The pullback in oil prices has created some attractive buying opportunities in both developing and established oil and gas companies, even if oil prices settle in the $80-90/bbl range. In this exclusive interview with The Energy Report, Joel Musante, senior analyst with C. K. Cooper & Co., gives us his insights into current energy markets and talks about several of his favorite names that may reward investors with an appetite for risk.

The Energy Report: We've had some pretty interesting ups and downs since your last interview with us in September of 2010. What's your assessment of the current situation in the oil market?

Joel Musante: Most of the focus is now on whether the European Union is going to hold together. This could cause the European economy to weaken and the dollar to strengthen against the euro, sending oil prices lower. At this point, we really don't see any resolution in sight. So there's still risk that oil prices could continue lower.

TER: What portion of the decrease is attributable to a stronger U.S. dollar?

"In a broad market pullback . . . there is an opportunity to buy quality names at discounted prices, providing you can stick it out and weather the storm."

JM: It's hard to separate all that out. Oil went up to $109/bbl when there was fear the U.S. or Israel might attack Iran's nuclear facilities. Now, this Eurozone crisis seems to be dominant in the market. Oil prices are very volatile, and they tend to trade on investor sentiment over political and economic risk rather than just supply and demand fundamentals of the commodity itself.

TER: Could we be headed down to $60/bbl oil as an ultimate downside?

JM: That price level is pretty low and not very sustainable. It could reach that, but I don't think it would stay there for any length of time. Saudi Arabia and some of the bigger Organization of the Petroleum Exporting Countries (OPEC) members need $80+/bbl oil to pay for their fiscal budgets. Outside of OPEC, $90/bbl oil is necessary for many commercial development projects or to maintain drilling at the current pace.

TER: In the short term, there is obviously going to be some effect on earnings of companies that are currently in production. How do you assess the impact of that?

JM: I still think it's going to be short lived, but if prices stay low for an extended period, it could have some negative impacts for companies. Drilling for oil is a very capital-intensive business. These companies depend on cash flow. When prices fall, they have to cut back on their development programs. The alternative is to take on more debt or issue equity at not-so-attractive terms, which most companies will try to avoid. Most companies will cut back on spending and accept lower growth. This will ultimately lead to lower valuations.

TER: The other side of the picture is the natural gas markets, which have been pretty sick for quite a while. Are you expecting anything to turn around there?

JM: We are starting to see the initial signs of a turnaround in natural gas, but it is still difficult to put a timeframe on it. The natural gas drill rig count has fallen significantly and dry gas production is starting to decline. But there is still a large storage surplus, and production is still outpacing demand by a pretty large margin, so we have a long way to go before supply and demand comes back in line. The interesting thing about this natural gas supply-demand cycle is that the oversupply was driven by aggressive development in shale gas areas. These wells come on at very high rates, which would account for the steep supply increase. But they also decline very quickly, which could mean we are in for a rapid correction. So far, the production data is not showing a fast correction, but it is still early in the cycle.

TER: Is the worst behind us as far as declining prices?

"If the gas buildup during the summer months is similar to what it has been in the past, then we may see full storage by the end of the summer. With nowhere to store the gas, we could see the gas price fall very steeply."

JM: Not necessarily, gas storage is at record-high levels. If the gas buildup during the summer months is similar to what it has been in the past, then we may see full storage by the end of the summer. With nowhere to store the gas, we could see the gas price fall very steeply. This would be temporary, as gas is depleted from storage during the winter months.

TER: Let's talk about some of the companies you cover. In your last interview, you discussed Evolution Petroleum Corp.'s (EPM:NYSE) artificial lift technology. What's developed with that? Has it been able to implement that more to its advantage?

JM: Yes. Tests on Evolution's artificial lift technology are ongoing. Early results look pretty promising. In one instance, the company increased production from a nonproducing well to 11 barrels oil equivalent per day (boe/d), consisting of about 60% oil and 40% gas. It's only been on-line for a short period, but the company is estimating that it could increase the reserves of the well by 50 thousand barrels oil equivalent (Mboe), though more testing is needed to better estimate the reserve increase.

TER: That's significant if the cost to do that isn't very great.

JM: It's actually fairly cheap—a couple hundred thousand dollars to implement the equipment in the well and it looks like you could get quite a bit of oil and gas out of it. So far, there are not a lot of results, but when you get these kinds of numbers, it looks very promising.

TER: Fifty thousand barrels at $80/bbl is $4 million (M). If it only costs a couple hundred thousand to do it and ongoing expenses aren't that great—that's found money.

JM: Yes. The company is not saying it can definitely get 50 Mbbl; it said it can get up to 50 Mbbl. Even with 40% of the production being natural gas, that's still an attractive proposition. The company's main asset is the Delhi Field in Louisiana, which another company operates. A carbon dioxide (CO2) flood is being applied to this old oil field and production has responded better than the company had originally anticipated.

TER: Can that production stay up at a reasonable level or is it going to fall off quickly?

JM: The CO2 that's pumped into the formation gets into the oil, lowers its viscosity and surface tension, releasing it from the pore spaces of the rock. The pressure from the CO2 helps mobilize the oil, and move it to an extraction well. Success of these kinds of operations depends on a number of factors, but in this case it is working exceptionally well, certainly better than expected. The field development is going to take place in phases. The company is in the third phase of five and is producing between 5–6 Mbbl/d. The whole field should get up to 12–14 Mbbl/d over time. Evolution's interest in the field will increase significantly after the operator recovers its initial development cost, per the agreement between the two companies. I have an $11 target, which is pretty conservative. The stock is trading at $7.90. All the company is doing now is converting proven undeveloped reserves to proven developed, so the market should recognize it.

TER: Last September you resumed coverage on FX Energy Inc. (FXEN:NASDAQ) That company is operating in Poland, which most people don't even consider as an area for oil and gas production. What's the story there?

"Poland is trying to develop its own resources, rather than depending on Russia, which has used its gas supplies as a political weapon against neighboring European countries."

JM: FX is unique because it operates almost exclusively in Poland. It targets high-risk, high-potential-return exploration prospects in contrast with most oil and gas companies in the U.S. that focus more on lower-risk resource plays. For investors who can tolerate the risk of an exploration-oriented company, FX may be attractive. Some of the drilling prospects the company is testing have the potential to double or triple its reserves, if successful. Some discoveries it has made are quite large and some not so large, but when it does hit a prospect, it's usually very economically attractive.

TER: Is Poland interested in developing gas reserves, rather than importing from Russia?

JM: Yes. There isn't a lot of gas production in Poland, so it does import a lot from Russia, which pegs the price of its gas to oil prices. But Poland is trying to develop its own resources, rather than depending on Russia, which has used its gas supplies as a political weapon against neighboring European countries.

TER: What caused you to resume coverage on FX?

JM: I thought it was an interesting story. It wasn't well covered at the time. In the past, FX was only drilling about one exploration well a year, and when it made a discovery it took a while to bring the well on-line and establish commercial production. Through the accumulation of its past discoveries, it has brought on a lot of production recently. Now, it's using its cash flow and reserves as a funding source and drilling quite a few exploration wells. Some prospects are small and others are quite large, so there is a lot more going on now than in the past.

TER: What is your target on FX and where is it now?

JM: I have a $9 price target on it. It's at $4.80. In an exploration-oriented company, valuation is tricky because you have to assume that it's going to make a discovery, and there's no guarantee that will happen. The only way that you can get ahead of this is if you buy it before it makes a discovery. If you don't, as soon as it makes one and announces it, the stock is going to appreciate, and you're going to miss out.

TER: So you are betting on a hit rather than just a somewhat predictable earnings stream.

JM: Exactly. In research reports, I try to make clear that my target price and rating really depend on a discovery, which is hard to predict, to say the least.

TER: Another one on your coverage list is PDC Energy (PETD:NASDAQ), which has been around for many years. That's a higher-priced stock, but it's become more of a bargain recently. What's the story on that one?

JM: The stock has fallen recently, mainly due to lower commodity prices. Some of the decline may have been due to lower expectations in the Utica Shale, which is a relatively new oil and gas play where the company has established an acreage position. Some recent well results have raised concerns that the Utica shale may be gassier than previously thought. We saw a pullback in the share price of several other companies that held Utica acreage around the same time the well data was made public.

I still like the story and its position in the Wattenberg field, which is one of the oilier regions to drill in North America. The Wattenberg has evolved over time. More recently, companies have tried horizontal drilling and hydraulic fracking in some of the formations there, and the field has responded pretty well to that new technology.

TER: So this company has somewhat more of a history, with hopefully more predictable cash flow and earnings. Is that right?

JM: That's correct. It's a much more established company with production and reserves comprised of a lot of natural gas. But most of its drilling is oriented toward oil and liquid-rich gas.

TER: What's your target on that one?

JM: I recently upped my price target. It's $45 now. It pulled back quite a bit recently with all of the economic turmoil in Europe. It got pretty close a short time ago, when macroeconomic fears were less of an issue.

TER: Where is it trading these days?

JM: $22.68.

TER: There's some pretty decent upside there if the market turns and oil prices strengthen. Are there any other companies you think are interesting that you'd like to mention?

JM: I just initiated coverage on Bonanza Creek Energy Inc. (BCEI:NYSE). Like PDC Energy, the company operates in the Wattenberg field. It has a strong management team and a lot of very attractive, oily prospects.

TER: So where is that one trading now and where do you think it's going?

JM: I have a $27 price target, and it's trading at $16. It IPOed in December, so it's a relatively new entrant to the public market.

TER: Do you have some closing thoughts on the energy markets and how people can best play things under current circumstances?

JM: I would suggest that investors focus on the quality names. In a broad market pullback like what we are seeing in the market today, there is an opportunity to buy quality names at discounted prices, providing you can stick it out and weather the storm.

TER: Thanks a lot for joining us today.

Joel Musante, CFA, is a senior analyst in the Research Group for C. K. Cooper & Co., a full-service investment bank. In 1998, he began his career with W.R. Huff Asset Management; in 2000, he joined the E&P team at Wasserstein Perella Inc. He has also worked with Ferris, Baker Watts Inc., Zacks Investment Research and John S. Herold Inc. He has a Master of Business Administration from the University of Rochester and a Bachelor of Science in geology and geophysics from the University of Connecticut.

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DISCLOSURE:

1) Zig Lambo 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: FX Energy Inc. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) Joel Musante: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this story.

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