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The oil party is not
over! In this interview with The Energy
Report, Hedge Fund Founder Josh Young explains how to get
the most returns out of a well-drilled oil field. There are plenty of
excellent opportunities in mature North American basins and Young tells us
why now is a good time to move in for the big kill.
The Energy
Report: Josh, what
is a "mature" basin? You're famously bullish on them.
Josh
Young: Mature
basins have well-known reservoirs and well-defined geologic characteristics.
Hundreds or thousands of wells are already producing in such basins. North
America has a range of them. My portfolio is almost entirely exposed to these
mature basins.
"There
is an old adage: 'The best place to find oil is an oil field.'"
Some of my
largest positions are in mature basins in Texas, Oklahoma and Kansas. One
company is active in the Sedgwick basin with the emerging Mississippi Lime
play, a horizontal redevelopment of vertical Mississippian wells, which were
originally drilled over the course of decades. And another company is active
in the East Texas field, which has produced for almost 100 years and is in
the process of being redeveloped.
TER: Why do you prefer the mature basins?
JY: There is an old adage: "The best place to find
oil is an oil field."
TER: What is the risk of being a Johnny-come-lately?
JY: Risk is always an issue, whether it's a new field
or an old field. It is important to do due diligence and evaluate the risks
in any investment.
TER: How does peak oil factor into your investment
strategy?
JY: I don't think we are running out of oil anytime
soon. But we have run out of cheap oil and are having more trouble
growing production and replacing existing reserves. Now we have to go into
shale or redevelop existing fields. This costs more money, of course, and
calls for higher oil prices, but it is not the same kind of scary situation
as that associated with peak oil.
TER: Is there an indefinite amount of oil for us to be
able to access in tandem with technological development?
JY: It is not indefinite. There is obviously a limited
amount, but there is more than has been predicted in certain circles. There
have been Malthusian predictions of mankind's running out of various
resources for hundreds of years. We typically overcome natural resource
obstacles by inventing new technologies. The biggest recent technological
improvements in oil production have been horizontal drilling combined with
hydraulic fracturing as well as tertiary recovery from carbon dioxide and
other solvents and surfactants that increase the recovery rates from existing
fields, as well as deep water drilling. These methods are very expensive and
are raising the marginal cost of production.
TER: Let's talk about your stock picks in the mature
basins.
JY: Gale Force Petroleum Inc. (GFP:CVE) is
focused on oil fields in East Texas. Its stock hasn't performed very well the
last few months, but at the same time, its production just keeps growing.
Last June, it was at 150 barrels per day (bbl/d),
and as of its latest report, it is producing more than 460 bbl/d. Management has provided guidance of more than 800 bbl/d by early next year. It is growing rapidly. It
trades at a low enterprise value versus production multiple and a low cash
flow multiple. At some point it will get big enough to catch a bid or will
trade in line with its peers.
TER: Why is Gale Force's share price not in line with
production?
JY: It's a Canada-traded company located primarily in
East Texas. Even though it has successfully grown production and deployed
capital more efficiently than other, better-known growing oil companies like Kodiak Oil & Gas Corp.
(KOG:NYSE.MKT), Gale
Force does not have a big following or a natural shareholder base. Canadian
investors aren't necessarily looking to get particular exposure to U.S. oil
fields. They may be looking for other Canadian fields, or international
fields beyond North America.
The
Canadian energy market, particularly the Toronto Venture Exchange, has
suffered and that has led to investors and investment banks circling the
wagons. There is a move toward companies paying a dividend, or companies that
are very well regarded by the Canadian investment banks. Small-cap companies
that the banks like get a lot of coverage and have maintained their
multiples. It used to be that investors would intentionally try to find
companies off the radar of the big banks, especially in Canada, because
investors knew that out-of-favor companies today are the ones that will be
the big winners over the next couple of years. Now, the dominant thinking in
Canada is defensive. Money ends up in overvalued companies.
But for
the long-term-oriented value investor, an operationally sound company like
Gale Force is going to trade up over time. Eventually, it won't matter
whether people want to own it or not, because it will get bought out in the
private market or repriced in the public market in
line with its production and cash flow.
TER: Can you talk more specifically about Gale Force's
operations?
JY: Gale Force made a big bet earlier this year on a
field called Texas Reef, which is a multiple stacked-pay field in East Texas.
According to technical experts at formerly leading companies such as XTO
Energy (now Exxon Mobil
Corp. [XOM:NYSE]), the Texas Reef is very similar to the Wolfberry
vertical play in the Permian, with fracking and
multiple stacked pays. Gale Force is in the process of proving that out.
If Texas
Reef works out similar to Wolfberry for Gale Force, it would have a
significant impact on the upside potential and production growth to the
company. If Gale Force drills $1 million ($1M) wells, and gets between 50 and
250 bbl/d, primarily oil,
Gale Force will be able to even more rapidly ramp up production at a
relatively low cost, and has hundreds of potential locations to develop.
TER: Can you explain what a multiple stacked pay is?
JY: Multiple stacked pay means that there are multiple
geologic zones at different depths in the ground in a certain area, which
each are capable of producing oil or gas. The idea with multiple stacked-pay
wells is that you can choose to simultaneously produce the most productive
zones. Some wells produce from one zone, and some wells produce from five
zones at once. Wells in the Wolfberry play in West Texas produce somewhere
between two and six zones concurrently. In the Texas Reef play there are
stacked zones that are potentially productive.
"The
idea with multiple stacked-pay wells is that you can choose to simultaneously
produce the most productive zones."
One of the
things that is compelling about a multiple stacked
pay is that it helps derisk a vertical well. With
vertical wells in a single-zone area, you drill down, and if you miss the
zone you aimed at, the well is uneconomic and you lose the money spent on
drilling. But if you are drilling in a multiple stacked-pay area, let's say
you miss the first zone and you miss the second zone. Then you hit the third
and fourth and miss the fifth. You still have two good zones, and will
probably get an economic well. If you hit all five zones, or if one of the
zones happens to be particularly productive, then you end up with a highly
economic well.
TER: Gale Force is scheduled to convert to a U.S.-based
royalty trust in late 2013. What are the benefits or potential drawbacks of
that form of ownership?
JY: The valuations on royalty trusts and MLPs are many
times Gale Force's current valuation. On an exit-rate, EBITDA multiple, Gale
Force is currently trading for less than $50,000 barrel oil equivalent per
day (boe/d) for the end of 2012, versus $250,000 boe/d or higher for some royalty trusts and MLPs.
TER: Does that make it an attractive takeover candidate?
JY: I am surprised that a Canadian trust or a U.S.
upstream MLP hasn't made an offer already. Gale Force's attractiveness and
profile will increase as it grows further. There is potentially a five-times multiple uplift. If production doubles, there
is potentially a 10-times valuation uplift, despite
some amount of equity dilution.
TER: Does the royalty trust system lock in the existing
properties and restrict further development and expansion possibilities?
JY: It depends on how you structure the trust. But
converting to a trust is an exit strategy for Gale Force. The final valuation
of the trust at conversion is the value that the shareholder walks away with
from the deal. The trust's new owners buy in for the yield.
TER: It sounds like a good idea to buy in to Gale Force
before it converts.
JY: It seems attractive to me. I own a lot of the
stock. I've helped Gale Force craft the strategy, and if the market for
royalty trusts holds up and if Gale Force hits its production targets, a
trust conversion should pay off meaningfully, particularly from the current
valuation.
TER: What are some of the other undervalued shallow oil
plays that you're watching?
JY: I was recently appointed to the board of Lucas Energy Inc. (LEI:NYSE.MKT). I acquired almost 20% of the company in an SPV
along with a business partner, and we were both appointed to the board. I
can't say much about it, but it does have multiple stacked pays with Austin
Chalk overlying Eagle Ford shale, and it is near extremely economic Eagle
Ford wells drilled by EOG Resources Inc. (EOG:NYSE) and Marathon Oil Corp. (MRO:NYSE). And it is in a joint venture with Marathon. It
also has acreage in the Woodbine play in East Texas, near Halcon Resources Corp. (HK:NASDAQ).
TER: What juniors do you like in the Mississippi Lime?
JY: Petro River Oil is doing a reverse merger that
should close sometime soon into a company called Gravis Oil Corp. (GRAVF:OTCPK). It doesn't have a lot of production, but it has
just over 100K net acres in the Mississippian. The enterprise value is
roughly $20M, which is really exciting because it essentially trades for $200
per Mississippian acre, which is a fraction of the valuation of other public
Mississippian-focused companies.
There are
not a lot of Mississippian wells that have been drilled recently in the area.
Encana
Corp. (ECA:TSX; ECA:NYSE) and Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) are very active in the area and we will soon see
results. Petro-River uses a similar methodology used by SandRidge Energy Inc. (SD:NYSE) and Chesapeake Energy Corp. (CHK:NYSE) when they built their initial positions in the
Mississippian. The methodology is looking at old vertical wells in the area
and building lease positions near where the vertical wells indicate
horizontal development would be most promising. Oil companies want to drill
horizontal wells near where there are really successful vertical wells,
because the really successful vertical wells indicate porosity and
permeability (and oil!) in the reservoir.
TER: These are mostly U.S.-based companies. Do energy
independence and finding safe jurisdictions play a role in your investment
philosophy?
JY: Absolutely. There are a number of different costs
and issues associated with being in areas where contract law isn't firmly in
place and where there are lots of risks, like Venezuela. I like to deal in
areas with predictable risks. Obviously, there are always some unpredictable
elements in an equity investment. But, expecting that Mozambique, for
example, is going to respect your contract is a big assumption. Obviously, it
is not a mistake for Anadarko Petroleum Corp. (APC:NYSE) to drill for huge gas fields in East Africa. It will probably end up
being worth it for it, but as a passive investor, given the types of value
I'm seeing in onshore U.S. and onshore Canada, I am not sufficiently
compensated to take that kind of risk.
TER: Do you have a hedging strategy?
JY: I hedge two ways—by shorting overvalued or
potentially fraudulent enterprises, or by hedging oil prices. Gale Force is
very well hedged, and Petro River is not as well hedged. For an equity
investment in Petro River, I'd hedge more oil, either via puts or shorting an
exchange-traded fund or with futures.
TER: Do you have any predictions for the oil and gas
sector in 2013 in terms of adjusting a portfolio to take advantage of any
changes that you foresee?
JY: When the turn happens in the equity markets, stocks
like Gale Force will rise. There has been a focus since the crash in
2008–2009 on larger, more liquid companies. Smaller companies have
suffered, and the stocks of a lot of companies that have newly created value
are not reflecting that value. Over the long run, small-cap stocks
outperform.
Also, I
think that natural gas has seen its bottom. Earlier this year, it was below
$2 per thousand cubic feet (Mcf). The full-cycle
replacement cost for natural gas is over $4/Mcf
gas. For instance, I like larger-cap natural gas companies that have started
to price in $4 or $4.50 gas, while smaller natural gas producers are still
pricing in $3.50 gas or less. For instance, I like GeoMet Inc. (GMET:NASDAQ), which is priced at $3.50 or less.
GeoMet is
particularly interesting because it may be one of the most leveraged ways to
get exposure to natural gas prices. It has less than $10M in market cap, versus
producing tens of millions of cubic feet of natural gas per day and versus
$120M in senior debt and over $40M of preferred stock. If GeoMet's
properties are worth $200M on a PV-10 basis at the current natural gas strip
price, that implies an equity value of four times the current market cap. And
if natural gas goes slightly above the strip and trades to $4.50 in the next
year, GeoMet's equity could be worth 10 times or
more what it is currently trading for. Obviously leverage works both ways,
but with sufficient hedges in place for the next couple of years, GeoMet will likely survive further volatility in natural
gas prices and may be one of the most leveraged ways to get exposure to
rising natural gas prices.
TER: Thanks for your time, Josh.
JY: You are welcome.
Josh Young is the founder and portfolio manager of Young
Capital Management LLC, which launched Young Capital Partners LP in 2010. He
previously served as an analyst at a multibillion-dollar single-family office
in Los Angeles. Prior to that, he was an investment analyst at Triton Pacific
Capital Partners. He was also a corporate strategy consultant at Mercer
Management Consulting and DiamondCluster. He holds
a bachelor's degree in economics from the University of Chicago.
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DISCLOSURE:
1) Peter Byrne of The Energy Report conducted this interview. He
personally and/or his family own shares of the following companies mentioned
in this interview: None.
2) The following companies mentioned in the interview are sponsors of The
Energy Report: Gale Force Petroleum Inc. and Royal Dutch Shell Plc.
3) Josh Young: I personally and/or my family and/or Young Capital Management,
LLC own shares of the following companies mentioned in this interview: Gale
Force Petroleum Inc., Petro River Oil, GeoMet Inc.
I was not paid by Streetwise Reports for participating in this story.
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