Apart from being an Andre Kostolany fan, as I pointed it out in my last article about Terra Energy, I am also a fervent fan of another idol whose name is Benjamin Graham. Graham is the founder of value investing, and his theory is that the safest way for an investor to survive in a tough market is to buy growing companies which trade below their book value. The difference between a growing company's intrinsic value and its market value provides a cushion of safety. This is the core of his philosophy, actually.
As I like the energy and the commodities sectors, I have read a lot about the Bakken formation in North Dakota and Montana during the last two years. Many articles have been released about the players which operate there such as GMX Resources (GMXR), Rosetta Resources (ROSE), Magnum Hunter Resources (MHR), EOG Resources (EOG), etc. That being said, I decided to move off the beaten path and I tried to find another overlooked prolific formation with similarly strong upside potential. This formation is the Beaverhill Lake in Alberta, in my opinion.
According to the National Energy Board of Canada, the Beaverhill Lake formation in the Swan Hills region is a Devonian aged carbonate reservoir. It covers a wide variety of limestones and dolostones that were deposited during the Middle Devonian, some 375 million years ago, when a large carbonate platform was situated in central Alberta. Since the 1950s, conventional oil and gas has been produced from the tall reef build-ups which represent some of the largest oil and gas pools ever discovered in Western Canada. The Swan Hills Field had an estimated 2.9 billion barrels of oil originally in place and had produced 0.9 billion barrels from its discovery to year-end 2010. BMO Capital estimates that there are an additional 2.5 billion barrels of oil in place in these potential unconventional developments around the Swan Hills Field.
As it happens in every formation, there are "Davids" and "Goliaths" in the Beaverhill lake formation, too. Since the Goliaths have always been looking to expand in their core areas, I thought to find an undervalued small player, thus a David in the Beaverhill Lake formation. This is how I picked Arcan Resources (ARN.V).
Operations
According to the corporate presentation, Arcan Resources (ARN.V) is a pure light oil producer which operates in Canada. It holds a large, contiguous land position in the Swan Hills oil play of 110,000 net acres (98% WI) which has excellent infrastructure (roads and pipelines) in place. The company has identified more than 400 potential horizontal drilling locations as of today. The light oil is considered "la creme de la creme" of crude oil and it is the most preferable oil from the refineries due to its low processing cost and higher margin versus heavy oil, for instance.
Fundamentals
Arcan is very profitable and also trades well below its intrinsic value, with a PBY of 0.27 currently trading at C$0.85. Therefore, it satisfies one of Graham's main criteria which focuses on "deep value." It has also strong growth year over year in everything from production to its top and bottom line (revenue, profits) so the company obviously satisfies Graham's second criterion as well.
The company has high operating netbacks ($/bbl) during 2012, and they will remain high for the next several months for several reasons. The primary reason is that the cost per well goes lower due to the increasing pricing competition among the drillers. Several drillers like Pioneer Energy Services (PES, Financial) have said lately that they face pricing pressure in their Canadian and U.S.-based operations as the natural gas rigs decline and the former natural gas drillers switch to oil and oil liquids drilling activities. To quote the statement from Pioneer Energy Services (PES): "Due to low natural gas prices and increased competition for energy services in oil and liquids-rich basins, we expect to see moderate pricing and utilization pressure for Drilling Services in the third quarter, which should be partially offset by the impact of deploying our new-build drilling rigs."
The long-term debt of the company consists of bank loans and convertible notes which mature in 2016, thus these notes are not an issue which requires an urgent remedy.
The total long-term debt after the latest two dispositions is C$300 million which gives an enterprise value of C$380 million currently. The company has 41 MMboe (98% oil) as of December 2011, meaning it trades for less than $10 per Mboe (98% oil) which is a very low metric. As the current production is 5,000 boepd (98% oil) approximately, it also trades for only 77,000 $/boepd (98% oil). Since the funds from operations annualized are estimated to be C$65 million approximately, the current market cap is just 1.2x the funds from operations annualized. The D/CF annualized ratio is 5, and this is what has to be addressed.
The company has initiated the sale of its non-core assets to reduce debt and it has sold two properties during the last six months. This disposition strategy is expected to go on for the next months. However, as mentioned above, the notes are due in 2016, so the DCF ratio annualized goes down to 3 if we take into account only the current bank loans which makes the debt situation more manageable.
The Price Drop in Second Quarter 2012
Some will wonder why the price dropped in late spring from C$6 to C$0.65. It was a combination of two factors. First was the severe correction of the stock exchanges. Second was the steep decline of the oil price which hit $77 per barrel.
Management
The insiders' ownership is 5% according to the latest corporate presentation. The current CEO has over 40 years' experience in the oil industry and has worked in several executive positions at other big Canadian energy companies (public and private) like Murphy Oil (MUR) and Amoco of Canada. The current president has over 20 years' experience in the industry and has spent much of his career in Tempest Energy and in Open Range (ONR.TO) which was acquired by the giant Peyto Exploration (PEY.TO) recently. The three vice presidents of production, engineering and exploration also have a cumulative experience of 45 years working either for Encana (ECA) or for mid-sized and junior oil players.
Guidance
The corporation's production guidance for 2012 is a production between 6,000 and 6,500 boepd (average) which is an 80% increase from 2011 levels.
Reasons for the Upside Potential
These are the factors which can trigger a significant rise at the share price:
1) Edmonton price has surpassed WTI price since August 2012, and this differential has ranged from $2 to $8, thus far favoring the Canadian oil weighted companies like Arcan which sell at Edmonton price. The old days where Edmonton price was lagging WTI price seem to have gone. The oil price has also found a floor for the next months due to the upcoming winter, QE3 and the political tensions and social unrest in the Middle East. These factors will strengthen further the quarterly funds from operations of Arcan, giving it more fuel to grow even at a modest pace year over year. Management has said that going forward, the company will continue to live within cash flow and that the new line exceeds the company's financial requirements.
2) The company has initiated waterflood operations lately. The effective waterflood techniques increase the production of the well from 50% to 120% according to the average industry data. Although waterflood takes time for results to manifest, the vice president of engineering, Kevin Gunning, and the vice president of production, Kyle Baumgartner, were buying shares over the last week. I think this almost guarantees that we have some decent IP rates from those wells. One of those vice presidents is also in charge of the waterflooding, which most likely means that the waterflood is working.
3) The banks are retaining Arcan's $200 million revolving credit line intact. This is another vote of confidence for the company's projects.
4) The M&A activity in the Beaverhill Lake is quite brisk and this is an additional factor that could fuel ARN higher. For example, Second Wave Petroleum (SCS.TO, Financial) received some unsolicited proposals in late February 2012 but the company preferred to stay free. We will see for how long. It is said that Second Wave was offered C$3.70 to C$4.00, but the insiders declined to sell as they believed that Second Wave Petroleum deserved a higher valuation after the extremely successful drilling results in early 2012 with IPs of 1,800 boepd. The thing is that SCS.TO truly hit very oil-filled wells in Beaverhill Lake, and this is why 4 out of the top 16 most productive oil wells in Western Canada during the 2010-to-2012 period belong to Second Wave Petroleum.
In addition, Midway Energy (MEL.TO) was acquired by WhiteCap Resources (WCP.TO) for $96,000/boepd in February 2012. Midway's production weighting is 67% oil and liquids, and it was one of the juniors of the Beaverhill Lake. It appeared on the Beaverhill Lake scene in mid-2011 and it had 23,000 net acres in Inverness and Swan Hills South. The Beaverhill Lake assets of Sure Energy (SHR.TO) were also acquired back in June 2012 as high as $150,000/boepd. That being said, Arcan could be an acquisition target primarily for Crescent Point (CPG.TO, Financial) as the giant Crescent Point already holds a 19% stake in it.
The Beaverhill Lake Potential Suitors
The notable major players in this formation which has been greatly de-risked are Apache (APA, Financial), Arc Resources (ARX.TO, Financial), Pengrowth (PGH, Financial), Penn West (PWE, Financial), Crescent Point (CPG.TO), Coral Hill (private) and Devon (DVN).
1) Apache has been one of the most active drillers on this trend since 2010, although it holds a relatively small land position of 55 sections in the House Mountain area to the North. Apache's well results here have been consistent with the industry average. However, interestingly enough, the company has been using horizontal laterals that are shorter than the norm.
2) Arc Resources carries a legacy position on this play in the Inverness/Swan Hills where it is the 100% WI owner and operator. The company owns 66 sections here. It has experienced stable, high-quality light crude oil volumes thus far. Arc completed financing of approximately $345 million and a debt issuance of $400 million in late August 2012. The total gives a cash pool of $745 million and its use remains to be seen.
3) Pengrowth holds a solid 260 net sections of land here, and it is one of the largest area landholders with exposure as far north as House Mountain and extending to the south to Carson Creek. It has been one of the most active drillers, and it plans to spend 40% of its total budget of 2012 on the Beaverhill Lake program. Pengrowth has been diligent in testing the horizontal multi-stage fracture stimulation concept in several different areas of the play, garnering industry average results. Two operated wells which were drilled and completed in first quarter 2012 showed an average IP-5 rate of over 800 boepd per well according to the Pengrowth second quarter 2012 report.
4) Penn West has a dominant position in the Beaverhill Lake play. The management team currently estimates that the company's 203 net sections of land hold 100 net drilling locations. The drilling activity of Penn West has been concentrated on the east side of Swan Hills East and Swan Hills South regions with results aligning well with industry averages.
5) Crescent Point has one of the largest land exposures to the Beaverhill Lake with 280 net sections. It completed a financing of $633 million just few weeks ago, which is another indication that this giant is about to hit again soon. Crescent Point has made a conscious decision to ramp up operations in 2012. Since January, the firm has struck just over $1.7 billion in takeovers, the latest of which was announced last May 2012. Under the latest agreement, Crescent Point bought the private oil and gas player Cutpick Energy, whose assets are in the Viking light oil resource play near Provost, Alberta. In exchange for the $425 million it is doling out, Crescent Point Energy will pick up production of 5,600 boepd, weighted approximately 65% to light oil.
Crescent Point says the new assets will "complement and consolidate" its existing position in the Alberta and Saskatchewan Viking light oil resource play. Crescent Point has announced a takeover in every month this year, except for April 2012. They may not seem like much because the largest was $625 million, but combined they total $1.7 billion. Crescent Point has acquired companies that operate on the Bakken, Viking and Shaunavon formations thus far. That being said, the core formation of Crescent Point which has not seen an acquisition as of today is the Beaverhill Lake formation in Alberta. Consequently, I expect Crescent Point to roll up the Beaverhill Lake formation and consolidate it sooner or later.
The peers
Now that we know the fundamentals and the current valuation of Arcan, let's check the current valuations of some other oil weighted Canadian oil players based on their latest news:
1) Spartan Oil (STO.TO) (2,800 boepd with 83% oil and liquids) trades for $130,000 per flowing barrel and the market cap is 8x the funds from operations annualized.
2) Raging River (RRX.V) (2,200 boepd with 97% oil and liquids) trades for $130,000 per flowing barrel and the market cap is 8x the funds from operations annualized.
3) Pinecrest (PRY.V) (3,000 boepd with 99% oil and liquids) trades for $130,000 per flowing barrel and the market cap is 5x the funds from operations annualized.
4) DeeThree Exploration (DTX.TO) (5,000 boepd with 70% oil and liquids) trades for 100,000 $ per flowing barrel and the market cap is 11x the funds from operations annualized.
5) Whitecap Resources (WCP.TO) (16,000 boepd with 67% oil and liquids) trades for $90,000 per flowing barrel and the market cap is 5x the funds from operations annualized.
6) Legacy (LEG.TO) (15,000 boepd with 85% oil and liquids) trades for $93,000 per flowing barrel and the market cap is 4x the funds from operations annualized.
Risks
Arcan is an exploration company which carries the inherent risk of disappointing drilling results as it applies to any oil exploration company. In addition, the oil price may drop significantly for a long period of time, creating problems in the quarterly funds from operations of the company which may not be able to serve its debt. On top of that, the share price is below C$1 currently, putting Arcan in the penny stock category although its market cap is $83 million. As a result, investing in penny stocks carries a higher-than-average risk. Consequently, investors should not rely solely on the information presented. Rather, they should use the information provided as a starting point for doing additional independent research on Arcan in order to form their own independent opinion.
As I like the energy and the commodities sectors, I have read a lot about the Bakken formation in North Dakota and Montana during the last two years. Many articles have been released about the players which operate there such as GMX Resources (GMXR), Rosetta Resources (ROSE), Magnum Hunter Resources (MHR), EOG Resources (EOG), etc. That being said, I decided to move off the beaten path and I tried to find another overlooked prolific formation with similarly strong upside potential. This formation is the Beaverhill Lake in Alberta, in my opinion.
According to the National Energy Board of Canada, the Beaverhill Lake formation in the Swan Hills region is a Devonian aged carbonate reservoir. It covers a wide variety of limestones and dolostones that were deposited during the Middle Devonian, some 375 million years ago, when a large carbonate platform was situated in central Alberta. Since the 1950s, conventional oil and gas has been produced from the tall reef build-ups which represent some of the largest oil and gas pools ever discovered in Western Canada. The Swan Hills Field had an estimated 2.9 billion barrels of oil originally in place and had produced 0.9 billion barrels from its discovery to year-end 2010. BMO Capital estimates that there are an additional 2.5 billion barrels of oil in place in these potential unconventional developments around the Swan Hills Field.
As it happens in every formation, there are "Davids" and "Goliaths" in the Beaverhill lake formation, too. Since the Goliaths have always been looking to expand in their core areas, I thought to find an undervalued small player, thus a David in the Beaverhill Lake formation. This is how I picked Arcan Resources (ARN.V).
Operations
According to the corporate presentation, Arcan Resources (ARN.V) is a pure light oil producer which operates in Canada. It holds a large, contiguous land position in the Swan Hills oil play of 110,000 net acres (98% WI) which has excellent infrastructure (roads and pipelines) in place. The company has identified more than 400 potential horizontal drilling locations as of today. The light oil is considered "la creme de la creme" of crude oil and it is the most preferable oil from the refineries due to its low processing cost and higher margin versus heavy oil, for instance.
Fundamentals
Arcan is very profitable and also trades well below its intrinsic value, with a PBY of 0.27 currently trading at C$0.85. Therefore, it satisfies one of Graham's main criteria which focuses on "deep value." It has also strong growth year over year in everything from production to its top and bottom line (revenue, profits) so the company obviously satisfies Graham's second criterion as well.
The company has high operating netbacks ($/bbl) during 2012, and they will remain high for the next several months for several reasons. The primary reason is that the cost per well goes lower due to the increasing pricing competition among the drillers. Several drillers like Pioneer Energy Services (PES, Financial) have said lately that they face pricing pressure in their Canadian and U.S.-based operations as the natural gas rigs decline and the former natural gas drillers switch to oil and oil liquids drilling activities. To quote the statement from Pioneer Energy Services (PES): "Due to low natural gas prices and increased competition for energy services in oil and liquids-rich basins, we expect to see moderate pricing and utilization pressure for Drilling Services in the third quarter, which should be partially offset by the impact of deploying our new-build drilling rigs."
The long-term debt of the company consists of bank loans and convertible notes which mature in 2016, thus these notes are not an issue which requires an urgent remedy.
The total long-term debt after the latest two dispositions is C$300 million which gives an enterprise value of C$380 million currently. The company has 41 MMboe (98% oil) as of December 2011, meaning it trades for less than $10 per Mboe (98% oil) which is a very low metric. As the current production is 5,000 boepd (98% oil) approximately, it also trades for only 77,000 $/boepd (98% oil). Since the funds from operations annualized are estimated to be C$65 million approximately, the current market cap is just 1.2x the funds from operations annualized. The D/CF annualized ratio is 5, and this is what has to be addressed.
The company has initiated the sale of its non-core assets to reduce debt and it has sold two properties during the last six months. This disposition strategy is expected to go on for the next months. However, as mentioned above, the notes are due in 2016, so the DCF ratio annualized goes down to 3 if we take into account only the current bank loans which makes the debt situation more manageable.
The Price Drop in Second Quarter 2012
Some will wonder why the price dropped in late spring from C$6 to C$0.65. It was a combination of two factors. First was the severe correction of the stock exchanges. Second was the steep decline of the oil price which hit $77 per barrel.
Management
The insiders' ownership is 5% according to the latest corporate presentation. The current CEO has over 40 years' experience in the oil industry and has worked in several executive positions at other big Canadian energy companies (public and private) like Murphy Oil (MUR) and Amoco of Canada. The current president has over 20 years' experience in the industry and has spent much of his career in Tempest Energy and in Open Range (ONR.TO) which was acquired by the giant Peyto Exploration (PEY.TO) recently. The three vice presidents of production, engineering and exploration also have a cumulative experience of 45 years working either for Encana (ECA) or for mid-sized and junior oil players.
Guidance
The corporation's production guidance for 2012 is a production between 6,000 and 6,500 boepd (average) which is an 80% increase from 2011 levels.
Reasons for the Upside Potential
These are the factors which can trigger a significant rise at the share price:
1) Edmonton price has surpassed WTI price since August 2012, and this differential has ranged from $2 to $8, thus far favoring the Canadian oil weighted companies like Arcan which sell at Edmonton price. The old days where Edmonton price was lagging WTI price seem to have gone. The oil price has also found a floor for the next months due to the upcoming winter, QE3 and the political tensions and social unrest in the Middle East. These factors will strengthen further the quarterly funds from operations of Arcan, giving it more fuel to grow even at a modest pace year over year. Management has said that going forward, the company will continue to live within cash flow and that the new line exceeds the company's financial requirements.
2) The company has initiated waterflood operations lately. The effective waterflood techniques increase the production of the well from 50% to 120% according to the average industry data. Although waterflood takes time for results to manifest, the vice president of engineering, Kevin Gunning, and the vice president of production, Kyle Baumgartner, were buying shares over the last week. I think this almost guarantees that we have some decent IP rates from those wells. One of those vice presidents is also in charge of the waterflooding, which most likely means that the waterflood is working.
3) The banks are retaining Arcan's $200 million revolving credit line intact. This is another vote of confidence for the company's projects.
4) The M&A activity in the Beaverhill Lake is quite brisk and this is an additional factor that could fuel ARN higher. For example, Second Wave Petroleum (SCS.TO, Financial) received some unsolicited proposals in late February 2012 but the company preferred to stay free. We will see for how long. It is said that Second Wave was offered C$3.70 to C$4.00, but the insiders declined to sell as they believed that Second Wave Petroleum deserved a higher valuation after the extremely successful drilling results in early 2012 with IPs of 1,800 boepd. The thing is that SCS.TO truly hit very oil-filled wells in Beaverhill Lake, and this is why 4 out of the top 16 most productive oil wells in Western Canada during the 2010-to-2012 period belong to Second Wave Petroleum.
In addition, Midway Energy (MEL.TO) was acquired by WhiteCap Resources (WCP.TO) for $96,000/boepd in February 2012. Midway's production weighting is 67% oil and liquids, and it was one of the juniors of the Beaverhill Lake. It appeared on the Beaverhill Lake scene in mid-2011 and it had 23,000 net acres in Inverness and Swan Hills South. The Beaverhill Lake assets of Sure Energy (SHR.TO) were also acquired back in June 2012 as high as $150,000/boepd. That being said, Arcan could be an acquisition target primarily for Crescent Point (CPG.TO, Financial) as the giant Crescent Point already holds a 19% stake in it.
The Beaverhill Lake Potential Suitors
The notable major players in this formation which has been greatly de-risked are Apache (APA, Financial), Arc Resources (ARX.TO, Financial), Pengrowth (PGH, Financial), Penn West (PWE, Financial), Crescent Point (CPG.TO), Coral Hill (private) and Devon (DVN).
1) Apache has been one of the most active drillers on this trend since 2010, although it holds a relatively small land position of 55 sections in the House Mountain area to the North. Apache's well results here have been consistent with the industry average. However, interestingly enough, the company has been using horizontal laterals that are shorter than the norm.
2) Arc Resources carries a legacy position on this play in the Inverness/Swan Hills where it is the 100% WI owner and operator. The company owns 66 sections here. It has experienced stable, high-quality light crude oil volumes thus far. Arc completed financing of approximately $345 million and a debt issuance of $400 million in late August 2012. The total gives a cash pool of $745 million and its use remains to be seen.
3) Pengrowth holds a solid 260 net sections of land here, and it is one of the largest area landholders with exposure as far north as House Mountain and extending to the south to Carson Creek. It has been one of the most active drillers, and it plans to spend 40% of its total budget of 2012 on the Beaverhill Lake program. Pengrowth has been diligent in testing the horizontal multi-stage fracture stimulation concept in several different areas of the play, garnering industry average results. Two operated wells which were drilled and completed in first quarter 2012 showed an average IP-5 rate of over 800 boepd per well according to the Pengrowth second quarter 2012 report.
4) Penn West has a dominant position in the Beaverhill Lake play. The management team currently estimates that the company's 203 net sections of land hold 100 net drilling locations. The drilling activity of Penn West has been concentrated on the east side of Swan Hills East and Swan Hills South regions with results aligning well with industry averages.
5) Crescent Point has one of the largest land exposures to the Beaverhill Lake with 280 net sections. It completed a financing of $633 million just few weeks ago, which is another indication that this giant is about to hit again soon. Crescent Point has made a conscious decision to ramp up operations in 2012. Since January, the firm has struck just over $1.7 billion in takeovers, the latest of which was announced last May 2012. Under the latest agreement, Crescent Point bought the private oil and gas player Cutpick Energy, whose assets are in the Viking light oil resource play near Provost, Alberta. In exchange for the $425 million it is doling out, Crescent Point Energy will pick up production of 5,600 boepd, weighted approximately 65% to light oil.
Crescent Point says the new assets will "complement and consolidate" its existing position in the Alberta and Saskatchewan Viking light oil resource play. Crescent Point has announced a takeover in every month this year, except for April 2012. They may not seem like much because the largest was $625 million, but combined they total $1.7 billion. Crescent Point has acquired companies that operate on the Bakken, Viking and Shaunavon formations thus far. That being said, the core formation of Crescent Point which has not seen an acquisition as of today is the Beaverhill Lake formation in Alberta. Consequently, I expect Crescent Point to roll up the Beaverhill Lake formation and consolidate it sooner or later.
The peers
Now that we know the fundamentals and the current valuation of Arcan, let's check the current valuations of some other oil weighted Canadian oil players based on their latest news:
1) Spartan Oil (STO.TO) (2,800 boepd with 83% oil and liquids) trades for $130,000 per flowing barrel and the market cap is 8x the funds from operations annualized.
2) Raging River (RRX.V) (2,200 boepd with 97% oil and liquids) trades for $130,000 per flowing barrel and the market cap is 8x the funds from operations annualized.
3) Pinecrest (PRY.V) (3,000 boepd with 99% oil and liquids) trades for $130,000 per flowing barrel and the market cap is 5x the funds from operations annualized.
4) DeeThree Exploration (DTX.TO) (5,000 boepd with 70% oil and liquids) trades for 100,000 $ per flowing barrel and the market cap is 11x the funds from operations annualized.
5) Whitecap Resources (WCP.TO) (16,000 boepd with 67% oil and liquids) trades for $90,000 per flowing barrel and the market cap is 5x the funds from operations annualized.
6) Legacy (LEG.TO) (15,000 boepd with 85% oil and liquids) trades for $93,000 per flowing barrel and the market cap is 4x the funds from operations annualized.
Risks
Arcan is an exploration company which carries the inherent risk of disappointing drilling results as it applies to any oil exploration company. In addition, the oil price may drop significantly for a long period of time, creating problems in the quarterly funds from operations of the company which may not be able to serve its debt. On top of that, the share price is below C$1 currently, putting Arcan in the penny stock category although its market cap is $83 million. As a result, investing in penny stocks carries a higher-than-average risk. Consequently, investors should not rely solely on the information presented. Rather, they should use the information provided as a starting point for doing additional independent research on Arcan in order to form their own independent opinion.
