The heavy oil price in Canada has been surprisingly strong this year, and that led me to purchase some Rock Energy (RE-TSX) on Friday.  It is one of the few (I’ve only found 2) juniors with exposure to heavy oil.  The stock is cheap on several metrics compared to their peers – so cheap that if it was bought at the valuations some of these juniors are getting upon takeout, at least one brokerage firm estimates the stock could be a double or triple. 

Rock currently has a recycle ratio of 1.9:1 – meaning they get $1.90 in profit per barrel of oil (boe) for every dollar in costs they have in getting it out – and almost nobody in the industry, gas or oil, is generating 2:1 at these energy prices. Few investors associate heavy oil with high profitability, but President Allan Bey and his team are doing it. (Rock is 1.9x company wide; but it is half natural gas – brokerage firm National Bank estimates the recycle ratio on just Rock’s heavy oil is probably 3.4:1 – very strong.)

So it is highly profitable, and they have had a high success rate in their heavy oil play, called Plains Core, and 60 low risk drill locations in this Alberta play are ready to go. But the wells only average 40 bopd, and with regular decline rates of 30%, along with a regular debt load (75% of the limit) make Rock a no-growth story for 2009.

So why did I buy on Friday?

 Because I don’t think the new heavy oil story in Canada is out there in the market, and that presents an opportunity to investors who do their research.

Heavy Oil has Light Discount in Canada Now

Heavy oil has been the star performer of petroleum liquids this year. As background, heavy oil trades at a discount to the world price you see quoted on the web or in the newspapers – either Texas West Intermediate Crude (WTI) or Brent (in the UK).  Sometimes it trades at a significant discount, usually 25-30% but sometimes 45-50%. Right now it is bouncing between 10-15%, resulting in heavy oil at a light discount – one of the lightest in years.

The reason for this is that when OPEC cuts production, it cuts its most expensive oil first – get rid of the small profit margin barrels. Heavy oil costs more to produce. Extra costs include:

-energy-intensive processes, like the large scale injection of steam into the reservoir to heat the oil and to get it to flow into a well. 

-sometimes expensive chemicals are required

-it produces more carbon and sulphur emissions, which must be removed

But oil refineries are built to handle a certain kind of crude; there is a huge spectrum going from sweet light oil to heavy crude.  You can’t just switch crude type very much easily or cheaply. Many of the US refineries have seen their supply of heavy Venezuelan and Mexican crude cut back – and they are looking for product. Where? North, to Canada.

So not only has the oil price moved up $10-15 a barrel this year, the heavy oil discount has narrowed, making the heavy oil price act like a comparative slingshot to other energy prices.

Why is Rock So Profitable?

Right now the heavy oil price for Western Canada select (at Kerrobert in Saskatchewan) is CAD$53.00 per barrel.  After transportation costs, Bey says that Rock gets $45.00, and has a $23 netback (Netback is the profit per barrel).  Rock’s 3-year Finding and Development Costs (F&D) are about $12 per barrel.  You get the recycle ratio by dividing the netback over the F&D. 23/12=1.9x recycle ratio.

Rock’s small wells also have small costs.  President Allan Bey told me that their vertical wells cost $525,000 and generate 40 boepd, for a price per flowing barrel of just over $13,000. That valuation can be accretive for companies and their investors, as the juniors generally trade at $25,000 per barrel. And on buyouts it can be very accretive. Tristone Capital out of Calgary reported in late March that the average valuation of the last 8 junior energy company buyouts on the Toronto Stock Exchange (most with smaller recycle ratios; or less profitability than Rock) was done at $41,000 per flowing barrel. National Bank, a Montreal based securities firm, has their buyout metric at $30,000.  Either way means a nice fat premium for investors, on a buyout done at average valuations.

For Rock, the numbers are a bit more striking because of their low valuation. As an example, brokerage firm Wellington West has Rock trading at $13,800 per flowing barrel, against a peer group average of $25,800.  Compare that to $41,000 per barrel and you can do your own math for what Rock could get bought at.  I think there is a case to be made that because of its high netback and Reserve Life Index (RLI) of 7.4 years, which is just above average for its peer group, it could get a better valuation than average on a buyout.

Rock is included in Tristone’s list of 10 undervalued juniors that they consider take-over targets. What was consistent across the several research reports I read on Rock was the steep discount to NAV it had, even amongst its undervalued peer group.  I think this gives me some downside protection on Friday’s purchase of 10000 shares at $1.18.

This consistent low valuation was likely because heavy oil traditionally does trade at a steeper discount than its current 10-15%. And Rock is small at 3300 bopd, only half of which is heavy oil.  But I’m not convinced that the heavy oil story and Rock’s high profitability is well known by the market, and that represented an opportunity to me. Its valuation is still cheap to its peer group, so I bought some.

The downside?

• 1. Liquidity. There is only 25 million shares outstanding, and doesn’t trade very much. (But that does give it some leverage)
• 2. And with only 8-12 wells being drilled this year, production will actually decline 5%. It is not a growth story in 2009. Without a buyout, the stock could trade here all year if oil prices don’t move up.
• 3. While they are looking for acquisitions, they have debt of $38 million on a $51 million revolving line of credit – not a lot of financial flexibility there to do a deal. 

This article will undoubtedly appear on several websites other than my own.  The purpose here is to give potential subscribers to my service an idea of the type of research they can expect – transparency, balance and lots of due diligence, including management interviews.