Reflexions on Petrobakken (Updated)

UPDATE October 4, 2011:  Devon Shire discusses the most recent news coming from Petrobakken and I agree with his sentiments expressed there:

The market has punished Petrobakken (PBN), not on any substantive news regarding the operations of the company, but on a downgrade by BMO:

BMO downgraded PetroBakken (C$8.22, -C$1.12, -12%) to underperform, saying “with a dividend policy that is looking increasingly unsustainable, PetroBakken continues to increase debt to levels that may be difficult to recover from.” It also said potential funding sources for the company may not be as readily available as in the past, given financial-market turmoil. PetroBakken is owned 59% by Petrobank Energy (C$8.16, -C$1.17, -13%), which is also down Wednesday.

As a consequence of this and the general market weakness in the last few weeks, Petrobakken has fallen precipitously in market price, from a 90 day intraday high of $15.11 to its close yesterday at $6.40.  It may fall still further, as some bullboarders have suggested it could go as low as $3.00.

Here are the main reasons that I’ve heard for pessimism:

(1) The debt now stands at 1.1 billion plus 0.75 billion in convertible debentures.  The fear is that the company will have to stop paying out the dividend.

(2) Weakness in world oil prices.   This actually should be stated as fear that there will be weakness in the oil price.

(3) The world-wide monetary crisis continues, and a general credit collapse could result in PBN’s lender recalling its 1.1 billion dollar loan.

(4) Petrobakken has paid way too much for its land base.

(5) The business model for Petrobakken is unsustainable because of fast decline rates for wells.

(6) Investors and would-be analysts are worried that something else is wrong that the company isn’t telling us but about which Calgary insiders are aware.  (Of course I know of no professional analyst who has made such an accusation).

These fears aside, here are my reasons for bullishness on the company and why I see it as a value investment and not a “value trap” as some investors have suggested.

(1) Petrobakken has two major land bases on which they have identified hundreds of drilling sites, in the Bakken and the Cardium.  There are billions barrels of oil in these fields which oil companies have identified after several decades of vertical drilling.  Petrobakken is on the leading edge of new technologies to produce these resources, including horozontal bilateral and trilateral drilling and multi-fracking, which will make it possible to extract more oil  than possible with vertical drilling alone.  But because these are already explored oil fields, drilling is de-risked–this is not wild-catting–i.e., drilling to determine if oil is in the ground, but drilling in oil fields that are already well-analyzed.

(2) Petrobakken already has excellent cash flow despite slow downs in production caused by bad weather.  They are still confident to achieve their exit production estimate (46-49,000 bpd) by the end of 2011.  If they achieve this objective, the share price could easily be around $20 per share or higher (earlier in the year PBN reached $23 on news of the estimated exit rate).  The price to cash flow at yesterday’s close was an amazing 2.1x (source TD Waterhouse).

(3) The dividend at almost 15% after the share price drop, now will pay you to wait for it to go back up.  While BMO is not certain that Petrobakken can maintain its dividend, the CEO John Wright hit back hard, in speaking with the Calgary Herald.

“The dividend is put in place because of the business philosophy of the company,” Wright said. “When there’s a short-term down spike people question if you should cut the dividend, but if we put our heads down and deliver on our program then the likelihood is that in the future we can possibly increase the dividend.”  Read more:

(4) The business model, about which Wright speaks, makes sense to me.  It is true that initial funds up front for drilling result in debt at the beginning (Petrobakken is still a young company), and it is true that the production rate drop off is rapid in the first few months, but it is also true that the net-back (profit after expenses) for each well is very high and that the first few months of production pay for all the drilling expenses; then the wells continue to produce at a low rate for many years, providing a continuous flow of cash as a return on investment.

(5) Enhanced Oil Recovery promises to make it possible to extract as much as 20% higher oil than suggested by the current method of calculating reserves.  Devon Shire writes:

For example Canadian producer Petrobakken (PBKEF.PK) has reserves booked assuming a 5% recovery in its Bakken play, but believes that eventual recoveries will be 25%. I’d say Petrobakken might be exaggerating if it weren’t for the fact that its nearest rival Crescent Point Energy (CSCTF.PK) is suggesting recoveries will be 30%.

(6) PBN has non-core land assets that it could sell if it runs into cash flow problems.

(7) PBN now has a very low share price to book value ratio 0.4.  TD Waterhouse lists book price at $17.43.  In the end, a company that has excellent cash flow, increasing production, and high book value, will continue to add value to shareholders.  (Book value equals assets [land leases, equipment, infrastructure, buildings, cash on hand] minus liabilities [bank debt, convertible debentures]).  I stick to the principle of value investing as taught by Benjamin Graham in his book The intelligent investor.  If you can buy a company at book value, you are getting the future profits of the company for nothing.  If you pay less than book value, unless the company is losing money, you are getting a percentage of the assets for nothing at all.

My plan is to continue selling put options on PBN while there is weakness in the share price.  I’ve lost a lot of money on PBG/PBN already, but my experience in oil investing tells me to be patient, hold on, and become greedy when this kind of market madness sets in.   I can’t be sure that tomorrow won’t be the apocalypse, or worse, that the bottom will fall out of oil prices.  But it is a risk I think is worth taking.

Disclosure:  I am long PBG, PBN, and getting longer

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17 thoughts on “Reflexions on Petrobakken (Updated)

  1. You laid out your case perfectly. The one variable that will decide it all will be the price of oil. If oil prices remain robust ie $75-$85 and the company executes on its guidance, i do not see why the market should not reward its share price. Good luck for all of us in these turbulent times.

  2. Let me lay the problem for you, since you missed it. PBN’s three year average F&D cost for proven reserves are $49.40/boe. At $80/oil the cash netback will be around $48/boe. Can you see the problem? From the netback they have to pay G&A, interest, and bonuses.

    Good luck with PBN, you may just lose it all.


    • Kevin:

      Thanks very much for reading and making a comment: it is very useful to consider a problem from all angles, to be sure. Therefore, could you please tell me how you arrived at the number of $49.40/boe as three year cost. Do you know for sure that it doesn’t include interest and G&A–and can you prove that point?

      On your own blog (“PetroBakken – 2010 Annual Review“), you wrote:

      In conclusion, it is vital that potential investors calculate returns on a per share basis and avoid the headlines in most press releases. I could have spent more time getting into how the PDP reserves (the BOE’s actually on production) cost $64.47/boe to find, develop or acquire, but why bother? The company nets around $42/boe for each barrel produced (Revenue less cash costs). Usually you want to find the barrel of oil for less than you can sell it for.

      It appears to me that the production cost per barrel, between Q4 2010 and today (presumably Q2 2011) has dropped (by your calculation) 64.47-49.40 =$15.07 boe. That is a very dramatic difference. Could it possibly be explained by the metrics in the chart above, which makes it clear that initial production will be much more costly and as more wells come online, the legacy production will continue at a lower rate for many years. Thus we would expect that number (cost per barrel) to come down regularly in the months to come.

  3. This is the last free analysis, and my last discussion on this subject. I don’t want to beat a dead dog.

    How did I arrive at my number, it is calculated using the net change in proven reserves over the last three years divided by the capital spent.

    Do I know for sure that it doesn’t include interest and G&A? This is a silly question… Yes I know for sure and No it doesn’t include those items. You want proof? Go to PBN’s website, and download the Q2 financials. Go to page 2. Revenue less royalties less production expenses is your operating netback (transportation should also be deducted). This is the cash left over after you product a barrel of oil and sell it. With that money you have to pay normal business expenses and hopefully find another barrel. You need a recycle ratio of 1.3 to just breakeven.

    Next problem. The $64.47/boe is for a proven developed producing (PDP) barrel. These are the reserves at are actually on production (producing oil or gas) as of the date of the reserve report. The $49.40/boe is for a Proven (1P) Barrel. Proven reserves (1P) are ones that are very highly likely to be recovered. However 1P reserves includes PDP reserves (already mentioned) + proven developed non-producing (PNP) + proven undeveloped reserves (PUDs). Proven developed non-producing are wells that are drilled but need to be tied into production. PUDs are wells that are not drilled but planned on being drilling usually within a year. PUDs are typically wells that are drilled in-between two known wells in a field and therefore have a very high likelyhood of containing reserves.

    Further 2P reserves included 1P reserves plus fringe wells that haven’t been drilled and may or may not be economic.

    The PDP cost of $64.47/boe is very high but can’t be taken in isolation. The three year average proven reserves is a good number but not as conservative as PDP for the reasons mentioned above. You have to understand the proven reserves contain a number of assumptions. These assumptions include what the reserves of the PUDs will be and what the actual capital cost will be to bring the well into production. When the PDP is consistently higher than 1P reserves cost over a 3 year period you can know one of two things is happening. One is either the reserves are not what they forecasted or the capital cost have been much higher than estimated. For PBN I would guess it’s a combination of both.

    If you don’t understand these things I would strongly recommend consulting a professional for investment advice.

    Best Regards,

    PS – It’s “Reflections” not “Reflexions”.

  4. Gosh Kevin. So nice of you to offer a free analysis on my blog. That’s really helpful. I’ll have a look at this, and run it by some others and then see decide what I think and get back to you.

    Oh, and thank you for the spelling lesson. You know, they didn’t teach us how to spell that word correctly where I did my studies. So very sorry.

    By the way, if you be would so kind to answer, I would really like to know if you, as a professional engineer, are actually engaged in the oil industry; your blog and your analysis are at such a level of sophistication, I assume you must be involved in exploration, drilling, reservoir analysis, or production. Which is your field of speciality and what is it that you actually do in your day job. Is your CV available?


    This is good news as far as I can see, indicating that fears about the exit production rate being below company estimates are unfounded, since they are already up to 43,000 bpd already. The press release also deals with the convertible debentures and their choices in deal with them if most of the investors decide to exercise their option for early payment. It includes a dividend cut, selling non-core assets, or instituting a DRIP.

  6. The conversation with Kevin Graham continued at his blog:

    Petros said…
    For the record, I am a blogger and a theologian and never claim to be an investment advisor. I am an investor of my own personal wealth, esp. in oil stocks, and I do indeed consult the advice of experts, including such people as Roger Serin at TD Securities. As for needing a professional investment advisor, I am DIY and doing well for myself, losses on PBN notwithstanding. Nevertheless, while I disagree with you strongly for various reasons, I do appreciate the vocabulary lesson.

    Finally, you be would so kind to answer, I would really like to know, in what aspect of the oil industry that you, as a professional engineer, are actually engaged; your blog and your analysis are at such a level of sophistication, I assume you must be involved in exploration, drilling, reservoir analysis, or production. Which is your field of speciality and what is it that you actually do in your day job. Is your CV available? Obviously publishing such information would buttress your street cred. But saying that you are involved in the oil and gas industry doesn’t make you an expert, for you could be involved in building roads to the oil fields, wiring the electricity to field ops or something else (a maintenance guy in the company buildings??). I.e., you could be a engineer in the field working as a civil or electrical engineer with no real experience in petroleum engineering.
    October 3, 2011 9:29 AM

    Kevin Graham said…
    Hi Petros,

    You look to Roger Serin for advice? Let me tell you a little story about Roger. Roger was looking to buy some natural gas wells from a company (that I owned) to pad his retirement account. When the company told him to take a hike, he promptly started downgrading the stock. He is no longer allowed to cover the company in question. You want to talk about conflict of interests. I’ll let you be the righteous judge of character in that case.

    As for my background, that is confidential. However if you send $500 to my paypal account we’ll see what happens.

    I am an engineer, love to read and have a lifelong passion for learning. What more do you need to know? I don’t judge people based on the number of letters after their name and I would recommend the same. Francis Chou used to be a Maytag repairman (or something like that) and I highly respect him.

    All of the information I shared about reserves and reserve reports is not all that complicated. If you read the reserve report from any oil company you’ve invested in you would learn all about those categories. The trouble is most people either find them too technical or too boring. Jim Rogers once said if all you did was read annual reports you would be miles ahead of other investors… it’s so true.

    October 3, 2011 10:24 PM

    This I replied to as follows (yet unapproved as I write):


    You seem all too willing to accuse others of crimes.  (1) You said, “Insiders are giving their friends an opportunity to sell before the news hits the steets.  Since the insiders don’t own any shares, they don’t need to sell.” Well this is just wrong (insiders do own shares) and you offer absolutely no evidence –just pure speculation.  Plus, telling your friends before the public about impending decision  is securities fraud; in case you wondering, that’s called “insider trading” and it is against the law; (2) You have now also publicly accused Roger Serin of dishonesty, of downgrading a security because of a personal vendetta–while I’m not sure this is crime, it is certainly unprofessional, dishonest, and unethical and would be severe blight on his reputation.  So if you are unable to prove accusation in a court of law, its probably better to take it back before you have a defamation law suit.  This is what gives me the general impression that you are an amateur; because a professional would be much more careful in the way they go about accusing others of dishonesty and fraud.  A professional would never open himself up to a lawsuit over things he can’t prove.

    But another thing that gives me the impression that you are not yourself totally transparent is that you have twice suggested that I should pay you; you say this was your last “free” analysis, suggesting that you are sufficiently professional that you could charge for you services.  Next you say that you would require $500 to tell me what area of the oil and gas business that you are actually involved in.  So from henceforth, Kevin, I will consider you a non-specialist, since I have no choice but to think that you are actually hiding from everyone what your real area of expertise is.  But you want my money.  This does not inspire confidence.  First tell me what your experience is. Then I will determine whether I can pay you for your services.  That’s the way it works in the real world.  But you claim not to be a professional (on your About Me page).  Well, there is a disconnect between your claim to be a non-professional, on the one hand, and your desire to be paid and your ueber-confidence on the other.

  7. Kevin followed up with the following comment on his blog:

    I don’t have time for you useless and baseless claims, but thanks for coming back for round three. While I don’t have to defend myself, this link should suffice.

    Since you have accused me of being dishonest and a fraud, I would tread very lightly. If you want to comment on my blog again, I expect a full apology and a more respectful dialog.

    October 4, 2011 1:17 PM

    Petros replied:
    I agree with the article that Serin shouldn’t have been covering Peyto and that full disclosure is insufficient. That still doesn’t prove that he downgraded the stock because of a personal vendetta, but nevertheless I apologize for accusing you of wrong on this count. You have sufficiently proved that something not quite right was going on.

    Still, what is your evidence that insiders at Petrobakken have given their friends a chance to sell before the news of dividend cut was made public?

    I did not say you were a fraud or dishonest. I said that you gave me the impression that you were an amateur and that you are not being transparent–which is not quite the same thing. And I did not start the lack of respect thing. Remember, you corrected my (British) spelling on my blog, and you said my question was “silly”. I don’t care if you approve this comment, because that would help end the discussion.

    • Hi Peter,

      While I don’t know if that was a full apology, I will accept and offer the same in return. I wasn’t aware that you are British.

      Just to give you a little background… Back in 2005 someone was saying that Peyto was about to take a reserve writedown. Peyto even hired a second independent reserve evaluator to disprove this rumour. GLJ and Paddock both evaluated the reserves to be with a few percentage points. Now as for why Peyto management blew the whistle, I will leave that up to you to decide.

      If you do want to see some candor, I would suggest reading what Don Gray and Darren Gee (from Peyto) have said in the past about this kind of stuff in the oil patch. Darren’s latest monthly CEO letter is another example. Let’s just say that they aren’t real popular because of it.

      I never said PBN insiders were spreading insider information. All I’m saying is that I wasn’t born yesterday. When PBN drops 20% in one day on no news something is up. I heard something today which may be part of the reason. Don’t get your hopes up… it’s not insider information (but it is information).

      As for my “silly” comment, I apologize if I offended you. It’s amazing how when one person says something the other person hears something totally different (just ask my wife, or blame the McGurk effect). I just found it silly that a shareholder in PBN didn’t know what an operating netback was despite it being on the second page of their Q2 results. And here I thought I was being gentle.

      Now this may sound harsh, but I’ll say it anyway. I don’t have time to debate things when the other party doesn’t want to do the appropriate analysis or lacks a basic understanding of key concepts. That is why I recommended professional help in selecting oil and gas investments.

      Best Regards,

    • I replied to Kevin:


      I am more bemused than offended by your tone, which you didn’t know could be taken as condescending. So no need to apologize, but I am glad that you accept my apology. As for me, I try to have a thick skin as a blogger and sometimes to respond in kind.

      As an investor, there are certain things I’m looking for; if an oil company, e.g., has a vast amount of oil in the ground that is not yet calculated into the market price, that is interesting to me. So I’m not too worried about current proven reserves vis-a-vis the cost to produce them. There was a great comment on my blog that is reflective of my own point of view:

    • Kevin replied to me:

      Hi Peter,

      Your like the energizer bunny, you just won’t quit.

      I have a thick skin however when you attack my credibility with no basis, I take offence.

      Your comment regarding is oil in the ground is evidence you don’t understand what’s important about analyzing O&G companies. Your not concerned about the reserves and the capital it costs to find them? That is fine. I am concerned because that is how a company makes money.

      I read the comment on your blog. He didn’t comment here or at least it didn’t come through. If the confirmation page doesn’t come up the comment wasn’t submitted (a blogger glitch). I have had this happen several times to me.

      Now as for his comments. He’s correct in what he says regarding land and reserve calculations. That is why I said above, you cannot take the PDP F&D cost in any one year in “isolation”. I then said a three year average for proven is better but not as conservative.

      I commented on the land problem in my PBN 2010 annual review and raised three questions.

      1) How prospective is the land (feel free to speculate)? Some blogger feel it’s like shooting fish in a barrel.

      2) Why are they buying all this land when they supposedly have thousands of drilling locations in the Bakken?

      3) Why are they drilling wells to retain land? Is land an asset or liability? Is land retention drilling the best use of shareholder cash?

      I would like to add two more questions just for fun (not from my 2010 annual review)…

      4) This year (2011) when PBN buys a bunch more land are we suppose to exclude that capital cost also from our F&D calculations again?

      5) Why do you believe management when the try to mislead by showing gross production increases yet it is actually declining on a per share basis? The same could be asked for reserves?

      Listen, I already told you no more free analysis. Ask your buddy Don to answer the above “great” questions. If course you won’t, because you flagrantly disregard any fact or evidence that is contradictory to your thinking.

      I will do the same analysis next year and we’ll see if PBN actually created any shareholder value (on a per share basis).

      Lastly, do you think O&G executives allow the engineers to spend a dollar in capex without a strong understanding of what the F&D costs will be? Or, do you think it’s just a game of lets drill some holes, and not worry about the costs?

      I’m being dead serious. You said, “So I’m not too worried about current proven reserves vis-a-vis the cost to produce them.”

      That’s the equivalent of saying, “I’m not too worried about how many widgits we produce vis-a-vis the cost to produce them.”

      Don’t make me use the silly word again. I am done with you. Quit wasting my time and your money. I will not be responding further.

      Best Regards,

  8. Why Kevin has done a poor job.

    Just curious Kevin – what did you include in the capital numerator when assessing F&D per BOE. The reason I ask is wouldn’t your number be GROSSLY overstated if you included all the land acquisitions PBN has made where no development has occurred.

    As an example, if I start a new O&G company, with a placement of $150 million, and I spend $45 million to acquire 15 sections of land. Say my company drills 5 wells on 5 different sections at $5 million a well. So that is another $25 million in CAPEX. Say each well books about 250k BOE. Then say, I build a $15 million dollar facility. How would you calculate F&D per BOE.

    I do it like this. $15 million (1/3 of land drilled) + $25 million (drilling and related costs) + $5 million (facility results in lower op cost so should be included, but designed for entire development) = $45 million / 1.25 million reserves = $36/barrel.

    Of course, if I drill 5 more wells (all successful) on those same sections of land, then what happens? Well, another $25 million in drilling costs, but no incremental land acquisition cost (already have the land, right?). Thus, $70 million / 2.5 million BOE reserves = $28 F&D cost per BOE. And this would continue until the drill spacing units for the sections of land are maxed out if enough targets exist.

    You, I believe, missed many critical considerations in your calculation – to the point of being a useless and harmful metric to base any type of analysis or decision.

    1) You included land acquisitions not yet being developed actively, or at the very least, very speculative land that has to be proven – which is unfair and wrong.

    2) You did not contemplate proportions. Meaning – that by including the acquisition cost of a large swath of say, Cardium land, without contemplating the wells that can be drilled per section, you are actively double, triple, and even quadruple counting the true cost per BOE reserves for acquisition costs.

    3) You are including facilities in full, that have independent value, and service both existing and future production. PBN, proportionally, has much greater infrastructure than its peers, and your calculation implicitly treats this is a negative. You need to recognize that PBN has improved netbacks because of this, and for a true F&D calculation this needs to be considered

    • Don: Thanks very much for this comment. I find it a very useful question, and I suspect that this is actually the way to show that Kevin’s negative assessment of PBN is problematic. It seems to me that business model requires a great deal of capital up front, which will be rewarded as the company moves towards long term production. That’s what the chart I presented in the original post shows.

  9. Of note, Kevin refused to post my comments on his site. Obviously the guy is trying to hide the fact he does not have the knowledge to complete the analysis that he did properly. I recommend staying away from his blog unless you want misinformation and poor analysis.

  10. Pingback: What does the sale of Daylight Energy tell us about the value of Petrobakken « The Righteous Investor

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