Alexander Montano, managing director of the Corporate Finance Group with California-based C. K. Cooper & Co., puts a lot of faith in technology when it comes to making oil and gas plays pay. Alex sees major opportunities for new technology in old oil basins and suggests some names making good on that thesis in this exclusive interview with The Energy Report.
The Energy Report: Alex, oil traders seem to be showing a growing confidence that U.S. economic growth will rebound next year. This is evidenced by the fact that they're taking advantage of the gaps between the current prices for crude and the six-month contracts, which are due early next year. Is C. K. Copper seeing similarly bullish prospects for the U.S. economy and oil prices in general in 2011? What's your outlook?
Alexander Montano: Well, we understand that oil prices are to some extent linked directly to economic growth. But we think that more and more, the outlook for oil prices is going to be less dependent upon U.S. economic growth and is going to become more a factor of global growth. We are not extremely bullish on the U.S. economy in 2011. We believe the recovery is happening, but we expect it to be slow and drawn out. We don't think it's going to be much fun.
But we believe that global demand is growing. We believe that the macroeconomic picture looks very strong. We remain bullish on oil into 2011, with a price between $70 and $85 a barrel.
TER: In which regions of the world do you see growth occurring?
AM: We think that it's going to continue to come from China and India. We think Latin America is going to remain pretty strong. We think that a lot of the emerging players are whetting their appetite on oil and that appetite is going to continue to grow.
TER: Along those lines, OPEC, the Organization of Petroleum Exporting Countries, turned 50 last week. Its control of the oil market is obviously less substantial than it used to be. What impact is OPEC having on the market now?
AM: Well, I think you correctly said that its direct impact in the supply/demand equation has been watered down over the last couple of decades. But I think that from a market leadership standpoint, they are still the clearest voice out there. I think that when OPEC establishes what they believe the oil price should be, whether it's directly a result of their production or not, the oil markets generally adapt to that. As far as short-term swings in production and the ability to fill necessary gaps go, OPEC remains the primary supplier. It's an organization that's been up and down, but I think they continue to be the leader as far as sentiment on world oil prices. I think people still respect that position.
TER: OPEC leaders are on record saying that they consider the current oil price "ideal" and that they will try to keep the oil price where it is. Do you think that they still hold enough influence to keep oil in the $80 range?
AM: I do. We're believers that demand growth is going to continue. I think if you couple demand growth with OPEC's willingness to basically manage supply better than they have historically, then we think that that price target is doable. If you could have a relatively defined price range and the commodities stay within that range, it is a win-win. It's a win for the industry. It's a win for the consumer. We understand that and believe in what they're trying to accomplish.
TER: What's your investment philosophy when it comes to oil and gas?
AM: We focus on technology. We believe that this is a much more technology-driven industry than anything else. Here in California there's a lot of heavy oil. Heavy oil has become a very fundamental piece of the supply picture in the United States. You take a look at what's happening with the heavy oil from the oil sands in Canada. Technology is revolutionizing the economic threshold there. We believe that there are lots of known reserves that will have a meaningful impact on the market in the future. It'll be technology that will make those resources work.
We generally try to target companies that are going to apply proven technology in areas that have not been subjected to that technology before. We believe that as these companies are successful, they become an attractive target for larger companies.
We tend to focus on companies with a market cap of $1.5 billion or less that we believe have some core thesis that's going to drive their share price. We believe there are companies working in certain geological plays that are hopefully bringing a proven technology to unlock the value there.
TER: Are you talking about things like old oil basins that are no longer economic with vertical wells, but that could perhaps be economic again through horizontal drilling and other newer extraction methods?
AM: Yes, horizontal fracking, water floods and tertiary recovery. The amount of knowledge in the industry is increasing quickly. A lot of times it's just a question of applying the right technology.
TER: What are some names that have found the right technology in some older plays?
AM: Evolution Petroleum Corporation (NYSE:EPM) is a company that, in our opinion, developed and put together a play for a carbon dioxide (CO2) flood at the Delhi Field in the southeastern U.S. They were able to turn that over to Denbury Resources Inc. (NYSE:DNR). They got a pretty nice upfront payment, and they have a production royalty. That was four or five years ago. Denbury has since basically developed the project to a point where it's a solid, safe annuity.
Evolution just came out with year-end reserves in the neighborhood of 9 million barrels, and it's a little company. Here's a company that's got a base value, but at the same time they're going into the Austin Chalk to apply new technology there and hopefully increase value. And they've got this new "artificial lift" technology that they're applying to uneconomic wells in Texas. With Evolution, the downside is protected because of their Delhi Field with Denbury, and all the other stuff is upside. If you're an investor and you've been waiting for three or four years, that risk has been basically removed and you're in a position to reap the upside.
TER: What's their position in the Delhi Field versus Denbury's?
AM: They basically have a back-in option after Denbury recoups its investment. That's somewhere between 20% and 25%. The reserves they booked are based on that deal. Our equity analysts have a target price in the $9 range for Evolution. They believe that the company is already worth $7 or $8, and the stock's still trading at a discount to that.
TER: Is there another investment thesis you like that's being applied and that looks appealing?
AM: Like I said, we like the idea of somebody buying an asset, unlocking its value and having another company buy them. That's why we like a company called Miller Energy Resources (NASDAQ:MILL).
They probably did the deal of the year in 2009 when they acquired the assets of a Canadian company called Pacific Energy. Pacific had bought those assets from Forest Oil Corporation (NYSE:FST) and probably invested in the neighborhood of $500 million in them. But when the credit crunch hit, Pacific was overleveraged and it ended up in bankruptcy.
Basically, through tenacity, Miller bought the cherries of Pacific's Alaskan assets for $5 million. Their fair market value is probably somewhere around $300 million. It's almost too good to believe. But as Miller restores a lot of the production that was shut down or fixes the wells that aren't producing at maximum rates, the market is really going to take notice. We think Miller's fair value is in the $12 range; it's currently trading somewhere just below $5. There's very little institutional ownership at this point. We think it's one of those companies where somebody is going to come along and say, "OK, thanks guys. You really cleaned up these assets. We'll take it from here."
TER: Among the micro-cap stocks on a list I saw recently, Miller is listed as fourth in terms of return on assets over the last 12 months. Obviously, they're getting a lot out of those assets already. But what about their being in Alaska?
AM: While Alaska may be maturing, I still would characterize Alaska as a bigger company kind of play. I think that Miller pulled off a small miracle, but to develop everything that's there is going to take really, really deep pockets. I think there will be a point where somebody with a lower cost of capital than Miller is going to buy it. I don't know if that's in two years or six years, but I think that is the ultimate exit strategy.
TER: All right, so buy and hold Miller Petroleum. What are some other E&P plays that you're excited about?
AM: Domestically there's a smaller company that we like called EnerJex Resources Inc. (OTCBB:ENRJ).
We made a decision about four years ago that we thought oil was a better commodity to invest in versus gas. If we could find oil in proven, safe locations, then that was the place to go and bet that technology could make it work. So we like Canadian production. We like U.S. production. EnerJex operates only in eastern Kansas, which is maybe not recognized as a leading hydrocarbon region. But Kansas is among the top eight oil-producing states. The thing about eastern Kansas is that it's older production, so ownership is very fragmented. I think there's something like 10,000 different operators in Kansas with the majority producing 50 to 80 barrels a day (bpd).
EnerJex basically said: "We're going to acquire those mom-and-pop shops and aggregate them." Most of these operations are so small that they aren't water flooding. They aren't down spacing. They aren't using artificial lift; they aren't using any kind of horizontal-drilling technology. Enerjex believes that they can apply these technologies and take production from their current 200 or 300 bpd to 3,000, 4,000, 5,000 bpd over the course of four or five years. At that point they become a nice target for somebody.
There's very little exploration risk. It's more of a manufacturing process because we know the oil reserves are there. It's just a question of getting them out economically by achieving economies of scale.
The Energy Report: Alex, oil traders seem to be showing a growing confidence that U.S. economic growth will rebound next year. This is evidenced by the fact that they're taking advantage of the gaps between the current prices for crude and the six-month contracts, which are due early next year. Is C. K. Copper seeing similarly bullish prospects for the U.S. economy and oil prices in general in 2011? What's your outlook?
Alexander Montano: Well, we understand that oil prices are to some extent linked directly to economic growth. But we think that more and more, the outlook for oil prices is going to be less dependent upon U.S. economic growth and is going to become more a factor of global growth. We are not extremely bullish on the U.S. economy in 2011. We believe the recovery is happening, but we expect it to be slow and drawn out. We don't think it's going to be much fun.
But we believe that global demand is growing. We believe that the macroeconomic picture looks very strong. We remain bullish on oil into 2011, with a price between $70 and $85 a barrel.
TER: In which regions of the world do you see growth occurring?
AM: We think that it's going to continue to come from China and India. We think Latin America is going to remain pretty strong. We think that a lot of the emerging players are whetting their appetite on oil and that appetite is going to continue to grow.
TER: Along those lines, OPEC, the Organization of Petroleum Exporting Countries, turned 50 last week. Its control of the oil market is obviously less substantial than it used to be. What impact is OPEC having on the market now?
AM: Well, I think you correctly said that its direct impact in the supply/demand equation has been watered down over the last couple of decades. But I think that from a market leadership standpoint, they are still the clearest voice out there. I think that when OPEC establishes what they believe the oil price should be, whether it's directly a result of their production or not, the oil markets generally adapt to that. As far as short-term swings in production and the ability to fill necessary gaps go, OPEC remains the primary supplier. It's an organization that's been up and down, but I think they continue to be the leader as far as sentiment on world oil prices. I think people still respect that position.
TER: OPEC leaders are on record saying that they consider the current oil price "ideal" and that they will try to keep the oil price where it is. Do you think that they still hold enough influence to keep oil in the $80 range?
AM: I do. We're believers that demand growth is going to continue. I think if you couple demand growth with OPEC's willingness to basically manage supply better than they have historically, then we think that that price target is doable. If you could have a relatively defined price range and the commodities stay within that range, it is a win-win. It's a win for the industry. It's a win for the consumer. We understand that and believe in what they're trying to accomplish.
TER: What's your investment philosophy when it comes to oil and gas?
AM: We focus on technology. We believe that this is a much more technology-driven industry than anything else. Here in California there's a lot of heavy oil. Heavy oil has become a very fundamental piece of the supply picture in the United States. You take a look at what's happening with the heavy oil from the oil sands in Canada. Technology is revolutionizing the economic threshold there. We believe that there are lots of known reserves that will have a meaningful impact on the market in the future. It'll be technology that will make those resources work.
We generally try to target companies that are going to apply proven technology in areas that have not been subjected to that technology before. We believe that as these companies are successful, they become an attractive target for larger companies.
We tend to focus on companies with a market cap of $1.5 billion or less that we believe have some core thesis that's going to drive their share price. We believe there are companies working in certain geological plays that are hopefully bringing a proven technology to unlock the value there.
TER: Are you talking about things like old oil basins that are no longer economic with vertical wells, but that could perhaps be economic again through horizontal drilling and other newer extraction methods?
AM: Yes, horizontal fracking, water floods and tertiary recovery. The amount of knowledge in the industry is increasing quickly. A lot of times it's just a question of applying the right technology.
TER: What are some names that have found the right technology in some older plays?
AM: Evolution Petroleum Corporation (NYSE:EPM) is a company that, in our opinion, developed and put together a play for a carbon dioxide (CO2) flood at the Delhi Field in the southeastern U.S. They were able to turn that over to Denbury Resources Inc. (NYSE:DNR). They got a pretty nice upfront payment, and they have a production royalty. That was four or five years ago. Denbury has since basically developed the project to a point where it's a solid, safe annuity.
Evolution just came out with year-end reserves in the neighborhood of 9 million barrels, and it's a little company. Here's a company that's got a base value, but at the same time they're going into the Austin Chalk to apply new technology there and hopefully increase value. And they've got this new "artificial lift" technology that they're applying to uneconomic wells in Texas. With Evolution, the downside is protected because of their Delhi Field with Denbury, and all the other stuff is upside. If you're an investor and you've been waiting for three or four years, that risk has been basically removed and you're in a position to reap the upside.
TER: What's their position in the Delhi Field versus Denbury's?
AM: They basically have a back-in option after Denbury recoups its investment. That's somewhere between 20% and 25%. The reserves they booked are based on that deal. Our equity analysts have a target price in the $9 range for Evolution. They believe that the company is already worth $7 or $8, and the stock's still trading at a discount to that.
TER: Is there another investment thesis you like that's being applied and that looks appealing?
AM: Like I said, we like the idea of somebody buying an asset, unlocking its value and having another company buy them. That's why we like a company called Miller Energy Resources (NASDAQ:MILL).
They probably did the deal of the year in 2009 when they acquired the assets of a Canadian company called Pacific Energy. Pacific had bought those assets from Forest Oil Corporation (NYSE:FST) and probably invested in the neighborhood of $500 million in them. But when the credit crunch hit, Pacific was overleveraged and it ended up in bankruptcy.
Basically, through tenacity, Miller bought the cherries of Pacific's Alaskan assets for $5 million. Their fair market value is probably somewhere around $300 million. It's almost too good to believe. But as Miller restores a lot of the production that was shut down or fixes the wells that aren't producing at maximum rates, the market is really going to take notice. We think Miller's fair value is in the $12 range; it's currently trading somewhere just below $5. There's very little institutional ownership at this point. We think it's one of those companies where somebody is going to come along and say, "OK, thanks guys. You really cleaned up these assets. We'll take it from here."
TER: Among the micro-cap stocks on a list I saw recently, Miller is listed as fourth in terms of return on assets over the last 12 months. Obviously, they're getting a lot out of those assets already. But what about their being in Alaska?
AM: While Alaska may be maturing, I still would characterize Alaska as a bigger company kind of play. I think that Miller pulled off a small miracle, but to develop everything that's there is going to take really, really deep pockets. I think there will be a point where somebody with a lower cost of capital than Miller is going to buy it. I don't know if that's in two years or six years, but I think that is the ultimate exit strategy.
TER: All right, so buy and hold Miller Petroleum. What are some other E&P plays that you're excited about?
AM: Domestically there's a smaller company that we like called EnerJex Resources Inc. (OTCBB:ENRJ).
We made a decision about four years ago that we thought oil was a better commodity to invest in versus gas. If we could find oil in proven, safe locations, then that was the place to go and bet that technology could make it work. So we like Canadian production. We like U.S. production. EnerJex operates only in eastern Kansas, which is maybe not recognized as a leading hydrocarbon region. But Kansas is among the top eight oil-producing states. The thing about eastern Kansas is that it's older production, so ownership is very fragmented. I think there's something like 10,000 different operators in Kansas with the majority producing 50 to 80 barrels a day (bpd).
EnerJex basically said: "We're going to acquire those mom-and-pop shops and aggregate them." Most of these operations are so small that they aren't water flooding. They aren't down spacing. They aren't using artificial lift; they aren't using any kind of horizontal-drilling technology. Enerjex believes that they can apply these technologies and take production from their current 200 or 300 bpd to 3,000, 4,000, 5,000 bpd over the course of four or five years. At that point they become a nice target for somebody.
There's very little exploration risk. It's more of a manufacturing process because we know the oil reserves are there. It's just a question of getting them out economically by achieving economies of scale.
