Since its inception in 2007, the Salman Partners' Top Pick Index has made a 251% return. The index is a huge pot for investors in the international oil and gas space to bet on, but it's not for the untutored. Salman Partners Analyst Justin Anderson walked The Energy Report through the risks and returns of the game. Find out how he plays his hand.
The Energy Report: Justin, welcome. Tell us about Salman Partners Top Pick Index. Why was it established?
Justin Anderson: Top Pick Index was established to contrast the performance of our company's favorite investment ideas against a Canadian benchmark of general stocks and to see how those investment ideas performed. Analysts look at the stocks under their coverage and then they try to pick one or two stocks that they think are going to be the best performers in that group over the next 12 months.
TER: What's the track record? Do Top Picks generally perform as advertised?
JA: So far it's been a really good track record. Since inception in 2007, the Top Pick Index of Salman Partners has had a 251% return versus the benchmark index, which has returned 30%. Over the last two years, the Top Pick portfolio has returned 38% versus 21% in the general S&P Index.
TER: Canacol Energy Ltd. ($CNE:CA) just earned the Top Pick recommendation in December. How did that happen?
JA: Over the last half of last year, Canacol was increasingly interesting for us, especially when it made a discovery called Labrador in the Llanos Basin of Colombia. That was an important discovery, not just for the intrinsic value of the discovery itself and the potential long-term cash flow that it would add to the company, but also because it meant that Canacol was going to be able to get to the finish line with respect to some of its other assets. What I mean by getting to the finish line is that Canacol has built up a very impressive Middle Magdalena basin unconventional position, very sensitive to time and funding. This conventional discovery at Labrador unlocked some less noticeable value in its Middle Magdalena position. That got us very interested. Then, when it made an additional discovery in the Llanos Basin called Leono, that discovery by itself looked really good, but the compounding benefit to the rest of the portfolio was very strong, so we upped it to a Top Pick.
TER: What are the most exciting positives about Canacol?
JA: To use a baseball analogy, I think Canacol is not really looking for the solid base hit. It's looking to hit a home run. This company really wants to go big. That's exciting, when you have a management team that is aggressively looking to make a multiple big return for its shareholders. The reason it's in that position, as I said, is that it built up this large unconventional position in Colombia. It's a position that, in terms of acreage, is second only to Ecopetrol SA ($ECP:CA) ($EC), the national oil company there. Should the unconventional Colombia space ever take off, look out. This is a company that will perform extremely well if that happens.
TER: What's the biggest concern?
JA: I think it's the other edge of the same sword. If the unconventional Colombian space never does take off, if some of the initial well results are not that great, then you could get in a situation where that acreage becomes less important overall. I think that's actually the biggest risk to the company as well. The nice thing about Canacol is that it has a very robust conventional portfolio that gives you a lot more downside protection in that scenario than some other companies that may be so exposed.
TER: South America is not the most stable operating environment. What are the political and security conditions in Canacol's main operational areas of Colombia and Ecuador?
JA: For Canacol, I think the main issue is in its heavy oil portfolio. That's in the center of Colombia; it has a bunch of heavy oil blocks. Those blocks are very close to some previous FARC strongholds, FARC being the organization that has been agitating through violence in the country to cause a communist revolution. Because of that proximity, people have been dissuaded from ramping up development activity in the area. It has affected Canacol's heavy oil exploration appraisal work. I think that's the biggest risk that it's exposed to. On the plus side, I don't think stockholders really care about its heavy oil position at this point, and it's of tertiary concern to the market.
TER: What about Ecuador?
JA: Ecuador is much more of a basket case than Colombia. Ecuador is problematic because it's not just lingering terrorist groups; the government itself is the issue. That being said, the contract Canacol signed with the government of Ecuador is one that provides much lower netbacks. It is a direct service agreement with the government. It's an isolated issue for the company; I don't really see any risk there.
TER: You created an unconventional portfolio for the Middle Magdalena unconventional play. Why?
JA: Unconventional positions, especially in the international locations, are extremely sensitive to initial results. You might have a very large position, but the fracking response, the geology and the capex/opex of the initial wells are going to have a major impact on the long-term development of the play—then slap political risk on top of that. We wanted to look at unconventionals in a unique way, rather than value all of that acreage in one blow. We built a stochastic or Monte Carlo model to try to capture the range of scenarios that those sensitive initial conditions could provide. That's why we set up this separate unconventional portfolio. The effect that you get is a much more tailing effect: Either things go very poorly and you get no value or things go extremely well and you get a huge amount of value. There isn't really much of a middle ground for these emerging unconventional plays.
TER: Why was it necessary to separate the unconventional portfolio from the other parts of your portfolio?
JA: A conventional prospect is more independent. If you have five conventional blocks, it makes sense to value them separately and then aggregate the results of those valuations, whereas with an unconventional position, you might have the same five blocks, but in this case they're either all going to work or none of them will work. It's much more common to see significant correlations between the successes or the failures, as opposed to a conventional portfolio, where it's completely normal for, say, two of the five blocks to work out.
TER: Outside North America, shale development has an uneven record. Why is Canacol's holding of 545,000 net acres of Colombian shale a positive thing?
JA: If you asked people in North America 10 years ago what would be the status of the Eagle Ford or the Montney or the Bakken, I think people would probably have been very skeptical about how those plays would perform. Ten years later, we're seeing massive growth in these resource plays. There's absolutely no reason why some of the best quality resources around the world won't see the same kind of activity that those plays have seen. We've seen it in North America first simply because we've got the most stable political environment, but the rocks are the same around the world and you're going to see the same booms in other countries.
The question simply becomes, where are we going to see the next boom? The answer to that question is, you've got to have great-quality rocks. We see some of that in Colombia. We see some of that in Argentina. We see some of that in places in Africa, India and China. Then the next question you have to ask is, considering those most prospective areas, where is the most likely place to see near-term capital flows? That's really a political question. In this department, Colombia actually shines for its relative stability. Combine quality rocks with good political environment, and Colombia starts to look pretty attractive. Obviously there's still a lot of uncertainty as to which way the tail will go in this one, but I think it's a pretty good speculative bet.
TER: One of the problems that has affected the viability of shale oil and gas outside the U.S. is that the quality of the rocks is different in new areas, like Poland, for example, than what they were anticipating.
JA: It depends on the location. I would argue that the best rocks in the world for unconventionals outside of North America are probably in Argentina, in the Vaca Muerta. That is an extremely high-quality resource. I would say that Colombia is comparable in quality to Argentina and the Eagle Ford. It's not as big, but the quality's likely there. Arguably the quality is actually a more important factor for early-stage development than quantity alone.
TER: Is Canacol management looking for a buyout?
JA: I think they're open to it. One of the great things about Canacol is its management is very down to earth. They're there to return money to shareholders, as opposed to some companies where we see them establishing a corporate kingdom. Canacol is focused on shareholder value. If a company comes in that offers that, I think they would go for it.
TER: Parex Resources Inc. ($PXT:CA) is another Top Pick. Why?
JA: Parex is an interesting company. It's a company that has a very undervalued production stream. It's trading at multiples far below comparable companies in Canada and the U.S. Nearly all of its acreage is in the Llanos Basin of Colombia. The Llanos Basin is known for high decline rates, quick payout times and light oil.
What happens is, investors are very focused on the near-term reserve number, and they do the calculation against production and say, oh, this is a short reserve life. Then they apply a significant multiple discount to the company. The problem is you can't just look at the reserves; in some cases you have to look at acreage as well. Parex has enough acreage where reserve adds are a foregone conclusion. It has built up such a robust position of acreage that it is going to book new reserves in the future.
Not all exploration acreage is equal. This company is sitting on exploration acreage that will become reserves. I think the market is not giving it any value for that when in fact it should be. That's the source of the opportunity with Parex, where the actual reserves in the future will be much more than the current reserves, but you're only paying depressed current reserve multiples to get access to the stock.
TER: The Parex stock has trended up since July of last year. You recently reiterated your Top Pick recommendation and raised your target from CA$9.30 to CA$10/share. What is the driver here?
JA: The strategy's working. We got really excited about this name mid-2013, when Parex had some drilling success, started to diversify its portfolio and also made some acquisitions to expand its acreage running room. All of this put the company in a position to apply its operational expertise to these different plays and take advantage of that.
What we've been seeing over the course of the last nine months is the company executing on the strategy, adding reserves. We just saw a great reserve number recently. The stock has climbed. That's being partially driven by reserve adds that the market seemed surprised to see.
TER: Parex is indexing its oil price to Brent instead of to West Texas Intermediate. What's the significance of that?
JA: It probably just underscores even further the ridiculousness of the low multiple that it's trading at because its production is more valuable than a lot of the Canadian domestic production, which is getting more depressed realized prices. When you look at the production multiples you just say, how is this possible when the company's selling its crude to Brent prices? It just exaggerates the opportunity that much more.
TER: Africa Oil Corp. ($AOI:CA) is not a Top Pick; it's a Hold. Is that because of the risky neighborhood it's in?
JA: There are two major issues there. One overriding issue is, will it see development anytime soon of some of the impressive discoveries that it has made over there? Africa Oil is not far from Uganda, where there have been significant discoveries that no one has been able to monetize, and Africa Oil's nearby discoveries are newer. Yes, the company is in Kenya. It's a little bit closer to the market, but at this point, there's still not as much oil discovered there as in Uganda. It is earlier stage. It's going to take more time to appraise it. There's still a lot of risk that it won't find enough oil there to justify a major development and pipeline project.
The other issue is, it's a really exciting stock. Africa Oil has done some incredible things in terms of exploration. Unfortunately, an analyst doesn't necessarily look at how well the company is performing. We look at how we think it will perform in the future relative to the expectations, which are reflected in the stock price. From that perspective, I see a company that could go one of two ways: It's either going to perform very well if it's able to make some more discoveries, perhaps extend the trend a little further north and find well over a billion barrels in that basin. Alternatively, if it's unable to open up any other basins in the area and there's a risk of stranded oil discoveries, then the stock could get killed. A buyer of the stock is going to go one of those two ways, big upside or big downside. The question then becomes, what price are you willing to pay? The current price just doesn't give me a compelling reason to say it's a good bet.
TER: When do you think you'll have a clearer picture of its prospects?
JA: I think it's going to be over the next six months. It's doing a ton of drilling this year, which is exciting, both in the Lokichar, where it's had its discoveries, and outside the basin. I think the Lokichar wells are far less important than the wells outside the basin. It's drilling on Block 9, for example, in a different basin. It's drilling north of its discoveries and it's also doing some work in Ethiopia. If any one of those three other play concepts that it's tinkering around with turns out to be successful, then it'll be an excellent story. We should know that in the next six months, but I think that all three of those other plays are very risky. Investors are taking on a big risk. If all three do not work then you could be in a tough situation with the stock.
TER: Mart Resources Inc. ($MMT:CA) is another hold and also another African operator. What's the status of its Umugini pipeline?
JA: It's under construction. It's been unfortunately delayed by forces beyond the company's control. Estimates are that it should be completed midyear 2014.
TER: How will the pipeline's completion benefit Mart's stock price?
JA: I think people appreciate that the company needs the pipeline to make the operation more robust. That is probably reflected in the stock. I don't actually see a huge potential from the pipeline completion alone. I think the more important thing will be production. If everything goes perfectly, the pipeline gets commissioned, production goes past 20,000 barrels/day through the line and the losses are cut to under 10% or 5%, that would be a positive thing for the stock, there's no question. It's certainly a possible scenario. The greatest concern for me is how much capacity is behind the pipe. How much can Mart ramp up production once the pipeline is installed?
Talking to investors who hold the stock, I think there are a lot of high expectations for how much capacity is behind the pipe. If you compare that to the reserve numbers, I'm a little skeptical over how much it will be able to push through there. The other issue I have is regarding the Pioneer tax status that has come to an end for the company. It started this year. Once it chews through all the tax credits, that will start to affect the cash flows in a material way as well.
TER: How will Mart ensure the Umugini pipeline will be more secure than the one it's using now?
JA: It will have to do the same things it's doing now, trying to make agreements with the government about the losses. It is encouraging see recent news that it's talking to the government and establishing a committee to review the losses. Just having two export options will be a good thing for the company. That, more than specific details of what it's going to do to protect the pipeline, is important.
TER: You have a lot more companies than those four under coverage. What are you really excited about right now?
JA: The other one to highlight would be Gran Tierra Energy Inc. ($GTE:CA) ($GTE). It has been our Top Pick for a long time. Just recently, we rated it a Buy only because we felt Parex and Canacol were even more compelling stories, but Gran Tierra remains a very exciting story. It's made major discoveries in Peru and it's a long-term, value-player's dream because it's getting a very cheap multiple on its reserves right now and has a lot of extra-exciting exploration in Peru.
TER: Justin, you've given us a lot to think about. I appreciate your time.
JA: Thank you.
Justin Anderson joined Salman Partners in December 2011 as an oil and gas investment analyst. He is the founder of the research company Xedge, which specialized in rigorous stochastic analysis of oil and gas exploration portfolios. Previously, he worked for the investment banking energy group at BMO Capital Markets, after having worked on energy company strategy and valuations at McKinsey & Co. Anderson completed a Bachelor of Science in mechanical engineering and a Bachelor of Science in Russian studies at the University of Calgary. He then completed a Master of Science in aeronautical engineering at MIT, with his research and thesis focus on energy economics. While at MIT, Justin founded and commercialized a high-tech company called Waybe and was an executive chair of the MIT Energy Club.
Source: Tom Armistead of The Energy Report (2/27/14)
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1) Tom Armistead conducted this interview for The Energy Report and provides services to The Energy Report as an independent contractor. He or his family owns shares of the following companies mentioned in this interview: None.
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