Source: Tom Armistead of The Energy Report (5/15/14)
When differentials emerge, it’s time for investors to take notice. Phil Juskowicz, a managing director in Casimir Capital’s research department, smells opportunity in micro-cap oil and gas companies, which have lagged behind the small caps for the last three years. In this interview with The Energy Report, Juskowicz explains how they are undervalued, and why they are the ultimate leveraged plays in the (very likely) event of natural gas demand growth.
The Energy Report: Phil, thank you for joining us. The Casimir Micro-Cap Exploration and Production (E&P) Index and the Standard & Poor’s Small-Cap E&P Index diverged in 2011 after closely tracking for several years. Why is this an opportunity for investors?
Phil Juskowicz: Investors wanting exposure to small E&P companies may do well focusing on the micro-cap space rather than small-caps. The S&P Small-Cap E&P Index has substantially outperformed the Casimir Micro-Cap E&P index since the beginning of 2013: The S&P index is up approximately 70% and the Casimir index 20% during this period. As a result of this outperformance, the S&P Small-Cap E&P index trades at rather heady levels, for example, on an EV/EBITDAX basis, compared with some micro-cap E&P shares.
In our view, the divergence reflects, in large part, the desire to invest in companies with exposure to shale plays. Such companies are often the E&Ps that have the financial wherewithal to conduct expensive drilling programs. As these programs ramp up, cash flow rises, and the big companies become even bigger. Additionally, and partially as a result of that trend, the large companies are becoming increasingly oily, with the smaller companies left with the gas-prone assets, or with plays that are less sexy, such as recompletions and workovers. As a result of these trends, we believe that some of the shares of the larger companies may be getting ahead of themselves, and that some of the microcap names offer compelling investment potential.
The micro-cap names we will discuss shortly actually have exposure to some of these shale plays, and are undervalued, in our opinion. Additionally, we believe that shares of other micro-cap E&P companies that are not in the shale plays may warrant analysis as well. As I said, these companies are often working on natural gas, rather than oil, assets. By 2020, we expect industrial demand for natural gas to increase some 15 billion cubic feet per day (15 Bcf/d), or 65%. Coupled with new demand from liquefied natural gas (LNG) exports of 7 Bcf/d, we are constructive toward natural gas prices.
TER: In Ohio, the state responded with restrictions on hydraulic fracturing after geologists found a “probable connection” between fracking and a series of minor earthquakes in the state. Ohio has both the Marcellus and Utica shales. What effects will the restrictions have on production there?
PJ: The drilling restrictions act as a reminder that the shale revolution is not without risk. We can’t assume that shale drilling will continue unabated. Nevertheless, we don’t believe that the restrictions, which govern permits within three miles from a known fault or area of seismic activity, will seriously affect drilling and production. Most of the industry activities are occurring outside of these zones, and the Ohio Department of Natural Resources has continued issuing drilling permits. We have not observed any drilling restrictions related to seismic concerns in any other major producing states. I believe Vermont and Massachusetts may have talked about drilling restrictions related to the issue, but those are not sources of significant production.
TER: What companies are you following in the oil and gas space that could benefit from some of these trends?
PJ: We cover a couple of companies that may benefit from being involved in the shale plays. Two such companies are PEDEVCO Corp. (PED:NYSE.MKT) andTrans Energy Inc. (TENG:OTCBB), which operate in the Niobrara and the Marcellus, respectively. And we recently initiated coverage of ENSERVCO Corp. (ENSV:NYSE.MKT), which is an oilfield service company that’s benefiting from the shale boom, though its services extend to other areas as well.
TER: PEDEVCO is talking about expanding operations in Asia. What opportunities does it see there?
PJ: It has an acquisition in process that’s anticipated to close in September in Kazakhstan, but I’ve liked the company to date more because of its focus on the Niobrara Shale. The company has a net enterprise value of about $60M. The current present value of its assets is significantly more than that, in our opinion. Recently, it purchased Continental Resources Inc.’s (CLR:NYSE) assets in the Niobrara with a PV10 of more than $100M, and it bought that for just $21M. It funded the acquisition with a 50/50 joint venture with a natural resource-focused private equity firm, which enables PEDEVCO to develop its now 15,000 net acres in Weld and Morgan counties, Colo. The company just reported healthy IP rates for three new wells drilled by Bonanza Creek Energy (BCEI: NYSE) on the acquired acreage. We were encouraged by the fact that each of the wells demonstrated similar results, thus supporting the reservoir model, in our view.
It also has 3,500 net acres with Mississippian Lime potential. That is an area that SandRidge Energy Inc. (SD:NYSE) continues to call a core focus area for itself, and SandRidge is an industry leader in that play. We don’t cover SandRidge. Those assets are located in Oklahoma.
I would say that the Kazakhstan assets are a longer-term view. However, the company management has experience working internationally, with Frank Ingriselli, the CEO, having come from Camac Energy (CAK:NYSE). The company, in addition to the private equity firm I mentioned before, has a strategic investment from MIE Holdings Corp. (1555:HKG), which is China’s largest onshore independent oil company. So I believe that longer term, PEDEVCO could benefit from its international ties. In the short term, it’s focused on the Niobrara Shale and the Mississippian Lime in Colorado and Oklahoma, respectively.
TER: Is PEDEVCO exposed to any blowback or downside from the slowing growth in Asia and the possible sanctions on Russia?
PJ: No. In general, again, Kazakhstan is about to become one of the largest oil-producing countries in the world. And oil is an international commodity with international-based pricing fundamentals and drivers. Again, PEDEVCO’s presence in Asia isn’t anticipated to happen until September on a commodity that can float anywhere in the world. So I don’t believe that we should see any significant impact from an Asia slowdown or the crisis in Russia.
TER: Why did you upgrade your target price for PEDEVCO to $3.50 in January and now to $5?
PJ: We initiated coverage with a $3.50 target, and we upgraded the stock from Speculative Buy to Buy in January while maintaining the $3.50 target because we were excited about the opportunity and the value the company was getting from the acquisition of Continental’s assets in the Niobrara. Again, it bought $100M of PV10 assets for $21M. It paid $52,000 ($52K) per flowing barrel of production. So we were excited about that; we felt that there was less risk and the company warranted a Buy as opposed to a Speculative Buy rating.
We recently upgraded the target to $5 once the company got the financing for this acquisition, enabling PEDEVCO to further develop its acreage. Our $5 target consists of present value calculations of wells, for which financing is in hand. The financing helps the company to develop its acreage and obtain increased net present value from its acreage. Our target also included the pro forma debt associated with such financing. So despite the debt, its target increased.
TER: Trans Energy’s stock jumped more than 30% in late December and has stayed up since then. What is behind that?
PJ: It likely reflects superior well results in the Marcellus, which continues to improve on what are already industry-leading production metrics, meaning the Marcellus is a play that is continuing to show among the strongest results in the country. Trans Energy is one of the few publicly traded, pure-play Marcellus E&P companies. So what prompted the stock to potentially increase more than 30% since late December is the continuing good results coming both out of the Marcellus and out of the company itself.
The company had two recent wells that had 60-day average initial production (IP) rates of 9.5 and 6.2 cubic feet equivalent per day (9.5 and 6.2 cf eq/day) of production. That came in late January.
TER: If you could boil it down to one or two factors, is the company benefiting from good luck, good selection of drilling sites, good management or maybe all of them?
PJ: I would say there’s an aspect of good luck in that Trans Energy’s acreage happens to be located in what would become the nation’s most important source of natural gas, the Marcellus. However, we believe management has done an excellent job with, for example, the two wells that we mentioned before. The company and management operated in the Marcellus long before it became the play that it is today. I would say that the wells’ performance has been above industry norms. If you look at those IP rates as well as estimated ultimate recoveries per 1,000 ft of lateral, Trans Energy is a top-tier performing company, in our opinion. I would also just mention that besides management’s ability to execute on production, it did a good job of culling the asset base and selling down some acreage that we saw as non-core for Trans and utilizing the money to ramp up its drilling program in its core areas.
TER: ENSERVCO has a somewhat different business focus. What prompted you to initiate coverage of it in February?
PJ: We think that’s a company that has limited analyst coverage, undiscovered by the Street. Management, in our opinion, has done an excellent job of managing businesses in general and, most recently, applying that to ENSERVCO, an oilfield service company. ENSERVCO is the only national provider of frack heating, hot oiling and acidizing services to the oil industry. It has existing footholds in some of the largest-producing basins in the country and is leveraging some of those to launch into new areas, most recently going from the Marcellus into signing agreements with Utica producers as well. The Marcellus and the Utica largely overlie each other, and that abates the need to establish new yards.
TER: Is ENSERVCO mostly operating in those two formations?
PJ: Actually, half of its business comes from the Rockies. Just 20–25% at this point comes from the Marcellus and Utica region, with the remainder coming from what it calls the central region—Mississippian Lime, for example. In that region, in addition to frack heating, hot oiling and acidizing, ENSERVCO is essentially hauling liquid. That’s a lower-margin business. Well enhancement services businesses are much higher margin.
I don’t want readers to come away thinking that ENSERVCO is a company that is solely tied to new drilling and industry activity and, therefore, subject to the boom/bust cycle of the oilfield service and oil industry. While half of what the company does is in fact tied to new wells, the other half is servicing wells throughout the well life, for example stimulating older wells to produce again with acidizing and reducing paraffin buildup with hot oiling. Therefore, ENSERVCO isn’t as cyclical as a typical oilfield service company may be, as it provides its services throughout the well’s life.
TER: Has ENSERVCO expanded geographically in recent years?
PJ: In addition to the agreements it has made to service companies that are targeting the Utica formation, the company recently announced that it is going to be entering Texas. I think that it’s going to do that in a smaller way, without risking too much invested capital there. Just based on the company’s history, I believe that it will not enter a market unless it has some indications of interest either from new customers or from existing customers that also operate in a different region.
Most of the companies that ENSERVCO services are national E&P companies with operations in Texas as well, companies like Anadarko Petroleum Corp. (APC:NYSE) and Noble Energy Inc. (NBL:NYSE).
TER: Is ENSERVCO’s capacity expanding to meet these geographic extensions?
PJ: Yes. It has expanded its asset base over the past couple of months and has set itself up for additional revenue to come in. It is spending within its cash flow at this time. Management has demonstrated, in my opinion, prudent investment management principles.
TER: The conventional wisdom says that shale is the future, but some voices warn about rapid decline rates. What should a careful investor do?
PJ: Similar to what we were describing before about the risks potentially associated with high production declines or regulatory risks like we’ve seen in Ohio, I would suggest that investors diversify and focus on natural gas-based companies. We see some 15 Bcf/d of petrochemical plants coming online over the next couple years, and 5 Bcf/d of liquefied natural gas facilities coming online the next couple years. That adds up to a lot of new demand for natural gas.
Again, some of these gas-focused companies may have been overlooked by investors until now, and have some value potential. At the same time, companies that are focused on exploitation of older wells, what they call workovers and recompletion, could be a nice place for investors to diversify into if they want to put their money into commodity-focused companies.
TER: You’ve given a lot of good information here. I appreciate your time.
PJ: Thanks again for having me.
Philip Juskowicz , CFA, is a managing director in the research department at Casimir Capital, a boutique investment bank specializing in the natural resource industry. Juskowicz began his career at Standard & Poor’s in 1998. From 2001 to 2005, he worked in equity research at both First Albany Corp. and Buckingham Research. At Buckingham, Juskowicz was senior oilfield service analyst, leveraging his extensive knowledge of the E&P space. From 2006 to 2010, he served as a credit analyst at WestLB, a German investment bank. He earned a Master of Science in finance from the University of Baltimore.
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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 toStreetwise 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: ENSERVCO Corp. Streetwise Reports does not accept stock in exchange for its services.
3) Phil Juskowicz: 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: Trans Energy Inc. and ENSERVSCO Corp. My company has a business relationship and has received investment banking and non-investment banking compensation from the following companies mentioned in this interview: Pedevco Corp. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. 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.
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