Energy junior looking to become a mid-tier gas producer

PRICE, Utah - I had no idea Utah was such a prolific resource-producing region. Passing the giant Bingham Canyon open pit mine on my way to a natural gas project in the Uinta Basin, I was reminded otherwise.

The combination of liberal political policies and bountiful deposits make Utah one of the most attractive resource development states in America.

I recently toured the Gordon Creek Natural Gas Project near the city of Price and two hours southeast of Salt Lake City. Operated by Thunderbird Energy (TSX: V.TBD, Stock Forum),of Calgary, Alberta, Gordon Creek seeks to become a mid-tier gas producer in less than two years.

This patch of Utah desert hosts some of the most beautiful rock formations you can imagine. Adjacent Drunkard’s Wash property, operated by Conoco Phillips, is the largest natural gas field in the state. Conoco’s property alone has produced nearly one trillion cubic feet of natural gas already. It is running strong due to the 20-30 year, roughly two billion-cubic-foot projected life of an average well on the site.

Neighboring Gordon Creek is on the cusp of an increase in development activity, including a $23 million, fully-funded Department of Energy contract to validate 1970s projections of as much as one trillion cubic feet of commercially viable CO2 beneath it.

My tour coincided with the kickoff meeting of the Southwest Regional Partnership on Carbon Sequestration, or SWP. More than 50 government and private-sector contractors were there.

The story of Gordon Creek is one of critical mass, targeted to be reached with these characteristics: consistent regional geology, above-average well life, in place infrastructure and an investment from Sandstorm Metals & Energy. (See details.)

Sandstorm Metals & Energy (TSX: V.SND, Stock Forum), spun out from Sandstorm Gold (TSX: V.SSL, Stock Forum) last year, is new in the resource business. Founded by the principals of royalty resource holder Silver Wheaton (TSX: T.SLW, Stock Forum), Sandstorm Metals & Energy seeks to become one of the largest non-precious metals resource royalty companies. In just a year’s time, SND has raised $150 million of equity capital and invested in numerous resource deals, with Gordon Creek being its largest oil & gas project to date.

SND’s executives, led by CEO Cam White and President Rick Ironside, want to tag long-term royalty stream opportunities. The company invested $25 million in Gordon Creek last month, targeting a production increase from roughly 900 mcf/day currently to an estimated 18,000 mcf/day by the end of 2012. The royalty agreement lets Sandstorm own 35% of the life-of-mine natural gas at a fixed price of essentially $1 per mcf in exchange for ‘development fees’ of roughly $500,000 for each of the first 50 wells; hence the initial $25 million commitment. Also requires is $325,000 per well for the next 100 wells. There are numerous other details in the agreement.

Due to the region’s consistent geology and the 2009 construction of the Rocky Mountain Express pipeline, Gordon Creek’s estimated breakeven operating cost is roughly $2 per mcf, among the lowest in the nation. This theoretically yields a 100% profit margin at current gas prices and strong long-term project economics.

The initial $25 million Sandstorm investment will fund the majority of the first 50 holes of delineation drilling (plus five work-overs). Turnaround time from completion to production tie-in is designed to be nearly instantaneous. The company’s plan targets 58 wells to be online by the end of 2012, each producing 350 mcf/day, on average. Currently, three wells produce. At a current natural gas price of roughly $4 per mcf, such production would yield to Thunderbird, net of Sandstorm’s 35% interest, a pre-tax cash flow run rate of approximately $13 million. This in turn could be reinvested into the next 50, or even 100, delineation wells in 2013, presuming Sandstorm continues to invest alongside.

The key valuation metric over the next 12 months is likely to be reserve growth given the company’s $20 million market capitalization and targeted eightfold reserve increase by the end of 2012. The key to this strategy probably is the pace of land acquisition in the Gordon Creek area, where Thunderbird aims to accelerate its efforts in the next year or so.

The pace of reserve growth will depend on how many adjacent blocks it can acquire, as the more land (with consistent or similar geology) the company can add to the property, the more dispersed the planned 50 drill holes can be. This allows for a wider volume of the deposit to be considered reserves under Canadian Instrument 51-101 reporting standards.

Thunderbird’s current land position at Gordon Creek is roughly 12 “sections,” or square miles. It aims to increase its holdings to 40 sections by the end of 2012, the large majority of which are USA federal lands and the remainder privately held.

Given the company’s position in the area, its pipeline infrastructure and relationship with government agencies thanks to the SWP partnership, it appears likely the acquisition strategy will be viable and I believe successful. Thunderbird’s management anticipates such acquisition costs to be $1.5 million to $2 million based on recent transaction statistics. Given the relationship with Sandstorm, most likely SND would contribute 35% of said costs to maintain its royalty interest.

If such transactions are not consummated, the company expects the 50-hole drilling program to increase the current 25 billion cubic feet of reserves to roughly 100 bcf by the end of 2012 (net of Sandstorm’s 35% interest), most likely at the 2P level. If the additional 28 sections are acquired, the more dispersed drilling targets would yield a “base case” expectation” of closer to 200 bcf, or eight times the current level. Assuming 119 million shares outstanding (79 million shares outstanding plus 40 million warrants with an average strike price of $0.25/share), and an average “per mcf” valuation based on 2008-2010 transactions, it is plausible that a stock revaluation will occur.

Thunderbird’s stock also might have significant “option potential” related to the $90 million SWP venture with the Department of Energy, per an agreement inked in mid-August. (See details.)

The DOE, partnering with a research group led by New Mexico Institute of Mining & Technology, aims to validate 1970s drilling programs that calculated estimated CO2 reserves of up to 1.3 tcf. The partnership also aims to show that CO2 from regional power plants can be reliably injected and stored in these vast underground caverns.

If either outcome unfolds, Thunderbird likely would receive most of the economic benefit, as the DOE’s primary goal is to prove the environmentally friendly “CO2 sequestration” process is viable. In the case of CO2 reserves, their estimated commercial value, for uses as diverse as enhanced oil recovery in the Uinta Basin and beverage carbonation, could be $25/ton or more (there are roughly 21 million tons in a tcf unit).

The Gordon Creek natural gas field possesses the potential to be a low-cost, major producer for several decades. Consistent geology and long-lived reserves make the Uinta Basin a nice Utah address to have.

Andy Hoffman of San Diego Torrey Hills Capital can be reached at ahoffman@torreyhillscapital.com.

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