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Why look for value in energy exploration and
production when you can get growth? For Global Hunter Securities' Senior
Analyst Philip McPherson, the story is first about taking advantage of supply
and demand fundamentals in the critical industry of E&P, and then getting
a deal on oil in the ground. In this exclusive interview with The Energy
Report, Philip outlines the characteristics he looks for in companies and
where his growth thesis can pay off for investors.
The Energy Report: Your area of coverage is
exploration and production. Do small caps and large caps trade similarly? Do
they follow similar patterns?
Phil McPherson: Yes. In the exploration and
production (E&P) space as a whole, it's a pretty simple business model.
The size of the company is basically a reflection of the ability to
accelerate that business model. And your ability to execute and meet
timelines usually has just as much of an impact on your market cap as the
success or the failure of the actual oil and gas (O&G) play. I'm covering
many California companies, including Berry
Petroleum (NYSE:BRY), Plains Exploration &
Production (NYSE:PXP) and this small
oil producer that I stumbled across, NiMin
Energy Corp. (TSX:NNN).
I think they all have the same type of idea. But in terms of how they trade,
every company is in some ways going to trade as does the commodity. So you're
going to go up and down on certain days because oil's up and oil's down. I
used to joke with people that you could announce the best well in the world,
but if oil prices are down, your stock is going to
go down. A small cap of $100 million to $500 million trades more on the net
asset value (NAV) or the value of the perceived potential of your properties.
When you get to that $500 million– $2 billion area, you start looking
at a multiple of EBITDA (earnings before interest, taxes, depreciation and
amortization) or cash flow multiples. When you get to be large cap, you're
really more of an earnings story; then you start thinking about P/E ratios
and cash flow ratios.
TER: Do inflationary pressures point towards higher
oil prices?
PM: With the economy recovering,
and as more people feel that the double-dip recession is not going to happen,
oil prices are tending to stay stronger. However, it seems to me the tail is
wagging the dog right now, with the U.S. dollar going down and the price of
bonds being up, and the yield being extremely low. To me, it has more to do
with the price of oil than necessarily the pure supply and demand
fundamentals, because we still have excess supply of oil via OPEC. If you're
bullish on oil or bullish on the economy, then you use those dips as
opportunities to gain more exposure.
TER: What about inflationary effects on margins?
PM: The biggest inflationary costs we're seeing
right now are on unconventional completion services, like fracking
crews, cementing and pressure pumping. But as with any business, when the
demand is there and the visibility is there, entrepreneurs rise up to the
challenge because they know they can make money. I think you're going to be
surprised that in 2011 the likes of Halliburton
Co. (NYSE:HAL) and Schlumberger Ltd. (NYSE:SLB),
as well as lot of other smaller companies, are going to have more crews out
working. There's going to be enough demand there. It's all a function of oil
prices, and as long as they are in this relative range, people are going to
continue to drill these wells. I don't think margin makes as much of an
impact as the NAV that you can grow with these companies via drilling these
wells and growing reserves.
TER: I know it's not your area, but would you
expect the vertically integrated oil companies and the oil field service
providers to benefit more from an inflationary environment than the E&P
companies?
PM: I think the oil field service guys will
definitely benefit because they're going to put more crews to work. They're
going to hire more people. They're going to be able to generate more revenues
and thus make more money. I've always stayed away from the vertically
integrated guys. The old joke in the oil patch is that you never make any
money on refining. That business has a very weird dichotomy, and it just
doesn't seem like these guys really ever make that much money. So I don't
know if it really affects them as much, but they can pass higher prices along
to the consumer.
TER: Phil, do investors have more leverage with
E&Ps than they do with these other kinds of companies?
PM: I've always believed that they do. The argument
against that concept used to be that if you're a service company, you don't
have the volatility of oil and gas prices to deal with, and you therefore
don't get hurt as much. I would argue that now they trade together. When oil
prices go up everybody goes up, and when they come down everybody comes down.
Where the real difference is, I think, is in value creation. That means an
oil company can literally go out and change the value of the entire company
in one day with one wellbore. It can make one discovery in one field, and set
in motion something that can last for 10 years. You don't get that type of a
big upside surprise from a service company overnight, but an E&P company
can really hit a home run and change the fates of the company and the
shareholders overnight.
TER: But the risk is greater in E&P.
PM: Well, for that perceived dry hole risk. Or if
they're betting everything on one well, but I think we've gotten away from
that. I would say 90% of companies right now are involved in more than one
type of project. You might be in the Bakken and the
Eagle Ford and the Niobrara Formation or whatever. So you don't have that
one-trick pony. There are still some that are pure plays, and I'm looking at
one now. Now, in general, it seems like the unconventional plays have taken
out some of that old-time wildcatter spirit—where you're going to be
either hero or zero. Some of the offshore guys like the McMoRan's
(McMoRan Exploration Co. (NYSE:MMR)
) of the world, with
their deep shelf stuff, are kind of unique. But all in all, I don't think
there is as much of that kind of mentality as there used to be.
TER: What is the minimum dollar price per barrel that
oil has to maintain for a small-cap E&P company to make money?
PM: That's not going to be necessarily dependent
upon a company's market cap. It's really going to be about the project. You
have certain fixed costs, like your general and administrative (G&A), but
it's really more on a project-by-project basis. The highest cost oil in the
world right now is probably the tar sands, where you probably need $50/barrel
to break even. If you're in the deepwater Gulf of Mexico, there are barriers
because of the economics of infrastructure, and you're not going to develop a
small discovery there, so your threshold for commerciality is much higher.
I've seen companies with $150 million market caps that have better margins
than companies with $6 billion market caps. It just depends on the amount of
leverage a company has and what play it's in. Right now you can be in an oil
play and your margins are going to be much higher. But the gas guys are
really hurting right now. At $4 per thousand cubic feet equivalent (Mcfe), it's pretty hard to be making any money; and, in a
lot of cases, you're actually destroying shareholder value by continuing to
drill.
TER: Phil, when you're doing due diligence on a new
company that you might add to your coverage universe, what's the first thing
you look at? Give me an example or an anecdote.
PM: If something new pops up on the screen, like a
brand-new company, probably the first thing I'm going to do before I call
anybody is see what the capital structure of the company looks like. That's
because I think we've all learned, coming through this last couple of years,
with the credit markets tightening and things of that nature, is that no
matter how great a company looks, or what it has, or however great the
management team is, if it's not set up properly to succeed, then it's already
put on its own handcuffs.
I've always been kind of a stock picker, and I know that
capital structure and how your operations are funded are sometimes more
important than the operations you're going to fund. An example would be NiMin Energy, which I recently initiated coverage on.
When it went public, it didn't raise as much money as was desired. The
company was eventually able to get a term loan to replace some of their
short-term debt. It now has a five-year window of opportunity to take that
money and go out and execute, grow production, grow reserves, grow value. Now
it doesn't have any short-term financing needs, so if the [debt or equity]
market's not there, the company won't be backed up against a wall. I think
people have learned that you don't want to be a victim of the markets. You
want to be able to pick and choose when you raise capital, and raise it on
your terms, versus letting the market dictate it. I believe that is one thing
that most people overlook. Right now, I can buy NiMin's
proved reserves for around $9 or $10/barrel in the ground. Oil's trading at
$90, and there's obviously a huge gap between those two numbers. If you take
into account inflation and the declining dollar, you have a unique way to
think of resources. It's almost like buying gold, but you're actually buying
a company's reserves at an attractive price.
TER: What other small-cap companies have a proper
capital structure and management?
PM: I'll just stick with the California theme and
then go elsewhere. One of the more interesting names now, and possibly in
2011, that will have a lot of people scratching their heads is Venoco, Inc. (NYSE:VQ). A Denver-based independent, but all its assets
are based in California. It's 50% oil, 50% natural gas. But it has this
emerging play called the Monterey Shale. The Monterey Shale is the source
rock in California for a lot of the legacy properties. The founder of that
company believes he can use horizontal drilling and modern-day completion
technologies to unlock a lot of hidden reservoirs in California.
TER: That's just a hard way to get oil, isn't it?
PM: California is actually pretty fortunate in that
our rock quality out here is very good. Although the formation is called is
the Monterey Shale, the word "shale" is in quotation marks because
the porosity and permeability of the rock are 10–15 times better than
the Bakken Shale. So, rather than having to do
these long laterals with 30- or 40-stage fracks,
which cost millions of dollars, you can do a long lateral into this better
rock and you're going to get more oil out of it. The analogy I use is that
it's like pulling the tab on a shaken Pepsi or Coke can. Once the hole is
opened, the oil flows out naturally as it's under pressure; so, when you pull
that tab, it should flow relatively naturally through the wellbore and back
up the wellbore. Then, once the initial pressure drops, you can pump that oil
out of the reservoir.
TER: What would be a market-moving event for Venoco?
PM: The company stubbed its toe a little bit. Its
first Monterey Shale well encountered a water zone, and it watered out. The
stock went from $21 to $15 and is starting to recover here again. Its second
horizontal well is done, and is in production. The company hasn't released
any results on it. Its third horizontal well has just finished drilling, and
the fourth one is getting ready to start drilling. So, by the first quarter
of 2011 when they report year-end reserves, you should also have data on two
or three more wells. I think as people see the data and start to believe in
it, the floodgates will open and the stock will move materially higher. To
put things in perspective, right now when we talk about buying a barrels in the ground, Venoco's
proved reserves are valued at about $16–$16.50/barrel in the ground. We
talked about NiMin being at $9/barrel, which is probably one of the lowest valuations I can find in my
group and one of the reasons I like it. Venoco at
$16.50 is in the middle of, or still slightly below, the group. The group
right now is trading at north of $24/barrel in the ground from an
oil-weighted perspective. The point being, investors are not paying a lot for
the upside potential in the Monterey Shale. The company has amassed 150,000
acres. The fully undiscounted value of the Monterey could be a multiple of Venoco's current stock price. I like that type of risk
reward and I think it should serve investors well in 2011.
One thing that may give Venoco
legs is that OXY (Occidental Petroleum Corp.
(NYSE:OXY)),
the 800-pound gorilla out here in California, is running 10 rigs targeting the
Monterey Shale in 2011. The company has actually gone so far as to say they
think shale oil will be a top-10 business unit for OXY in the next 10 years.
For a $70-billion dollar company to say that is a pretty bold statement. The
last time I checked, OXY had zero debt and was buying back stock. A lot of
people don't realize that OXY is one of the largest oil producers in
California and in Texas. So while news from Venoco
will move its stock, news from OXY also could move Venoco's
stock, because from a small-cap investor's standpoint, you're not going to
buy OXY to make 5% or 10% of your money. You'd buy Venoco,
which could potentially provide a two-, three- or four-bagger.
TER: Was there another one that had the right
characteristics?
PM: Yes, there's one company that I recently
downgraded. You know, the life of an analyst is interesting because you have
to make long-term decisions and you also have to have short-term impactful
calls. So, in January this year (2010), I actually initiated on a company called
Magnum Hunter Resources Corp.
(NYSE.A:MHR), which is a second reincarnation of Magnum Hunter, at $2 a share, and
it recently hit my price target of $6 a share. It went all the way almost to
$6.50. So I downgraded it from a buy to a neutral on valuation, stating that
the stock had made a great move this year. We made investors a lot of money
and at this price, I wouldn't commit new capital to
it. West Virginia is a very natural resource favorable environment, with all
the coal and drilling that's been going on there for hundreds of years.
Magnum Hunter is in the West Virginia window of the Marcellus Shale. It's one
I'd be looking at buying on a dip.
TER: Magnum Hunter is up about 250% over the past
year. Congratulations on that one.
PM: Yeah. Not bad. Thank you.
TER: So, what other characteristics suit your
investment preferences?
PM: My newest foray has been looking at more
international opportunities. I cover Houston American Energy Corp.
(NYSE.A:HUSA), a company that is getting ready to drill some pretty high-impact
exploration wells in Colombia, of all places. I initiated that one at around
$3.50 or $4, and it's at $17 today. It's been a solid performer though we're
waiting for drilling results. The company is going to start drilling in the
first quarter. Houston American is like the old analogy that you can buy the
smallest house in the best neighborhood and the price of your house will go
up, right? Well, it's got this block in Colombia and it's surrounded by all
the big boys. A Canadian company has been drilling wells that have had
initial production rates in excess of 10,000 barrels a day. For onshore exploration,
you haven't seen anything like that in the United States in 50 years. We say
this is like being in Texas 50 years ago when people first started to drill
some of the Spindletop stuff and things like that. It's just the fact
that Colombia was such a bad place to be for the better part of the 20th
century.
TER: You see this company as low hanging fruit?
PM: Yes, because there haven't been a lot of wells
drilled. People were scared they were going to get kidnapped. Now, in the
last seven or eight years the country has had a democratic president that
pushed the terrorist FARC out of the country, improved the fiscal regime and
improved the oil and gas business. This guy came in and formed an entirely
new division of the oil and gas ministry and stopped all the automatic back
ends (royalties). There's a public company now, called Ecopetrol S.A. (NYSE:EC; TSX:ECP),
that has to compete in the licensing rounds along with everybody else. The
entrepreneurial spirit has been brought back.
TER: You have an accumulate rating on Rosetta Resources Inc. (NASDAQ:ROSE). You said in a note that it is divesting nine
core assets that would ultimately impact operating margins in a positive way.
It is converting from a natural gas to an oil company. What does this portend
for investors?
PM: They used to be just a conventional player,
mostly in natural gas. A new CEO, Randy Limbacher,
came in about two years ago from Burlington Resources' exploration group, and
he brought in a lot of his old guys from Burlington—good old-fashioned
oil and gas guys. The company started looking at basins and places where they
wanted to be. They ended up in the Eagle Ford Shale, and they were one of the
first to drill a well there. They acquired big blocks of acreage, the major
one being the Gates Ranch, which is about 29,500 net acres. So, now they've
got 10 years of drilling inventory just in that one property.
TER: We've mostly been talking about growth
stories. Are there any deep value plays in your universe?
PM: Well, you know, I don't look for companies that
are just deep value. They need to have a little bit of growth. But the one
that pops up to me is an offshore company called W&T Offshore Inc. (NYSE:WTI). It's only grown maybe 10% or 15% per year. But
at $16 a share right now, the company is trading at less than two and
one-half times cash flow. So that's relatively cheap. I would call that a
value story. They're looking at taking advantage of this post-Macondo operating environment, buying more assets in the
Gulf if they can get them at attractive prices. They are acquiring and
exploiting them, and they continue to generate huge amounts of cash-flow.
TER: There was one more story on your coverage list
that was zero-debt: Evolution Petroleum Corporation
(NYSE:EPM).
PM: Yes, that would be a sort of deep-value
company, and it's basically a play on oil. But its primary asset is a
revisionary working interest in an override on the Delhi Field. It bought
this field all-in for about $6 or $7 million, and sold it to Denbury Resources Inc. (NYSE:DNR) for $50 million. So Evolution got six or seven
for one on its money there, and then kept a 7.2% overriding royalty on a 25%
backend working interest. Denbury had to build a
$200 million pipeline to start injecting CO2, which it started doing in the
beginning of 2010. Now we're getting first response, and those reserves are
booked as proved. This company has an enterprise value of $160 million. In
the Delhi Field alone, there are about 12 million barrels. So it's about
$13/barrel to own this company with zero debt and 90% oil.
TER: Is there anything you'd like to leave with our
readers today?
PM: My closing thought is that what always amazes
me about investors, particularly in the oil space, is how scared they can get
when oil goes down. They feel like Chicken Little, like the sky is falling.
To me, if you believe in the global economy and you understand the supply and
demand dynamics with China and India, and that their economies are growing at
such rapid paces, it's very hard to poke holes in the oil thesis. Maybe oil
prices won't go to $100 or $150 overnight; but, over the longer term, they're
going to continue to trend higher. My advice has always been that when some
unemployment number or something comes out and scares the market, and oil's
down $2 or $3, those are the best days to sharpen your pencil and buy your
best companies.
TER: Phil, I've enjoyed talking with you. Thank
you.
PM: Thank you.
Philip McPherson joined Global
Hunter Securities in
June of 2007 as a senior equity research analyst in the firm's energy group.
Prior to joining GHS, Mr. McPherson was director of research at C. K. Cooper
& Company, a boutique investment-banking firm located in Irvine,
California, which focused exclusively on small-cap exploration and production
companies. In his role at C. K. Cooper, Mr. McPherson was responsible for new
initiations of E&P companies; additionally, he generated the firm's
macroeconomic analysis in relation to oil and natural gas price forecasts,
which generated the firm's price decks. Mr. McPherson was rated a five-star
analyst by Zacks in 2002, 2003, 2005 and 2006.
Prior to joining C. K. Cooper, Mr. McPherson was a partner in Mission
Capital, which was acquired by C. K. Cooper in 2001. Mr. McPherson began his
career in the securities industry at Mission Capital in March of 1998 as a
retail stock broker. He graduated from East Carolina University with a BA in
economics.
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