Canada at nearly 700 net sections. Liquids yields from Celtic's Montney wells at Resthaven help improve the overall well economics and should aid in buffering the company against the low gas price environment. In addition, its 172 net sections of Duvernay land are in the sweet spot of the play and are surrounded by larger players, such as Encana Corp. (ECA:TSX; ECA:NYSE), Chevron Corp. (CVX:NYSE), Husky Energy Inc. (HSE:TSX) and Talisman Energy Inc. (TLM:TSX), that are chasing the exact same formation. Given the recent sale of Progress Energy Resources Corp. (PRQ:TSX) to Petronas, we believe Celtic could be next to be taken out.

    TER: Do you have any others that could have some reasonable upside?

    RK: Another name I'd mention is Renegade Petroleum Ltd. (RPL:TSX.V). If you're looking for oil, it's over 95% light oil, and close to 4,000 barrels per day (4,000 bbl/d) production wise. The company is expected to grow that to 5,200-5,400 bbl/d oil, over 95% light oil, by year-end. If you want to talk about who has one of the best operating margins or operating netbacks, Renegade would certainly be in that camp. Even at $85/bbl oil, it should be generating more than $45/bbl in operating netbacks. It's a solid company that has a strong balance sheet and is growing, despite the current volatility in oil prices.

    TER: Are most of these small-cap and mid-tier companies potential takeover targets?

    RK: I certainly think so. We believe the theme over the next couple of years is "bigger is better." Given the shift toward horizontal multistage fracture stimulation, per-well costs are moving up, requiring junior oil and gas companies to achieve a certain cash flow or production base in order to fund their program. To get to that level, acquisitions will be part of that equation. Nowadays, we believe acquirers are being more selective about the asset bases they want. Typically, acquirers will want to purchase a producer that has a lot of production and a well-delineated and contiguous land base, so there is little risk going forward. Small-cap and mid-tier producers that have these qualities are the first to be considered as a takeover target, in my view.

    TER: It seems like the average life expectancy for most of these smaller companies is less than 10 years.

    RK: I agree. What's great about Western Canada is that oil and gas executives here are an entrepreneurial bunch and are good at creating new companies, looking at new plays, turning people's capital into production and cash flow and eventually selling it to a larger company. It's formulaic: "Rinse and repeat." That's why you don't see many companies with over a 10-year life span: These executives are moving on to the next big idea.

    TER: It's sort of an easy business to get into and an easy business to get out of, if you play things right.

    RK: Definitely. The one thing I would probably highlight is that the quality of the management team is key in this industry. As you said, it is easy to get in but you need to be well connected and have a strong technical background to extract the most out of the company's assets.

    TER: To summarize, how should investors pick their oil and gas stocks?

    RK: In my view, it's really a stock picker's game. Oil and gas stocks are definitely going to ebb and flow with the macro environment, but investors with a longer-term view should start accumulating over the summer. We expect oil prices to firm up by year-end, and the equities will follow.

    TER: You've given us some interesting names. Thanks for joining us today.

    RK: Thanks. I appreciate it.

    Ray Kwan has been with Macquarie since 2007, where he covers small- and mid-cap oil and gas producers and reports on activities in emerging and established resource plays. Prior to Macquarie, Kwan was employed at a major Canadian integrated oil and gas company, where he gained experience through various technical roles, including design, project management and production engineering. He holds a Bachelor of Science degree in chemical engineering from the University of Alberta and is a registered professional engineer.

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    3) Ray Kwan: 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 story. I was not paid by Streetwise Reports for participating in this story.

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