Contrarians only: A “left-for-dead” energy opportunity with incredible upside today
From The Energy Report:
Sometimes a major’s trash is a junior’s treasure. That’s the story in East Africa, where majors began outlining resources and then ditched them for onshore assets. In their wake, junior companies with technical expertise are ready to unlock more wealth than the large caps thought possible. In this interview with The Energy Report, Canaccord Genuity Director of Research Christopher Brown fills us in on hidden opportunities in the rift basins of east Africa. He also shares an interesting perspective on how to make money on oil and gas ventures in Ukraine.
The Energy Report: Christopher, you cover oil and gas explorers operating in the rift basins of Africa and South America. How is the introduction of hydraulic fracturing technology affecting the oil and gas industry operating in these rift basins?
Christopher Brown: Fracking is in its infancy in the eastern African basins. Companies are mostly pursuing conventional targets. As these prospects mature, the companies will need to unlock the remaining resource. The idea is to identify the conventional targets first in order to understand the migration pathways from the source rock. Once those pathways have been identified, and the low-hanging fruit plucked, drillers will start fracking the source rock.
TER: What companies are you following in the African rift basins?
CB: Two companies are doing exceptionally well in the rift basins: Africa Oil Corp. (AOI:TSX.V) and Caracal Energy Inc. (CRCL:LSE). Both companies are run by Canadians who took their homegrown technology and expertise overseas, unlocking millions, if not billions, of dollars in resources that were overlooked by majors who had previously drilled in these regions.
TER: Why is the geology of rift basins propitious for fossil fuels?
CB: The rift basin complex is geologically interesting because the rifts form where the continent pulls apart. Ancient lakes coalesce inside the rifts into what we now consider to be source rock, and then sediments backfill the declivities. The East African rifts can be viewed from outer space; they are very dominant features in the modern landscape. As technologies improve, we can drill deeper, down into the ancient lake beds in the rifts to unlock the oil and gas. Since mid-2005, a flurry of exploration activity has identified billions of barrels of recoverable opportunity in these basins.
TER: What was the technological advance that allowed us to unlock the opportunities?
CB: Initially, it was drilling technology that allowed explorers to dig deeper while managing increasing pressure and temperature with improved mud systems. The next step is to enhance oil recovery with unconventional, complex fracking completions.
TER: What are the newest developments with Africa Oil Corp.?
CB: Africa Oil has successfully explored a number of plays on its Kenyan blocks. It is getting ready to submit development plans. Because Kenya does not have any oil production in place, the plan approval will likely be accelerated to enable Kenya to become a very significant contributor to the global oil markets.
TER: Will the approvals involve production sharing contracts?
CB: Yes; production sharing contracts are different from the concession contract, with which North American investors are familiar. Production sharing contracts are very lucrative and attractive to foreign investment because they allow for cost recovery. It enables an operator to recover its investment dollars upfront before the profit sharing component of the contract kicks in. After investors recoup their capital and operating costs, the state takes a certain percentage, and the investors keep the rest. It is a very good contract for emerging economies and encourages foreign investment.
TER: What is Caracal Energy doing in the rift basins?
CB: Exxon Mobil Corp. (XOM:NYSE) had tried to delineate a number of properties in the rift basin, and it left behind a lot of low-hanging fruit for the juniors. In Chad, Caracal analyzed the data and realized that with today’s Brent pricing, a lot of the exploration wells that Exxon had drilled and walked away from are now commercially viable. Incrementally, they found millions of barrels more oil than Exxon had originally deemed present in its portfolio of African rift plays.
TER: Where are these plays located?
CB: Caracal operates in the southern area of Chad. It enjoys excellent rapport with the locals. It abides by very high environmental standards, unlike some of the international companies in the region. As one of the only independents in the country, Caracal treats the Chadian environment and the Chadian people with respect.
TER: In terms of environmental standards, what is Caracal doing that is different?
CB: When it recovers drilling fluids, it stores them in a lined pit. Some companies dump the fluids into an open pit without lining it, and the fluids leak into the soil and water. That kind of contamination does permanent damage.
TER: Caracal was recently acquired by Glencore International Plc (GLEN:LSE). What’s the story there?
CB: Glencore is predominately an oil marketer. It generates billions of dollars marketing crude. Recently, it has moved into exploiting upstream opportunities. Caracal is Glencore’s first large upstream acquisition. Glencore bid high, because Caracal has a significant net asset value due to its proven reserves in the ground. Glencore incrementally benefits due to its ability to gain an increased margin by selling that crude itself. A lot of the Caracal group will probably remain with Glencore for the foreseeable future to assist in operations. And there are lucrative incentives for Glencore to acquire other operators in the region as it consolidates drilling and marketing operations.
TER: How did the acquisition affect the stock price of both parties?
CB: Glencore being a multibillion-dollar entity, its stock price appreciation was not as significant as Caracal’s, which appreciated 60%. The deal is still in the process of closing, but everyone that originally invested in Caracal ended up profiting nicely. We also saw a good valuation in the near-term for what Caracal has already unlocked in Chad; and there is much more to unlock.
TER: Let’s turn to South America. Which oil and gas explorer firms do you like there?
CB: We like Canacol Energy Ltd. (CNE:TSX) and Parex Resources Inc. (PXT:TSX.V), which are both operating in Colombia. The companies are well established with base production levels, and they are also pursuing fracking opportunities. Canacol has partnered with Exxon, ConocoPhillips (COP:NYSE) and Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) to pursue unconventional resources in Colombia that could turn out to be a multiple-billion barrel opportunity.
Parex, on the other hand, is taking an old-fashioned, western Canadian basin approach in Colombia. It is sliding down the resource triangle gradually. It does not require super large fracks, just a little bit more stimulation in tight rocks where there are conventional traps and recoveries.
In Argentina, we like Americas Petrogas Inc. (BOE:TSX.V) for its unconventional pursuits. It is leading the way for junior exposure to the Vaca Muerta. Argentina is looking up for foreign investments with the government’s recent settlements regarding the expropriation of the YPF ownership from Repsol. The government is now reimbursing Repsol for those expropriated assets. Consequently, three companies in Argentina—Americas Petrogas, Crown Point Energy Inc. (CWV:TSX.V) and Madalena Energy Inc. (MVN:TSX.V; MDLNF:OTCPK)—are experiencing very positive share price increases. This development shows that people are overcoming their former apprehensions about investing in Argentina and are now looking at what these companies are capable of unlocking in the region.
TER: How does the price to cash flow basis shape up in South America?
CB: South America is drawing a lot of attention now because our domestic E&P universe is getting pricey. On a price to cash flow basis, in general, our domestic E&Ps average about seven times price to cash flow. International price to cash flow ratios are still in the five times range. There is a great international investment opportunity for netbacks—solid cash flow for base investment with exploration upside in Colombia, Argentina, and Brazil.
TER: Who are you following in Brazil?
CB: Alvopetro Energy Ltd. (ALV:TSX.V) is pursuing a rift basin in Brazil, which is analogous to the East African basins. Alvopetro was doing pure exploration in Brazil, but through geological serendipity it came up with conventional opportunities that had been left behind by Petrobras (PBR:NYSE; PETR3:BOVESPA). Petrobras had massively migrated its investment out of the basin when the subsalt discoveries occurred offshore Brazil. Petrobras moved from the onshore regions, where Alvopetro now operates, to almost exclusively offshore. This situation is similar to how Exxon and Shell abandoned their smaller wells in the eastern Africa rift basin, leaving room for Africa Oil and Caracal to take them over.
TER: Let’s turn to the Ukraine, where there’s a great deal of economic uncertainty these days. How is the political situation affecting oil and gas development in the region?
CB: The Ukraine is a gas-focused country. Oil and gas operators in the Ukraine are still executing their programs, albeit with some apprehension. A lot of their operations are outside the major cities. They do not have to deal with government building occupations and protests. The direct operations themselves are not impacted. The overriding concern is whether a portion of the eastern Ukraine will be handed over to Russia. My contacts with the companies in the Ukraine say that a small group of people are causing a large amount of disruption and headlines. The larger population is not inclined to join Russia, even though they do speak Russian. “Been there, done that,” seems to be the prevailing mass sentiment.
TER: What firms are poised to do well in the Black Sea region as the politics shake out?
CB: We cover Cub Energy Inc. (KUB:TSX.V) and Serinus Energy (SEN:TSX). Both have operations in eastern Ukraine. We are cautiously optimistic on both of them. The reason for caution is that on a gas pricing basis, and netback basis, there was concern when Russia lowered gas prices in the region. We saw a bit of pressure on gas prices in the first quarter, but now we are starting to see Russia decoupling, it will no longer be able to sell low-cost gas to the Ukrainians.
That decoupling will fantastically benefit Serinus’ and Cub’s netbacks in the Ukraine. We are going to see an upward movement of the gas price into the $10–12 per thousand cubic feet ($10–12 Mcf), which will be amazingly profitable. Both companies have fallen under the investment radar, because no one wants to look at Ukrainian investments right now. In terms of being a contrarian regarding the Russian impact on the Ukraine, Cub and Serinus provide great entry opportunities at their current trading prices.
TER: How do their fundamentals shape up in terms of debt load and management skills?
CB: The two firms are interlinked because Serinus owns 70% of an entity called KUB Gas in Ukraine, and Cub Energy owns the remaining 30%. Serinus is the primary operator on the eastern side of the asset base. And in terms of EV to DACF, they both trade at good discounts, but Serinus gets an uptick because it is the operator. It currently trades forward EV to DACF at a 2015 estimate of 2.7. Cub’s EV to DACF is 0.9, which is substantially below the multiples that we see on the domestic side. Because the EV accounts for their debt position, it reflects how much of a political discount both of these companies are trading at because of their Ukraine exposure.
TER: Are there any other promising junior oil and gas firms that you like around the globe?
CB: For a safe investment, but with a nice exposure to Brent optionality for upside pricing, the best bet is Bankers Petroleum Ltd. (BNK:TSX) in Albania. It is run by David French. He is taking the low-cost producer approach and slowly building up production volumes. But he is also providing investors with an interesting upside for a polymer-enhanced type of recovery on one of Europe’s largest oil accumulations. Bankers Petroleum is worth watching!
TER: Thank you, Christopher.
CB: Take care, Peter.
Christopher Brown serves as director, research, international oil and gas at Canaccord Genuity and has provided international analytical coverage since 2006. Previously, Christopher worked as the international oil and gas analyst for BMO Capital Markets. Brown’s industry experience includes reservoir engineering work at various large-cap oil and gas companies. Prior to that, he was employed at an international M&A firm with mandates out of London. Brown holds a Bachelor of Science in chemical engineering.
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