The Energy Report: Stephane, do you think the oil price has hit bottom and is now recovering?

Stephane Foucaud: When the Brent oil price was close to $50/barrel ($50/bbl), I think it was the bottom. It has recovered quite a bit. There is a risk that it might dip again, but I don’t think we will reach the low $50s for quite some time. The reason I think there is a risk that the oil price could dip is that there has been an overreaction to the North American rig fleet reports, and particularly to what appears to be a large number of rigs being taken out of the market. Those rigs are, however, associated with lower-producing areas. Therefore, I think it’s more sentiment than reality in terms of impact on the supply. The recovery has been too steep. 

TER: What prices are you forecasting for 2015 and 2016?

SF: For 2015, we are anticipating $59/bbl Brent. For Q1/15, we have $54/bbl; Q2/15 at $58/bbl; we expect to end up at $63/bbl. For next year, we have $72/bbl. The trend on the one-year view is upward, but with some fluctuation.

TER: The Islamic State of Iraq and Syria (ISIS) is growing in Libya, and is threatening the oil industry there. How would capture of the oil fields by ISIS affect commodity prices?

SF: Though it is part of the equation, and Libya is a problem, production in Libya has already dropped a lot, and is arguably already factored into the oil price. I think the situation in Iraq and Kurdistan with regard to ISIS is equally, if not more, important. If you have deterioration of the situation in Kurdistan and Iraq, that will have a positive impact on the oil price. Now, that has to be considered in the context of Venezuela potentially blowing up, which would be very serious, or Russia disappointing. And Russia is currently a black box.

TER: What do you mean by black box?

SF: There are currently sanctions on Russia. But I think most of the market does not really expect much decline in supply this year from Russia. Very few oil forecasting agencies have a detailed model as it applies to Russia, because there is very little visibility. So analysis is often focused on the U.S., and to the north in Canada, where there is a free flow of information and a lot of granularity. We don’t have that level of detail on Russia.

“There is a risk that the oil price could dip because there has been an overreaction to the North American rig fleet reports.”

Russia is one of the largest producers in the world. Any deviation from the broad assumption of production not dropping this year in Russia could be very meaningful. 

TER: You have a four-tier strategy for investment, and you’ve slotted some of your companies into one tier or another. How do you evaluate where they should go?

SF: First, I look at whether a company remains fairly defensive, even in the current oil price environment, on the strip curve for Brent. I am cautious about companies with overall asset value being marginal on the strip curve for Brent, or with funding issues on the strip. Second, I look at whether a company is operating in an area where the risk profile is not too high, so there is not something that could suddenly blow up. Taking too much political risk in the current market needs to offer really material upside. Third, I look at the share price and see where I find value on the house view for Brent. 

TER: How has the collapse in commodity prices affected the oil and gas companies you cover?

SF: First, their share prices have been hit extremely hard. Most companies have seen their share prices halved—and sometimes more than halved—but not all of them. The ones that are very well funded have been more defensive. Second, the fundamental values of the assets have gone down. Third, given the reduced cash flow, companies face issues with their balance sheets and the repayment of any debt. 

So today it’s about looking at companies that are able to survive in the current environment, and are still offering value on the strip. The companies we like in the current environment are those whose share prices have dropped much more than the underlying value of their assets, and those that are still funded. 

“If you have deterioration of the situation in Kurdistan and Iraq, that will have a positive impact on the oil price.”

Companies we like at the moment include Premier Oil Plc (PMO:LSE) and TransGlobe Energy Corp. (TGL:TSX; TGA:NASDAQ). Premier is a North Sea story, and the market is somewhat concerned with its debt. The company is embarking on a relatively low-risk exploration program in the Falklands. A success could attract a farm-in partner, which would be a rerating event as investors do not seem to ascribe much value to this group of assets. TransGlobe Energy is cheap, and arguably offers the benefit of being in an area where the politics are getting a bit better.

TER: How will TransGlobe Energy’s writedown of its Yemeni assets affect the company?

SF: I think the writedown was broadly expected. The situation in Yemen is difficult and pretty complex. We are not fundamentally surprised that the company decided to write down its assets. The contribution to the company value compared to shareholder expectation is absolutely minimal.

TER: How has Premier Oil responded to the collapse in oil prices?

SF: Premier has kept its net debt almost at the same level. The net debt level has been higher than the current market cap for some time. 

The fact that Premier explores in the North Sea means it is, by definition, quite sensitive to the oil price. At one point, the share price was half what it was before the oil price collapse. That’s quite significant given that Premier is one of the blue-chip exploration and production companies listed in London, with good hedge in place on its production. The shares are also very liquid. 

So it has been difficult. The value of the company has gone down because the oil price is lower and it has fairly high-cost assets. But, again, that’s what you’d expect in a world where the oil price drops.

TER: Premier has described its hedging policy as “conservative.” What does that mean in practice?

SF: It means that the oil price at which the company is hedged is quite high, and that a fairly important component of its production is being hedged. Particularly when you look at the lower oil price environment, the overall cash flow of the firm is enough—or close to being enough—for the company to operate with confidence. 

“Any deviation from the broad assumption of production not dropping this year in Russia could be very meaningful.”

For instance, if the indebtedness of a company is quite low, and if the costs associated with its assets are also quite low, one would argue that such a company would need less hedging than a company that needs a high oil price to make its assets work and to repay debt. By “conservative,” Premier means it is quite resilient to a low oil price, and can deal with fairly high-cost assets and a high level of debt. 

TER: Is there a last company you would like to mention?

SF: Our argument for Tethys Petroleum Ltd. (TPL:TSX; TPL:LSE) is based on growing production to China, increasing gas export price, and exploration upside in Tajikistan. But more than anything, it’s all about the completion of the deal with a Chinese private equity firm that would be buying 50% of Tethys’ Kazakh asset. The value of this deal is more than Tethys’ current market cap. At the time that this deal closes, the company gets over US$80 million (US$80M), which compares with a market cap at the moment of less than £30M (about US$45M). You can see the investment logic. This is almost 50% upside on the transaction with the Chinese private equity firm. Beyond that, there is production growth and exploration upside in Tajikistan. The upside is quite significant.

TER: How are you advising investors to proceed in the oil and gas space now, given current prices?

SF: Look for names that offer liquidity. Look at the value of a firm based on the future curve for the oil price, and look for companies that have value at that level. If the oil price gets better then great, there will be some upside. Our approach is quite cautious—liquidity, value on the strip, upside beyond the strip, and the relative assurance that there won’t be a serious debt issue in the near term.

TER: Thank you very much for your time, Stephane.

Stephane Foucaud is managing director, institutional research, of FirstEnergy Capital LLP. Before joining FirstEnergy, he was head of oil and gas research at Fox Davies Capital and senior oil and gas analyst at Société Générale in London, covering Royal Dutch Shell, BP, BG Group, Statoil and Cairn Energy. Foucaud also worked for Schlumberger for seven years in various technical, operational management and corporate strategy roles. He holds a master’s degree in engineering from the National School of Electrical and Mechanical Engineering of Nancy, France, a master’s degree in exploration production from the French Petroleum Institute, and a master’s degree in business administration from INSEAD in France.

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DISCLOSURE: 
1) Tom Armistead conducted this interview for Streetwise Reports LLC, publisher of The Gold Report, The Energy Report, The Life Sciences Report and The Mining Report, and provides services to Streetwise Reports as an independent contractor. He owns, or his family owns, shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of Streetwise Reports: None. The companies mentioned in this interview were not involved in any aspect of the interview preparation or post-interview editing so the expert could speak independently about the sector. Streetwise Reports does not accept stock in exchange for its services. 
3) Stephane Foucaud: I own, or my family owns, shares of the following companies mentioned in this interview: None. I personally am, or my family is, paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: Tethys Petroleum. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I determined and had final say over which companies would be included in the interview based on my research, understanding of the sector and interview theme. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview. 
4) Interviews are edited for clarity. Streetwise Reports does not make editorial comments or change experts’ statements without their consent.
5) The interview does not constitute investment advice. Each reader is encouraged to consult with his or her individual financial professional and any action a reader takes as a result of information presented here is his or her own responsibility. By opening this page, each reader accepts and agrees to Streetwise Reports’ terms of use and full legal disclaimer.
6) From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles and interviews on the site, may have a long or short position in securities mentioned. Directors, officers, employees or members of their families are prohibited from making purchases and/or sales of those securities in the open market or otherwise during the up-to-four-week interval from the time of the interview until after it publishes.

The Energy Report: Oil prices have made a minor recovery, with West Texas Intermediate (WTI) at about $50/barrel ($50/bbl) and Brent at about $60/bbl. Where are oil prices going in the short term?

Brian Bagnell: That’s a hard question to answer. What we know for certain is that prices will remain volatile throughout H1/15. The numbers bear this out, with the global supply/demand overbalance predicted to come in around 1.5 million barrels per day (1.5 MMbbl/d) in Q1/15 and 1.9 MMbbl/d in Q2/15.

TER: The U.S. oil rig count reached a five-year low earlier this month. How long before U.S. oil production shows a significant decline? 

BB: Our commodities team thinks the loss of another 150 rigs in the U.S. will bring the growing disparity between supply and demand back into balance. The rig count is being reduced by about 80 rigs per week, so the reduction will take a couple of weeks. Losing any additional rigs could mean we start seeing declines in late 2015.

TER: When U.S. production declines, will we see a price spike? 

BB: No. I don’t think we’ll be back to $70/bbl anytime soon. The forward curve for WTI—what we call the strip—suggests we will hit $60–61/bbl by the end of this year. That seems reasonable to me. 

TER: Do you believe in peak oil? 

BB: No, I don’t. Higher prices tend to spur innovation. We once thought that peak oil existed, but that was before we discovered horizontal drilling and multistage fracturing, etc., and those technologies still have not been applied to shale reservoirs worldwide. Potentially, a lot of untapped resource in the world still can be accessed through newer technology and improved efficiency. It is possible we could see peak demand before peak supply.

TER: Many oil majors and the banks that lend them money have taken tremendous hits with the collapse in the oil price. Does this suggest that loans will not be available for expansion of shale oil drilling in the near future? 

BB: Most bank lines are tied to reserve growth. What we’ve seen this year, so far, are year-over-year reserve increases. And the banks have tended to use price decks in the $65/bbl or higher range, which is obviously much higher than the current strip. This suggests they are still willing to increase credit lines, even in this environment.

TER: What conditions would lead to oil prices once again topping $100/bbl? 

BB: In the next couple of years, I can imagine only two. The first would be a geopolitical event, such as a Nigerian civil war or even greater turmoil in Libya and Syria. The second would be a decision by member nations of the Organization of the Petroleum Exporting Countries (OPEC) to break ranks and act unilaterally to decrease production.

TER: Would open Russian military involvement in Ukraine count as one of those geopolitical events? 

BB: Probably not. Ukraine is more of a gas-producing country than an oil-producing country. Armed retaliation against Russia from outside could cause prices to spike, but I highly doubt oil prices would reach $100/bbl.

TER: Since September, the price of natural gas has fallen from above $4.20 per million British thermal units ($4.20/MMBtu) to below $2.80/MMBtu. How badly has this drop hurt producers and explorers? 

BB: It’s had a tremendous impact. In this gas price environment, the key to survival is to have the lowest possible cost structure. We have seen some Canadian producers with low cost structures demonstrate pretty resilient share prices, even though gas prices are near five-year lows. There is a lot of gas out there, and only the most productive wells and efficient companies will continue to make a profit. 

TER: In the current cycle, how important is cash flow for oil and gas juniors? 

BB: Cash flow is always king—the foremost consideration for all oil and gas companies in any commodity price cycle. It’s more important now than ever. Cash flow is the top metric we examine, so long as the company looks solvent. And it is of even greater importance to the juniors, as they don’t tend to have as much access to capital as larger companies. 

TER: What’s your favorite Western Canadian junior gas producer?

BB: Advantage Oil and Gas Ltd. (AAV:TSX; AAV:NYSE). This company was a very different entity a year ago, when it was consolidated uneasily with a company called Longview Oil Corp. Advantage has since sold Longview to Surge Energy Inc. (SGY:TSX), and has become a pure-play Montney producer with a large, contiguous land base in the Glacier region of western Alberta. 

This company is trading at a discounted multiple compared to the rest of its peer group. It has a very solid balance sheet, and a decent amount of production growth coming in 2015, most of which has already been paid for and drilled. On a combined basis, cash costs have averaged between $6–7/barrel of oil equivalent ($6–7/boe) over the last couple of quarters, which puts Advantage in the conversation about lowest cash costs in western Canada. In a poor natural gas environment, all this looks very attractive.

TER: Advantage shares are up significantly recently. 

BB: The whole market has been up. Several Canadian small- and mid-cap companies are up similar amounts in the last few weeks. DeeThree Exploration Ltd. (DTX:TSX.V)comes to mind. But from my discussions with institutional investors, there is not a lot of attention being paid to Advantage as compared to some of its higher profile peers, such as Peyto Exploration and Development Corp. (PEY:TSX; PEYUF:OTC) and Tourmaline Oil Corp. (TOU:TSX). 

Canadian Gas-Weighted Peer Valuations

Courtesy Brian Bagnell, Macquarie Capital Markets

TER: Advantage has announced its intention to spend $735 million ($735M) in capital expenditures (capex) over the next three years. What do you make of that? 

BB: That has been the company’s plan for quite a while. And Advantage has been executing according to that plan, framed within the prevailing commodity prices environment of the last couple of years. The company recently reduced its three-year capex forecast to $545M; it was able to do so because of higher productivity and lower than expected declines from its 2013 Montney wells. Not a single one of its 33 wells drilled in 2014 has yet been tied in, which means the company can cut back on its spending and still hit its three-year growth targets. We like that Advantage has a measured, achievable pace of growth that it can finance internally; in my opinion, the market isn’t paying for big growth numbers anyway, like it was in mid-2014. Companies are being rewarded more now for having sustainable balance sheets.

TER: How big a producer could Advantage become? 

BB: Quite large, if it were to continue to fulfill the $735M plan. Certainly, the company could close to double its current production. Producing up to 50 thousand barrels of oil equivalent per day (50 Mboe/d) is not out of the question. 

TER: Which new Alberta oil junior do you like? 

BB: We recently initiated coverage on Toro Oil & Gas Ltd. (TOO:TSX.V), the newest western Canadian junior to be publicly listed. It is focused in the Alberta Viking play in the Provost-Halkirk region. It acquired its main asset from Zargon Oil & Gas Ltd. (ZAR:TSX) in November. 

There are a few interesting things about this company. The management has had past success. President and CEO Barry Olson was formerly CEO of Orleans Energy Ltd., which discovered the Ante Creek Montney pool and then merged with RMP Energy Inc. (RMP:TSX) in 2011. RMP has gone on to be very successful, with one of the most attractive assets in western Canada. Toro is focused on high netback Viking oil. Of course, netbacks for all oil plays in the current environment are challenged, to say the least, but the Viking is one of the plays we think will recover the soonest. 

TER: How does Toro stand for cash? 

BB: It has $12M cash on its balance sheet, which is a boast very few Canadian junior oil and gas companies can make today. Most have some form of bank debt, and that is hurting them in this environment. Toro, with its access to a $25M credit line, is in a position of strength. 

TER: How does Toro’s resource base compare to those of its peers? 

BB: We have compared it to Beaumont Energy Inc., a private oil and gas Viking producer in Saskatchewan. Beaumont acquired a similar-size pool in late 2012, began horizontal drilling on it right away, and was able to grow production from 1,000 barrels per day (1 Mbbl/d) to between 5–6 Mbbl/d in about two years. Toro’s oil pool is very similar to Beaumont’s, and it has seen very little horizontal development to date. With proper application and drilling techniques Toro should be able to enjoy a success similar to Beaumont’s. That is certainly not being priced into the stock today.

Toro Oil & Gas Case Study: Beaumont Energy

Courtesy Brian Bagnell, Macquarie Capital Markets

TER: You initiated coverage of Toro on Jan. 30 with a 12-month target price of $1.50/share. Shares are currently trading at about $0.68. That would be a 124% increase. 

BB: Yes. But that puts the stock at only a median multiple. The target price is based on a multiple derived from the average of all the Canadian small- and mid-cap companies we have under coverage today.

TER: Can you discuss a natural gas junior you recently assumed coverage on? 

BB: Storm Resources Ltd. (SRX:TSX.V) is another company doing great things in the Montney. Its main asset is in the Umbach region of British Columbia. It has increased its type curve every year, all while showing pretty significant production growth from its Montney wells. The company is reasonably valued and has a very conservative management team, which I like a lot. I like a team that doesn’t grow just for the sake of growth. 

TER: How does Storm’s balance sheet look? 

BB: We quote based on current forward pricing, which we update every week because we don’t think the market is paying us for our commodity price forecasts. We think investors want to know where a company is trading on market-implied pricing. On that pricing, we see Storm staying below 1.8x debt:cash-flow through 2015, which is in the top tier of peers. We have Storm trading at around 9x 2015 enterprise value:debt-adjusted cash flow, which is about the median multiple of the gas-weighted group in Canada. It ranks among the highest of the gas-weighted group on current forward pricing in terms of production/share growth and cash flow/share growth.

TER: What are the company’s prospects for growth? 

BB: We like that Storm doesn’t give itself credit for much outside its core Umbach region, even though it appears the company has a lot of resource potential there and also, potentially, in the lower layers of the Montney. Storm’s share price has been on a roll in the last month, and we think it’s trading at a very reasonable valuation today.

TER: Can you name another Alberta junior that’s not growing solely for the sake of growth? 

BB: Manitok Energy Inc. (MEI:TSX) has decided to suspend drilling at its Entice and Stolberg properties and apply 80% of its cash flow to debt reduction in H1/15. This is a prudent move. This is survival of the fittest, and maintaining a flexible balance sheet so that you can come out on the other side when commodity prices improve is crucial. 

This company has had some good wells out of Entice, and some not-so-good wells. We think Manitok has a lot of potential in some of the formations on that property, but today, most of those wells are likely not economic. It makes more sense to wait the downturn out. 

TER: Manitok has hedged 70% of 2015 oil production at $93.67/bbl WTI, and its 2015 natural gas is hedged at $3.47/MMBtu. Is this prescient or commonplace? 

BB: It’s quite uncommon, actually. It is at the very high end of the entire Canadian small- and mid-cap space for hedging—probably the entire oil and gas universe. A lot of what Manitok has for hedges are in the form of puts. That’s a way to protect the downside without locking in your upside. Hindsight is always 20/20, but right now, what Manitok has done with hedging looks absolutely fantastic. 

I am personally a fan of hedging, and I think any company with a big growth component in its platform should hedge a considerable part of its production. This mitigates commodity price environments like today’s, when unhedged companies are forced to shelve rigs and abandon growth. Manitok is in good shape because of its prudence, and yet it is trading very cheaply versus its peers.

TER: Let’s talk an oil and gas junior outside North America you follow. 

BB: Serinus Energy (SEN:TSX) has operations in eastern Ukraine, Tunisia and Romania. Obviously, with all the strife in eastern Ukraine right now, it’s having a tough time. While the troubles haven’t affected its drilling operations, the government in Kiev has imposed policies that make it difficult for this company. For instance, capital controls have been instituted, and now it is essentially illegal for cash to be sent out of the country. Serinus gets most of its cash flow from its Ukrainian operations.

TER: Serinus’ Ukrainian operations are in the Donbass, the region that has demonstrated support for Russia, correct? 

BB: Yes, but its operations are north of the areas that have seen the most fighting.

TER: What’s your opinion of Serinus’ operations in Romania and Tunisia? 

BB: Its Moftinu project in Romania is very early stage. Both its wells discovered multiple hydrocarbon-bearing zones, and the company is moving forward with completion and testing in mid-March. It’s really too early to call, but it looks to be a very interesting prospect.

Serinus’ Sabria concession in Tunisia is more advanced. Its first horizontal well there started producing at a rate of 635 boe/d and grew to 1 Mboe/d after cleanup, an excellent result that warrants further exploration and development drilling.

TER: To close, can you describe a good 2015 strategy for oil and gas investors? 

BB: Again, this space will be characterized by extreme volatility, so it will not be for the faint of heart in the short term. Many Canadian companies are implying WTI prices of $70/bbl or higher, which means that they’ve already priced in a large chunk of the pending recovery.

TER: Is this perhaps a good environment for bargain hunters?

BB: There are some bargains to be found within the Canadian energy space. Some examples would be Advantage Oil and Gas, DeeThree Exploration and RMP Energy. All three are still trading at discounted valuations and could have potential for a catch-up trade.

TER: Brian, thank you for your time and insights.

Brian Bagnell, CFA, is a research analyst in Canadian oil and gas company analysis for Macquarie Capital Markets in Calgary. He was formerly an investment associate at the NB Investment Management Corp. He holds a bachelor’s degree in business administration (finance and accounting) from the University of New Brunswick. 

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DISCLOSURE: 
1) Kevin Michael Grace conducted this interview for Streetwise Reports LLC, publisher of The Gold Report, The Energy Report, The Life Sciences Report and The Mining Report, and provides services to Streetwise Reports as an independent contractor. He owns, or his family owns, shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of Streetwise Reports: Manitok Energy Inc. The companies mentioned in this interview were not involved in any aspect of the interview preparation or post-interview editing so the expert could speak independently about the sector. Streetwise Reports does not accept stock in exchange for its services. 
3) Brian Bagnell: I own, or my family owns, shares of the following companies mentioned in this interview: None. I personally am, or my family is, paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: Manitok Energy Inc., Toro Oil & Gas Ltd., DeeThree Exploration Ltd., RMP Energy. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I determined and had final say over which companies would be included in the interview based on my research, understanding of the sector and interview theme. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview. 
4) Interviews are edited for clarity. Streetwise Reports does not make editorial comments or change experts’ statements without their consent. Oil and stock prices were current as of the date of publication. 
5) The interview does not constitute investment advice. Each reader is encouraged to consult with his or her individual financial professional and any action a reader takes as a result of information presented here is his or her own responsibility. By opening this page, each reader accepts and agrees to Streetwise Reports’ terms of use and full legal disclaimer.
6) From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles and interviews on the site, may have a long or short position in securities mentioned. Directors, officers, employees or members of their families are prohibited from making purchases and/or sales of those securities in the open market or otherwise during the up-to-four-week interval from the time of the interview until after it publishes.