Are Canadian junior and intermediate oil stocks in a bubble?

In 2008, those of us who were invested in the junior and intermediate Canadian oil and gas sector, experienced the collapse of a bubble.  I had bought 500 Enerplus, e.g., at $48, and I watched it collapse to $18.20 by March 2009 for $14,900 (62%) loss.  Losses for 100% natural gas Perpetual (pmt) were similar, only it hasn’t recovered much of its lost ground.  Midway Energy Ltd (then Trafalgar Energy) plummetted to a tenth of my original purchase price, but is now back up to $4.33, which is above the highest price that I ever paid for it.

As a result of an aggressive averaging down, oil and gas holdings in my current portfolio are now 65% above book–and that doesn’t take into account profit taking along the way, as I’ve taken the opportunity of the extreme volatility of the last two years to buy low and to sell high.  But with the buy and hold part of the portfolio, diligence is necessary.  Is there any sense in which there is a bubble–that these stocks are just too high and that it is now time to bail, or at very least to reduce?  This is a particular concern to me since my portfolio is 87% weighted towards Canadian junior and intermediate oil and gas companies.

The first consideration is commodity prices.  Natural gas is at a nadir.  Therefore, it is hard to imagine that natural gas weighted companies can go much lower.  These would include Terra Energy, Prospex, and Perptual (TT, PSX, PMT).  Oil is high at $80 but nowhere near where I believe it can go with a rapidly rising demand from emerging markets (esp. China and India) and the constant inflation being forced upon us by our central banks.

A second consideration is low interest rates.  At the moment, most of the intermediate stocks pay dividends far in excess of currents rates in savings accounts, GICs and short term bonds.  Thus, the sector is still attractive as investors seek yield.

A third consideration is fear.  About once a week I read an article indicating that retail investors, if not institutional funds, are still afraid to get back into the stock market, indicating that billions of dollars are still resting on the sidelines.  There won’t be a stock market bubble until more people are all in.

So let’s look at a few of the companies to determine if they are in a bubble.  Statistics are from the TD Waterhouse Market & Research, which I find is often inaccurate, but lets say for now that the numbers are representative of the larger trends.  Market price is as of close yesterday.

Petrobakken (PBN) $18.96 book 17.18 Price/Cash Flow 6.1x

Crocotta Energy (CTA) 1.77 book 2.52 Price/Cash Flow 9.1x

Midway Energy (MEL) 4.33 book $1.44 Price/Cash flow —-

Crescent Point 40.51 book $19 price/cash flow 11.2x

Prospex (PSX) 1.37 book 2.00 P/cash flow 9.4x

Now part of the story is that almost every company in the sector is ramping up its development costs in order to increase production and reserves.  Midway, for example, is on a fast pace of developing its Cardium holdings.  They have 150 drilling sites with an estimated netback of 4 million each (see their corporate presentation), which would provide a potential profit from these holdings alone of $600 million.  That is double its 294.6 million market capital.

Nothing yet indicates to me that there is anything remotely like a bubble in this sector.  Indeed, I am still bullish and think that there are still buying opportunities despite the recent surge in the sector.  In consideration also that the Obama administration has shut down future competition from new offshore drilling in the Gulf of Mexico–putting production behind by at least six months–the Canadian oil and gas sector begins to look extremely attractive.

The Shale Gas Bubble

On the first of this month I mentioned reading an article from Oil Drum on the Marcellus shale play.  The article suggested that shale gas would only be profitable when the market price is above $7 mcf.  Now other analysts are saying that 7.50-8 mcf is needed to cause shale gas to break even.  In an article by Dave Cohen, the words “bubble”, “sleight of hand”, “shenanigan”, “magic tricks” and “fraud” are terms that are being applied to shale gas.  The bottom line is that drilling takes place in order to increase reserves so that the play seems to increase in value but the reserves are overstated because they require decline rates which are much less dramatic than they have proven to be.  Cohen summarizes (emphasis his):

The shale gas boom has been the sole bright spot in America’s energy picture, and maybe the only bright spot in the economy as a whole. And what does that bright spot turn out to be? An asset play whereby shale gas producers, conniving with bankers, inflate their own value, hoping to get out while the getting is good.

I’ve now completely emptied my portfolio of Enerplus Resources which is seriously invested in the Marcellus shale play.  Enerplus has a lot of other great things going for it, and a fat dividend, but when you see an investment that doesn’t make sense then it is time to get out.

(Hat tip:  Devon Shire, “Can Shale Gas Companies Who Drill Uneconomic Wells Make Good Investments ?“)