Oil stock valuations increasing-and not just from higher oil prices

I have noticed valuations in the junior oil sector creeping up – sometimes to the point where I have to blink. But it’s not just the increase in the price of oil this year that has driven up valuations.

Technology is increasing how much oil or gas companies can produce from a well in a day, and in the overall amount of oil or gas they can recover from a given formation – essentially how fast and how much they produce. Technology is giving investors more leverage to the price of oil.

This is especially true of the hot new “tight” plays that are being developed in western Canada and the US, where I have been focusing our subscriber portfolio.

(“Tight” means the oil is held in rocks like shale or sandstone, as opposed to the more conventional type of looser sands that hold hydrocarbons, and from which almost all the world’s production has come from in the last 100 years.)

As an example of valuations increasing, in August 2009 TriStar Oil and Gas merged with Petrobank’s Canadian operations, and was valued at about $109,000 per flowing barrel, which was almost double its average peer group valuation at the time. They were a 20,000+ bopd producer, and the larger the company, generally, the larger the valuation.

But now I am seeing junior producers one tenth that size – 2000 bopd or even 1000 bopd producers – get valuations in the $90,000 – $110,000 per flowing boe (barrels of oil equivalent) range. Most of these are in the 3-year-old Bakken play in Saskatchewan, or the several-months-old Cardium play in Alberta. Several Canadian brokerage firms have issued reports saying these two oil plays have the best economics of any in Canada.

And as long as the big producers in these basins, like Crescent Point Energy (TSX: T.CPG, Stock Forum) trade at $193,000 per flowing boe, there can be lots of money making takeovers for investors.

The Bakken oil play, located in the Dakotas and Saskatchewan, is a great example of how technology is constantly improving economics. Three years ago, expected recoveries were 10%. But as companies are learning how to better frac these wells (sending fluids down at very high pressure to break up the rock that holds the oil), recovery factors (RF) have gone up (so far) to 22.5%.

Independent consultants gave each Bakken well a proven reserve of 50,000 barrels in 2007. Now that’s up to 100,000 barrels, and likely to go higher. The play is only three years old.

Initial Production (IP) rates have increased, as fracing techniques have evolved. The number of fracs a company does in a formation from one drill pad has increased, in several stages, from five to 40.

These production increases that stem from technology are happening in natural gas plays as well. RBC Dominion, Canada’s largest securities firm, puts out a detailed chart every week outlining the IP rates in gas wells in the Haynesville-Lower Boissier shale in Louisiana. It shows the average IP rate of a well there in Q1 2008 was 2.4 mmcf/d (million cubic feet of natural gas per day). The Q2 average was 6.3 mmcf/d. Q3=10 mmcf/d. The average so far in Q4 2009 is 14.6 mmcf/d. The average IP rate has increased in nine consecutive quarters.

Also in the Bakken, the decline curves of these wells are not as steep as they used to be. Wells decline in production every year, but in these tight rock formations, the production levels decline rapidly – up to 70%-80% in one year, before flattening out. This big elbow in production is called the decline curve.

Petrobakken Energy (TSX: T.PBN, Stock Forum), one of the leaders in technology advances in fracing, has a slide on their most recent powerpoint that shows almost no decline in production for their recent wells over the first six weeks (at a very high 340 bopd!). I couldn’t tell if this was a statistically significant sample or not, but this is rare, if not unheard of, for this play. These tight oil and gas formations are characterized by initial steep decline rates.

While overall costs are up, costs are lagging increased revenue with all the new technology; i.e net cash flows per well are increasing. Wells in the Bakken with one vertical stem and four horizontal legs coming off it are not that much more expensive – $9 M each – than drilling 4 vertical wells.

These are several reasons why, according to both Haywood Securities in Canada and UBS Securities in the US, these Bakken wells have 300% IRR with all costs factored in.

This is at least twice what any other play is generating. And this is why the valuations for even the small, junior producers are well above what most investors are used to. Better production. More cash flow.

As well, these formations have a high repeatability factor; once one well hits oil or gas, and geologists can see the oil formation underground with seismic, companies can give the market a high degree of predictability on what future production and cash flows will be. Investors are clearly willing to pay up for that.

And as long as Crescent Point trades at $193,000 per flowing barrel, (still only 1x NAV, according to the most recent BMO Nesbitt weekly report) these highly valued juniors will make investors money, because CPG or Petrobakken will end up buying them all up at some point. So the high-priced junior trading at $110,000 per flowing barrel theoretically can still have a 75% capital gain left in it, plus whatever organic growth it can create.

In one of my upcoming issues, I will outline which junior producers have land packages in these new plays, and what kind of production growth subscribers can expect from each of them. Many of these highly profitable juniors are brand new, have just raised money (so little to no debt), and are run by proven management teams who have built and sold E&P (Exploration & Production) companies before. As production grows, these ground floor opportunities will soon be gone.

DISCLOSURE: I own 200 shares of Petrobakken.

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