Unconventional Oil and Gas Plays

By
Keith Schaefer
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Part 2 of a 3-part Series:

The new “tight”or “unconventional” oil and gas plays being discovered all over the world are so different from conventional production that independent reserve evaluators face new challenges when calculating reserves.

That was one of the findings that came out of a conversation I had with Doug Ashton, Vice President of AJM Petroleum Consultants in Calgary, Alberta.  AJM is one of “The Big Four” reserve evaluation companies in Canada.

It’s the annual reserve reporting season for energy producers, where everyone has to say how much oil and gas they have found in the last 12 months, and what it cost to find it.  Companies like AJM (and Sproule & Associates, GLJ Petroleum Consultants and McDaniel and Associates) are basically appraising the asset base of the company… and deciding what is economic at current energy prices.  The reserve report is like the balance sheet.

This document is so important I wanted Doug to help me understand how the independent firms like AJM estimate (because that’s what it is) how much oil and gas a company has in the ground.

And one very interesting thing that came up was how the new tight sand or shale plays – which is what many of the junior and intermediate producers are chasing when they talk about ‘resource plays’ – are creating challenges for reserve evaluators.

That’s because the average well profile on resource plays is so different than conventional wells.  The dynamic duo technologies of horizontal drilling (HD) and multi-stage fracking (MSF) are used to create a lot more contact between the well bore and the oil/gas formation.  This often makes for a higher Initial Production (IP) rate than conventional wells in western Canada.

But history is showing that those IP rates fall off quickly – that’s called the decline rate.  The decline rate on tight plays is initially very steep and then flattens, while most conventional wells exhibit a more stable decline throughout their entire life.  Everything is so different with resource plays that they present a challenge to reserve evaluators.

“For these (tight) resource plays there are not a lot of analogies out there,” Ashton says.  “You’re trying to build a “type” well with data that’s less than 4-5 years old.  In a reservoir with low permeability, it may take 4-5 years to get a stabilized flow rate, so it makes it difficult use the result of other wells to predict and estimate reserves.”

Investors forget that history is short on these plays.  We all invest in tight oil/gas plays now, but HD & MSF have only been opening up tight sand and shale formations for 12 years, starting with the Barnett shale gas play in the late 1990s (and it’s not analogous to western Canadian plays).  And it has really only been 4-5 years now since HD & MSF have gone wildly commercial in many different basins.

“So we try to be conservative in calculating reserves for resource plays,” Ashton continues.  “That “conservative” word doesn’t always make our clients very happy – while both the evaluator and the client want the most realistic type well, sometimes it takes a bit of discussion to agree on what realistic looks like.

“There needs to be a lot of caution exercised by both the evaluator and the client.  If the production on the producing wells doesn’t follow the type well, the proved undeveloped and probable reserves could be at risk of being mis-stated.”

I asked Doug to walk me through how reserve evaluators do their job each year for their junior clients:

“We start by going through all their ownership information to determine their working interest and other royalties. Companies in Canada are required to report their working interest share of recoverable reserves.

“Step Two is figuring out what the company’s operating costs have been in the past year.  We use that to forecast future operating costs.  By definition you can’t have a reserve unless it’s economic.  If you have a producing well and ‘op costs’ have increased in the past year… it is possible that increase could render your reserves uneconomic.

“Step Three is figuring out reserves, which is the most time consuming part of our process.  Early on in the life of wells and pools we use “volumetric assessment,” which is a lot of geological work, where we determine the geometry of the reservoir, net pay (thickness of reservoir-KS), porosity, water content, pressures and temperatures.

“We then use that data to calculate the Original Oil or Gas in Place volume and then, based on what we think are good analogies we build our type well and estimate a recovery factor for the reservoir – which ultimately should result in a reasonable production profile. This is our predominant evaluation method for unconventional reservoirs.  We start our evaluation at the well level, then consolidate the results to the field level, and then the company level.  We look at each individual well.”

I asked how much time the reserve evaluators are in the field checking out wells.  He said they essentially spend  100% of their time in the office and that everything they need is shipped into the office electronically.

“The reality is that we’re working with data, so on-site visits, especially in Canada, don’t really add any value to the process. Some international clients want us to look at wells, often because the data isn’t as readily available, and we will do that if required,” says Ashton.

He added that each reservoir engineer uses their own price deck to determine what is economic – and these can vary, but not by a lot (to a regular investor like me).

Interestingly, these reports aren’t public documents.  But the law – in Canada it’s called National Instrument 51-101 – says companies must disclose a lot of the information that is in the reserve report.  Most companies summarize it in a press release. The hard-core investor can go to www.sedar.com, the regulatory electronic filing database for public companies in Canada, and find all the required-to-be-public data in the Annual Information Form (AIF).

I asked Doug what he would suggest that retail investors should look for in the press release that outlines the reserve report highlights.

There are different types of reserves, including
1.       Proved developed non producing
2.       Proved undeveloped

These reserves both need more capital to get into production and the companies have to disclose how much capital that requires, which is called “future development capital” or FDC.  Sometimes – but not often – you will see a company add reserves but not add in the FDC.  This can be tens of millions of dollars, so by not having it included, it could be misleading for investors.

Ashton added that investors should check what portion of proved reserves are in production vs undeveloped non producing.  The higher percentage of reserves that are producing, the less risk there is – so if only 25% of reserves are producing then a lot more capital is needed, which is more risky.

But as an investor, I say the flip side to that is – the more undeveloped reserves, the more upside there is in the stock, which should be realized as those assets do get into production.

Either way, you get all the data from the reserve report.

– Keith Schaefer
Publisher, the Oil & Gas Investments Bulletin

Part III — The “Reserve Report” — How some junior heavy oil companies are benefiting greatly from these reserve reports… and how it can tip off investors to profits in the junior oil space.

Part 1: Using the ‘Recycle Ratio’ for O&G Investing

How To Use the ‘Recycle Ratio’ To Invest in Oil & Gas

By
1940bkg
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0

Dear OGIB Reader,

Over the next few weeks, oil and gas companies are going through a special sort of reporting period… and it’s going to have some important ramifications for stock prices — especially for junior gas producers.

Here’s why:

At the end of each calendar year, every single junior energy producer is obliged to prepare an independent reserves report — essentially a snapshot of the value of their inventory of oil and gas in the ground as of Dec. 31.

Oil and gas companies produce away their main asset each year –- reserves — and have to replace them or eventually go out of business. It’s a fact of life. Valuations, debt lines and ultimately stock prices flow from this single piece of paper, which is how you figure out profitability.

The oil and gas business is not about how fast you can get it out of the ground. Big IP rates can give a stock a quick pop, but the real money wants big reserves that they can rely on to provide LONG-TERM cash flow that provides funds for reinvestment. The market will pay more for bigger, less profitable reserves than smaller, highly profitable reserves.

This is important for a few reasons, but especially because it gives a glimpse into a company’s finding and development costs, or F&D as the industry calls it.  This measures a company’s ability to replace production at low cost. How good is management at finding oil or gas?  And how good are they at getting it out cheaply, so there’s lots of profit left for shareholders?

The reserve report is also the first clue into a key valuation tool called the Recycle Ratio – which is profit per barrel (the industry calls this the “netback”) divided by costs per barrel – the F&D.

If you spend $20 to get a barrel of oil out of the ground, and get $60 profit for that barrel after all costs, then you are recycling your money 3:1 – hence the name ‘recycle ratio.’

The Recycle Ratio is only easy to find if you know where to look.  It’s usually in the middle of the quarterly financial document called the MD&A – Management Discussion and Analysis.

Most junior producers in Canada are gas-weighted, so this year, there’s a lot to chew on. The release of year-end reserve reports will highlight the growing chasm between the oily haves and the gassy have-nots, especially considering gas prices fell by 20 per cent in 2010, on top of a 25 per cent drop the year before.

According to Dundee Capital, lower gas prices means that several gas-weighted juniors could see their reserves reduced.  Reserves by definition have to be economic at a certain gas price, and obviously reserves will be less with a lower gas price.

Just this week, junior gas weighted producer Orleans Energy (OEX-TSX) dropped 1.34 million boe in reserves because of low gas prices, adding that their reserves dropped 35% year over year.  They also announced they were selling their deep mineral rights for $10 million on the same day.  The stock fell off a cliff, dropping 17%.

Energy producers use a lot of debt, and the banks will lend them money against their assets – their reserves.  Lower reserves will mean a lower credit line – but what if their debt is already above their newly reduced credit line?

It’s like having the value of your home be worth less than the mortgage – your asset value is less than your debt.  Then the bank forces you get enough collateral by selling assets or raising equity to pay down debt (which dilutes net asset value per share) or go out of business.

Because the reserves value is calculated at year-end, which just happens to be the coldest part of the winter heating season, the gas guys have been lucky the past couple years. But not even the coldest winter in a decade could help them this year– the going rate for gas at Dec. 31 was barely four bucks and change.

This only serves to highlight what a tough game the gas business has become. At the end of the day, abundant cheap supplies are definitely good for consumers, and probably the economy as a whole.

But for producers, it’s a tough way to make a living.

You can still make money in gas but it means you have to be the lowest cost producer. He who adds the most reserves the cheapest will probably weather the storm and come out better for it. That what doesn’t kill you definitely makes you stronger.

Dundee says names to watch (and possibly avoid, depending on your point of view) include top ranked picks like Orleans Energy Ltd. (OEX-TSX) (good call Dundee) and Open Range Energy Corp. (ONR-TSX) that face the greatest risk of having credit lines slashed. Terra Energy Corp. (TT-TSX) and DeeThree Exploration Ltd.(DTX-TSX) are two more names with attractive assets that have wound up on Dundee’s watch list.

All these companies are desperately trying to shift to oil prospects, and rightly so because they’re the most gas-levered names in the business. The oil industry is a fashion industry for investors, after all. But it’s tough to turn on a dime and by the time the gas market breaks it might be too late to prevent these guys from being bought out – cheap.

We say pay close attention, because these are the names that are going to be the prey for consolidators. Encana’s multi-billion dollar deal with PetroChina shows even dry gas assets still have substantial long-term value, but markets can stay irrational longer than you can stay solvent.

This is a nice way of saying that any gas-levered company operating in Western Canada is ripe for takeover, especially for deep pocketed majors with time — and money — on their side.

Some juniors in the OGIB portfolio have been relatively strong performers, especially given where gas prices have been. But the trend is always your friend or worst enemy.

As always, timing is the key for investors trying to get ahead of a company sale/buy-out. Get it right and you could be looking at some attractive capital gains relative to (the newly reduced) net asset values when the predators start looking for some easy pickings. But beware. Jump in too early and you could be riding a slippery slope to the downside; wait too long and you could miss out all together.

But the reserve report will be the first clue.

by +Keith Schaefer

Part 2:  An Inside Look at Unconventional, “Tight” Oil & Gas Plays
Part 3: What the “Reserve Report” Can Teach Investors

 

Canada’s Junior Gas Stocks: The Surprise Performers

By
Keith Schaefer
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0

It’s strange but true – some of the best performing energy stocks in Canada have been the junior GAS stocks.

And there is also an argument that the future may be brighter than previously thought for a select few gas stocks.

All these stocks have three things in common:

1.      They have core areas in the Montney formation that straddle the BC-Alberta border.
2.      Their wells are liquids-rich, i.e. high Natural Gas Liquid (NGL) count, or wet gas count – especially CONDENSATE.
3.      They hit big wells, and better understand the multi-zone potential of the Montney

In January Artek (RTK-TSXv) jumped 30% from $1.30 when it announced a well that was 1895 boe/d – including an eye-popping  1000 barrels a day of condensate, which gets roughly the same price as oil. And the stock has kept rising – now at $2.10

Cequence (CQE-TSX) almost doubled from $1.60-$3.10 per share in the last three months as it announced several Montney wells, including one well that was 8 mmcf/d (million cubic feet of gas per day) and 200 bopd of NGLs.

Painted Pony has gone from $6-$11 in the last few months not because of its great Bakken oil lands, but because of its Montney reserves, production and flow rates.  One of their wells flowed 13 mmcf/d, and all their wells had more than 20 bbl/mmcf – 20 barrels of NGLs for every million cubic feet of gas.

My own little favourite, Donnybrook Energy (DEI-TSXv) has gone from 23 to 70 cents on its Montney lands – a triple for OGIB subscribers (not many junior gas stocks can say that…).

These stock are popping up because the industry is still improving how well they frack this formation, and are continuing to get higher and higher flow rates.  But I think more importantly, the ENTIRE market is now getting just how profitable the NGLs, especially condensate, really are for these producers.

Condensate, or C5, as the industry calls it, is a very light oil, over 50 API, and has a ready market in Alberta as it is used to dilute the goopy, syrupy heavy oil from the oil sands, so it will flow in a pipeline.   As oil sands production increases, the need for condensate will keep its price strong power for many years.

An ‘Alternative’ Trade that Should Reward Investors for Years

 

Conventional water-based fracking has become contentious in many parts of the oil patch.

(So much so, in fact, that New York State has essentially banned the practice.)

That’s all changing, right now… thanks to one very unique, fast-growing company.

Learn all about its innovative fracking process — and how it should enrich investors for years to come — in this new video.

Doug Ashton, VP Engineering at AJM Consultants in Alberta just posted a great model at their website that shows how just a little condensate can go a long way to improving economics for gas producers:

http://www.ajmpc.com/ajmblog/133/Got-Condensate/d,blog_detail.html

 

Doug writes: “At AJM, we were wondering just how much of an impact condensate can have on the economics of a new well, so we ran a few test cases.

“First, we picked a play: the Montney in NE British Columbia and NW Alberta.

“Then, we built a type well: Initial rate, 4,500 Mcf/d. Ultimate reserves, 3.0 Bcf. The production for the well has been profiled to have a very steep initial drop, flattening to around a 20 percent annual decline after about one and a half years.

“Finally, we estimated capital and operating costs based on data in our in-house files, added some royalty incentives (assuming crown lands), loaded in AJM’s December 31, 2010 forecast pricing, and voilà:

“While even the “dry” type well shows fairly robust economics, it is clear that even a small condensate recovery can have a significant impact on the profitability of continued gas drilling in North America.”

(Their website, www.ajmpc.com, is a great resource of free information for the dedicated oil and gas investor – one of my favourite bookmarks.)

And it’s not just stock prices that are rising in the Montney – land values are going up as well.  The Montney generally runs 20-40 bbl/mmcf, but a new liquid-rich play at the bottom, the Duvernay shale (about 1000 m below the Montney), has been shown to have 75 bbl/mmcf and have OGIP (Original Gas In Place) of 5x what the Montney has.

The industry has since paid $800 million for land where the Duvernay is the focus.

Trilogy, Celtic Explorations (CLT-TSX) and Yoho Resources (YO-TSX) are now drilling the Duvernay shale at the bottom of the Montney, and this formation goes out across much of the play.   This consortium has found the Duvernay has 100 bcf of Original Gas In Place (OGIP) per section, compared to 20 bcf for the Montney.  So recoverable gas in the Duvernay could be 2-3x what it is in the Montney – across much of the play – and with twice the condensate content of the Montney.  Many juniors don’t have the $10 million per well to drill the Duvernay – but if it’s there under their property, whomever buys them out almost certainly will.

– Keith

P.S. Follow these links for more of my research on the Montney gas formation:

The Montney Gas Play: Here’s where the attention is shifting now

An Unconventional Gas Play Goes “The Full Montney”

Oil Service Stocks in 2011: What’s Pushing the Sector Forward

By
Keith Schaefer
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0

Dear OGIB Reader,

Following is a story my research team put together on the oil field service sector, including what it is that’s driving the positive numbers… and two ways to play the momentum. Enjoy,

– Keith

————————————————–

Drilling levels in Western Canada are often a good barometer of the weather. And according to the Canadian Association of Oilwell Drilling Contractors (CAODC), January’s rig utilization averaged 66 per cent compared to 46 per cent last year… making it the best start since 2007.

That says two things:

First, it’s been a cold, cold winter, which is a good thing for service companies – the ground is rock hard and it’s easier to move rigs.

Second, it tells us the oil field service sector as a group could be in for the best year since the financial crash.

Likewise, the Petroleum Services Association of Canada (PSAC) on Monday increased its forecast 2011 well count by 500 wells to 12,750 compared to 12,000 or so rig released last year. While it’s a far cry from the 24,000 wells punched in 2006, the trend is moving in the right direction.

Typically drilling is overwhelmingly weighted to natural gas, but the interesting thing thus far in 2011 is that oil is carrying the day for only the second time in a decade (the first was in 2010) thanks to the application of horizontal drilling and multi-stage fracking technology.

Some third-party engineering firms in Canada and the U.S. are saying onshore conventional oil production could start rising again for the first time in 30 years. In the U.S., it already has, according to a report last week from the Energy Information Agency (EIA).

Analysts agree the renewed focus on oil is what’s driving the positive drilling numbers.

Despite a 20% drop in the number of new gas wells, Canadian brokerage firm Wellington West is forecasting a 30% increase in overall capital spending this year to more than $30 billion in Canada alone.

Like fishing and farming, drilling is a seasonal activity and it’s overwhelmingly front end loaded onto the first quarter, which can make or break the entire year. Wellington also pegs 2011 as the start of a multi-year “super-cycle” that won’t peak until 2013.

According to services analyst Greg Colman, that increased capex will mean a further 13% year over year revenue growth for his group of service stocks in 2012.

Most service outfits have already had some big runs – up anywhere from 75-100% in the last six months.

As a result, we’re seeing some big names get bigger through consolidation… and we’re also seeing some new entrants that present opportunistic buying opportunities (many of which we’ve bought into in the Oil & Gas Investments Bulletin portfolio.)

One example is Western Energy Services Corp. (WRG-TSX). This is a small, early-stage entrant that’s already managed to pull off a few acquisitions while it strives to gain critical mass.

The company is run by former Precision VP Dale Tremblay, who was arguably the driving force behind the creation of the country’s largest contract drilling firm.

It’s always a good play to invest in management and the stock has doubled since October, from 20 cents to 40 cents as of Friday.

That’s when the company outlined a $50 million capital budget to add new iron tailored specifically to the new resource plays.

Watch for Western to hit the acquisition trail to further speed its growth, as there are quite a few smaller mom and pops that are ripe for the picking.

Thanks to the uptick in drilling, there is no shortage of work. And as margins and profitability return to the sector, companies like Western will be poised to execute even if gas prices don’t recover over the longer term.

Longer term, it takes a couple of quarters to get companies like this rolling. The proof will come in the next winter drilling season in 2012, when Western could be a much bigger company, and very active.

Tuscany International Drilling Inc. (TID-TSX) is a relatively new Calgary-based drilling company but focused exclusively in Latin America, where demand – and profit margins – are high.

The company is initially focused on Colombia and Peru with plans to expand into Brazil. Foreign service companies are still relatively scarce even as several Canadian juniors and intermediates are starting to make waves, which gives it a first-mover advantage in an area where services are still relatively scarce.

After going public last April, the company has managed to pull off a clean double since September, closing Monday at $1.87.

– Oil & Gas Investments Bulletin Research Team

DISCLOSURE – Keith Schaefer has a position in Tuscany.

P.S. Here’s an article from December, written by guest columnist Brian Hoffman:
Why oil services stocks are outperforming oil producer stocks

Want to learn more about investing in junior oil and natural gas stocks? If you have a Facebook account, just “like” this article and a hidden link to Keith’s 10 page how-to on oil and gas investing will appear:

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ETF Investing in the Oil & Gas Market: Part 2

By
Keith Schaefer
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Understanding the future—not just the present—is very important to ETF returns. And this is where the two basic questions for investors get answered.

What is the timeline of the trade?

The real question here is, how many times does the ETF have to “roll” its futures contracts between now and that trade date?

Use oil as an example. Because the ETF issuers never want to physically own the oil, they must sell their futures contract before it expires, at which point they would need to take possession. So they sell it and buy a longer-dated futures contract — either the next month or several months out. This buying and selling of futures is called “rolling” it forward.

Are the futures contracts showing higher prices (in contango) or lower prices (backwardation)?

When the market is in steep contango or backwardation, that is to say when the futures market is very different than the spot price, indicating a big move in commodity prices, the ETFs get caught in a tight spot.

InvescoPowerShares’ Lake explains: “If you’re rolling into a contango market, an upward sloping curve, you will roll into a more expensive contract, and there will be a drag on performance.” (The PowerShares oil ETF symbol is DBO-NYSE.) “We use a more flexible rolling strategy, so we can reduce the impact of contango and increase the benefits of a backwardated futures market.”

In 2009, that drag was severe, as the spot price of oil rose almost 70%, and the futures market correctly anticipated that move, as there was a ladder of higher prices in the futures contracts. The problem: ETFs had to sell their lower-priced contracts that were nearly expired and buy the more expensive contracts dated farther out. And the more often they rolled, the greater divergence there was between spot prices moving and ETF prices moving.

That scenario caused many retail and professional investors, like Philip Treick, managing partner of Thermopolis Partners, to avoid going long the ETF sector.

“The contango futures curve forces an ETF manager to sell the current expiring contract low and buy the replacement contract higher — hardly a recipe for success,” says Treick, who manages two natural resource funds out of San Francisco and Jackson Hole, Wyoming.

“Institutional and individual investors bought these ETFs hand over fist assuming they were gaining exposure to a rising commodity price when actually, the roll was obliterating returns.”

In 2010, however, Hyland says it has been a different story.

“Year-to-date, the amount of contango in the front-month oil contract for WTI has been eroding a bit more than 1% from the return. If someone is looking at this investment as a three- or four-week play, how much do they care about contango or backwardation? It’s not that you won’t feel it, but in the bigger picture, how much does it really matter? In any single day the spot oil price often moves 1% to 1.5%.

“But if you’re looking at 12 months, then it’s a bigger factor.”

In other words, the trade timeline is greatly affected by the roll.

Hyland’s funds continue to roll their contracts forward monthly, to the nearest contract. While this is simple, it also increases any distortions from contango or backwardation. Other ETFs, like PowerShares’ DBO, use a more flexible strategy that can roll once or many times a year.

Morningstar ETF analyst Abraham Bailin says the ETF issuers are evolving their products to meet the market’s concerns about the roll.

“Futures-based funds are using dynamic strategies, like USCI, The United States Commodity Index Fund, for instance. They can choose contracts out as far as 12 or 13 months, that can maximize gains or minimize losses posed by the implied roll yield. Some of these dynamic methodologies are getting very crafty.”

USCI trades all commodities, not just energy, and will buy futures in backwardation, where it can sell higher-priced, near-term futures contracts and buy lower-priced contracts farther out in time, pocketing the difference.

___________________________________________________________________

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Tax Issues with ETFs

A secondary characteristic of ETFs that few investors pay attention to is their tax treatment, which depends on the funds’ structure. The Wall Street Journal reported in April of this year that ETF holders could get taxed at 23% — higher than the 15% rate investors are used to paying on stocks and mutual funds in the U.S. — on gains they haven’t taken yet under I.R.S. rules, which state that open positions in futures contracts are to be “marked to market” at year-end.

“We find it (futures-based commodity funds) irritating to customers at tax time,” says Richard Shaw of QVM Group, South Glastonbury, Connecticut. He buys a lot of ETFs for his clients, and writes about them as well—but he doesn’t buy energy ETFs, because of the roll issue, and “they are taxed in complicated ways. A CPA has to take more time.”

There are other issues with energy ETFs as well. Sometimes the popularity of an ETF will cause it to trade above its net asset value if the issuer is not granted permission to increase the number of units.

Professional traders claim they can “front” the roll at the expense of other ETF shareholders, by buying large amounts of the same futures contract that the ETF does — just before the ETF buys it. They then sell into the ETF buying.

There are also a growing number of levered commodity ETFs, which try to give investors two or three times leverage to the moves in commodity prices or commodity indexes or commodity equities. These often take the form of exchange-traded notes, or ETNs, which have completely different issues for investors and taxation methods.

But for ETFs, understanding how the futures market works, and how the ETFs play that market, are two sides of the same coin that investors must have comfortably in their pocket before spending a dime on the funds.

People invest in ETFs like they would a stock, but because of the way they are structured, they act more like a bond. Like a bond-maturity date, the futures market tells investors where their investment in a futures- based ETF is likely headed, and they need to determine which ETF product gets them there the most profitably.

– Keith

Follow this link for Part 1 of my report, ETF Investing in the Oil & Gas Market

* Article originally published in Oil & Gas Investor in December 2010

ETF Investing in the Oil & Gas Market

By
Keith Schaefer
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0

*Editor’s Note: The following is a report I developed for Oil & Gas Investor magazine, published in its December 2010 edition. Part 1 of the story is re-printed below with their permission.

Exchange-traded funds have been on a roll. Here’s how to find the one with the best fit, and make it pay off. But watch for the “roll.”

Commodity exchange-traded funds, or ETFs, were created early in the last decade to give retail investors an easy way to play hard assets such as oil and natural gas and metals in one broad investment vehicle.

And the strategy has worked—in spades. A low fee structure, preferential tax treatment and strong marketing have propelled commodity ETFs to $97.8 billion in assets under management as of September 30 2010, according to industry data from BlackRock, one of the largest ETF issuers. BlackRock’s data also indicate that overall ETF assets at the end of September were just under $800 billion and growing—up 13% over 2009.

Now, almost 10 years after ETFs’ launch, retail investors have a lot of access—31 energy ETFs and related products alone; 890 total, across all sectors in the U.S.; and 149 new ones just this year. But quantity hasn’t equalled simplicity.

Management from even the most straightforward—and largest—energy ETFs have had to defend themselves at congressional hearings in describing how their funds work. And other energy ETF issuers have launched products that use new and different ways to both track commodity prices and increase returns.

With all the choices of energy ETFs and the confusion around how they work, how can investors decide which one is right for them? And more importantly, how can they make money at it?

Choosing ETFs

ETF issuers and independent analysts say investors need to know the answers to three basic questions before making a purchase:

• What is the timeline of the trade?

• Is the futures market for that commodity in contango or backwardation?

• Do you know what you’re buying? ETFs now have very different exposures to energy prices.

“It’s not that complicated,” says John Hyland, chief investment officer for U.S. Commodity Funds LLC, which issues the United States Oil Fund LP (USO-NYSE) and the United States Natural Gas Fund LP (UNG- NYSE).

“By the time you’ve answered question No. 1 and No. 2, your choices have now been limited to a couple ETFs—those questions have done 90% of the work” for investors looking to invest in ETFs, he says.

“If someone comes to you with a bond, you ask what the time frame is (until maturity), and ask yourself are interest rates going higher or lower over that time, and then you pick what you’re going to do. I don’t think it’s any more complicated than that, really,” Hyland concludes.

Michael Johnston, senior analyst at ETF Database in Chicago, agrees, adding, “What we find is that people don’t understand how they’re getting exposure” to the underlying commodity when they buy ETFs.

An energy ETF can try to track the spot commodity price, or an oil and gas stock index, or a basket of stocks—or, as the market is seeing now, the ETF can track a custom product that the issuer has made up itself.

But Hyland’s USO and UNG are by far the largest and most liquid investments in the energy ETF world, and they use—in fact, most issuers use—the futures market to run their ETFs.

And using the futures market is where the biggest frustration for investors becomes apparent, in the cost of “rolling” futures contracts. Knowing how the futures market works, not just how the spot price market works, is key in who wins or loses in ETF investing.

“Some investors came into ETFs looking at spot prices to gauge the success of their investment, but that exposure is not something you can always achieve,” says Bryon Lake, senior product manager for Invesco PowerShares, an ETF issuer. “The next best thing is to use a futures contract.”

But the wild volatility in energy prices over the past two years brought about the near- market collapse in 2008, and the recovery so far in 2009-2010 has meant that the futures market sometimes did not track spot prices.

Tracking the future

Most energy ETFs actually track a futures contract, not spot prices. And during volatile markets, investors were getting the former, when they thought they were getting the latter. That made for some big discrepancies in 2009; Johnston says the price of natural gas was only down 1% on the year but Hyland’s UNG ETF lost half its value. (Johnston wrote in March 2010 that while UNG continues to decline, it is actually tracking the natural gas price almost perfectly once the wild volatility stopped.)

So understanding the future—not just the present—is very important to returns. And this is where the two basic questions for investors get answered.

What is the timeline of the trade? And are the futures contracts showing higher prices (in contango) or lower prices (backwardation?)

Follow this link for Part 2 of my report, ETF Investing in the Oil & Gas Market.

– Keith

* Article originally published in Oil & Gas Investor in December 2010

Want to learn more about investing in junior oil and natural gas stocks? If you have a Facebook account, just “like” this article and a hidden link to Keith’s 10 page how-to on oil and gas investing will appear:

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What I’ve Learned about Junior Oil & Gas Trading

By
Keith Schaefer
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0

Every year the stock market gives me new lessons to learn, and I’ll share a few from 2010.

When it comes to the junior and intermediate North American oil and gas plays, I want to buy expensive stocks.  I rarely buy cheap stocks.  That sounds counter-intuitive, but it makes sense.

When a company trades at a high valuation it can raise money with less dilution, and can use its stock as currency to take over other companies.  They can grow more quickly and more efficiently than companies with low valuations.

It’s my experience these companies get more growth priced in faster.  It’s a circle of prosperity where these companies use their stock or stock price to raise money to buy the better properties.  And the brokerage firms that raise them that money (and get all the fees and commissions!) support them by issuing research with higher and higher target prices.

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It was difficult for me to buy BlackPearl Resources (PXX-TSX) at $2.96 this year – I looked at the production rate, the reserve base, the growth that IMHO was a little too far down the road…it was just too expensive.  I loved their heavy oil space, but at first I didn’t think that was the right stock.  But the market told me I was wrong; I was missing something and I had to put aside my own interpretation on the same facts everybody else knew, and buy it.  It hit $7 and I still own (most of) it. ;0)

Of course there are turnaround stories, but they are few.  And the ones that meet expectations, in my experience, are even fewer.   This last year Bellatrix (BXE-TSX) was one – a heavily gas weighted producer laden with debt that brought in new management, developed their Cardium oil play… and the stock turned around.

My experience is that once the analysts and funds have pegged a stock on its valuation, it takes a big success by management to change the street’s mind.

I learned how trade “recaps”.  A new trend on the Toronto Stock Exchange (in the last 2 years) is the “recap.”  This is where a debt-laden junior with few prospects getsrecapitalized with new money directly from the wallets of a new management team (and their friends and underwriters).  As such, any debt is reduced or wiped out – and the new team has a big, cheap share position.  Often a new suite of properties is vended in at the same time or shortly thereafter.

These stocks are often tightly controlled and can quickly get and keep a big valuation, based solely on management’s reputation (think Legacy (LEG-TSX) or Wild Stream (WSX-TSX).  The team gets such a quick premium into the stock that it takes months to “backfill” the value into a stock chart – see these recap charts:

Many, but not all oil-weighted recaps had charts like these.  So I learned that if you still own a recap 2-3 weeks after the press release announcing the new team, you will likely have a losing investment for awhile. One exception is Scott Ratushny’s Midway Energy (MEL-TSX) – one of the first juniors to get into the Cardium play in late 2009.  It was a great success, as was Brett Herman’s Result Energy, which was taken out by Petrobakken after only being listed for three months.  That symbol was RTE-TSXv.

The natural gas-weighted recaps, as you would expect, did much worse than the oil weighted ones.  Companies like Cequence Energy (CQE-TSX) never regained the share price they achieved in the enthusiasm of their initial days. (Though I am quite excited about their new Montney drilling…)

I also learned that when I know I have invested in a a market leader with lots of room to run – which usually means they have a large land package in productive oil and gas area – I need to have more patience.  (But I do like to sell stock…)

With Painted Pony (PPY.A-TSX) I knew that their properties – both the Bakken oil lands and the Montney gas plays – had great addresses.  There was no question the oil and gas was there.  It was a question of whether or not I could wait long enough with my investment for management to develop its lands – because I was sure tempted to sell the stock in the summer when it was correcting and volume in the stock was low.

I was smart with Painted Pony – I did hold on and am now enjoying a tripling of my money.  But I was dumb with Wild Stream, (WSX-TSX), another OGIB stock pick this year.   Again, I knew Neil Roszell and his team to be very capable, and their four resource plays to be a relative no-brainer.  But it was a small position for me, and I succumbed to impatience and sold the stock in the summer.  While that was a profitable trade, it has since gone MUCH higher, just as I knew it would.

There are very few trades that I KNOW are going to work, and when I find one, I should be betting the farm and buying much larger than normal positions and be willing to accept a smaller return. (I’m talking% 50%-75% + vs. 200% or 400% that I get with some of the penny stocks.)

When it comes to exploration stocks – especially the international ones – I want to invest early in plays that have a BIG prize – one that creates what analysts call an “unrisked NAV” that is a multiple of its current stock price.  This unrisked Net Asset Value is a bit of a pie-in-the-sky number they come up with by saying – IF this company hits on ALL of their drill holes they will create a resource worth THIS much.  It’s a fantasyland valuation.

After I bought TAG Oil at $2.35, an analyst came out a couple months later and suggested it could have an unrisked NAV of $225.00 per share – a hundred fold increase.  Because international exploration involves more political risk, you want a big prize to outweigh that risk.

I know 2010 was a good year when my learning didn’t cost me anything.  Despite all my lessons, the OGIB subscriber portfolio – which is my real money – managed to eke out a 74.5% gain for the year.

– Keith

International Junior Oil Stocks

By
Keith Schaefer
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Part 2:  How To Position Yourself for High-Risk, High-Reward International Plays

How do you find – and play – the junior oil exploration stocks that can be 10-baggers for investors?

These are the companies that are drilling high-impact wells that can produce thousands of barrels a day – and their success can make shareholders a lot wealthier. As I wrote in my previous article, all these exploration plays are international – and the big winners often come from orphaned stocks that get financed at a very low valuation.

One of my subscribers, Craig in Seattle, rode OGIB stock pick Xcite Energy (XEL-TSXv) and their North Sea heavy oil play from 60 cents to $6/share and sent me this email just before Christmas: “Thank you many times over – this “plucky” investor has just become a millionaire (on paper) due to you bringing it to my attention and of course me doing my own research.”  I love those stories.

I’ll share with you how I find these companies, how I invest in them, and at the end I outline my current favourite international oil play, which has a big, short term catalyst.

1.      My investment philosophy is to have the biggest “deal flow” I can get; create a big hopper of ideas and keep it full.  So that means I have accounts with a lot of smaller, regional brokerage houses that cover the junior international exploration companies.  In Canada this means securities firms like (alphabetically), Cormark Securities, Haywood, Jennings Capital, Union Securities and Wellington West among others.

Some of the national firms cover a few international juniors, (Canaccord Capital, GMP Securities, Macquarie Capital) but these junior companies often don’t raise a lot of money before their first big success, so it’s tough for the larger brokerage companies to make any money covering them.

Whatever firm you’re with, have them email you their morning letter and specifically an energy letter if they have it. (I get 8 each day, and get some of my best investment ideas from them.)

In the U.S. the analysts are more myopic and they don’t do near the small cap international coverage that the Canadians do – in fact, it’s not unusual for US based teams with international projects to list on the Toronto Stock Exchange first.

These companies often get orphaned as the investment bankers in Toronto and Calgary don’t know the management that well, and they fall through the cracks – unless management can raise their own money or has a remarkable track record in exploration.

2.      Another free and easy way is to sign up for the daily emails from some of the trade magazines – I read the daily email from Rigzone.com – I find that the best one.  I also get the daily email from www.platts.com andwww.upstreamonline.com, and I also pay for The Daily Oil Bulletin in Canada.

3.      I also have Google Alerts to track some very talented energy writers, like Toby Shute from the Motley Fool.  (Another great writer — though he doesn’t cover much in the way of international plays — is Allen Brooks’ Musings from the Oil Patch http://energy-musings.com/)

4.      I also create Alerts for specific areas, like “offshore West Africa” or “North Sea oil”.

5.      Every six months there is an investment conference of junior oil and gas companies in Calgary hosted by SEPAC – the Small Explorers and Producers Association of Canada (www.sepac.ca) that is worth attending.

6.      And if you do all these things, guess what will happen?  You will create the single most important and powerful profit center of your investing career – your network of friends and contacts.

They send you research.  They share talks they’ve had with other people. They may know of a junior company that has just assembled a big land package right beside a big new discovery in Timbuktu or Nowhere – and they’re doing a cheap financing.

OK, so now you are slowly building your information flow and have a list of several exploration stocks you’re following.  Which ones to buy?

Like any other energy investment, you want to check out management, find out how much production they have, how big their land position is, and whether or not their production is nearby.  You want to know the cash balance, and the share structure, and how transparent or corrupt the country is. (Download my Top 20 Questions to Ask Management at the top of my homepage!).

I want to find a big play that is getting financed now, but won’t get spudded for several weeks or months. I want to put my money in when The Big Money comes in.  I may have been watching the company for months, or longer, but I wait for The Money to come in. (I also call this the BIBA Machine – Brokers, Investment Bankers and Analysts.)

Getting the timing right is very important to me on these high-risk, high-reward international plays.

One thing I don’t want to do is be too early to the play.  Perhaps management is waiting for permits of some kind – the politics and bureaucracy in many countries is very slow.  Or maybe the hot property is in a legal dispute.  Or there is some negative attribute (“hair on the deal,” it’s called) that is keeping The Money away.  Without The Money, the chances are much less that the stock can build a speculative premium close to drilling.  The Money promotes the stock with management.

And that is key.  I like to make my investment several weeks before results are due on the well.  That gives management time to promote the stock to analysts, who can get their reports out to their clients.  Hopefully management can spend a lot of time doing investor presentations to institutions and other investors to create some excitement around the play.  Who organizes most of those presentations? The Money.

I want this “excitement” to cause the stock to go up so I can choose to sell enough stock to cover the cost of my investment and ride for free on the results.  If the timeline from investment to results is too short, I might not get that opportunity.

My favourite international oil play right now has all the attributes I’m looking for – except time, though the market has cured that as the stock has had a strong speculative run.

Winstar Resources (WIX-TSX) is only three weeks away from announcing the results of a high impact oil well in Tunisia, North Africa – the CS SIL #1, targeting to prove up an extension of a prolific oil field.  I love this investment, because only a few small firms in western Canada and only one in Toronto have research on it. No other firms were actively supporting Winstar.

The company has a tight market capitalization with only 35 million shares out and no debt.  It was trading at 4x cash flow, despite high netbacks of $57/barrel on 2000 bopd production.  So there was no speculative premium built in yet for this high-impact CS SIL#1 well.

The fact they missed last November on a $7 million well I’m sure helped create a low valuation.

This well is about 30 km away from the nearest production in south west Tunisia, but other producers in that area have had an 80% success rate with wells having IP rates of 6000 bopd.

IF Winstar hits on this well – and they have said publicly that four zones showed positive signs – what impact could that have on the stock?

In the first week of January there was a sale of Tunisian oil assets which gives an update valuation of Winstar’s assets and what the potential upside could be upon success of its current well.

Pioneer Natural Resources Company (PXD-NYSE) announced that it has agreed to sell its Tunisian assets and production to OMV AG, an Austrian company, for US$866 million.  The assets are close to Winstar’s Chouech Essaida and Ech Chouech blocks, as well as several other concessions.

Analyst reports valued the production at $94,000/BOE/d, and $22.80 and $14.65/BOE for the 2P and 3P reserves respectively. (That was BEFORE the current political turmoil in Tunisia.)

Applying the OMV-Pioneer metrics to Winstar’s production and reserves, analysts suggested it values Winstar at $5/share on a production basis, and $9/share on a reserves (2P) basis, before any new production or reserves from the CS SIL#1 well currently being tested.

So IF this well comes in at 2000 bopd, an increase in market cap of $188 million ($94,000 x 2000) would not be ridiculous. On 35 million shares out that would add $5.37 a share to the current price of $5.50 – making it a short term double. And success would mean there are multiple potential new well locations in the field if this well hits that would enhance shareholder value for a few more years.

BUT if the well misses, I expect the company to halt the stock and see it open later in the $3.50 range – at best.

The good news is that the company has no debt, has (great) positive cash flow, and a miss on this well will not destroy the company.  But a lot of speculative money in the stock will leave over the coming weeks, putting constant downward pressure on the stock.

The hard part is gauging how the market may take a result that is a lot less than expected, say 500 bopd.  While that would likely be economic, the market might be happy and bid the stock up or disappointed and sell it down.

High risk, high reward.  But these are the plays – for the risk-tolerant investor – that can be 10 baggers over short periods of time.

– Keith

DISCLOSURE – I own Winstar Resources.

Publisher Note:  Follow this link for Part 1 of my International Junior Oil Stocks report.

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