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Message: Josef Schachter.... WZR top pick
TER: You mentioned Delphi and WesternZagros, which are your top-two picks. One thing that jumps out at me is that neither of these companies has had spectacular returns. So, is this your contrarian gas play?
JS: Yes. DEE got hurt because of their gas bias, but they always had land with liquids-rich capability. For example, in 2009, Delphi was producing about 15% oil and 85% natural gas. This year, it's going to do about 27% oil and liquids—and that number will go north of 30% by the end of the year. It's going to generate over 50% of its revenue from oil and liquids; so cash flow will go up, and production volumes will go from 6,700 boe/d in Q109 to north of 9,500 boe/d by year-end. Delphi is doing the right things, in terms of the mix. It's going after the liquids-rich capabilities on its land, but the company always has the dry gas sitting in its inventory; so, when gas prices go back to $7–$8/Mcf, Delphi can move those assets. In the meantime, it can increase its net asset value (NAV) and cash flow by going after the liquids. It's similar to the gold business—when prices are low, you go after your best veins; and when prices are high, you go after your bad veins.
TER: Your target price on Delphi is $4, which implies a 60%–65% return, but I noticed the company's NAV is $3.78. It sounds like a very conservative target price.
JS: Yes. And that's because we're looking for Delphi to trade at a ratio of its cash flows, and we're looking at it annualizing about
.60 in cash flow by Q411. The cash flow multiple should be no greater than the proven reserve life index (RLI); and, if you have seven-and-one-half years of proven reserves, you also have probable and possible reserves, tax pools and land value to protect the value for shareholders.
So, we take an approach in which a company's maximum cash flow multiple should be equal to its proven RLI. However, we didn't even use that in this case. So, you could argue that we may have an even higher target, but our view is to use a reasonable target that we can see makes sense. Then, if it gets to that target and the company is doing better than expected, we can always review it again and come up with a new target.
TER: Your other top pick was WesternZagros, on which you have a target price of $1.50. That represents a roughly 175% return. What are the risks here?
JS: Well, this is in Kurdistan and now the Baghdad and Kurdistan governments are getting their collective act together, in terms of allowing money to be paid to the players in the area, which makes a lot of sense to us. WesternZagros has a lot of cash on the balance sheet, so it has enough for the next phase of drilling. What we like about the company is that the Sarqala-1 well has tested at 9,444 bpd light, +40-degree oil. So, it may have a massive oil field there. WesternZagros' biggest shareholders are George Soros and John Paulson. Thus, we have big, international investors that believe this company has a big land spread, very attractive base and has proven that there is light oil on it.
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