Is TAG Oil An Appealing Value Play Or A Value Trap?

| About: TAG Oil (TAOIF)
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Another horrific round of price slashing in the energy sector leaves many small cap energy producers trading at less than net asset value.

TAG Oil carries roughly half of their market cap in cash, with zero debt.

Despite this, there are some troubling matters of concern with regards to profitability and income stability.

Bargains, Bargains, Bargains

The energy sector got into the Black Friday spirit with deep discounts levied across the board on energy stocks. With the usual hysteria carrying on through Monday, with additional markdowns on nearly all producers smaller than megacap titans like Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX), one could easily forget that oil had actually rebounded a bit from a low of about $66.

Of course, when panic sets in there is often very little to do but to carry on as usual, bite down on your mouthpiece and take the punches as they come. Careful investors who had saved some dry powder can take advantage of remarkable investment opportunities amid the panic. Everyone else, well, will just have to sit and wait while sanity is restored.

Until then, far too many small cap energy producers are being marked down well below their asset value. One can almost be forgiven for forgetting that while oil seems to be turning from black gold to a black hole, the actual properties themselves seem to be relatively insulated from rapidly fluctuating commodity prices. By way of example, Zargon (OTCPK:ZARFF) recently closed a disposition of their Hamilton Lake assets to Toro Oil And Gas (NYSE:TOO), land producing 170 bbl/oil per day and 1.4mmcf/day of gas, with reserves of 704,000bbl/oil and 3.02bcf/gas. This asset sale netted Zargon $25 million.

For perspective's sake, after taking another beating today in the marketplace, Zargon's market cap is C$161 million and their current debt (before this transaction) was C$129 million, leaving us with an enterprise value of C$290 million. However, this asset sale comprised of less than 4% of Zargon's Q3 2014 oil output, 9.3% of Zargon's Q3 2014 natural gas output, and a mere 3.5% of Zargon's 2P oil reserves, while divesting Zargon of one of their lowest netback properties. This is in addition to $11.3 million tendered earlier in 2014 for sales of small properties totaling 50bbl/day of oil and 8.1mmcf/day natural gas. Zargon retains well over 20 million barrels of 2P reserves, and similar metrics applied to the rest of their properties would easily swallow up the enterprise value and leave plenty left over. We can see therefore that the depressed stock price is not representative of the true value of Zargon's holdings.

My intent is not to discuss Zargon at length, however, but merely to show by way of example that despite the general panic in the marketplace the actual assets seem to retain their value well. This was just one example; Bellatrix Exploration (NYSE:BXE) concluded a similar transaction on December 1st even as stock prices imploded for the second day in a row. And so on.

Mergers and acquisitions are as integral a part of the oil and gas industry as apple pie is to the fourth of July. Certainly many of us have anxiously watched the tickers day by day, hoping for a suitor for our struggling stocks even as the underlying companies chug along without incident. Until then, we simply have to wait for the market to catch up with the underlying value that's on sale right now. At the very least, the wait is giving us some time to rummage through the dirt to find some lost gems. Let's take a look at one potential candidate now.

TAG Oil Ltd.

TAG Oil And Gas (OTCQX:TAOIF) is a New Zealand-based oil exploration company with 2.8 million acres of assets in the Taranaki, East Coast and Canterbury basins, and 30,000 acres worth of shallow water offshore assets as well. TAG exited 2Q 2015 (e.g. September 2014) with an average output of 1,845boepd comprised of 76% oil. (TAG's primary listing is on the TSX as TAO.)

While oil discoveries in the Taranaki basin can be traced back to 1866 with the 20m deep Alpha well, early efforts proved unsuccessful and it was not until 1911 and many subsequent efforts afterward that a Taranaki-based drilling enterprise first came to be financially successful. Many unsuccessful attempts from then did nothing to turn New Zealand into so much as even a territorial player in oil production, and by and large New Zealand continued to import the majority of its oil even as massive deposits beneath their feet remained unclaimed.

TAG was founded in 2002 under the premise of exploiting previously untapped resources in an energy market that had begun to fear the specter of declining production. The company survived a 2007-2008 shakeup in the management team and continued to successfully court institutional investors while posting middling drilling results. In 2009 TAG acquired Trans-Orient Petroleum, though their production still languished at sub-500bbl/day levels. A series of guidance estimates by management in 2012 promised explosive growth that unfortunately did not pan out, and the issue fell from a high of well over $10/share to its current level of $1.53 (December 2, 2014). Pictured here is the equivalent American OTC issue, TAOIF.

At first glance TAG appears to be an exciting value prospect. The company has been slowly growing production without amassing any debt, while curbing itself of its former habits of overpromising and underproducing. The company reports massive reserves and generally productive drilling results. Hilariously, the company has very nearly half of its market cap available in net cash.

So, What's The Catch?

As hinted before, some investigation reveals that TAG has a somewhat checkered history with investors. The stock was bid up to well over $10/share in 2012 on speculation of big growth, aided by rather rosy projections that spectacularly failed to pan out. In fact, current production has declined since 2013, While one wonders what the management team was thinking by announcing such a lofty goal, the company did receive favorable pricing on several waves of bought-deal financing in 2010, 2012, and 2013.

In fact, the 2012 financing was completed with the sale of 4,170,000 shares at $10.45 per share. (All dollar figures are in CAD unless otherwise noted.) Amusingly, only seven months later the company offered a normal course issuer bid for up to 5,586,926 shares which had by now cratered in value. (A similar bid was offered in 2011 and in 2008, although the bid in 2011 did not result in any purchases). I cannot speculate on the intent of management in providing such lofty guidance numbers prior to obtaining financing, but there is no doubt that the transaction proved accretive in the end.

TAG did not fully utilize their issuer bid in 2012, nor their subsequent bids. Their 2013 annual report indicated only a minimal repurchase of 260,000 shares at an average price of $3.23, while the 2014 annual report indicated repurchases of 1.1 million share at an average price of $3.45. Of course, TAG had made a new normal course issuer bid to close out 2013, this time for up to 6,073,339 shares; this offering came only a single month after the aforementioned $25,800,000 bought deal offering at $4.40 per share.

Upon closer analysis, it appears that the company merely likes to keep its options open with regards to stock repurchases. While certainly the company should exercise all available opportunities to profit, I do not see it as a positive sign when the company's most historically profitable product appears to be shares of its own enterprise. This is important particularly given management's past troubles with severe guidance over-promises. And another problem looms-with the stock price now in the tank, TAG Oil has no reasonable chance to raise further capital without either incurring debt or taking on disproportionate share dilution.

Is There A Cash Crunch Coming?

Capital expenditure appears to be an area of concern for TAG. The company reports quarterly profits when not counting capital expenditures, but the figures loom greater than net income with only minimal and incremental quarterly increases in production.

Aggressive capital expenditures are excusable when sustained production and revenue growth can be profitably executed in the long term. By way of example, Lonestar Resources (LNREF) has spent US$44.5 million on drilling 7 net wells for 3Q 2014, slightly over twice their net income for the quarter. However, their production bloomed from an average of 3,613boepd in 2Q 2014 to 4,660boepd in 3Q, a 28% increase, and year-end guidance suggests a potential exit rate of 6,500-7,000boepd.

Meanwhile, capital expenditures at TAG have consistently exceeded net income to the tune of $6-20 million per quarter, but production has remained stagnant despite constant spending. In fact, production peaked in Q1 2014 at 2,354boepd and declined to a Q2 2015 rate of 1,845boepd, with only a slight increase in the cut of oil versus natural gas over that time frame. Pictured here:

In other words, it appears that despite being well-positioned with a large cash balance and gigantic reserves, TAG is slowly bleeding out to capital expenditures that struggle to merely maintain current levels of production. Note that these losses extended through 2013 and 2014 while oil was well over US$100/barrel, raising the question of whether the Taranaki basin can be profitably drilled at all, or at the very least, if TAG can make money doing it. With cheap oil flooding the market now, the cash flow gap will only widen further. And if TAG cannot drill the basin profitably, one must wonder who would offer a takeover.

After all, while Zargon's property sale proved to be handsomely rewarded even during troubled times I the energy sector, TAG has not yet ably demonstrated the ability to profitably drill in Taranaki basin. Furthermore, there is much less of an existing base of nearby competitors who could offer TAG an opportunity to divest themselves of assets. Consequently, I see an asset disposition as a less likely remedy for TAG's cash spiral.

So, while I don't immediately see a cash crunch coming soon for TAG given their enormous bank balance, the constant drip-drip of thinly rewarded capex promises to be a thorn in their side if oil prices do not swiftly and significantly improve soon.

Hedging In An Unstable Market, Or The Lack Thereof

In fact, the drop in oil pricing brings us to another critical point. OPEC's wisdom in not cutting production can be debated, owing to the very large percentage of North American drillers who have wisely hedged production through at least 2015. It could be a long and protracted price war for these drillers, who will likely slowly scale back non-hedged production while continuing to produce to the extent of the most profitable point of their production curve. Quick, cheap drilling coupled with rapid decline rates give American shale drilling the curious quality of being able to swiftly draw down minimally profitable acreage and adapt to a dynamic pricing environment. Many companies have already announced reduced capex budgets for 2015 with an eye toward self-preservation.

However, TAG finds itself in a bit of a pickle with the current decline. Their hedging programs have focused strictly on acquiring a fixed cost for electricity, and they have not hedged their actual oil production per their 2Q MD&A (page 15):

The Financial instruments on the Company's balance sheet include cash, accounts receivable and accounts payable. The carrying value of these instruments approximates their fair value due to the short term nature of the instruments. The Company manages its risk through its policies and procedures, but generally has not used derivative financial instruments to manage risks other than managing electricity pricing risk through hedges that approximate electricity consumption for third parties.

In shorter words, TAG is exactly the kind of oil company OPEC is looking to target with a price war. A fragile and variable income stream and lack of true profitability in better economic times mean only bad news for TAG while prices are on the decline. And while TAG certainly has a large cash balance to weather a temporary storm, so does Saudi Arabia.

The Investment Thesis, Or Lack Thereof

In summary, it appears that TAG is completely exposed to declining oil prices while struggling to maintain stable production levels, and has been utilizing capex funded by bought deal financing offers and not by operational cash flow.

Therefore, an optimistic outlook on TAG would be one that assumes that both the price of oil will rapidly increase, and that future capital expenditure can produce a greater return on production than in previous quarters. I think this is a little too optimistic for my tastes at this point, and exposes an investor hoping to profit from the sector's temporary swoon to unnecessary risk given TAG's history. One can instead play direct oil plays such as (NYSEARCA:USO) or (NYSEARCA:BNO), or simply choose another beaten-down producer with more secure income flows.

After all, everything's on sale for Black Friday.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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