DeeThree Exploration's Surprise Reorganization Gives New Investors A Gift
- DeeThree Exploration has best-in-class oil assets for a small cap Canadian oil producer.
- Company's recent decision to split into two separate public entities has surprised current shareholders.
- Shareholders waiting for final resolution provide opportunity.
Value investors thrive on seeing equity pricing errors that often originate from emotional reactions that all investors have. One common emotional condition a stock can be in is a sentiment washout, where shareholders become exhausted by the prolonged drops in a stock, say one caught in a negative macro trend (for example my last article on RMP energy). But another condition that I look for is a personal favorite. That is a shareholder base that becomes confused about where things are heading due to some kind of material change in the story. The natural reaction in the short term to confusion is almost always sell at least parts of a position and worry about value later. But if you can cut through that short term murkiness, you can receive a discount on assets based on nothing more than people's feelings. I believe that DeeThree Exploration (OTCQX:DTHRF) is one such company. In fact, I would argue its caught in the middle of both of the above conditions, which may make it even more interesting.
DeeThree is a highly regarded light oil company that operates two major projects both located in the Western Canadian Sedimentary Basin in Alberta. Over the past years its oil output has increased nicely and several well timed equity sales over those same years have allowed the company to maintain an excellent balance sheet. Its successful property development thus far should put it in the position to maintain is 2014 exit production for the duration of 2015 with a dramatically shrunken capital budget, therefore avoiding any additional stress on the balance sheet or poorly timed equity sales. A very good summary of the company's prospects (albeit with some oil prices out of date now) can be found here. If you can't see that Seeking Alpha Pro article let me quote the company's own website to briefly explain these two different core projects. The first area is the Brazeau-Belly River while the second is a region of Bakken siltstone located close to the Alberta/US border,
- DeeThree was a pioneer in proving that historical Belly River oil pools could be revitalized through horizontal drilling. The application of horizontal wells completed with multi-stage hydraulic fracturing, using fluid systems appropriate for the specific reservoir, has created an exciting growth play at Brazeau.
- For decades, the multiple stacked sands of the Belly River had yielded natural gas across Alberta, plus modest volumes of oil from vertical wellbores. In only three years, DeeThree has grown its Brazeau asset from a strategic acquisition with modest vertical production and limited reserves, into a multi-zone growth engine with hundreds of future horizontal locations. It has been established as being among western Canada's largest oil accumulations.
- The Upper Bakken siltstone at Ferguson has been a remarkable success for DeeThree. DeeThree first noticed this formation's potential on an old vertical well log, at a time when the Company was more interested in drilling the better-known (but ultimately sub-economic) Middle Bakken. DeeThree drilled a short-leg horizontal well into the Upper Bakken in 2011, discovering the industry's first commercial oil in this zone. By the end of 2013, the Company had drilled 38 horizontal wells, establishing a large Upper Bakken fairway. Successive exploration, delineation and step-out wells had confirmed a pool spanning approximately 14X4 miles, with the western boundaries still largely undefined.
So as a simplistic summary, the company has successful two halves producing high netback light oil. One half is a light oil horizontal recovery play that relies on being able to drill several different layers all located within the same acreage, with the sum total very large amount of oil in place. The other half is a large light oil play that encouraged the deployment of some pressure support to upgrade the wells from good to great. Overall, the company has had enviable success in both its oil projects while maintaining a strong balance sheet from 2013 to this year. New sand layers were commercially tested over that time with great success in Belly River while a program to re-inject high Co2 content natural gas was installed and initiated with good preliminary results in the Alberta Bakken properties. More recently, it looked like DeeThree would be one of the first small cap oil companies in Canada to get back to clear skies after months of brutal down moves as analysts and investors looked over the 2014 year end release and the information therein. To keep the article brief, lets see a sample of analyst reactions to the 4th Q report, this short quote from RBC (among many others) on March 26th when the stock was around 6.50C$:
- Reiterate Outperform with $10.00 12-month price target. Our price target reflects a 0.8x multiple of the $12.71/share sum of our adjusted base net asset value of $7.16 plus $5.56 of risked unbooked inventory. Our 0.8x target multiple reflects DeeThree's solid financial position, strong per-share organic growth outlook, above-average resource exposure, and future drilling inventory
Even better, just days after the well received 4th quarter report, the company confirmed the pressure support technique they have been installing, tweaking, and testing for almost two years at Ferguson now seems on the verge of complete success.
CALGARY, ALBERTA--(Marketwired - Apr 1, 2015) - DEETHREE EXPLORATION LTD.("DeeThree" or the "Company") is pleased to announce results from its latest Alberta Bakken horizontal well 11-20-3-16 W4M. This is the first well designed specifically to optimize the Company's ongoing gas re-injection Enhanced Oil Recovery ("EOR") scheme. The 2,000 meter horizontal lateral well was drilled in the base of the Alberta Bakken zone within the core EOR scheme area and near where the Company has been re-injecting produced Bakken gas with a high CO2 content since July, 2013. At the end of a five day production test, the well continued to flow at approximately 1,000 bbls/d of 30° API oil and 500 mscf/d of natural gas at a flowing wellhead pressure of 300 psi. The significant rate and, more specifically, the low gas to oil ratio ("GOR") of the production further demonstrates the efficiency and effectiveness of DeeThree's gas re-injection EOR scheme. To date, the Company has not seen any material gas breakthrough or increasing GOR's in existing wells.
The one-two punch of this news flow began to move the equity higher and the stock even appeared to be ready to breakout. On the macro side, the oil washout around this time was seeming to bottom, with the shrill calls for oil to hit numbers like 30$ unfulfilled for long enough that many began to wonder if the bottom was in for global oil prices. Everything seemed to finally be turning up for this battered oil company.....
Look Out Below!
Without warning on April 7th, DeeThree Exploration announced that they were splitting the company into two totally independent, separately listed public companies. One part would be a dividend payer based on the lower decline EOR Bakken assets the company owned. The other would be a growth-targeting light oil play using the large asset base in Belly river operation. The strategic rationale was very straight forward. One play would grow by exploiting the large stacked asset play while the other would be a lower decline but far slower growth enhanced recovery operation, both profitable at lower "real world" oil prices, but with totally different goals. Using the classic "sum of the parts" concept, the Board of DeeThree apparently assumed that two focused, pure plays would do better in the market than one company with two excellent but highly different assets would.
This bolt from the blue was not met with applause, but with a firestorm of selling. During that first day the stock price fell nearly 10%. Shareholders (and analysts) who thought they had this situation well in hand woke up to a whole new world.
On top of this foreseeable shock effect there were also some avoidable mistakes. One complaint I heard from multiple sources was the new share structure. The split of shares for the two new companies, Boulder (see its presentation) and Granite (see its presentation) grants .5 shares of Boulder and .33 shares of Granite for each share of DeeThree held. This means you will receive in total fewer shares than you started with, which while mathematically irrelevant so long as the percentage of company ownership is the same, angered some retail investors who didn't like the appearance of a share number loss.
But the most pressing problem is that DeeThree Resources hasn't split yet. It meanwhile contains now two future pieces that largely attract two unrelated types of investor. The natural base of income investors likely has no desire to own a high growth, higher risk oil stock. Those looking for high growth are likely not looking for some kind of middle yield dividend payer whose biggest excitement is managing cash-flows for a few percentage points of better POR.
The above element is the confusion mentioned at the beginning of the article. Just as the stock was (successfully I believe) trying to drag itself out of the Macro oil sentiment washout, the already beaten shareholder base was suddenly blindsided with an un-telegraphed corporate sundering. Investors sold in this confusion and seem to be holding off as of this writing.
Having covered the negatives and the history, what about the future? Here I agree with the company's logic that in the longer run, two pure plays probably will do better in the markets, and the two offspring both seem large enough to stand on their own. The assets are still best in class. The positive reality of what the company's land base represents has not changed despite the financial engineering. But until this split is fully executed sometime in May and the company can deposit these two new stocks into their respective natural constituencies, I think DeeThree will trade at a discount to its peers. Therein is the opportunity I feel I am taking advantage of. The company is widely acknowledged to have excellent assets (even in the new realm of lower oil prices) by a number of different analysts, and yet those assets can now be bought at a discount because people are not happy with being surprised and are confused about what to do with the split personality of the company.
But I am not the only one who thinks this may be a good idea in the long run. Buried in the release explaining the company's thinking about this breakup was this section buried near the end:
The directors, officers and certain shareholders of DeeThree, holding approximately 17% of the common shares of DeeThree, have entered into support agreements with DeeThree pursuant to which they have agreed to vote in favour of the Reorganization.
Now I am a cynical investor. Perhaps this entire effort was the dream of crazed insiders who just wanted to play in separate sandboxes. Has any small cap investor not seen management make mistakes to keep a job or enrich a position before? But 17% of the shares were worth around 100,000,000C$ at the time of the announcement. That's an awful lot of stock to throw away if this plan is a transparently terrible idea. The only reason for the owners of that much equity would outright support this tremendous change in the corporate plan would be because they think it will increase the value of their stock over time. One assumes that large and insider shareholders consulted beforehand would be in a good position to understand the potential rewards better than scared or confused retail holders.
In conclusion, I believe that this company's two offspring will head materially higher once the damage created by this shock separation fades from memory this summer. This will be due to nothing more complex than a recognition of the asset's underlying values in each case. Further, I believe that oil will prove to have bottomed sometime in the past few months, and while it may not rocket back to the 100$ levels of the past, it will also not stay near recent lows. It is my view that both the macro sentiment washout will be fading this summer on oil while on the micro side DeeThree shareholders will settle into the new corporate structures once both are public listed and trading. I plan to take advantage of the short term doubt and unsteadiness brought on by the creation of these two pure light oil plays that have been timed to go public right into the beginning of what I view as a larger macro energy recovery.
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