I've been working away at investing my own capital for almost fifteen years. What I've learned the hard way is that it is very rare that I actually turn up a really exceptional idea.
I'm sure you know what I'm talking about. It isn't unusual to find investment opportunities that look like pretty good ideas, and you likely come across those on a regular basis. What I'm talking about are ideas that you find where you just know that five years from now a certain company is going to be worth two or three times the current share price.
Those are rare, and should attract most of our investment capital. For me these rare exceptional ideas encompass a few things:
- Very little chance of actually losing money
- Extremely attractive valuation
- Very likely growth in cash flow or asset value to make for a great long term investment
Warren Buffett believes an exceptional investment idea should be blindingly obvious. Buffett compares finding an exceptional idea to not needing a scale to know that a very obese person is overweight. Similarly, a good investment idea should leave no doubt in your mind.
When I get one of these exceptional ideas I like to concentrate my bets and try and make a material difference in my net worth. I believe that today many pure play unconventional oil producers are such an opportunity. And over the past year I've put a lot of my money where my mouth is.
I'm going to use Petrobakken (PBKEF.PK), which I've written about frequently (and own through its parent company Petrobank) as an example, since I know the company pretty well. I think that Petrobakken isn't the only opportunity, though, and that there are many of these focused unconventional players that are exceptionally attractive for the same reasons.
Why Petrobakken (and other Unconventionals) Are Exceptional Investment Opportunities
If Petrobakken was a traditional E&P company, which every year has to go out and find new reserves by drilling high-risk exploration wells to replace production, I would say that it is pretty sensibly valued.
Petrobakken's Valuation metrics are:
- Less than 5 times expected 2012 cash flow
- Roughly 1 time the PV10 value of its proven and probable reserves
But Petrobakken and other pure play unconventional oil producers are much different than conventional E&P companies. The difference is that Petrobakken doesn't need to go out and find new reserves to replace and try and grow production. There are no exploration wells to be drilled. No crossing of fingers hoping to find some oil. Petrobakken has ten plus years of low risk development drilling locations on the unconventional acreage that it already owns.
That is beauty of the unconventional oil company. These are manufacturing operations that go out and drill a location. Then move the rig and drill another. The exploration risk is virtually non-existent. These companies know exactly where reserve, production and cash flow growth is coming from. It is coming from the undeveloped acreage the company has inside the defined boundaries of a resource play.
If you buy a company like Petrobakken, which has the potential to grow production and reserves at a pretty high clip for the next ten years at 4 or 5 times cash flow, I think one of two things will happen:
- The multiple stays the same but the stock price increases as the same multiples are applied to higher production, cash flow and reserve levels; or
- The market realizes that these are growth companies and the share price increases on increasing multiples and production, cash flow and reserve levels.
Let me look at it this another way. Petrobakken has a large land position in the Bakken in Southeast Saskatchewan. That Bakken property controlled by Petrobakken has an estimated 1.8 billion barrels of oil in the ground. At this point Petrobakken has either produced or been allowed to book reserves assuming a recovery of 6% of this oil. That amounts to 108 million barrels of oil.
Petrobakken believes that the ultimate recovery will be more like 25% to 30% as the company drills up the remainder of its undeveloped Bakken acreage and implements an Enhanced Oil Recovery program. A recovery factor of 25% would mean that Petrobakken would recover 450 million barrels of oil, which is more than four times what has been recorded in the company reserve figures.
Petrobakken's current stock market price basically values only the current booked reserves. I think good things will happen if those reserves go up 4 times. Pay a no-growth stock price for a high-growth future.
Petrobakken's quoted ultimate recovery factors of 25% to 30% match exactly with what its closest competitor, Crescent Point Energy, believes will be recoverable from its Bakken properties. These aren't pie-in-the-sky numbers.
So then, do these unconventional produces meet my criteria for an exceptional idea?
- Is there very little chance of losing money? I sure think so. Most of them are priced at very reasonable multiples of cash flow and reserve value which offer significant downside protection. As long as an investors avoids companies using excessive leverage I believe these are pretty low risk bets because even if growth somehow disappoints, it shouldn't hurt too much because no growth is currently priced in.
- Do these companies have attractive valuations? Yes, they do. The companies, like Petrobakken, that I own are valued as if there is little or no growth ahead. The reality is that many of them have the land positions and drilling inventories to grow for another ten years. I think these companies should be valued at premium multiples to reflect the high likelihood of significant growth in the future. Instead they are priced at no-growth multiples.
- Is there virtually likely cash flow or asset value growth? Again, I think these unconventional companies have growth prospects that are about as certain as an investor can hope to find. Petrobakken, for example, has almost 2,000 drilling locations ahead of it to grow production from. These aren't exploration wells, these are development wells within the defined boundaries of an unconventional play. Last year Petrobakken's drilling success ratio was 99%. The year before, exactly the same. I expect next year to be similar.
I believe these unconventional producers are GARP (growth at a reasonable price) investing at its finest. The oil business has become a real estate game. The companies that have locked up the land in these unconventional plays have set themselves up for a future of year after year of production, cash flow and reserve growth. It seems to me that if these companies continue to grow, the stock prices are going to have to follow.
Please be aware, of course, that if you think oil prices are going to average $50 per barrel or some other relatively low number in the future, your assessment of the risk involved here should be much different than mine. I think the next ten years are far more likely have an average oil price of $150 per barrel, which makes the current multiples on these companies even more attractive to me.