The Lato Letter: Volume 1, Issue 26.

The Lato Letter: Volume 1, Issue 26.

Last week, I attended the Peters & Co. Fall 2012 Oil & Gas Conference in Toronto at the Toronto Ritz Hotel. It was an interesting setting since that week the hotel was also serving as the official hotel of the Toronto International Film Festival (TIFF). With a throng of paparazzi lining up outside the hotel, the only star sightings for me were not the Hollywood stars at TIFF but rather a few oil & gas stars from Calgary.

There were several themes that were in evidence throughout the conference. The key themes were, as detailed in the Peters & Co. research summary:

1) North American Natural Gas Outlook – All the Right Things are Finally Occurring; Will Supply Ever Respond
2) Canadian Oil Differentials will Remain Volatile Throughout 2013
3) Maintenance Capital Requirements in the Oil Sands have been Vastly Underestimated
4) Propane Prices Crash – Does Liquids Rich Drilling Still Make Sense
5) With More Data, Vast Differences in Play Economics are Beginning to Show
6) Service – Activity Levels & Pricing Under Pressure, but Encouraging Trends Beginning to Emerge
7) International Companies have been Largely Forgotten; Time to Revisit
8) Several Large M&A Transactions have Occurred- What are the Majors up to in Canada

I saw many presentations surrounding these themes; both companies in the Padlock portfolios and several that were not. Hands down, the two most impressive presentations in my mind were from two old favourites, Canyon Services Group and Tourmaline Oil Corp. I know, I am biased, but I do feel that these two companies offer as sure a bet as you can get in the oil and gas industry today.

The final presentation that was most noteworthy because of the sole question that was asked was the Parex Resources Inc. presentation and the question was “why is your stock so undervalued compared to your peers”. Other than the suggestion that in the current environment, investors have pared risk and were less willing to take on the additional risks inherent in international exploration, Parex was equally befuddled as to providing an explanation. On a purely statistical basis, it is more undervalued than the above two names with only the added risks of that international exploration keeping it from being classified as a “sure bet” as well.

Under Theme #6, in a very difficult environment, Canyon has grown its business dramatically over the last two or three years by continuing to grow with its customers by providing them superior, reliable service at competitive pricing. By utilizing the most modern fleet in the industry and maximizing the knowledge they have gained over the years, Canyon has maintained solid margins that they feel they can maintain even in this difficult pricing environment. The company will continue to focus solely on the Canadian market where they feel that they have a decided advantage because of their dedicated workforce. Unlike the US market, which has an underutilized labour pool, the Canadian labour pool is very tight and acts as a huge barrier to entry for US service companies eyeing the Canadian market and putting further pressure on pricing.

Canyon has funded the growth of its fleet from 110,500 HP of capacity at the end of 2010 to its current capacity of 225,000 with internal financing, leaving the company with no debt. They feel confident that they will be able to continue to expand capacity up to 450,000 HP within five years, again through internal financing while at same time feeling very comfortable about their 60 cent per share annual dividend that is poised to increase should the growth continue.

The main theme underlying Tourmaline’s attractiveness would be Theme #1. In spite of decade-low natural gas prices, Tourmaline has continued to increase its production and its forecasted production, while maintaining a very strong balance sheet. You may recall that I featured Tourmaline in an earlier issue of The Lato Letter after attending a company presentation in March. Coming off 2011 production of 37,000 BOEPD* Tourmaline’s Five Year Development Outlook and Guidance for Production at that time is shown in Column 1 while its current outlook (only six months later) is shown in Column 2:

Column 1 Column 2
Year March 2012 (BOEPD*) Sept. 2012 (BOEPD*)
2012 50,000 50,000
2013 63,000 67,000
2014 75,576 81,519
2015 88,354 92,413
2016 98,097 101,127

*Barrels of Oil Equivalent Per Day

Two of the keys to Tourmaline’s original business plan that still exists today are to achieve profitable annual growth via low operating cost/high netback properties while striving for large land positions, operatorship and infrastructure control on those properties. They have succeeded thus far and I strongly believe that this great management team will continue to succeed in delivering on their guidance and in doing so rewarding their shareholders.

Clearly, Parex falls under Theme #7 and given its valuation of just over 2.0 times cash flow for this year and next, it may indeed be the most forgotten of the international exploration and production companies. The stock has been a disappointment this year since it was purchased in many accounts in February, but the company has continued executing their game plan to not only increase production and cash flow but also broaden the sources of that production.

Parex has spent the past several months proving numerous Columbian properties and although it has encountered some problems, for the most part it has been successful in doing so. From inception in 2010, production grew from an average of 5,345 BOEPD in 2011 to the company’s exit rate guidance of 13,000 to 14,000 for 2012. As exploration properties are brought into production during the remainder of this year and next, the company’s extremely low valuation will be difficult to ignore let alone “forgotten”.

**In addition to owning these stocks for clients, I also own the stocks personally and for other family members.

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