Trying To Find The Lightest Valuations Of The Heavy Oil Patch

Includes: BTE, CRK, EGY, KWK, SBOW
by: Value Digger


As numerous articles talk about the light oil or natural gas producers, I decided to move off the beaten path and not to write one more article about Swift Energy (SFY), Penn Virginia (PVA), Quicksilver Resources (NYSE:KWK), Comstock Resources (NYSE:CRK), Kodiak (NYSE:KOG) or Vaalco Energy (NYSE:EGY). So I decided to explore the heavy oil space of North America instead. To make it more complete, I thought to capture those producers that are also engaged with the oil sands as heavy oil is a sister resource to bitumen. That being said, I will have to write this article in two pieces so my heavy oil summary becomes easy to read as well.

The pricing

Heavy oil production has a price discount of ~20% to WTI but it is still very profitable. Netbacks (profit per barrel) are high because the drill targets are relatively shallow depth (400m - 700m) where each vertical well costs around $0.55M to drill and equip. The figure doesn't come close to the cost of drilling a deep unconventional horizontal well and completing it with multistage fracturing which can easily surpass $3M. To sum it up, it is profitable because it is low risk conventional development. For heavy oil development there is no fracturing required so it is pretty straight forward (conventional vertical wells).

Although most investors ignore the benefits from the exploitation of the heavy oil assets, the fact is that these benefits are significant and indisputable. For instance, NuVista Energy (NUVSF.PK) holds a significant portfolio of heavy oil assets in the Lloydminster area (W3/W4) and according to the company:

"This core region provides a large part of the cash generation that funds NuVista's growth opportunities in other parts of our portfolio. The W3/W4 heavy oil development wells represent the best risk/return profile within our inventory as payout occurs in as little as six months and recycle ratios of three times can be achieved. Throughout the year we drill a mix of low-risk development wells and higher impact exploration wells that ensure we are able to maintain a healthy inventory of development projects. While this area does not offer the same scope as some of our larger resource plays, strong economics, lower drilling and completion costs and short cycle time allow these wells to deliver low risk, near term operating and financial results.

Following up on strong results from this area in 2010, our 2011 capital program was more heavily weighted to repeatable execution on our development projects. During the year, we drilled more than 20 Birdbear heavy oil wells at Zoller Lake and Hallam in Saskatchewan, including several successful delineation wells allowing us to further extend the Hallam pool to the south. In order to reduce well costs and further enhance the economics of this play, in the second half of the year we also tested the use of pad drilling and other repeatable efficiency techniques achieving well cost savings of 10 to 20 percent.

Our capital program from this area in 2011 was extremely successful. We delivered record oil production as a result of our consistent, successful Birdbear wells. Development drilling is ongoing in 2012."

The link of this source is here.

Heavy oil incurs price differentials like light oil does. The heavy oil sales are based on WCS pricing. WCS typically trades at a discount to WTI at anywhere from $10-$20. So if WTI is trading at $90, a producer ends up with a wellhead price of $90-$15(Differentials)-$10 (blending) =$65 per barrel. However these differentials can be significantly reduced through:

1) A hedging strategy like the light oil producers follow as well.

2) The transportation of the heavy oil by rail. According to First Energy, North American rail shipments of oil are estimated to reach 465,000 bpd this year. That's the equivalent of a major pipeline such as Enbridge's Seaway which is expected to ship 400,000 bpd by the end of the year. Recently Southern Pacific Resource Corporation committed to ship its entire output by rail totally bypassing pipelines. That is 12,000 bopd trucked to a rail terminal where it will head south 4,500 km by rail. The oil will then be hauled on barges to the refineries of the Gulf coast. Transportation cost for moving oil by truck, rail and barge adds up pretty quickly to a whopping $31 per barrel. But the end result is selling the oil at Brent pricing. The link of this source is here.

3) The new pipelines (Seaway, Keystone South Leg). Seaway used to move refined products north from the Gulf Coast but has now been flipped to carry oil south. It is currently moving some 150,000 barrels of oil a day. Volumes are expected to rise through the year to reach 400,000 bpd by early 2013. The pipeline's owners would ideally like to twin the pipe, but regulatory proceedings for that project are not yet under way. The much-debated Keystone XL pipeline will also help. While routing and approval for the northern section of the pipeline are still under debate, the southern leg of the project, running from Cushing to the Gulf Coast, could be operational in late 2013.

In terms of the significant role of the Seaway pipeline, Tuscany Energy (OTC:TSCAF) notes: "Tuscany expects WTI oil prices to remain above $90 per barrel through the balance of 2012, as the demand for oil continues to be strong and distribution bottlenecks at Cushing, appear to have been alleviated with the reversal of the Seaway Pipeline. The Seaway Pipeline now allows oil to be delivered from Cushing to the US Gulf Coast. Using current heavy oil discounts, this should result in the company realizing average prices for its heavy oil production in excess of $60 per barrel for the remainder of the year. At this price the company believes continued development of the heavy oil projects have very positive economics." The link of this source is here.

The M&A activity

The M&A activity looks to be quite brisk in the heavy oil arena for 2012. So let's have a quick look on it:

1) Apart from the natural gas and light oil buyouts of the Canadian companies by the Asian energy giants, the Asians hit recently the heavy oil projects of Canada. So after Nexen (NXY) and its heavy oil projects which were acquired by China's CNOOC (NYSE:CEO), a Korean fund bought few days ago a 70% stake of Twoco's working interest in the Company's Sparky heavy oil property in the Warspite area of Alberta for C$28 million. The Warspite area is close to the Lloydminster area, the motherland of the heavy oil projects. Twoco's current production from the heavy oil property is approximately 150 bopd of oil and natural gas liquids. To me, this is another indication of the Asian landing into the heavy oil projects of Canada. The valuations of this transaction in the heavy oil arena also look to be quite good and this event will spark the interest of other Canadian heavy oil producers to look for buyers in Asia if they want a capital infusion.

2) Athabasca Oil (OTCPK:ATHOF) has already made one deal on its heavy oil properties. It took place in Jan 2012 with PetroChina (NYSE:PTR) which bought the 40% stake in the MacKay River Oil sands project it did not own for US$ 673 M. So now PetroChina owns 100% of this project. The second deal for Athabasca is about to occur soon as it has already signed an LOI with Kuwait Petroleum for a C$4 billion deal for its Hangingstone and Birch oil sands properties.

3) Twin Butte Energy (OTC:TBTEF) keeps being a very active heavy oil buyer in the greater Lloydminster area. Twin Butte recently announced its third acquisition this year, a private heavy oil producer called Waseca Energy owned mostly by Sprott. TBE's acquisitions have been transformational as it built a solid foundation for production growth and acquisitions. This intermediate heavy oil producer has been very successful with its new business model and it is one of a few oil weighted producers that can boast a sustainable yield. The Waseca acquisition is certainly not TBE's first one. The company initially acquired Emerge Oil and Ga last January and followed up with the acquisition of Avalon Exploration (private) in August 2012.

4) Palliser Oil (OTC:PSLRF) is also active lately and it acquired certain producing heavy oil properties (140 boepd with 98% heavy oil) in the Lloydminster area from a number of private companies for $5,3 M.

The junior and intermediate players

1) Rock Energy (OTCPK:RENFF) experienced a transformational year in 2012. The formerly natural gas weighted Rock Energy sold almost all of its natural gas producing assets for $82 M in Q1 2012, it paid off all the debt and it has been drilling on its heavy oil assets in Lloydminster with the remaining cash on hand. So now it is debt free, it is 100% oil focused, it has a production of 2,300+ boepd (74% oil and liquids) currently which grows consistently every quarter. As it has also initiated a water flood project, Rock Energy estimates to hit an average 2,400 boepd (79% oil) production for 2012 and exit Q4 2012 at 2,700-2,900 boepd through its low risk, low decline and low cost drilling activities in Lloydminster. The insider ownership is significant and ARC Resources (OTCPK:AETUF) also holds a 18% in this company. The recent low cost oil discovery in Mantario seems to be a very significant heavy oil pool for Rock's further growth. Rock Energy trades for only 17,000 $/boepd (74% oil and liquids) and $4,5 per Mboe for its oily 2P Reserves (8,3 MMboe with 79% oil) which are obviously dirty low valuations. Rock Energy trades well below its book value (pbv=0,3) and at 2x its funds from operations annualized. As the Net Asset Value stands at $3,46 it also trades at 0,3 of its NAV. The company has 83,000 current net undeveloped acres and it aspires to become a dividend payer in a few years if it is not acquired by the other heavy oil operators of the Lloydminster area which are mentioned below.

The current gross undervaluation of Rock is also apparent when we see that Twin Butte acquired the private Avalon in June 2012 for $89 M, debt included. Avalon had a production of 1,920 boepd and 5,2 MMboe 2P Reserves which are much lower than Rock's current production and 2P Reserves. Twin Butte also paid $127M to acquire the private Waseca (debt included) which had 3,500 boepd production (100% heavy oil) and 8MMboe 2P Reserves.

2) Palliser Oil has two core areas which are the Lloydminster heavy oil area and a natural gas area located near Medicine Hat, Alberta. The company is currently focused on the higher netback conventional heavy oil production in the greater Lloydminster area. It produces 2,400 boepd currently (98% heavy oil), it estimates to exit 2012 at 2,600-2,800 boepd and it has 62,000 current net undeveloped acres. It trades at 33,000 $/boepd and 3x its funds from operations annualized with a pbv=0,9. In addition Palliser Oil has 4,2 MMboe 2P Reserves after the latest acquisition and thus it trades at $19 per Mboe.

3) Twin Butte has been expanding all along 2012 and it has completed 3 heavy oil acquisitions thus far as it has already been mentioned above. As it has been so aggressive in its core Lloydminster area, its shareholders wonder which company Twin Butte will buy next there. According to the latest corporate presentation, it produces 19,100 boepd currently (89% oil and liquids) with the third acquisition included and it trades at 44,000 $/boepd. Its market cap is 5x the funds from operations annualized. It also gives a 7% dividend annually.

4) Baytex Energy (NYSE:BTE) produces primarily heavy oil from the Lloydminster and Peace River areas. The heavy oil is more than 70% of its total production which is around 54,000 boepd (86% oil and liquids) currently. Its light oil production is focused on the Bakken formation of North Dakota and the company pays a 5,5% dividend annually. As Baytex has 231 MMboe as of Dec 2011, it trades at 110,000 $/boepd (86% oil and liquids) and at $28 per Mboe.

5) Longview Oil is a spin-off of the gassy Advantage Oil and Gas (NYSE:AAV) which still owns 45% of it. Longview operates in 3 core areas of West Central Alberta (light oil), Southeast Saskatchewan (light oil) and Lloydminster area where it produces heavy oil of course. It has a production of 6,300 boepd currently (74% oil and liquids), 38MMboe 2P Reserves and it pays an 8% annual dividend which is questionable as it is paid partly by the credit line. Since the credit facility is definite, I estimate the company will most likely reduce the dividend soon if the funds from operations do not rise significantly in the short future. The NAV is $15,12 and the company trades 6x the funds from operations annualized.

6) Bonavista Energy (OTCPK:BNPUF) has 3 core areas. Northern and Western Alberta are for the production of oil and liquids rich natural gas and it also produces heavy oil from the Lloydminster area of its Eastern Alberta properties. After the latest natural gas weighted acquisition, it produces almost 75,000 boepd (61% natural gas) and it has significant insider ownership (13%). Although it is very gassy, it has a low operational cost which gives it the ability to pay a 8% dividend annually. However the sustainability of this dividend is questionable as it is funded partly by the credit facility currently due to the low natural gas price. Bonavista has an EV of $4 billion so it trades for a decent 54,000 $/boepd (61% natural gas) and $11 per Mboe.

7) Marquee Energy (SKWEF.PK) has a 2,900 boepd production currently (55% oil and liquids) and a significant portion of its oil production is heavy oil which is produced in Lloydminster of course. Marquee has completed 3 acquisitions during the last 12 months and it has grown both the light oil and the heavy oil divisions significantly. However Marquee still remains very gassy. It has 12,6 MMboe 2P Reserves so it trades for 35,000 $/boepd (55% oil and liquids) and $8 per Mboe. According to the latest corporate presentation, "Marquee is actively pursuing opportunities to expand its position in Lloydminster area." So I will watch closely which company will be the next target of Marquee in Lloydminster.

8) NuVista (OTCPK:NUVSF) is another gassy company (70% natural gas) which is attempting to become more oil and liquids weighted. Its oil production has a significant portion (50%) of heavy oil from Lloydminster. After selling some assets recently to pay off its long term debt, it has a 16,200 boepd (70% natural gas) current production and 81MMboe 2P Reserves. It trades at 33,000$/boepd and $7 per its gassy MMBoe.

9) BlackPearl Resources (OTCPK:BLKPF) operates in 3 core areas which are the Blackrod and Mooney properties in Northern Alberta and the Onion Lake in the Lloydminster area. The company constructed in Blackrod in 2011 its own oil sands project which is at the very beginning of its production phase with 400 bbl/d production currently. BlackPearl produces 9,500 boepd (99% oil) primarily from conventional wells at its Onion Lake in Lloydminster. It has 36MMboe 2P Reserves and it trades at a rich valuation of 115,000 $/boepd and $31 per Mboe.

10) Southern Pacific Resource Corporation (OTC:STPJF) operates the Senlac thermal project with a 4,156 bbl/d production currently. It also completed the McKay thermal project (first phase) in June 2012 which is going to produce the first oil by the end of 2012. The McKay project has a design capacity of 12,000 bbl/d. Southern Pacific is going to produce bitumen from this project through the exploitation of its oil sands assets. The company has a C$900 M enterprise value and 234 MMbbl 2P Reserves currently.

11) Bankers Petroleum (OTCPK:BNKJF) produces heavy oil in Albania. It has a 15,000 bopd (100% heavy oil) production currently and it submitted recently a bid for the privatization of Albpetrol, the state owned oil company. It trades for 60,000 $/bopd with a rich 2012 pe = 22 despite the social turbulence and the general lack of political stability in that former communist country.

To be continued soon with a second article about the major heavy oil producers....

Disclosure: I am long OTCPK:RENFF, OTC:TBTEF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.