The Energy Report: In a previous interview, you said that
Trapeze Asset Management uses its valuation model from a bottom-up
perspective to tell you where to find individual bargains, and from a
top-down perspective to tell you whether markets or sectors are overvalued,
undervalued or fairly valued. What is that model telling you about today's
oil and gas space?
Randall Abramson: Overall, the U.S. stock market appears to be
smack on its fair market value and, unusually, has held there for about a
year. In fact, we have had the least amount of volatility in the first six
months of 2015 than, apparently, in any first six-month period in history.
That said, with oil and gas prices having dropped so far from this point
last year, the industry appears to be trading at a 20% discount. Some of the
quality names are only bargains assuming higher oil and gas prices, which is
reasonable given that oil is trading below the average cost of production—and
way below where it ought to, since it normally trades at a premium to the
cost of production. Some of the smaller names have traded way off, and they
represent unusual bargains even at today's oil prices. Those names appear
particularly attractive.
TER: Do you see Iran flooding an already flooded market with crude
after the recent landmark nuclear deal?
RA: We don't. Based on the readings we've done, we think there's
only a few hundred thousand barrels per day that Iran could add to the
system. Total Iranian production today is roughly 2.8 million barrels a day
(2.8 MMbbl/d). It could possibly get to about 3.2 MMbbl/d, but it's not going
to be all that meaningful to the overall picture, in our view, given
ever-growing demand and declining or flatlining supplies around the world.
TER: What did you make of the recent American Petroleum Institute
(API) crude inventory numbers?
RA: The numbers in the U.S. mask the reality. They show big
inventory growth, but it's somewhat based on a model. Our readings show there
are some potential inaccuracies, because U.S. demand seems to be growing
smartly, yet the U.S. Department of Energy's production figures are
model-based and likely overstated. U.S. production has likely flatlined. We
expect to see the inventories wane in the months ahead. Already, only 19
MMbbl have been added this year, since May, versus 24 MMbbl normally.
Global oil inventories are more important to the oil market and are more
in line. That's because, in the global market, we haven't seen the oversupply
issues that we've seen in the States. Global demand for oil has grown even
faster than the most bullish prognosticators have predicted.
TER: What is the current drill rig count in the U.S.? How does that
influence your view on near-term and medium-term oil and gas prices?
RA: We're down to about 870 rigs in the U.S. That's less than half
of the peak. That tells us that, even if we are more efficient today, there
are fewer people finding oil and gas. The decline rate, particularly in the
shales, where most of the growth has come from, is huge, especially in the
early stages. While we have yet to see major declines in U.S. production,
it's inevitable that production is going to be flat or down for the
foreseeable future, unless we have a massive recovery in the oil price. Even
still, I doubt that most boards would approve drilling projects unless they
are highly robust because of the glut-less decline in the oil price in the
absence of a recession.
TER: How long do you expect the price decline to last?
RA: We believe there will be a supply deficit in Q4/15, or sooner.
Therefore, we should see $75/barrel ($75/bbl) Brent or higher. Take your
appropriate bottleneck discount to West Texas Intermediate to come up with
North American prices.
The $75/bbl Brent price will come about because we're going to get a
supply/demand deficit that the Organization of the Petroleum Exporting
Countries (OPEC) will not be able to meet, in our estimation. Saudi Arabia is
already at full production capacity. The demand globally has been growing
faster than expected. Not long ago global demand was in the 70–80 MMbbl/d
range, and in the next six to 12 months, you're going to see it at 100
MMbbl/d, given the growth rates we've witnessed. And the key point is, I
don't think the world can meet that level of demand with a sub-$60/bbl oil
price. The price at the margin should adjust rapidly.
TER: Given how much the energy sector has fallen out of favor with
investors, what are three or four fundamentals investors should specifically
pay attention to in oil and gas equities?
RA: If you and I sat to develop a wish list of what we'd want in a
company, we'd seek a company with low financial leverage so it could have
staying power, along with high internal rates of return (IRRs) due to low
finding costs, lower variable costs, or higher deliverability per well. You
want solid IRRs at prices below where everybody would be making free cash
flow, and a management team that knows not to get so levered as to imperil
the business. That would be a recipe for success.
TER: Management experience is key. What other management attributes
do you seek?
RA: Management must wear the three hats needed in this business:
geology, engineering and business. If you foul up any one of those three,
you're done. There have been countless examples of projects that look great
geologically but for which the engineering does not work, and others that
work at $75/bbl oil but not at lower prices.
TER: Are there steps you prefer to see companies taking in a low
oil price environment?
RA: You need to make sure that a company is cutting costs to boost
its IRRs, or focusing on projects with positive free cash flow. This is
important because if a third-party engineer lowers the reserves due to lower
oil prices, then the company's line of credit is reduced since the reserves are
no longer worth as much.
TER: Are there some back-of-the-napkin metrics you commonly use to
separate the better companies from the lesser?
RA: Not necessarily, because there are a lot of moving parts. It's
like looking at any other business. With Apple
Inc. (AAPL:NASDAQ), it might be about profit margin and the number of
units it's selling. In an oil and gas company, it's typically the IRR, how
many cookies it can cut from its land package, and what's it going to cost
per well versus the returns on those wells. As long as you have a balance
sheet that can withstand the hits, you can throw off free cash flow to keep
redeploying cash and increasing your reserves.
TER: What are some oil and gas equities that Trapeze continues to
own at $50–60/bbl oil?
RA: We are enamored with Manitok
Energy Inc. (MEI:TSX.V). Manitok's share price suffered because it
satiated the market with shares after doing a reasonably large-size issue at
$0.80/share. That enabled the company to make a big acquisition that will
leave it with up to 300 drilling locations with IRRs in excess of 50% at
today's oil prices in both its Basal Quartz and Lithic Glauc zones in
southeast Alberta.
But Manitok is a smaller company; it's trading at CA$0.60/share on about
85 million (85M) shares. It is an under-CA$50M company with just shy of
CA$70M of debt, so its enterprise value (EV) is about CA$120M. Yet it's
trading at less than 4x EV:earnings before interest, tax, depreciation and
amortization (EV:EBITDA) at today's oil price, and at about 2x EV:EBITDA
assuming $65/bbl oil—about the global average cost of production—with years
of growth ahead.
TER: You had a $2.50/share target price the last time we talked.
What gives you confidence that Manitok can approach $2.50/share inside 12
months?
RA: Essentially, the company's NAV at about $60/share oil would be
in that ballpark. Now, whether the market wants to take it there is going to
depend on production from Manitok's wells staying on the type of curve that
it has been at so far.
TER: Are companies this size in the oil and gas space typically
trading at a similar discount?
RA: Few. Right now, in "Commodityland," the smaller you
are, the harder you've fallen. So you might have senior companies trading at
6–8x EV:EBITDA, and midsize to junior companies trading at 4–5x. It's rare
that you get a junior that's trading at 2x, like Manitok. The reason is that
the company had production mishaps last summer and fall. Then guidance came
in a little lower than expected, followed by the share issue related to the
acquisition. In the meantime, it's trading at about $18,000 per flowing
barrel—the private market value is likely three times that amount.
TER: Does that list of issues give you pause to question
management?
RA: Absolutely. You always question management. But you have to
also look at whether this was the hand management was dealt, or whether the
situation could have been managed more effectively. This was a poor hand.
Sometimes things fall out of the sky and you have to deal with them.
TER: What other small-cap companies do you follow?
RA: We continue to like Orca
Exploration Group Inc. (ORC-A:TSX.V; ORC-B:TSX.V), a natural gas company
based in Tanzania. Orca has suffered the last few years because the Tanzanian
government has not paid its bills on time, to Orca and others. We think that
is all but over. The government is once again making payments, but still owes
Orca for previous deliveries.
A pipeline the government had planned to build for some time is now built
and should be commissioned in the next month or two. The World Bank and its
various arms are about to provide financing so that Orca can drill some wells
to help fill that pipeline. That should allow Orca to have significantly more
cash flow than it does today.
TER: Does approval of the financing by the World Bank give you
greater confidence in this story, given the risk profile of where the company
operates?
RA: Absolutely. Tanzania is actually one of the better African
countries in which to operate, but there was a corruption scandal in the
government, along with the financial issues. The fact that the World Bank is
involved definitely gives us greater confidence. Amazingly, Orca still trades
at just over CA$3/share, even with a reserve-based NAV in excess of
CA$11/share.
TER: What are some other smaller oil and gas names you're focused
on?
RA: We've owned a company called Powder Mountain Energy Ltd., which
was just acquired by Canamax Energy Ltd. (CAC:TSX.V). We think there is some
serious upside to Canamax, which trades at less than $0.50 on the dollar
based on our valuation. The merged entity should be quite profitable, even
at, say, $60/bbl oil. If Canamax exits 2016 with more than 4,000 bbl
production, which should be about 70% oil and 30% gas, at $65/bbl, that would
be about CA$45M in EBITDA. It is trading at just over 1x EBITDA today, based
on those metrics. It trades at about CA$0.45/share today at, let's say, a 5x
multiple of cash flow. Assuming oil reverts to just above the global average
cost of production around $65/bbl, then it would be more like CA$1.30/share
by the end of next year.
TER: Why did Canamax and Powder Mountain get together?
RA: Canamax needed funds because it was making an acquisition to
expand production. Powder Mountain had more than CA$20M cash and a
significant land position. But Powder Mountain's land is more for tomorrow,
because it works at $70/bbl oil or higher. Powder Mountain was looking to do
something with its cash rather that put it into its own land at $50/bbl oil.
It was almost a perfect match. Powder Mountain had looked at something like
40 different companies to fold itself into, and determined that Canamax was
by far the best opportunity.
TER: Any others?
RA: We like a handful of names in the service sector, like Halliburton
Co. (HAL:NYSE), which we think is trading at less than $0.80 on the
dollar. We also like Weatherford International Ltd. (WFT:NYSE), which is even
cheaper. But my favorite is still Technip
S.A. (TEC:EP; TKPPY:OTC), which is probably trading at $0.65 on the
dollar and has an EV:EBITDA of just over 3.5x with a fine balance sheet.
TER: Technip recently won the contract for the Trans Adriatic
Pipeline. Is that a material catalyst for that company?
RA: Not necessarily. The contracts the company has are relatively
diversified and go to the overall strength of its business. This underpins
our estimate of the company's discounted cash flow-based value, which is
about 75 euros, or 40% higher than its share price.
TER: When do you see the energy space fully recovering to previous
highs? Or will it?
RA: The Energy Select Sector SPDR Fund (XLE) is 30% below its
previous size. The XLE has a big coal component, which I'm not sure is ever
coming back. But if we get $75–85/bbl oil over the next six to 12 months,
that should go a long way toward helping oil and gas companies recover. You
could see the sector jump dramatically if we get to the $75/bbl mark. Some of
the quality names are not going to move as much, but the smaller names could
move substantially higher.
TER: Have you reduced your exposure to oil and gas names given
current crude prices?
RA: We have not really changed our share allocation. We added more
Manitok with the new issue but, otherwise, we've held our full complement
throughout the downturn.
TER: Any parting thoughts?
RA: We don't think oil is like copper or nickel. The price of
copper or nickel tends to go up and down in a much more harried manner
because the demand is more cyclical. The demand for oil, even in a recession,
is normally positive. It was only in the last recession that oil demand
actually declined and the price went from $145/bbl all the way to $30-something,
where it bottomed.
We tend to like oil because it's a less cyclical commodity. We have to
heat our homes, drive our cars and transport things about the planet. That
means, especially with the Chinese and Indian economies continuing to grow,
that demand will continue to move higher. And that bodes well for underlying
oil prices.
TER: Thank you for talking with us today, Randall.
Randall Abramson, CFA, is CEO and portfolio manager of
Trapeze Asset Management Inc., a firm he cofounded in 1999 shortly after
founding its affiliate broker dealer, Trapeze Capital Corp. Abramson was
named one of Canada's 'Stock Market Superstars' in Bob Thompson's Stock
Market Superstars: Secrets of Canada's Top Stock Pickers (Insomniac Press,
2008). Trapeze's separately managed accounts are long/short or long only, and
have either an all-cap orientation or large cap-only mandate via the
company's Global Insight model. Abramson graduated with a bachelor's degree
in commerce from the University of Toronto in 1989, and his career has
spanned investment banking, investment analysis and portfolio management.
