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.

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Marcellus disappoints

An important report from Oil Drum, published at the Business Insider, explains that the Marcellus shale play will not break even when natural gas is selling at less than $7/Mcf, as the result of faster than expected decline rates for the wells.  Why then do companies continue to drill?  The report says:

Returning to the broader subject of shale plays in general, why do operators keep drilling while their own over-production has depressed the price of natural gas by half of its value since January 2010? It seems fairly clear at this time that the land is the play, and not the gas. The extremely high prices for land in all of these plays has produced a commodity market more attractive than the natural gas produced.

Foreign companies invest in U.S. shale plays for different reasons but the most often-stated reason is to learn about the technology that they may be able use to their advantage in future shale plays around the world. It is possible that some companies enter into joint ventures with U.S. shale operators for strategic reasons based on fears of future resource scarcity particularly as China expands its efforts to control everything from petroleum and minerals to rare earth metals around the world.

Read more: http://www.businessinsider.com/marcellus-shale-disappointment-2010-10#ixzz144mz6QDy

But with currently reported natural gas futures at $3.84, it does not seem like this play is going to be viable.  Indeed, the report explains that while debt for Marcellus-focused companies has gone up and reserves have increased somewhat, shareholders’ equity has dropped dramatically.   To add insult to injury, the states of Pennsylvania and New York are placing moratoriums on new drilling in the play for fear of the new fracking technology that is used to exploit these wells, and in the case of Pennsylvania, because of a dispute between the republican legislature and the democrat Governor Edward Rendell over the drilling tax; of course, it’s the democrat who is insisting on a higher rate and has thus issued the moratorium.  I wonder if Governor Rendell has read the Oil Drum report showing that the drilling is largely unprofitable in the region.  This is no golden goose.  But I suppose a brass goose can also be strangled by taxes.

As a result of this, I’ve decided to sell 50% 75% 100% (update 11 Nov) of my holdings in Enerplus (ERF.un: TSX; ERF: NY) which has a large Marcellus shale operation.  This follows an excellent run for Enerplus, which still has many other great holdings.  Along with Marcellus, Enerplus recently acquired some lands on the US side of the Bakken.  I am uncomfortable with their large stake in the US with Obama at the helm–he illegally shut down  drilling in the Gulf and he and the other democrats in the US intend to destroy the US-based energy industry, all while subsidizing Brazil and Soros.  I will probably sink the funds that are now freed up into Pengrowth Energy and Penn West Energy, which are both listed as Action-List Buys by TD Newcrest.  These can also be bought on the New York Stock exchange and they can thus add to my US dollar carry trade.

The bad news for Marcellus shale may turn out to be good news for conventional natural gas plays in Canada, and it would come at an excellent moment.  The shale plays in the US have put great pressure on the prices causing a glut of available gas. I am maintaining my shares of Perpetual Energy (PMT:TSX) which dropped about 7% immediately after being trashed on BNN by Eric Nuttall of Sprott Asset Management (hat tip: Devon Shire), who said it is due for a dividend cut if natural gas prices don’t improve soon.  Some think that dividend cut is already factored into the current price. I’m looking to buy in at $3.85-4.00. Nuttall, a cognoscente of the Canadian oil industry, claims that no managed funds own Perpetual, only retail investors because of its high dividend yield.  Ouch!  He excused himself for previously recommending Terra Energy (TT:TSX), a natural gas weighted junior (which I started buying recently).  So Nuttall is not inerrant.