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-- Posted Thursday, 19 August 2010 | | Source: GoldSeek.com
Atticus Lowe, chief investment officer with West Coast Asset Management, is the kind of guy you would want making your investment decisions. He is coauthor of The Entrepreneurial Investor: The Art, Science and Business of Value Investing. In this exclusive interview with The Energy Report, Atticus discusses his value investing strategy. He also talks about the long-term potential of natural gas, questions shale gas production projections and offers a few names with oil exposure that he believes are not getting enough love from the markets.
The Energy Report: Atticus, on the institutional side, fund and pension managers are keeping their portfolios a little light on energy plays. What sort of event is needed to get the institutional side back to pre-2008 levels in terms of equity?
Atticus Lowe: Institutions are light on energy right now because nearly all of the independent oil and gas companies out there are leveraged to natural gas. The outlook for natural gas is pretty foggy, at least in the short term. The discovery of massive shale gas resources has been a blessing for the country and to some extent a curse for the exploration and production (E&P) industry. The implication of these shale gas discoveries is that natural gas prices are likely to remain quite elastic until demand increases.
There's so much shale gas out there that it's going to keep a cap on gas prices, albeit perhaps somewhat higher than where we are today. Credit Suisse recently averaged the cost structure of more than 40 independent producers and found the total unit cost to be $5.74 per Mcf of natural gas equivalent. Current prices are $4.25 and the 12-month strip is at $4.65, which creates a puzzling situation. Why would companies be drilling today if they can't make a return on capital, let alone break even? There are several reasons.
First off, oil prospects are scarce and most companies don't have much to drill other than natural gas prospects. Second, many companies are drilling to hold leases with the hope that natural gas prices will increase in the future and provide attractive economics for further drilling on these leases. In addition, many companies feel pressure from shareholders to spend money and increase production and cash flow. All of these issues are weighing on natural gas, and that has backed a lot of institutions away from energy.
TER: How about longer term?
AL: Long term, I fully expect domestic natural gas demand to increase, and I expect that to be a driver for gas prices and to be fantastic for the industry, our country and our economy. I don't know whether you have seen the "Pickens Plan" or if you've seen T. Boone Pickens talking on CNBC during the past couple years, but he points out that domestic natural gas is clean, it's cheap, and it's American. I expect demand for gas to increase as a result of compressed natural gas vehicles, primarily from the fleets of larger vehicles, and also from plug-in electric vehicles, which source their power through electricity, which is often generated from natural gas. Honda already makes a compressed natural gas vehicle and they are big in Europe. In that context, you're paying less than half the price for the same amount of energy from natural gas versus oil and emitting far less CO2, and you're supporting the economy while creating tax revenues and jobs.
I also expect more dirty coal-fired power plants to be replaced by natural gas-fired power plants over the long term.
TER: With institutions shying away from natural gas companies, does that create opportunities for the retail investor?
AL: I really think it does. Oil prices right now are tied closely to the economy; historically, it's been an uncorrelated asset, a hedge. But right now everyone is confident that supply and demand for oil is very tight, and long-term demand is going to significantly exceed supply. I don't know if supply and demand will converge in one year, two years or five years, but I definitely expect to see $150 oil again this decade, and I wouldn't be surprised to see oil touch $100 by next year.
The independents are being penalized for being really gas heavy right now. You're seeing the oil and gas companies scrambling to get domestic oil exposure, and that includes acquisitions. Buyers are often paying more than $100,000 per flowing barrel of oil right now and oil reserves are trading hands at more than $20 per barrel. Most of the big oil was had in America decades ago. There's still a lot of oil out there, but it's in small pockets that typically aren't enough to move the needle for the larger independents and the majors. But for the micro- or small-cap exploration and production (E&P) company, there is a lot of opportunity.
TER: How so?
AL: There's opportunity to create value through aggregating assets, and through discovering relatively small fields that may have been overlooked. And there is definitely opportunity to apply modern technology to established tight oil deposits that weren't commercially viable at lower historic prices. With modern technology, you can go back into a lot of known deposits and make them into economic plays. Some of these are big enough to attract the majors, such as the oil window of the Eagle Ford shale, but a lot of them are small company plays.
TER: That's certainly happening in the Permian Basin.
AL: Sure, it's happening in the Permian. It's also happening up in the Bakken Formation, and it's happening in the Niobrara Shale play. What you've seen the technology do with the shale gas plays, well, you can take that same basic technology and apply it to certain tight oil plays.
TER: Are you talking about radial drilling and that kind of thing?
AL: Primarily fracture stimulation, through either vertical or horizontal wellbores. A lot of the tight oil plays have responded well to fracture stimulations in vertical wells, and some of them are now responding well to horizontal wells. Long laterals with multi-stage fracture stimulations are having great early success in the Eagle Ford shale, the Bakken, and in the Niobrara Shale. Now, this kind of success is at the very front end of the production curve, and we don't have a lot of data yet. I don't know how the oil shale plays are going to ultimately work out, but there is already a lot of long-term evidence supporting the benefits of fracture stimulation in tight conventional reservoirs. With modern fracture stimulation technology, even conventional reservoirs that may not have great permeability can really be opened up and improve economic returns.
TER: You have a three-pronged approach to energy investing, and that involves ultimately knowing a few companies really well. As part of that approach, as you have stated in previous interviews, you put the strongest emphasis on management. But others might argue that good assets trump good management because you can always bring in good people to get the most out of existing assets, whereas even the best management can do little with poor assets. Why do you put such a strong emphasis on management over assets?
AL: It's funny you say that about good assets trumping good management. We've been guilty of making that assumption before, and some bad experiences have really led us to our emphasis on management. You can certainly bring in good people, but bad management won't necessarily bring in good people. They might not be "incentivized" to. And good assets can be ruined by bad management; bad management can take a good asset base and overleverage a company and kill it. They can allocate the cash flow poorly; bad management can do all kinds of things with good assets that destroy shareholder value. It doesn't mean that the underlying asset won't still be good, but it does mean that there is a lot more risk to making money as an investor because the company won't necessarily be creating per-share value. That's what we're intensely focused on: per-share value creation. We're not looking for a company to grow exponentially if its share count or debt grows at an even more rapid pace.
TER: But what can good management do with poor assets?
AL: We're not looking for good management with poor assets, but we would certainly consider it if the price were right. Good management can create opportunities that create future value. That is one of the first things that we look at: is the company a good steward of capital? Does management have their own skin in the game? How are they incentivized? What is their track record of allocating capital? What is their focus? We like to find people who are focused on creating per-share value and have a track record of doing so.
TER: Do you have a management ownership threshold that you think is ideal? For instance, if a manager owns 10% of a company, is that good? If they own 30%, is that too much?
AL: We like it if it's meaningful to them. If it's someone who has a giant net worth and they have hardly any skin in the game, then it's a turnoff. But if it's someone who isn't necessarily wealthy, but they've got a sizable amount of their net worth in the company, then that is more important to us than owning a specific percentage.
Another thing we pay close attention to is company culture. Our co-founder here at West Coast Asset Management is the founder of Kinko's. He really built that company into a success based on a positive company culture. We like to eat in the lunchroom when we visit a company, talk to the co-workers and get a feel for the people. Are they hungry for success or are they just there to collect a paycheck? That's an intangible that you can't quantify, but it's something that we pay attention to. Management has a lot to do with that.
TER: The other two prongs of that strategy are the assets and catalysts for growth. Please explain those.
AL: We like to find underpinning asset value that not only supports the price the stock is trading at, but also provides upside. We want to buy a stock at a discount to what we think its underlying proven reserve value is. We will look at the proven reserves, the expected cash flow from those reserves, and try to buy the company at a discount to those values.
And the third prong would be catalysts, whether that's something the company has on its plate or something that the company is able to pursue through its strategy. A catalyst might be a company sitting on a lot of undeveloped acreage that is highly prospective and not accounted for in its reserve value and share price. Or it might mean a strategy like the one EnerJex has, where the company can deploy capital opportunistically in a sweet spot: something that could provide a catalyst over the long term to increase shareholder value.
TER: In an interview you did with Oil & Gas Investor, you said: "I'm skeptical about a lot of these average type curves you see for the shale plays. We shouldn't be surprised to see the economic threshold of these plays really increase over the next five years." That seems a bit bearish.
AL: Bullish on prices, but bearish on the information that is being given to Wall Street.
TER: Are you saying these companies are lying to The Street?
AL: I personally looked into a number of these gas shale plays where management teams are holding out curves of what the production from a single well on average is expected to do over its life. If you look at the actual production of the wells they've drilled to date, the median is nowhere near the curve they're showing people. It's looking at the potential through rose-colored glasses in my opinion. The results from the wells that have been drilled often don't jive with the type of curves we're being shown. Even if they did, you're at only the very front end of the well's life in these shale plays. In some cases, we only have data for less than a year of production on some of these large horizontal shale plays. Yet projections for production are being made 20–30 years out about what the wells will be producing down the road. And those projections are being extrapolated back to present quantities of proven reserves and associated value. I think its quite risky to assign value to reserves based on future production that is largely unknown.
Atticus Lowe is the chief investment officer of West Coast Asset Management, Inc. , a founder and principal of Montecito Venture Partners, LLC, and a director of Black Raven Energy, Inc. Atticus has been a featured speaker at the Value Investing Congress as well as the Value Investing Seminar in Molfetta, Italy. He is a CFA Charterholder and holds a Bachelor of Arts degree in Economics and Business from Westmont College in Montecito, California. Streetwise - The Energy Report is Copyright © 2010 by Streetwise Reports LLC. All rights are reserved. Streetwise Reports LLC hereby grants an unrestricted license to use or disseminate this copyrighted material (i) only in whole (and always including this disclaimer), but (ii) never in part. The Energy Report does not render general or specific investment advice and does not endorse or recommend the business, products, services or securities of any industry or company mentioned in this report. From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles on the site, may have a long or short position in securities mentioned and may make purchases and/or sales of those securities in the open market or otherwise. Streetwise Reports LLC does not guarantee the accuracy or thoroughness of the information reported. Streetwise Reports LLC receives a fee from companies that are listed on the home page in the In This Issue section. Their sponsor pages may be considered advertising for the purposes of 18 U.S.C. 1734. Participating companies provide the logos used in The Energy Report. These logos are trademarks and are the property of the individual companies.
-- Posted Thursday, 19 August 2010 | Digg This Article | Source: GoldSeek.com
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