Alan Knowles' Picks Energy stock picks provided

Haywood Senior Oil and Gas Analyst Alan Knowles says we haven’t seen a bottom yet, advising investors to watch the large companies when the market strengthens again. Meanwhile, demand continues to slide as OPEC plays catch up on a series of announced production cuts. And a pilot project involving a new oil sands technology is exceeding expectations; Knowles explains the significant advantage of upgrading oil in situ and foresees a bright future for the company that patented it.

TER: Now, I think it was Exxon that came out after Q3 with record quarterly profits. What’s to keep these big oil companies from financing these large projects?

AK: Well, first of all, that’s profits, not cash flow, and there are a lot of nuances into the earnings number that don’t translate into cash flow. So, these large companies—the really large companies—are generating a lot of cash flow, but they’re reinvesting a significant amount of that cash flow into the ground already. Exxon and BP, for example, had so much cash flow at the $140 price that they actually did build a significant cash reserve because they couldn’t spend the money they were making. But that will quickly erode because their capital commitments will continue at an oil price that is a third of those prices so they’re not going to have excess cash in a year or two.

There definitely will be M&A activity going on. Larger companies will acquire smaller companies that might be undervalued but, more importantly, are also a strategic fit for their operating areas or growth plans. But that’s not adding new production, remember. When you see companies acquiring other companies, that’s not adding new production; in fact, as far as the capital expenditures of those two companies, one plus one doesn’t equal two anymore, it might equal 1.5 because the two combined companies will drop projects off the table that separate companies would have done.

TER: Well, as an investor, I am looking at some of the companies you’re following, which range from trading on the New York or Toronto Stock Exchange to trading on the Toronto Venture. What should an investor start looking at—the producers or the explorers?

AK: When we start to see the market strengthen again (as I said, I don’t think we’re at the bottom yet), you want to watch the large companies. The larger companies tend to be the first ones to respond positively when the market turns, followed by the medium and then the smaller companies.

TER: Would you expect to see some of these smaller companies go bankrupt or will they be acquired?

AK: No, I don’t think the larger companies are going to buy a company just because it’s cheap. They’re going to buy companies that offer some strategic value to them and fit with the existing assets. Bankruptcy might not be in the cards, but we’ve already seen quite a few announcements of companies that are seeking strategic alternatives. So, they might not actually go bankrupt; they will be able to service their debt, for instance, but growth is going to be muted. Ultimately some weaker companies will be on the edge of bankruptcy but I expect the assets will be acquired, but now at a discount price.

TER: So, as an investor, we look at this like some of the mining industries where there’s an expectation that many will kind of go away. When it comes back around, there is at least a potential that these smaller companies will eventually make a turnaround with the increase in the economy.

AK: Right now, the equity markets are not really available to any of these companies, and the debt markets are selectively available depending on the quality of the assets and the management; so if a company is not at its bank line already, it has more flexibility to grow. So, you shouldn’t just go in and just buy the sector. You have to be careful which names you pick; you want to pick companies that have quality assets and low costs associated with running that company (i.e., operating costs, admin costs and the interest costs—I’m talking about the cash costs here). In this environment, a company fully extended on its bank line isn’t likely to get that line increased; in fact, it could be decreased, depending on how the banks look at their risk going into the first quarter. So, you want to be looking at companies that have some, if not a lot of, flexibility on their balance sheets going into 2009.

TER: Can you share with us some of the companies that you feel qualify for those three areas you just mentioned—quality assets, low cash costs and bank line availability?

AK: Well, in the large caps, I think both Nexen (NYSE: NXY, Stock Forum) and Talisman Energy Inc. (TSX: T.TLM, Stock Forum) have that going for them. On the medium size, Petrobank Energy (TSX: T.PBG, Stock Forum), which we cover, has room on its bank lines and has a quality asset base that is generating a lot of cash, even in a $45 oil environment. TriStar Oil and Gas (TSX: T.TOG, Stock Forum) is another company that we cover that is in that boat. Crescent Point (TSX: T.CPG.UN, Stock Forum) has a very good balance sheet and quality assets. And on the internationals, Petrominerales (TSX: T.PMG, Stock Forum) right now appears to be there—they’ve got some very positive drilling successes; they’ve got more drilling to do, and they’ve got high net-back oil production even in a $45 oil environment. So, having said that, in a $45 oil environment, all these companies will be reducing their capital investment due to, as I said earlier, the expectations of the oil price coming back in a year or two. I think a lot of these companies will look at the rate of return on the investment now versus a higher oil price and choose to defer drilling wells for now.

TER: Let’s say that oil goes back up. What is a reasonable number to start drilling again—$65, $80?

AK: I think $65 would be a good number. I think Crescent Point, Petrobank, TriStar, and Petrominerales can really do something with $65 oil because of their low royalty, low operating costs. Crescent Point and TriStar are involved in the same play here in Canada, called the Bakken play, and that’s light oil, so it receives quality pricing. The first year’s royalty on those wells is only 2.5%, and the operating costs are in the $8 to $9 range, generally. Even in a $45 oil environment, they have a decent net back but the rate of return on a well at $65 versus $45 is significantly better; so, they wouldn’t stop drilling but rather slow it down in a $45 oil environment.

TER: And with the $45 oil, you indicated that the various oil sands projects are not really moving forward; do they move forward at $65?

AK: $65 causes you to start thinking seriously about them, but you have to see higher prices than $65, especially if there’s an upgrader involved. When demand goes down, then the discount from heavy to light oil is larger, which is what we’re experiencing now. So, the heavy oil producer is seeing a disproportionate decrease in its oil price than a light oil producer.

TER: And the companies you mentioned before—Crescent Point, Petrobank, and TriStar—are all light oil?

AK: Yes.

TER: Very good.

AK: Well, Petrobank does have an oil sands project, but it also has an oil sands technology, which is why it’s more complicated than the other companies mentioned. The company’s oil sands technology is in the pilot stage now, but all indications are that that pilot is working. The oil is upgraded in situ in this process, so instead of producing 9- or 10-degree oil, it produces 20- to 21-degree oil—a significant advantage; and capital costs are a third to a quarter of competing projects. This is a new technology and it is getting a lot of attention now, especially in the lower oil price environment. And Petrobank owns the technology; the company has already signed two contracts for joint venture agreements with third parties to use this technology in their fields. It’s not just an oil sands technology, by the way; you can use this technology in any heavy oil field.

TER: That is quite an advantage.

AK: It is very significant, and it provides the company leverage against the technology in the future. The value of the technology for the company increases as more and more companies do a joint venture with them, and the technology becomes more proven. So far Petrobank’s deal has been to retain a 50% working interest in, and a 10% override on, the other company’s project. The benefit of that, of course—it adds to the company’s growth. The other benefit is that it also recovers 70% of the oil in place in the reservoir, and a competing or just a standard expectation is somewhere between 25% and 40%, depending on the project. So they get almost twice as much oil out of the ground from their well than a competing project would get from their well.

TER: That is substantial. That’s amazing. So, it’s still officially in pilot, and they’re actually going out and doing these joint ventures? You mentioned that they had two that they’re doing.

AK: Yes its still is a pilot project. But the pilot has produced above expectations, and it has upgraded the oil. I guess now you really want to see that pilot kept on stream for an extended period of time, say six months, at least. But so far, it has been very positive; Petrobank has signed two projects—one with Duvernay Oil, which was recently taken over by Shell, and another with a company in Canada called True Energy Trust (TSX: T.TUI.UN, Stock Forum). It has signed confidentiality agreements with most South American state oil companies—and there’s a huge amount of heavy oil in South America; and it has ongoing negotiations with other companies besides the state oil companies in South America.

TER: Is this technology capital intensive, meaning to replicate it across several wells, it’s hundreds of thousands of dollars, or is it like pure technology where it’s highly leverageable?

AK: Like I was saying, the technology is actually cheaper; for instance, the estimates are that this will cost $20,000 per producing barrel to put a project together, and it likely will be less, whereas your average SAGD (steam assisted gravity drainage) project is $60,000 per producing barrel. So, it’s a third, and if you add an upgrader, you can get into the $80–$100,000 per producing barrel. And so you’re comparing $20,000 versus those higher numbers, depending on the project.

TER: Wow, these guys could make it just on the technology.

AK: They could. They have this Bakken play in Saskatchewan that I mentioned to you, which by itself probably justifies the current share price because in this market where everyone is beaten up, and the market is not paying for anything unless you actually have it physically in hand, you have it on production. So, our view is this technology is not in the share price at all right now.

TER: That’s going to be amazing. I was wondering what small cap names you cover and if you had any names in that category that you like right now.

AK: Well, Petro Vista Energy (TSX: V.PTV, Stock Forum) is one that we’ve been watching and I like it because of the inventory of assets it has and the opportunities those assets present for the company right now. Due to their size however, they do have some exposure on their balance sheet compared to their desired

TER: Aren’t they in Brazil?
AK: They’re in Brazil and Colombia, and the Brazil project is one that is low risk and can provide a good return that is average. The Colombian assets provide a little bit higher risk but also potentially a greater rate of return. Petro Vista falls into the smaller cap group; and, in terms of funding, its pockets aren’t as deep as a larger company, so it’s in the process of establishing a cash flow base. Its drilling and exploration activities are being funded from the cash the company currently has on hand plus possible asset sales.

TER: Are they producing right now or not?

AK: No, they could be producing in the first half of 2009 if current drilling activities work out as expected. This is a company that will have to slow down its operations because of the limited nature of available capital right now.