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Greg Chornoboy: Size of the Prize May Be Worth the Wait

Source: The Energy Report 12/10/2009
December 13th, 2009

Jennings Capital VP and Senior Oil & Gas Research Analyst Greg Chornoboy shares his take on the prospects for prices in oil and natural gas—and what he sees driving those prices—in this exclusive Energy Report interview. Cap and trade, "a lot of smoke and fire and great rhetoric," isn't on his list. Sharing insights into prospective investments, too, Greg favors large, well-capitalized companies for natural gas, while for oil he leans toward what he calls "embryonic" juniors with overseas properties in politically stable jurisdictions. That's where the size of the potential prize can be tempting. But don't look to them as get-rich-quick schemes, he cautions. "If you're not prepared to wait it out, it's not an appropriate investment."

The Energy Report: Supply and demand fundamentals haven't driven oil prices for years, according to Fadel Gheit, a senior analyst at Oppenheimer. He feels that the financial players actually control oil prices now more than either OPEC or oil companies. What's your view of what drives oil prices today?

Greg Chornoboy: I tend to agree with Mr. Gheit, although perhaps not as strongly as he puts it. An analogy I read last year in The Economist is quite useful in this context. There is only one buyer for a barrel of oil and that's a refinery. You and I can't use a barrel of oil for anything other than to sell it to a refinery, which can turn it into useful products. There are lots of refineries, of course, but only one market. If you look at futures, they're uncovered, whether it's the NYMEX (New York Mercantile Exchange) WTI (West Texas Intermediary), or the futures for Brent or whatever else. The act of buying or selling a future on crude does not add or remove any supply. In that sense, trading a future is a little bit like betting on a football game. Absent game-fixing, the betting shouldn't affect the outcome. You're betting on what the price is going to do.

That analogy breaks down a little bit in that the refineries themselves can buy or sell futures to hedge their cost. So there is a bit of game-fixing, so to speak. There's also the signaling effect that the futures markets have, because people look to those future curves in terms of setting their budgets and plans for exploration, drilling and development. So, at the end of the day you do have financial influence in the markets. We saw that snap back quite brutally at the end of 2008 and early 2009 in favor of who's actually using oil and who's not. Now we're starting to see the financials play a larger role again.

We saw this when the contango was quite strong, when tankers were contracted just to sit with oil in storage and sell the future a few months out and lock in the differential. That's competing with the supply and demand fundamentals. So certainly the financial sector is not without influence. It maybe not quite as strong as Mr. Gheit thinks, though.

The other thing driving oil prices right now is weakness in the U.S. dollar, because that's the currency in which oil is priced. It's somewhat perverse, since a weaker dollar is also indicative of a weaker economy—which should translate to lower demand and lower prices. So you have these competing forces.

TER: But even based on what you said, it's not supply and demand driving the price because we saw the price increase so dramatically in 2008. Then that huge bubble crashed down to almost nothing. We're barely back to where we were in January of 2008.

GC: Clearly the financial sector has some influence and now we have the added factor of the weaker U.S. dollar. And if you're selling oil, you don't want real value to erode. You're going to start demanding more of those U.S. dollars in return for your oil.

TER: So as you look at companies to invest in, what role do oil prices projections play in your analysis?

GC: What companies actually get for their oil or gas plays a crucial role, but it can vary from company to company. It depends on the fiscal terms of the country and its contract. In the more onerous fiscal regimes, after profit sharing and royalties and operating costs, a company might net back only 10% or 15% of the price of the barrel of oil. In others, they could get 50% or more. But generally, the net backs certainly increase as the price of oil does. There are a few jurisdictions however, where taxes and royalties effectively cap the price of oil and/or gas.

In the medium and long term, costs will chase the price. For instance, one of my companies, Calvalley Petroleum Inc. (TSX:CVI.A), is working on a deal for marketing their crude oil and building a pipeline in Yemen. A year ago the estimate of the cost for that pipeline would have been about US$90 million. Now that oil prices have come down, more recent estimates are probably more in the range of $60 million to $70 million. If oil runs back up over $100 per barrel, those costs will start to chase it up again, although there is a lag.

There will be a lag as long as there's slack capacity in the system. Right now there is spare capacity. Drilling costs, for instance, depend entirely on how many more rigs are available. If four rigs are laid down looking for work, rig costs aren't going up. If every rig is employed and has a year's backlog, rig costs are going up. Same with steel for pipe and instrumentation and so on.

TER: But if the financial markets rather than supply-demand fundamentals drive the price of oil, aren't you also forced to gamble on what the financial markets decide to do?

GC: That's true, but there is also typically a difference between what the companies actually receive and what the futures market is. One of the best examples of that lately has been in the North American gas market. They are getting closer now, but a month ago, the near-month future, could be trading for as much as $$1.00/Mcf higher than the Henry Hub spot price

TER: What do you think oil prices will do in 2010?

GC: We're expecting an average of $75.50 for WTI, and roughly a dollar per barrel lower for Brent.

TER: If you're a believer in peak oil, will that affect prices?

GC: The short version—and I'll expand on that in a second—is that someday the peak oil theorists will be right. The peak is more likely to be a plateau rather than scaling to the top of the mountain and hitting the slippery slope down the other side. That's because technology and development tend to extend the life of reserves. About 10 or 12 years ago in a former life, I did a lot of petroleum asset divestiture work, acting as the agent for companies wanting to rationalize their holding. With one particular property, it seemed as if every year we'd sell a piece of it but the reserves never went down. There was a whole year's worth of production in between, but because of infill drilling, new technology, better water flood response and so on, the reserves never changed.

Eventually the wells will deplete, but fields these days aren't just drilled up and simply produced until abandonment. Companies are constantly looking at how to optimize each well's production, anything to maximize the recovery. The fact of the matter is that, yes, the oil will run out, but the field lives tend to get extended quite a bit.

If you look at the world macro type of situation, shorter-term variances will be driven by prices. There's no shortage of estimates as to what the worldwide average decline rate is. I've seen as low as 3% to 5% per year and as high as 25% per year. I think the 25% is probably in a theoretical scenario where all drilling and development cease abruptly. Not another well to be drilled anywhere and you just let what you've got go down to zero.

If you look at the 5%, which includes some reasonable amount of exploration and development, then you're losing maybe 4 million to 5 million barrels per day every year. When you have low prices—as we've had—projects get halted, put on hold, maybe even cancelled outright. Now we're getting back up into the $70 and $80 range, which is probably a reasonable threshold for development. So in essence, we've lost a year to the recent financial meltdown. There's a lag time between when you find a new field and then start to develop it, and sometimes the lag between initial discovery and first production can be several years. If we start to see a pickup in economic activity and oil demand, because of the loss of that year due to the low prices, in the short and medium term we'll see something that looks like an apparent shortage while the system just catches up.

TER: As you suggested a bit ago, at least in North America, natural gas prices are really low now and lots of it is in storage. Some sector commentators are saying that since rig counts are down we'll deplete the natural gas storage and should expect price increases. What's your view?

GC: Increased prices are possible, but I think the biggest decrease in rig count has been in the vertical wells drilled in conventional reservoirs. There's not been a whole lot of change in the horizontal wells that have been drilled into some of the very prolific gas shales. On top of that, I understand that a number of the larger companies that tend to get valued more on a profit multiple than a cash flow multiple have spent large sums on the infrastructure: pipeline, gas compression, dehydration and whatnot. They now have assets that are depreciating and they want to fill it with gas that will give them some revenue to offset that depreciation expense. So on a cash flow basis, it may not be as clear-cut an investment. There are also companies that have drilling obligations to maintain their land holdings—if they don't continue to drill, they lose the lands.

The marginal producers have a fairly low cost right now and those are the shale guys. That's because we've got more gas than there is demand for, and there's an awful lot of gas shale out there. In the longer term—two or three years out—once demand catches up to supply, the marginal gas supply will probably come from the higher-cost producers. Gas prices will start to go up in response to that. So we have some small increases in gas prices built into our forecast, but nothing really significant for a couple of years.

TER: Would you recommend investors get in at this low?

GC: Yes, but you need a long-term timeframe. If you think you're buying at the low and can get out within the next two or three months with a handsome profit because of rising gas prices, you run the risk of being disappointed.

TER: How would an investor play the natural gas market?

GC: On the domestic side, I would look for large, well-capitalized companies. You want cash on the balance sheet that will allow them to carry on drilling and development and add the reserves. With the smaller ones that are likely to need to finance in order to continue their drilling and development programs, it's probably a little premature and you run the risk of dilution. Let me add a caveat, though. It depends on what the smaller company is doing. For instance, Corridor Resources Inc. (TSX:CDH) has gas reserves in production and development in New Brunswick. It has a tight gas reservoir that they're producing now and they have been testing an underlying gas shale called the Frederick Brook. They recently announced test rates on a well there that gave them 4.1 million cubic feet per day rates at pressures up over 2,000 psi. So at a normal system operating pressure, this well could be capable of producing far more than 4.1 million CF.

A very reputable engineering firm that looked at their potential holdings in that shale came up with an estimate of over 59 TCF (trillion cubic feet) of free gas in place. Make no mistake—gas in place is just what's physically in there. How much you can get out is a completely different issue. Recovery factors on gas shales can go anywhere from 5% up to 60% or so. But what if they can get 10% of this gas out? That's 5.9 TCF of gas, an enormous amount. Corridor is a relatively small company. They are also talking to a number of different outfits about farming in on the property for the development of the Frederick Brook shale. Then somebody would be paying a substantial chunk of the capital costs associated with proving this up and developing it and still getting some form of a carried interest. In this particular case you have a very large potential resource and a company with existing reserves, production and—importantly—cash flow, and is not necessarily having to look to issue new equity. That adds up to relatively limited downside and a lot of upside.

[On December 7th, Corridor announced that they had reached a farm-out agreement with Apache Canada Ltd. with respect to this property. Apache will spend as much as $125 million in two phases by March 2013, with potential to earn a 50% interest in the property.]

TER: Earlier you said we need to look two or three years out for demand to catch up to supply. Are you implying that demand will increase to the point that we use up what's in storage, or just what's in storage won't be replenished?

GC: It will be a combination. There will be some increase in demand. The typical production profile on those shale wells is that they start at quite a high level, maybe up to 10 million cubic feet per day. But after one year in production, they could lose 60%, 70%, 80% of that rate. It's a very quick treadmill, and they have to drill constantly to keep the output up. In the long run all production depletes. So, yes, a couple of years out I expect to see both declining production and growing demand.

TER: What strategy do you use to select the oil companies you follow?

GC: Framing this within the context of international junior exploration companies (both oil and gas), the sector we tend to look at, the first thing we want is the appropriate management team in place, the people who are running the company with the track record and the expertise they need.

The second thing we're looking for is very large targets, but in underdeveloped and perhaps even virgin basins so you have exploration risk, but the potential size of the prize is much greater than you would find in North America. North America has been drilled and developed. The monster finds aren't there anymore, whereas some of the developing countries have virtually untouched basins. You can have monstrous reserves, multiple TCF of gas, hundreds of millions or billions of barrels. That's the kind of thing we look for.

Another thing is political stability and strong property rights. That may seem a little contradictory in light of some of the places I have coverage, such as Kazakhstan and some of the Middle Eastern countries. There are some places, though, that I'd be extremely nervous about wanting to invest in. Nigeria, for instance, is one, because of all the disruptions constantly going on there. In Russia, it seems that if you get big enough, you will no longer own the asset. A number of companies have had exploration success in Iraq, but it's not clear to me who will be in charge. Will it be the Kurdish provisional government? Will it be the Iraqi national government? They have issues to be settled there.

As I've touched on before, we would also like these companies—and some of them can be very embryonic—to have some existing reserves, production and cash flow. Without cash flow, they just whittle away at working capital and ultimately have to go back to the market, which means dilution.

TER: Talking about political and the property rights stability, you mentioned a few countries that you avoid. Are there others that you find particularly appealing?

GC: I follow Cirrus Energy Corporation (TSX-V:CYR), which is working in the Dutch North Sea. I have no qualms about the political stability of the Netherlands and its respect for property rights. In Western developed economies, that's not much of an issue. After that there's a whole range of soup to nuts. I don't know that I would single out anything as being particularly good or bad. India is good with respect to respecting property rights. The system and the bureaucracy can move very, very slowly, but the risk of expropriation is quite low. They run on what's essentially, a British common law system.

TER: What should The Energy Report readers look at on your list?

GC: I already talked about Corridor with the big gas potential in Atlantic Canada. Another one is Bankers Petroleum Ltd. (TSX/AIM:BNK), which has a well-defined heavy oil property in Albania. The field was first discovered in 1928 and was drilled and developed by the Albanians in the decades afterwards. The gravity range of this oil ranges from 10 degrees up to 22 degrees and it has never had modern heavy oil technology applied to it.

The Bankers Petroleum team used to be in charge of Rally Energy Corp. Rally had heavy oil in Egypt and was extremely successful in implementing cold recovery techniques, thermal recovery techniques. Rally was a huge success. I think it was trading around $2.50 when I picked up coverage and they ultimately sold the company for $7.30 two years later. What this team is doing in Albania now is essentially the same thing. They are bringing in modern techniques, a lot of which were developed in the heavy oil sands in western Canada, and applying them to the reservoirs in Albania. I'm expecting them to be at about 8,000 barrels per day production by the end of this year and looking for an average of about 16,000 barrels a day for 2010.

They have hundreds of drilling locations and there's no question whether the oil is there. It's just a case of executing on the plan to drill all of these wells. Bankers Petroleum is also establishing reserves in areas of the reservoir that had never been drilled up before. So I would expect we'll see both very good reserve and production growth rates and, therefore, cash flow coming up over the next several years.

TER: The company is at a two-year high and has already increased fivefold just in 2009. How much upside potential can be left?

GC: My 12-month target right now is $5.75. But as they continue to do all of this development, I see this stock easily being up into the $10 range within the next several years, barring a collapse in oil prices.

TER: That's always good news when it's going up. Who else should our readers look into?

GC: Calvalley Petroleum. It has oil production in Yemen, a very large concession. They've been constrained over the last three years having to truck the oil from their property, a field called Hiswah, about 250 kilometers to the west, to another block that's run by a Yemeni company whose facilities have trouble handling Calvalley's heavier and slightly more sour crude. That has limited Calvalley's oil production.

So the company has been working diligently to get a marketing agreement in place so they can build themselves a pipeline and not have to rely on trucking. They will have an announcement to make perhaps within the next few weeks that they've come to such an agreement, in which case construction will start on the pipeline and we would expect it to be finished late in 2010.

Their production rate now is in the neighborhood of 2,200 barrels a day. Once they get the pipeline in place, we could see production in the neighborhood of 3,500 barrels a day and increasing from there. On top of that, they have a potential discovery in a second field within their block and any day now we're expecting test results from another exploration well they have drilled. So there could be a great deal of good news coming out of Calvalley shortly.

TER: Tell us more.

GC: Winstar Resources Ltd. (TSX:WIX) has properties in Tunisia and Hungary, with current production all from Tunisia at the moment. They put out around 1,900 to 2,000 BOE a day, a combination of both oil and gas. They have extinguished the debt they had on the balance sheet and sold some Canadian properties during the third quarter so they now have $7.6 million in working capital. Winstar will be getting back to drilling new wells and we would expect production to rise to about 2,250 BOE per day for 2010.

They're also in a fairway for a deeper zone called the Silurian, where a number of other companies have had huge success. Verenex Energy Inc. (TSX-V:VNX) to the east in Libya drilled 14 or so wells and the average test rates was about 4,500 BOE per day. Closer to Winstar's properties, OMV (OMVV.VI - Vienna Stock Exchange) has drilled some gas wells just offsetting, the largest of which had a test rate of 129 million cubic feet a day of gas and 3,500 barrels a day of oil. There's also some oil production offsetting in the area, fields that are in the tens of thousands of barrels a day of production.

During 2008, Winstar shot a 3D seismic survey over their concessions to identify the little anomalies and features to drill. They were hoping for four or five targets and came away with potentially 12. They have some negotiations underway, too, that if successful by the end of this year or sometime in January, may mean drilling the first Silurian well perhaps in mid-2010. The order of magnitude of a success there would double the company's production almost instantly.

TER: Any other investment insights you care to offer our readers?

GC: Particularly in our sector with these embryonic little companies, you have to look in the longer term. Sometimes getting things done in foreign countries can take much, much longer than you expect. The timeframes are years, sometimes due to the complexity of getting government approvals and sometimes because it's difficult getting the proper services mobilized. The size of the prize can be very large, but if you're not prepared to wait it out, it's not an appropriate investment. This is not a day-trading operation.

Gregory Chornoboy joined Jennings Capital's Calgary office in 2005. As Vice President and Senior Oil & Gas Research Analyst, he covers energy companies with international operations. An engineer by training, he began his career with Amoco Canada Petroleum in 1978, and subsequently worked for Saudi Aramco and Ultramar Oil & Gas, as well as undertaking consulting assignments with various Canadian energy companies. Greg entered the investment banking sector in 1993, as VP of Corporate Finance with FirstEnergy Capital. He later moved to the buy side as an investment manager with CanFund VE Management, an activist investor specializing in the energy industry. A professional engineer, Greg has a bachelor's degree in chemical engineering from the University of Calgary and an MBA from the University of Chicago.

Source: The Energy Report 12/10/2009

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