Blessed by the Potato

The market looks to have gone a bit crazy lately, which I guess shouldn’t be unexpected given the turmoil all over the world. The world is a mess, and I just need to rule it which should (eventually) lead to opportunities presenting themselves. Oil was down a fair bit recently, which I found a bit surprising given the headlines, but I suppose some pullback was due. Oil stocks seemed to follow with gusto, which lead to me looking again at the sector for another value name to stick in there.

I should note that I have a bullish bias on oil long-term. Approx 12% of my active portfolio is in the energy sector (plus whatever’s in the TSX in my indexed portfolio), and that’s not including pipelines (which do have some exposure to energy prices; they make up 11%), or other companies that have some exposure (e.g., part of Canadian Helicopters’ business is servicing the oil & gas industry). That seems high to me, but it’s actually considerably less than the TSX (which is 27% energy). Most of my exposure is through the ETF on the sector, XEG. My thinking’s a bit torn on that. On the one hand, it’s a great, low-cost way to just pick a sector if one has a strong feeling about it, without having to pick individual companies. My ability analyze an oil company is admittedly weak (how to value reserves? what is land in one “play” worth vs. another?), so that works out for me, and gives a good amount of diversification. On the other hand, I could go even further and index more of my portfolio, and just get energy exposure through the TSX. Which I suppose comes back to my schizophrenic view on passive investing in general, which may be worth a post of its own in the future. The short version: I think it’s great, most people should do it (and it’s the only thing I recommend to others), as it’s hard-but-not-impossible to beat the index… but for 3 years running, I have. Which is terrible, because as they say, one of the worst things that can happen to a novice investor is to get lucky early on. So I try to stay grounded, and I do engage in passive investing (indeed, that’s largely where new savings go). Anyway, that brings me back around to wondering if, on the active/value side, I can do better than just say “I like oil” and buy the ETF.

I have to acknowledge my weaknesses: I can read a balance sheet, and look at cash flows, make back of the envelope calculations, and reason. But, even though I’m a scientist, I’m not a geologist, so I have no clue about formations and different plays, and have no idea how to even begin to value a company that isn’t at the production stage. So I don’t look at junior/exploration players (though that’s a high-reward, high-risk area that may serve a properly trained active investor well… that is definitely not me). Even with producers, I have to admit that I’m new at trying to examine them, and this next part is basically going to be me thinking out loud (unlike the rest of the blog). I would definitely welcome feedback on my thought processes and how to analyze these companies.

Example: Petrobakken (PBN). PBN is a little interesting: it has just tanked this year as its growth has slowed. It is an oil-weighted company (~85% oil, ~15% natural gas) with lots of land in Saskatchewan and Alberta (the Bakken and Cardium areas — it’s mostly focused in the Bakken, hence the name). The issue that seems to have brought down the share price is that the wells in the Bakken have been tailing off very quickly. Now there is normally a “decline curve” for oil wells: lots of oil can be pumped per day when the well is new, but as the pressure tails off (and, I’m sure, a host of other factors), less oil per day comes out as the well ages. But for Petrobakken, the decay has been very quick. The biggest declines have been in the namesake Bakken area, with new drilling not able to keep up with declines: the rock formation is “tight” and has to be fractured (“fracced”) to open channels for the oil to flow from the pockets it lives in to the well. The Cardium region has been making up the gap.

There are a few ways to try to put a price tag on an oil company, and I’m sure I’ll screw them all up.

The first is the way I look at many companies: discounted cash flow valuation. PBN reported cash flow per share of $3.51/share. If I assume that their production levels have roughly stabilized (tough to say, as they had a lot of growth, then some pull-backs, but many of the analysts say they’ve stabilized or will grow) and that oil prices (i.e.: cash flows) go up 4%/year, then I can plug all that into a discounted cash flow spreadsheet and get a valuation. Note that to be conservative, I’m using a 12% discount rate, assigning a -$9/share book value/starting value. That’s because they have about that much debt, and the assets (capitalized drilling costs, reserves, etc.) are not subtracted from cash flows, so if I counted them towards book value, they’d be counted twice (at least, I think so — if I’ve screwed up my accounting, let me know!). I’m not sure that I’ve fully accounted for the cost of drilling in this (because I’m not sure that their statement of cash flows discounts drilling costs), but hopefully I’ve been conservative enough in the other aspects that it’ll all come out in the wash. This quickie valuation gives me $23/share as my target price — indicating that the current price of $19 represents a substantial discount.

Another way is to try to multiply out the value of the oil they have in the ground. I could approach that in a number of ways, which will hopefully get me to the same ballpark. One is to take the total reserves (2P*) of 170 MBoe, and multiply that by a dollar value per BOE. That’s a little subjective: I pulled $35 out of my butt, partly by discounting their reported netback per barrel, and assuming that natural gas (15%) would be just break-even. TD suggests that the average valuation right now is $27/2PBOE, but $33 for oil-weighted companies, so I guess that gets me close. Multiplying out gives $6B value. Subtract the debt of $1.8B, and that’s $4.2B, or $22.50/share. This is a method prone to errors, for example, I wouldn’t want to pay $33 for a barrel of oil today, expecting to sell it for $33 in the future: I’d want a discount for the time invested. I would assume though that that premium would come from the price of oil increasing (I am bullish on oil), and also from growth in the reserves as more drilling and exploration is done (and their replacement ratio — the finding of new oil to replace what they drill — is above 1).

A similar method might be to try to multiply out by well instead of by reserve: it looks like their wells return something like 100 kboe in their life (with ~200 bbl/day initially, which rapidly decays). I’m getting conflicting readings on how much it costs to drill each well. They budget for $800M in capex, and plan to drill 200 wells this year, which to me translates to $4M per well, but the reports have figures all over the place, down around $2M. It looks like $4M might be a good conservative estimate, so I’ll use that. They have 2200 total well sites planned out (with, I’m sure, the potential for more as reserves are explored and firmed up). I’m not sure what figure to use for the amount they can sell the oil for: their “net back” is around $43, but that includes a cost for operations, and I don’t know if that includes the drilling, or just the ongoing costs. If I assume it includes the drilling, then I don’t need to subtract the drill cost, and I get a value of ~$9B (from which the debt should be subtracted). If I do have to subtract the drilling costs, that’s much less attractive: a value below $1B comes out in the end. So I don’t think I’m approaching this method right.

So mathy stuff aside, there are some concerns with PBN. The biggest one to my mind is the fact that they pay a nice dividend, but that they have been over-paying, racking up debt in order to finance the dividend. The debt is at least cheap, but still, I’d prefer they cancel the dividend to pursue the growth, and keep the leverage down. A close second concern is part of what caused the slowdown in the growth rate: they halted fracing in some areas because of “fracing out of zone”, which is when the rock structure is fractured beyond where the oil pool is, and they get water coming into the well. It’s a technical challenge, and it sounds like they have some solutions to improve the oil flow rate. What concerns me though is the potential liability if this fracing out of zone, into a water pool, means that they’ve contaminated groundwater in the area. I honestly don’t know if that’s a material concern or not, but it has me worried. Divestor has an article up on whether PBN is a value trap, and unfortunately, I can’t really refute his concerns, and I don’t have much confidence in my ability to put a value on the company here (again, any help appreciated!).

I’m primarily a “value investor” in my active portfolio (my passive portfolio is, naturally, passive, and designed to protect me from being too clever by half), and I don’t tend to pay too much attention to my asset allocation: instead I look for opportunities in individual stocks. Nonetheless, despite my statement about being bullish on oil long-term, I don’t have a huge exposure to oil (especially after selling BP). And, thanks to a great run in Canexus and Chemtrade, I find myself with a bizarrely high allocation to sodium chlorate producers — not normally a sector of much significance. I still think they’re both pretty attractive, so I’m hesitant to trim them down, but I think that’s probably where I’ll be getting the cash for an oil company (or more XEG) like PBN above.

* – 2P: Proved and probable (or possible). To put it simply: there are usually 3 levels of reserves reported, proved (1P) being oil in the ground that the company has a very high certainty (usually 90%) is there and can extract using current technology. Probable is oil that’s likely there (to some confidence, say 50%) and can likely be extracted using current technology.

Disclosures: don’t listen to me, I’m just a blogger, blah, blah, blah, long XEG, HSE, DAY, CHL.A, CHE.UN, CUS.UN, no position in other companies mentioned.