The Lato Letter: Volume 2, Issue 12.

The Lato Letter: Volume 2, Issue 12.

For the past three days, I have attended the Peters & Co. 2013 Energy Conference and have enjoyed many presentations by a wide range of North American energy companies. After seeing these presentations, I was struck by the wealth of enterprising, very capable, and shareholder friendly management teams that we can be proud of in Canada. The level of ownership by management is very comforting as was the knowledge that the stewardship of Canadian oil and gas assets is in the strong hands of these men and women.

I won’t attempt to review every presentation but rather present my thoughts on some of the broader themes that I felt were evident. The first overall theme is that the future growth of oil production in Canada will essentially come from oil sands and heavy oil projects. There are still numerous conventional oil areas of growth but they are dwarfed by the magnitude of the projected expansion in oil sands and heavy oil production.

The first theme leads right into the second theme in that with the growth in oil sands and heavy oil production the demand for diluent to produce and transport this oil will also grow substantially. Current Canadian supply will be inadequate to meet this demand starting in 2014 which will greatly benefit the natural gas producers who are most exposed to liquids rich gas (particularly condensate) in their production. The ability to sell natural gas by-products helps lower the cost of the production of their natural gas giving them a huge competitive advantage.

Lowering costs struck me as another major theme for both the producers and the service companies. The industry is influenced by many factors beyond their control (commodity prices, differentials, weather and access to markets being a few among many) so controlling costs that they can control is critically important. The technological advances made by both the energy companies themselves and the service providers has been nothing short of outstanding in making the seemingly impossible task of getting energy out of the ground that much more affordable.

There were many other topics broached (LNG potential, rail transport, pipeline expansion, etc.) during the conference but I felt that these were the most evident takeaways along with the specific company comments. I attended presentations by companies that Padlock’s clients are shareholders of and many others that they are not. I would briefly like to review three of those companies that are held by Padlock’s clients (in alphabetical order; Canyon Services Group, Parex and Tourmaline).

Canyon Services Group Inc. (FRC-TSX, $12.02)

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Canyon provides well stimulation services including hydraulic fracturing, hi-rate nitrogen fracturing, coiled tubing and chemical stimulation throughout the Western Canadian Sedimentary Basin (WCSB). 2012 and 2013 have been difficult years for services companies in North America and Canyon has not been spared. After earning $1.53 per share in 2011, Canyon’s earnings fell to 87 cents in 2012 and current estimates call for 20 cents for this year. Being a high fixed cost business, the drop in earnings is essentially all attributable to an almost estimated 20% drop in revenues over the last two years.

Fortunately, Canyon has and will continue to maintain an excellent debt free balance sheet. With the bulk of their costs being non-cash depreciation charges on their equipment, the company is very comfortable in maintaining and projecting its current 60 cents per share annual dividend which provides for an approximately 5% yield. Canyon expects a pickup in activity in 2014 and is well positioned to capitalize on it. The company has not chased low margin business over the last couple of years to help to preserve their equipment fleet for the return of that increased exploration activity, hopefully in 2014 and beyond.

Canyon operates only in Canada where it feels the potential for increased natural gas exploration to meet the future demands of Liquefied Natural Gas (LNG) exports is very real. There are currently seven LNG proposals with a planned capacity of 8-14 billion cubic feet (bcf)/day, which very conservatively translates to 750 wells per year if only 5 bcf/day are realized, which would represent a significant increase over the wells drilled in the past two years.

Parex Resources In. (PXT-TSX, $5.95)

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Parex was created in late 2010 as a spinoff of the Columbian and Trinidadian assets of Petro Andino Oil which operated primarily in Argentina and was sold to an Argentine company. In its short history, Parex has grown its reserves from zero to almost 24.0M barrels (Proven & Probable) and its production to over 15,000 barrels/day (primarily oil). Parex has not raised either debt or equity since 2011, so this terrific growth has been entirely funded from internal cash flow which preserves the future rewards for shareholders.

In spite of its very auspicious start, Parex and other Columbian producers fell out of favour in 2012 as investors perceived risks inherent in Columbian exploration. Coupled with that, Parex had a couple of disappointing drill results in early 2012 and the stock was “put in the penalty box”. With renewed exploration success in 2013 and the release of a revised independent reserve report in early July, Parex’s valuation has gone from ridiculously cheap to very cheap. Even after the recent increase, Parex is trading at less than 3.0 times cash flow based on this year’s consensus estimates

Parex continues to provide very conservative production guidance for the balance of the year and is certainly poised to surpass that guidance as they report on their exploration activity and resultant production.

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Tourmaline Oil has been a Padlock holding since its initial public offering (IPO) in November 2010. In spite of its name, Tourmaline Oil is predominantly a natural gas exploration and production company. After a great “rookie year” in 2011, Tourmaline’s share price succumbed to falling natural gas prices in late 2011 and early 2012. While the share price might have been falling, Tourmaline’s reserves and production growth continue to expand dramatically. From reserves of 158.2M boe and production of just over 15,000 boe/day at the end of 2010, those figures have grown to 438.1M boe and 55,000 boe/day at the end of 2012. Production has continued to grow this year and just prior to the conference the company raised its production to 80,000 boe/day for 2013.

With the judicious use of its balance sheet and in a less than stellar natural gas price environment, Tourmaline has produced this tremendous growth while only exhausting a small fraction of the potential well sites on its vast acreage. The company’s five year development outlook calls for production to grow to almost 180,000 boe/day in 2017 and if I have learned anything from Tourmaline’s past forecasts, it is that they have proven to be far too conservative on their production growth and too optimistic on their natural gas price outlooks. Their production forecast and natural gas price forecast for 2017 translates to cash flow of $7.71 per share.

Whether that cash flow forecast proves to be accurate or not, the growth profile for the company continues to be the best in the industry. That growth profile is recognized in the valuation and the stock cannot be described as “cheap” but the strength of Mike Rose and his management team, the huge number of potential drill prospects, and the value that can be recognized at some point from this combination makes me feel very comfortable that Padlock’s biggest oil and gas exposure for its clients is through Tourmaline.

This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change without notice.

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