"The Street is expecting a narrower spread, but I have the opposite view for a pretty straightforward reason. It starts with light oil. The amount of light oil being produced in the U.S. due to the shale revolution is..
The Street thinks oil price differentials stem from lack of pipelines. That's only partly true, says Keith Schaefer, editor of Oil & Gas Investments Bulletin, arguing that limited refinery capacity is just as big a challenge.
Schaefer expects most investors to be caught completely off guard when the Brent/WTI gap widens and light oil prices plummet later this year, and in his nuanced interview with The Energy Report, he tells us who stands to profit, who stands to lose and why select natural gas companies are getting a lot of love right now.
The Energy Report: There's been a lot of talk about the spread between West Texas Intermediate (WTI) and Brent narrowing considerably this year. What are you expecting to happen?
Keith Schaefer: The Street is expecting a narrower spread, but I have the opposite view for a pretty straightforward reason. It starts with light oil. The amount of light oil being produced in the U.S. due to the shale revolution is going to completely overwhelm the refineries as early as July. Over the last 25 years, oil refineries in the U.S. have been moving away from light oil to heavy oil.
But more recently, light shale oil has been replacing expensive, Brent-priced imports in the Gulf Coast, providing a relief valve for high Brent prices. But there is only so much capacity; over the last five to seven years, about 0.5 million barrels (MMbbl) of refining capacity for light oil has been lost in the States just from switching to heavy. Thus, the light oil price in North America depends on the very limited light oil refinery capacity.
Meanwhile, an extra 250–350 thousand barrels a day (Mb/d) will come out of the Bakken this year and easily that same amount out of Texas. Louisiana Light Sweet (LLS) crude could easily drop at least $5–10/bbl once supply overwhelms capacity, and the whole energy complex is unprepared. The big question is if that is going to become a regional differential, or if light oil prices up the mid-continent through to Canada will drop. Right now, the most expensive oil in North America is LLS at the Gulf Coast. Light oil gets cheaper the farther north you go.
The next domino after LLS will be WTI at Cushing, Oklahoma. All these new pipelines that everyone is expecting to narrow the Brent/WTI spread are only going to move the logjam from Cushing down to the Gulf Coast. That logjam will start to build due to—again—limited refining capacity, and back right up to Cushing again. So I see a much higher WTI/Brent spread at the end of this year going back to the highs around $20, and this could catch the Street off guard. The Street thinks it's a problem with pipelines—with WTI, it's not. We just don't have the refining capacity to handle all this stuff. I hope these light oil producers are hedging like mad right now because I think there could be a bit of a surprise coming in Q3/13.
TER: Do you expect a shale production falloff?
KS: The amount of drilling right now is crazy. At least 0.25 MMb/d more are expected out of the Bakken, adding up to just a hair under 1 MMb/d this year. Over the last three years everybody has been drilling what's required to hold their land base. Most of that is now done, and at this point, many will get to drill where they want to, therefore increasing Bakken production. Plus, pipeline constraints have been alleviated by rail, which is now the preferred source of takeaway out of the Bakken, relieving infrastructure constraints.
In Texas, the amount of pipeline building between the Eagle Ford and the refineries is unbelievable. I'm reading that there is about four times the amount of pipeline capacity needed right now for all the Eagle Ford. So there's absolutely no barrier to super-high growth in oil production in the two main U.S. plays.
TER: Assuming that this does happen, what's the effect going to be on the industry?
KS: There are going to be winners and losers, like always. The big winners are going to be the Gulf Coast refineries. That's why I've made Valero Energy Corp. (VLO:NYSE) one of my top picks. It has seven Gulf Coast refineries. Three are light oil and four are heavy oil. I think you're going to see the light oil side of the refinery business get way more profitable. That's starting to get priced in now, in a big way, into the refinery stocks. Valero, which is the largest independent refinery company in the U.S., has cash flow that is absolutely on fire. If I'm right about Q3/13 oil prices, it's going to get an absolute turbocharge in profitability. They're going to be the big winners.
The losers are obviously going to be the light oil producers. That's why I'm hoping that they're hedging like mad, so that they can keep their margins for a long time.
TER: You've recently written about condensates produced in connection with gas. Can you explain their importance?
KS: Condensate, which is a both a natural gas liquid and a very light oil, is used by producers to dilute thick tar sands oil. Oil sands production growth is continuing at a very high rate and Canadian oil producers need a lot of condensate to make oil flow smoothly in the pipelines. Canada is producing a very flat amount of condensate, and needs to import as much as possible from the States. In the U.S., condensate sells at a discount, but Canada is a totally different market wherein condensate trades at $15 above WTI.
In Canada, most of the condensate is produced with gas. With Canadian gas producers, the number-one question to ask is how much condensate they are producing along with gas. This situation should continue for at least another two years. At around $110/bbl compared to about $85–90/bbl oil, condensate gives these natural gas producers even better economics than oil.
In Canada, they're building new processing facilities to handle it, and in the U.S., they're building new pipelines, reversing pipelines and using railcars to get condensate up to Canada. The Canadians then load those same railcars with heavy oil and send them back to the Gulf Coast. There are very few natural gas companies that are getting high amounts of condensate in their gas and those stocks can make investors lots of money.
TER: Which gas companies are rich in condensate?
KS: Most of the Montney producers are doing really well. One would be NuVista Energy Ltd. (NVA:TSX). Contact Exploration Inc. (CEX:TSX.V) is also a great junior for that play. Bellatrix Exploration Ltd. (BXE:TSX) down in the Cardium is getting decent condensate rates. Anybody with good condensate levels is getting a lot of love on their stock right now. The natural gas producers are actually starting to get some good-looking charts due to those high condensates.
TER: Do you expect this situation to continue for a while, or is it short term?
KS: I see very high prices for condensate producers for another two years until industry is able to truly organize infrastructure changes, reverse pipeline flows and get enough railcars to move sufficient condensate from the Eagle Ford in Texas to match Canadian demand.
TER: Canaccord Genuity just came out with a report showing that the stocks of junior producers in their coverage universe went from trading at 9.3 times their debt-adjusted cash flow in 2011, to 1.8 times in 2012. What are the implications of that?
KS: The junior market is seeing a narrowing of the deals that are able to raise money. Unless you're one of the best teams in Calgary, you're not getting funded. Even though the big boards are having a bull market, the juniors are not. The shale revolution mania is now three years old on the junior side and there is enough data at this point to understand that these plays don't recycle cash fast enough for the juniors. The beauty of these wells is that they're easily repeatable over a large area. They produce for 30 years, but at a very low rate. We see that despite high initial production rates, most wells just don't recycle enough early cash to allow organic growth for small-cap companies.
The investment community is realizing it can't keep giving these juniors so much dilutive equity because we're not going to get payback. They've stopped buying junior shale plays, causing valuations to fall quite dramatically. Only the best companies that are able to produce cash flow fast enough to allow them to drill another well without going to the market are getting any love. Former market darlings like Pinecrest Energy Inc. (PRY:TSX.V) and Surge Energy Inc. (SGY:TSX) have fallen out of bed and are having trouble getting back up. The market has become much pickier. Investors looking to invest in junior oil plays have to understand the new reality. You have to look at what the management teams are doing to address that cash flow problem.
TER: Some of the juniors are paying out significant dividends to attract investors. Do you think this strategy will work, and which companies might benefit by doing so?
KS: Trying to put a Blue Chip dividend model on a junior, high-risk play makes no sense to me because you have the same management teams drilling the same plays, just more slowly. What they're saying to investors is, "We're going to pay out some of this money to shareholders, which means we're not going to have as much money to drill, so we're going to grow more slowly." They don't recycle cash fast enough to do this. So, unless they are able to change how they do business to get more oil out of the ground, faster and cheaper—nothing's changing. To me, this is a fairly desperate attempt to keep their valuations. I don't think it's going to work.
When you add up their dividend payments and their drilling budgets, these companies are paying out over 100% of their cash flows. That's a very risky game, especially if we see a $10–15/bbl drop in light oil prices in North America this year, which would reduce your profitability by about 25%. So if you're getting $90/bbl for your oil and that suddenly goes to $75/bbl, that's a huge percentage coming out of your profits. These guys will have to raise a lot of money or cut their dividends. Either way, it equals lower stock prices. I'm avoiding all dividend plays in the junior and intermediate side in Canada right now, except for Argent Energy Trust (AET.UN:TSX).
TER: So we know what you're avoiding. Let's talk about some companies that look interesting at this point.
KS: Strategic Oil & Gas Ltd. (SOG:TSX.V) is a very interesting story. It has a play called Keg River right on the border of the Northwest Territories in Alberta. There's this statistic called the recycle ratio that's basically the profit-per-barrel divided by the cost per barrel. Most of these companies run anywhere between 1:8–3:1. This Keg River play is 10:1, where every dollar that goes into the ground produces $10. This is one of the highest recycle ratio plays I've ever seen in my life. With 50–60 well locations like that, it can really pay for a lot of its other development work. It has been able to secure railcars to go down into the U.S. to deliver its oil, giving it a better price than it otherwise would have to the pipelines. It's run by a very smart guy, President and CEO Gurpreet Sawhney. He had his own reservoir engineering company in Calgary, so he's very technical.
He knows how to model these reservoirs, and he's very bright. I really like that story and the Street is starting to reward it.
Raging River Exploration Inc. (RRX:TSX.V), Neil Roszell's company in the Viking, has the absolutely top blueblood management team in the junior sector right now. It has great cost discipline. It knows how to use the premium in its stock as currency to get what they call "tuck-in" acquisitions—small land packages right beside and adjacent to where it is. That's a quality name.
Novus Energy Inc. (NVS:TSX.V) is also in the same play and is probably my number-one takeout target for the year. It's put itself up for sale, and I really do believe that sometime this quarter we're going to see a bid from somebody. That's a great stock for investors to look at.
Also, if your readers are interested in learning more about a specific company that I'm following right now, one that I believe has a lot of potential in 2013, I have put together a special free report thatEnergy Report readers can download for a limited time.
TER: Great, thanks Keith. Do you have updates on any of the companies you've mentioned in the past?
KS: Lynden Energy Corp. (LVL:TSX.V) is a really interesting story. It's a Permian play in West Texas and has this asset called Mitchell Ranch, with more than 100,000 gross acres in the heart of the Cline shale.
Net, it owns about one-third of that. That big a land package in that location in one big block is very rare. If it spun out that asset and IPO'd it, it could probably get $250 million for it, worth $2.50/share. Lynden is just going to sit on the land for a little while and let everybody else prove up the ground around it.
That asset could double or triple the current stock price if it gets one really good well out of that play. It raised its own money, so it doesn't need the Street. Because it doesn't pay the Street, there's not a lot of research on it. It's a bit of an undiscovered gem.
TER: Do you think it may be contemplating a spinout on Mitchell?
KS: That's what I'd be thinking. Its Wolfberry production justifies the price of the stock on its own, so you're basically getting Mitchell Ranch for free.
TER: What are the prospects in general for the junior and mid-tier Canadians and what should investors be doing?
KS: Investors need to be very cautious right now. The junior market is starting to bubble and get some life. So this is a time when investors can get sucked into the wrong deals. Because I see a light-oil price drop later this year, investors need to be taking quite a bit of money off the table in these junior producers in the next three months and buy refinery stocks. They've had a great run already, but I think they're going higher.
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