Sector Diversification: Target Oil Sands

Just about everybody on Earth ought to know by now about the oil sands are a vast and virtually limitless supply that’s going to backstop North American energy security for a century or more.

But for all the hype and hoopla, surprisingly few investors know how to play the full oil sands value chain.

The thing to remember about a massive development undertaking — a mega, mega project — is that it’s not a single homogenous entity, there’s a whole support network that has to be built around it.

Oil and gas producers are basically procurement houses that go out and buy what they need. Everything from drilling wells to building and operating pipelines — even the catering — is contracted to third parties. By entering specific points in the supply chain, it’s possible to create a surprisingly resilient portfolio that’s diversified while still taking advantage of big growth opportunities in the many, many years ahead.

The first link is the producers. For almost half a century oil sands have traditionally been a game for Majors, Everyone thinks of trucks and shovels, but more than 80 per cent of the resource is actually too deep to be mined. Most of the new production over the decade will come from specialized steam injection schemes.

The past 18 months there have been some high profile IPOs, backed with foreign capital from China. Names like Athabasca Oil Sands and MEG Energy are but two. Given China’s voracious appetite for overseas investment, there will inevitably be more IPOs to come.

On that front, the first half of this year also promises to be active, with Laricina Energy and OSUM Oil Sands hitting the street this spring. Calgary-based Peters and Co. recently did a valuation on both companies and says that they’re going to be popular issues. Laracina could fetch $37/share and OSUM $16/share on their respective IPOs. Call it informed speculation considering they’ll probably be in the underwriting syndicate, at which point they’ll be restricted.

Another bright light is Black Pearl (TSX-PXX) headed by former Black Rock Ventures guru John Festival. You might recall he sold his predecessor company to Shell a couple of years back for a few billion, little wonder the shares have tripled in less than a year.

The real key to this oil sands renaissance is horizontal drilling and steam injection. By now SAGD (Steam Assisted Gravity Drainage) is a relatively mature technology that sees pairs of parallel horizontal wells work in tandem to inject steam and bring oil back up to the surface. This is a sophisticated undertaking that requires the skills of a surgeon and some heavy iron. Enter the drillers.

The coldest winter in a decade means all of Canada’s contract drillers are really hot right now. Precision Drilling (TSX-PD) (NYSE: PDS) is up almost 20 per cent in the past two weeks alone and rivals like Trinidad Drilling (TSX-TDG) (OTC: TDGCF.PK)and Murray Edwards’ Ensign Resource Services (TSX-ESI) (OTC: ESVIF.PK) have had a good run this winter. Both have good exposure to the oilseeds, with Ensign running nearly 300 coring rigs that are used to prove up reserves, while Precision has the heavy iron need to drill the new steam assisted thermal wells.

The best performer of all is Stoneham Drilling Trust (TSX-STG.UN) (STHMF/STHMF.PK)which is fast becoming a player with its share price quadrupling since last October. It’s one of the last remaining oil and gas trusts, but that will change around Canada Day when it converts to a corp. One of the company’s biggest customers is Cenovus Energy (TSX-CVE) (NYSE: CVE)which is the industry leader in the thermal oil sands space.

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Keeping those rigs turning requires a whole support network of its own — where do you go when a reamer or a winch goes down in the middle of the night? That’s where CE Franklin comes in. (TSX-CFT) (NASDAQ: CFK) is the Canadian Tire of the oil patch, supplying literally thousands of products like valves, flanges and drill pipe that are essential to support field operations. The company’s web site boasts that it can fix everything from quads and pick-up trucks to full blown drilling rigs.

In February, the company reported that oil sands accounts for about 15 per cent, or $11.5 million of its fourth quarter sales revenue and the company said it is committed to leveraging its presence in the Fort McMurray area to capture a bigger slice of this pie.

Although it’s firmly rooted in the oil and gas industry, the company’s operating metrics have a retail character, like the oil patch version of Walmart. IROC (TSX-ISC) is another new entrant that has managed to post impressive share price gains while remaining affordable. Higher drilling levels will inevitably translate to higher sales revenue for everybody in the space and IROC is positioned for growth.

In its most recent operational update, the company said its Canada Tech division hopes to start realizing positive returns from a series of products and solutions designed specifically for steam assisted gravity drainage projects in the oil sands.

Up until now we’ve been talking about upstream production. But selling all that oil to American — and possibly Asian — markets is the key to true diversification for investors and oil companies alike. The downstream is the one area where your interests are truly aligned with industry.

Led by pipelines, it’s a whole parallel universe of support services that connect producers with refineries and trading hubs. Canada’s pipes are in an exciting growth period, and we’re talking about some extremely ambitious projects: namely Enbridge’s proposed Gateway to the West Coast and TransCanada’s Keystone to the Gulf of Mexico. When completed, the projects will move more than 1.5 million barrels of oil sands crude for export. To put it in perspective, Libya — an OPEC member — was only exporting 1.5 million barrels a day before it came unhinged.

TransCanada’s (TSX-TRP) (NYSE: TRP) Keystone is banking on the U.S. to get over its fixation with “dirty” oil, but rival Enbridge (TSX-ENB) (NYSE: ENB) has been looking to the West Coast and threatening to break-out to Asia. Both are taking bold steps that will allow Canadian production to get the full world price and open new markets.

Both have had good share price appreciation and it’s hard not to like the steady returns offered by owning a high-yielding dividend. They are also a lot less exposed to volatile commodity prices. Due to the way they’re financed, pipelines are considered lower risk lower reward, but both companies have been showing good near and long-term growth.

Either one is a good hold or place to park when the market turns south. Enbridge will be splitting its shares later this spring, which will make them more affordable to own.

Finally, it’s one thing to throw a bunch of steel into the ground but quite another to keep it up and running. Sometime in the next year or two, the amount of money required to maintain all these pots and pans is going to surpass the amount of new capital investment, which is estimated at around $18 billion this year, according to the Oilsands Review magazine.

Put another way that means almost half of all the spending in the oil patch will go to keeping these oil sands projects going — it’s a staggering sum.

On that front, Flint Energy Services (TSX-FES) (OTC: FESVF.PK)is probably the best positioned to capitalize. Last November it announced a $450-million contract with Suncor to keep its oil sands projects — some of which have been operating for 40 years — in tip-top shape.

Company representatives told the OSR it expects revenue from its oilsands maintenance unit to equal and surpass its oil sands construction division in the next five years.

There you have it, a long and rather exhaustive look at the oil sands value chain. By picking spots along each length of the chain it’s possible to actually diversify within the sector and profit on what will likely prove to be the last big oil rush on Earth, providing even the humblest investor with a steady stream of profits for decades to come.

– The OGIB Research Team

Editor’s Note:  In my last story I explained how lower gas prices could affect reserves, as reserve reporting season is underway.  Below, here’s a look at how some junior oil companies might fare.
– Keith

Part 3 of a 3-part Series

Reserves redux:

Last time we talked about reserve reports and how natural gas producers could have their credit lines and valuations cut because of the low carrying value of their reserves.

This time we’re going to talk about how the same phenomenon is going to have the entirely opposite effect for oil producers, especially heavy oil that makes up the majority of the crude stream coming out of Western Canada.

If you’ll recall, we talked about how oil and gas companies have to file an inventory statement effective Dec. 31 that details the net present value of their reserves based on future projected cash flows (which in turn are based on independent price assumptions for the next 12 to 24 months).

Then we talked about how any drastic change in the valuation of those reserves was akin to lowering (or increasing) the net worth of your house against the balance of the mortgage on your home. We also talked about how a 20 per cent decline in the price of natural gas was going to bite into the NAVs of several high profile gas producers and possibly send them scrambling to shore up balance sheets, by jettisoning unprofitable assets, selling equity and paying down debt — or else.

The good news is that oil-weighted producers are going through the same exercise with a different conclusion. The really good news is that most of them are going to see their net asset values and credit lines increased, given where crude prices have been for the past 12 months and given where they’re likely to stay thanks to all the trouble in places like Libya and Egypt.

And the best news of all is that it means we’re probably looking at a round of upgrades — and higher stock prices — for the entire sector. This, even though the rising Canadian dollar essentially wiped out any oil price gains in 2010; Canadian-denominated crude prices were actually down about two per cent year over year.

But nobody wants to hear us crash the oil price party with mundane things like currency valuations. Much better to party like it’s 1992 — the last time the Middle East looked like it was set to explode. Back then, if you’ll recall, Saddam Hussein had oil prices pushing the then unheard-of heights of $75 with George the Elder banging at his door in Desert Storm I.

Then, as now: peace sells. The problem is that nobody’s buying.

According to a recent report by Peters and Co., the oil-weighted guys are going to be flush with cash which will drive consolidation within the junior heavy oil space. The start-up of Keystone into the U.S. Gull is going to change the market no matter what happens in places like Cairo or Tripoli.

The North American market is too localized to really be affected. The upshot is that tensions in far off places like Libya and Egypt only increase the role for Canadian oil, as the U.S. tries to diminish its dependence on Middle East crude.

Based on geography alone, Canadian producers hold an almost insurmountable advantage.

But before we go any further, a note of caution. The geopolitical risk trade is the worst trade you’ll ever make. Just because the world seems to be going up in a hand basket doesn’t mean oil is going to hit $150 any time soon. Or stay there for more than a few weeks if it does. Don’t get sucked into what MIGHT happen. More often than not, it doesn’t happen and you’ll be left holding the bag.

Think about WHAT’s going to happen when everything settles down.

Take some time, dig into the financial statements and look for that reserve report. Then take the forecast price of oil used in the financial statements, and knock it down 15 or even 20 per cent.

Anybody that’s showing profits at $50 a barrel is going to be doing just fine at $70 or even $80. Assuming prices do spike above $100 you’ll be in a good spot to reap big rewards — just don’t be banking on the sky to fall for it to happen.

A couple names to consider: Black Pearl Resources (PXX-TSX). Here you’re getting proven management in addition to oil price exposure. These were the guys behind Blackrock Ventures before it was sold to Shell for mega-billions a couple years ago.

Black Pearl is a new stage entrant, but they’ve got some good production history — 7,700 barrels a day and rising — and a lot of expertise working their main assets near Peace River. But a big chunk of their meteoric rise in stock price over the last few months is vastly (and fastly) growing reserves (sense a theme emerging?).

In January, the company released its 2010 reserve reconciliation showing they added 7.5 million boe in reserves, but added almost 750 million barrels in a more risky category – contingent resources – and about 98 per cent of it oil. That’s a staggering sum; we’re talking resources to production of almost 300 years at current rates.  Most of these resources come from its Blackrod SAGD heavy oil project (Steam Assisted Gravity Drainage).

As CEO John Festival said in the news release: “Our objective over the next few years is to get these barrels reclassified from the resource category to reserves.”

In doing so, the company will be adding real value that will inevitably translate into higher share price multiples. Think about what that family room addition will do to the resale value of your house.  And like I said, this management team has sold a company before for a lot of money.

Likewise, consider Twin Butte Energy (TBE-TSX). They started off as a gas company but quickly shifted to oil around 2006 when it became clear the Katrina Premium on gas prices was just a figment of the imagination.

Earlier this month the company reported a23 per cent increase in total proved plus probable oil and gas reserves, which rose by 6.9 million barrels of oil equivalent to 37.5 million boe.  That reserve addition was nearly quadruple 2010 reserves it produced.

Finding, development and acquisition (FD&A) including future development costs came in at $10.48 per boe on a proved plus probable basis and $14.28 per boe on a proved basis, which is right up the fairway and a chip shot to the green as far as industry-wide performance goes.

In other words, these guys will do quite well even if oil prices come down from current levels — which they probably will, if past events like the first Gulf War are any guide.

But the increase in reserves combined with the low operating and development costs will ensure a steady stream of cash and higher valuations for you, dear investor, dictators be damned.

It may be the end of the world as we know it, but as long as you’re long on oil, we’ll all be fine.

– Keith Schaefer
Publisher, the Oil & Gas Investments Bulletin

Editor’s Note:  Ever wonder how companies can estimate tens of billions of barrels of oil on their property before they drill it?  I explore that here in this report: How Big Shale Formations Get Estimated – All Over the World.

The first two parts of the above series:

Part 1: How To Use the ‘Recycle Ratio’ To Invest in Oil & Gas
Part 2: Unconventional Oil & Gas Plays: What I Look for in the “Reserve Report”