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.