Get Positioned Now for the Next Great Natural Gas Switch

The Energy Report: Ron, welcome. You are making a presentation at the Money Show conference in Orlando in late January. What is the gist of your presentation?

Ron Muhlenkamp: The gist of my presentation is that natural gas has become an energy game changer in the U.S. We are cutting the cost of energy in half. This has already happened for homeowners like me who heat their homes with natural gas. We think the next up to benefit is probably the transportation sector.

TER: What is behind this game change?

"Natural gas has become an energy game changer in the U.S."

RM: The combination of horizontal drilling and fracking has made an awful lot of gas available cheaply. There's a whole lot of gas that's now available at $5/thousand cubic feet ($5/Mcf) or less. I live in Western Pennsylvania, and 30 years ago, Ray Mansfield was in the oil and gas drilling business, having retired from the Steelers. He said, Ron, we know where all the gas is in Pennsylvania; it's just a matter of price. If the price runs up, we will drill more. If the price runs down, we will drill less. Any way you slice it, we are just sitting on an awful lot of it.

Two years ago, we had a warm winter, and the price of gas actually got down to $2/Mcf. You saw an awful lot of electric utilities switch from coal to gas. Literally in a year, what had been 50% of electricity produced by coal went to 35%. The difference was made up with natural gas.

In transportation, the infrastructure to make the switch to natural gas has not been in place. We didn't have the filling stations or the trucks. Now, the trucks are just becoming available. You can buy pickup trucks from Ford Motor Co. (F:NYSE) and General Motors Co. (GM:NYSE) that run on natural gas. Furthermore, Clean Energy Fuels Corp. (CLNE:NASDAQ) has established natural gas filling stations coast to coast, every 250 miles on five different interstate highways.

Westport Innovations Inc. (WPRT:NASDAQ) has been producing 9 liter (9L) natural gas engines. Waste Management (WM:NYSE) uses 9L engines on garbage trucks and expects 8590% of its new trucks to be natural gas fueled. Westport has just come out with 12L engines, which are used for over-the-road trucks. I don't expect those engines to get adopted as fast as the utility industry made the switch to natural gas, but there has been a fairly rapid adoption in the waste management industry. I think we're on the cusp of a major trend.

TER: That fuel switching in the power industry has been going on since 2008. Is it still progressing at the same rate or is it picking up?

"The big switch is over in utilities. But we've barely begun the transition with transportation fuel."

RM: It's pretty much leveled off. In fact, there's probably a little bit less gas used than when gas was below $3/Mcf. The latest numbers I've seen show that we're running about 37% coal and about 3334% gas. Going forward, I think coal use will continue to decline, and natural gas use will continue to rise. The big switch is over in utilities, and it will be gradual from here. But we've barely begun the transition with transportation fuel.

TER: So the game has changed for the power industry, and the transportation industry is next. What other changes do you foresee in the future?

RM: We will continue to use more natural gas and less crude. Right now, for equal amounts of power, crude oil is priced at about three times the natural gas price in the U.S. That is too wide a spread to ignore, economically.

The Natural Gas - Crude Oil Spread

source: Bloomberg

Incidentally, in Europe, natural gas is still at $12/Mcf. It's on a par with crude. Most European chemical plants use a crude oil base to make chemicals. U.S. plants use a natural gas base. Natural gas becomes ethane, then ethylene, then polyethylene and then plastic. So producers of plastics or the feedstocks for plastic in the U.S. now have an advantage they didn't have before.

"The natural gas price advantage will be with us in North America for quite a long time. It's huge."

In Japan, the natural gas price jumped from $12 to $16/Mcf just after the tsunami wiped out the Fukushima nuclear power plant. To ship gas from the U.S. to Japan, the cost of compression, liquefying and decompression is about $6/Mcf. Executives at U.S.-based companies like Dow Chemical Co.

(DOW:NYSE) are saying they don't want the U.S. to export gas because that would drive the price up. But domestic gas consumers already have that $6/Mcf advantage. Meanwhile, in Williston, N.D., the natural gas price is effectively zero. Producers still flare it because they don't have the pipelines to take it out of the area. So this price advantage will be with us in North America for quite a long time. It's huge. That's why we call it a game changer.

TER: So how can investors take advantage of these changes?

RM: Well, any number of ways. We hold some fracking services companies, like Halliburton Co. (HAL:NYSE). We own a couple of drillers, including Rex Energy Corp. (REXX:NASDAQ). And we invest in the people who build natural gas export facilities, such as Fluor Corp. (FLR:NYSE), KBR Inc. (KBR:NYSE) and Chicago Bridge Iron Co. N.V. (CBI:NYSE).

I already mentioned companies building natural gas-fired engines, including Westport, which makes a kit to modify a common diesel engine. And because natural gas will require new, larger fuel tanks, investing in companies that build natural gas tanks is another way to play it. One of the disadvantages of natural gas versus gasoline or diesel is compressed natural gas takes about three to four times the volume to get the same range. Liquefied natural gas (LNG) takes about two times the volume.

Of course, compressed natural gas is stored in pressure tanks, so it takes a pressure tank of larger size. Fuel tank conversions have been almost as expensive as the engine conversions. 3M Co. (MMM:NYSE) has gotten in that business, as has General Electric Co. (GE:NYSE). There's another outfit called Chart Industries Inc. (GTLS:NGS; GTLS:BSX), which has already run a good bit.

"We want a foot in each of these camps because we're not quite sure who the ultimate winners will turn out to be, but we know what the product lines will have to be."

We want a foot in each of these camps because we're not quite sure who the ultimate winners will turn out to be, but we know what the product lines will have to be. Don't forget about the companies that own the LNG export facilitiesCheniere Energy Inc.'s (LNG:NYSE.MKT) facility should be up and running in probably 2015, but, again, that stock has run up a good bit, too.

Pipelines will benefit from the switch. One of the biggest pipelines in the country is Kinder Morgan Energy Partners L.P.'s (KMP:NYSE) Rockies Express Pipeline, which stretches from Northern Colorado to Eastern Ohio and ships gas east. Kinder Morgan recently filed to reverse the flow on part of the line. Right now, in Western Pennsylvania, we have a glut of gas. A few months ago, they reversed the flow of the pipeline from the Gulf Coast that used to come up to Western Pennsylvania. There's a whole lot going on.

TER: After some serious oil train derailments in recent months, pressure is building now to increase pipeline capacity, but there is also pressure on producers to reduce flaring, which is happening on a huge scale in the Bakken Shale. How will the economics and the operations of Bakken producers be affected if they can't flare and pipeline capacity is not increased?

RM: The Bakken is primarily an oilfield; the gas is a byproduct. We hear a lot about the Keystone XL Pipeline, which is meant to carry oil from the Bakken south. I can't speak specifically, but if you're going to lay an oil pipeline from the Bakken, you should lay a gas pipeline alongside it. You can ship oil by rail, but it's not economic to ship gas by rail. One way or another, the oil will be shipped.

TER: Bill Powers, the independent analyst and author of "Cold, Hungry and in the Dark: Exploding the Natural Gas Supply Myth," says gas prices are going to rise steadily to as much as $6/million British thermal units ($6/MMBtu) because U.S. gas production has peaked and now is now flat or declining. Do you agree with that?

RM: Our production of gas has not peaked and is not declining. We are using fewer rigs drilling for gas, but each well, particularly if you drill horizontally instead of just vertically, is producing so much more gas. Production is not declining and isn't likely to for at least a decade. At current rates, we can drill in Pennsylvania for another 50 years. Yes, you drill the best wells first but also, over time, you get a little bit better at timing this stuff. I'd be very surprised if the price in the next decade gets over $5/Mcf for any extended period of time because there's an awful lot of gas that's very profitable at that price. I'm willing to make that bet with Bill Powers. But even $6/Mcf gas would equate to $55/bbl crude, which is still a huge spread and wouldn't negate my general argument.

TER: What's your forecast for gas prices in 2014?

RM: My forecast is $4/Mcf, give or take $1. We just had a big cold snap on the East Coast. What used to happen is any time you had a cold winter, the price of gas jumped. For instance, in 2005, when crude was selling about $50/barrel ($50/bbl), gas began the year at about $7/Mcf, which was on par with crude, but in the wintertime, it doubled and ran up to $14/Mcf. The recent cold snap took gas all the way up to ~$4.20/Mcf. Gas is going to be in that range for a long time.

TER: Your advice to investors in natural gas is to get exposure to exploration and production companies, service companies and even LNG plant constructors. What about the LNG plant owners, the pipelines and the railroads?

RM: The pipelines will do well. They've already been bid up. The railroads will benefit from oil and gas, but they're getting hurt because coal tonnage is way down, CSX Corp. (CSX:NYSE) just reported. So for the railroads, it's going to be a wash. They'll haul less coal and more oil. The railroads won't haul gas. How much oil they haul is an open question. We're about to tighten restrictions on how tank cars are built.

TER: What did well in the Muhlenkamp Fund last year?

RM: The fund was up 34.4%. We did very well in biotech stocks. We did very well in financial stocks. We also did well in some energy stocks. Airlines did well for us. Incidentally, airlines benefit big time from cheaper energy, as you know. So it's fairly diverse.

TER: How are you adjusting your portfolio this year?

RM: Not too much has changed. We're no longer finding many good companies that are cheap. So we're monitoring and adjusting a little bit around the edges. We do think banks have further to go. We think the economy will grow somewhere between 2.53% this year. We've owned no bonds for the past couple of years, but with the Treasuries now, the interest rates on the longer end are high enough so that savers can get a little bit of return.

TER: I was surprised to see a really sharp drop in November for Fuel Systems Solutions Inc. (FSYS:NYSE). Why did that happen?

RM: Fuel Systems makes conversion kits for cars to burn compressed natural gas. In places like Pakistan, 40% of the cars run on natural gas; this is not new technology. A number of its customers decided to make these kits in-house. Fuel Systems is a small position of ours, but, yes, it got hit in Q4/13 when it announced that a number of its customers decided to produce their own kits. One of the nice things about this is there's no new technology involved. We've been using natural gas as a power source for generations. What has changed is the amount that's available reliably at a cheap price.

TER: There was another sharp drop in Clean Energy Fuels in October. What happened there?
RM: Clean Energy, so far, doesn't make a profit because it has been shelling out all the money to build all these filling stations. It's just taking a little longer than people expected. The stock is compelling at these levels. A number of these companies ran. Westport doubled, and we took some profits. It's now back down, and we should do a Buy rerating. There is volatility in this stuff, but the economics are undeniable. We still managed a 34.4% gain this year, which isn't bad.

"Royal Dutch Shell Plc is building natural gas fueling stations in concert with another truck stop operator."

Clean Energy has signed a joint venture with Pilot Flying J to build natural gas fueling stations at Flying J truck stops coast to coast. Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) is doing a similar thing in concert with another truck stop operator. For instance, the Port of Long Beach, Calif., passed a rule several years ago that the trucks on the port need to burn natural gas. The Port of Hamburg, Germany, has contracted to put a natural gas-fired power unit on a barge so that when cruise ships come into the harbor, instead of running their own power off their diesel engines and generators, they'll use this barge to supply power to the cruise ship because natural gas exhaust is cleaner than diesel exhaust.

TER: A couple of other companies had surprising drops Rex Energy and Westport Innovations. Rex rose all year until October or November, when it suddenly dropped. Westport also dropped suddenly. You had a wild ride in your portfolio, didn't you?

RM: We bought Rex at $13/share, and it went to $22 or $23, and it's now $19. I can live with that. The dips give you a chance to load up again. That volatility is why we have a diversified portfolio. That's why you don't just bet on three stocks.

As an investor, most of the time what you're looking for is to find a difference between perception and reality. Today, we have two realities: One is the price of crude oil, and the other is the price of natural gas. So it's literally an arbitrage if you can buy energy either at the equivalent of $100/bbl or at a third of that.

Four dollar gas is equivalent in energy content to about $35/bbl crude. So I can buy my energy either at $100/bbl or $35/bbl. Economics says that spread is too wide. It won't necessarily close, but it sure as heck will narrow a good bit. For instance, I own no conventional oil companies. I think the price of oil will be coming down.

TER: So what companies in your portfolio look most promising?

RM: If you really want to get me excited, we can talk about natural gas, which we've been talking about. We could talk about biotechnology, which is exciting but I don't understand it as well. We can talk about U.S. manufacturing, but that's basically based on cheaper energy. I just bought more Rex. At these prices, I'm buying Westport. I just bought Chicago Bridge. I just bought KBR.

TER: What is your main motivation in buying these companies? Is it just the stock price or is there something about the management of the company or the technology?

"I want to buy Pontiacs and Buicks when they go on sale. I don't want a Yugo at any price. I would like to buy Cadillacs, but they don't go on sale very often."

RM: We're in the investment business. What we rely on is good companies, and we look to buy them when they're selling cheaply. Our first measure of how well a company is run is we start with return on shareholder equity. So we like companies that are at least above average in return on shareholder equity. I cannot yet say that about Clean Energy, but we do think Clean Energy is at the forefront of something that's needed for this transition. We're always looking for good companies. Then the question is whether you can buy them at a decent price.

My phrase is: I want to buy Pontiacs and Buicks when they go on sale. I don't want a Yugo at any price. I would like to buy Cadillacs, but they don't go on sale very often. But if I can get Buicks when they're on sale, I'll make good money for my clientele. We think that the companies we have are at least Buicks. If we can get them at Chevy prices, that's when we buy them. I will not pay an unlimited amount for any company.

I've never seen a company that was so good it didn't matter what you paid for the stock. To us, value is a good company at a cheap price. Some people bottom fish. They look to see when they can steal companies, and there are times when you can make money that way. But at that point it's not often a very good business, and there aren't too many well run companies at bargain basement prices. So it's very unusual for us to buy a weak company or a weak industry.

TER: Ron, this has been a good conversation. I appreciate your time, and good luck with your Money Show presentation.

RM: Thanks; it'll be fun.

Ron Muhlenkamp is the founder and portfolio manager of Muhlenkamp Co. Inc., 


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The Energy Report: Where to Drill for Portfolio Outperformance

The Energy Report: Chad, you recently released an early look at 2014 titled, Drilling Down for Outperformance. You noted that you saw an average 3540% upside on your Buy rated names. What are your criteria for picking companies?

Chad Mabry: To start, we use a discounted cash flow based net asset value (NAV) approach to valuing exploration and production (EP) stocks. While cash flow is an important metric, NAV does a better job of comparing companies with different asset profiles, specifically within the small and midcap EP space. NAV does a better job of accounting for a company's upside potential than cash flow metrics. We use a bottom-up approach to drill down into a company's asset base, its average type curve, estimated ultimate recoveries (EURs), well costs and so on. In this way we find out about the economics of those plays and what the sensitivities are to our commodity price deck. We then try to sort out companies that aren't being valued appropriately and identify strong risk reward opportunities.

TER: There has been a lot of commodity price volatility this last year. How do you determine what prices to use when you're estimating NAV?

CM: That's a good question. Given the volatility inherent in oil and gas commodity price movements, forecasting prices is somewhat of a losing proposition. We try to set a long term price deck based on the industry cost structure, which is based on the marginal cost of new production. Over the long term, laws of supply and demand will win out and commodity prices should normalize toward equilibrium levels, which are currently about $90 per barrel ($90/bbl) for oil and $4.50 per thousand cubic feet ($4.50/Mcf) for natural gas.

TER: The Energy Information Administration (EIA) is forecasting U.S. oil production to increase by about 1 million barrels/day in 2014 with year-over-year growth in the 1015% range. What impact could that have on the price of oil going forward?

CM: There is an oil production renaissance in the U.S. We expect that to continue, driven by the independent EPs. We're forecasting production growth in 2014 of about 5055% in our coverage universe. That is going to be driven by oil growth as companies continue to allocate the vast majority of their capex budgets next year to oil and liquids-weighted projects.

TER: Are there certain sectors of the oil market that you like better than others?

CM: We feel the outperformers into 2014 are the companies that have established core positions in some of the more economically attractive oil and liquids resource plays in North America. It won't come to anyone's surprise that some of the best-in-class resource plays include the Eagle Ford, the Bakken and the Niobrara, to name a few. But we also feel like there are some pretty intriguing, earlier-stage plays that offer exposure to oil and liquids that we're going to be keeping an eye on into next year, specifically the Utica, the Tuscaloosa Marine Shale and the Woodbine.

TER: What do you like about developed areas, like the Eagle Ford?

CM: Eagle Ford has become the standard bearer for the oil and liquids resource plays in the U.S. The geography is best in class and it is a repeatable play with very compelling economics. As we move into development mode in the play, we continue to see the potential for additional catalysts, which should continue to lead to outperformance for our names that have exposure there.

As well costs continue to reduce and recoveries and completion designs improve, we expect rates of return to drift higher. As various operators focus on additional zones, there is additional upside potential to companies' drilling inventories in the form of additional pay zones.

The best exposure to the Eagle Ford and one of our top picks is Carrizo Oil Gas Inc. (CRZO:NASDAQ), which has established a very nice sweet spot in La Salle County.

We also like Sanchez Energy Corp. (SN:NYSE), which has become somewhat of an Eagle Ford pure play with a very robust inventory across the play.

TER: Carrizo is in the Utica, the Marcellus and the Niobrara. In November, it announced record oil production, and the stock price is up pretty dramatically, although it's off its all-time highs. Is there still upside?

CM: We believe so. We see roughly 50% upside to our NAV from current levels. One of the reasons that it is a top pick of ours is that it has core positions in very attractive plays. You mentioned its position in the Utica, the Niobrara and the Marcellus. It has some best in class exposure to these plays.

We expect the company to have some downspacing results in the Eagle Ford as it continues to test 500 foot (500 ft) spacing versus 750 ft, where it is today. We don't have that in our numbers right now. We estimate that could add about $10/share to our NAV from current levels.

"Given the volatility inherent in oil and gas commodity price movements, forecasting prices is somewhat of a losing proposition."

In the Utica, the company's acreage is in a very delineated, core spot of the play. While it is still early on in its activity in the play, we expect it to have initial well results in the near term. We think that could be another catalyst for the name.

Then, like other operators in the Niobrara, Carrizo is also testing downspacing, which, if successful, could yield incremental upside to what we're giving it credit for right nownot only core positions in core plays, but also the catalysts that we expect to drive the stock up toward our NAV over the next 12 months.

TER: You have a Buy rating on Sanchez. It also has a secondary in the Tuscaloosa Marine Shale. What impact could the Tuscaloosa have on its share price?

CM: We have just $1/share of Tuscaloosa Marine Shale value in our NAV right now. It's very minimal at this point. At current levels, investors are getting a free option on Sanchez' Tuscaloosa Marine Shale potential, which could be very meaningful.

One of the reasons that we like these more emerging areas is that you're not really paying as much for some of these positions. Contango Oil Gas Co. (MCF:NYSE.MKT), which is more of a legacy name, also has exposure. I'd even classify it as a Tuscaloosa Marine Shale sleeper because it doesn't register on a lot of people's radars as having a significant position in that play following its merger with Crimson Exploration Inc. (CXPO:NASDAQ).

If you're a believer in the long-term commerciality of the play, which we are, then a name that you need to own is Goodrich Petroleum Corp. (GDP:NYSE), which has by far the most leverage to that play with around 300,000 net acres. As that company accelerates to a five rig-operated program in the Tuscaloosa Marine Shale next year and gets away from the well watch nature that's made for a volatile 2013, its position in that play delivers outperformance for the stock. If you're a believer in the play, then Goodrich is a must own name. As the play advances further along the development curve, Goodrich becomes a takeout candidate for any larger company looking to gain exposure in a material way.

TER: What else is intriguing in the Niobrara?

CM: A lot of these names with exposure to the Niobrara have been some of 2013's outperformers.

But when we look at who has exposure to the play and who maybe isn't getting as much credit as the next guy, an attractive name to us is PDC Energy Inc. (PDCE:NASDAQ). It's the third-largest producer and leaseholder in the Wattenberg. In addition, it has a pretty significant position in one of the emerging areas of the Utica. At these levels, it's a pretty compelling investment.

TER: The price is down from earlier in the year. Is this a buying opportunity?

CM: The stock did correct a bit after a Q3/13 earnings miss and its initial results in the southern part of its Utica position, which didn't meet Street expectations. This did present a nice buying opportunity. It does have a number of upcoming catalysts, not only in the Utica, but also from additional downspacing and testing of other formations in the Wattenberg/Niobrara. At current levels, investors are getting a free option on its position in the Utica.

TER: Are there any neighbors you like?

"As we look into 2014, we're more focused than ever on company-specific fundamentals and relative performance indicators that should help pick the outperformers into next year."

CM: Yes, as a matter of fact. Bonanza Creek Energy Inc. (BCEI:NYSE) has a very quality position in the Niobrara; it's essentially a Niobrara pure play. But at current levels, it is receiving closer to full valuation for that position, and we see better risk-reward in other names, specifically Carrizo and PDC.

TER: Bonanza Creek is both in Colorado and the Cotton Valley sands in Arkansas. What are the next steps?

CM: Its focus will be on its Wattenberg/Niobrara position. It has a four-rig program in the play, which should drive 2014 production growth of 4550%. But at the same time, the Wattenberg valuation is more than $50,000/acre, which just seems closer to full value at these levels.

TER: Did you also initiate coverage on Gulfport Energy Corp. (GPOR:NASDAQ)?

CM: Yes. We have a Hold rating on Gulfport for similar reasons. Whereas Bonanza Creek has a quality position in the Wattenberg/Niobrara, Gulfport has a fantastic position in the core of the Utica. The valuation is a bit stretched at these levels, however.

TER: You have a Buy on Midstates Petroleum Co. Inc. (MPO:NYSE). Is that based on its exposure to the Anadarko Basin?

CM: The Buy on Midstates is based on the fact that its portfolio is misunderstood and undervalued. It also has a leading position and is one of the biggest operators in the Mississippi Lime play in Northern Oklahoma. Then it has the third leg of the stool, if you willthe Wilcox play in Louisiana, which is an earlier-stage play that it is not receiving any credit for. As we move into 2014 and the company executes and delivers what we feel like will be above-average production growth, that value gap is likely to narrow.

TER: Do you still like the Gulf of Mexico?

CM: It's all about relative valuation. The Gulf of Mexico players had a nice tailwind earlier this year with Light Louisiana Sweet oil prices enjoying a healthy premium to West Texas Intermediateclose to $20-plus/bbl earlier this year. That premium has since eroded. It's not something that will likely come back in a meaningful way in the near term. As a result, you lose that benefit looking into 2014. But, like I said, it's all about relative valuation.

We do think there are some nice opportunities in the Gulf, specifically Stone Energy Corporation (SGY:NYSE). It has several impactful catalysts in the form of deepwater exploration wells that should have results starting in early 2014, which could drive outperformance for the stock. Investors aren't paying for any of that upside at these levels, so that's really why we have the Buy rating on Stone at this time.

TER: Its stock is up to $40 from $32 last month. Is that mainly because of the new spudding in early 2014?

CM: Fortunately for Stone Energy, there are a number of wells, operated and non-operated, that should provide a steady flow of catalysts throughout 2014 and 2015 in the deepwater Gulf of Mexico. We expect several catalysts over the course of the next couple of years.

TER: Are there other relative outperformers in the Gulf of Mexico?

CM: Right now, our two names that operate exclusively on the Gulf of Mexico shelf are Energy XXI (Bermuda) Ltd. (EXXI:NASDAQ) and Energy Partners, Ltd. (EPL:NYSE). We have a Buy rating on Energy XXI and a Hold rating on Energy Partners. Shares of Energy XXI, on a relative basis, are more attractive because they are trading below their proved-only valuation and the company is pursuing a number of exploration objectives, which could cause the stock to outperform. Energy Partners has had some issues in some of its core fields recently, which could provide a headwind for shares in the near term.

TER: Energy XXI also has been doing quite a bit of consolidating of other smaller players. It is pursuing some deeper salt plays. When could those start to pay off?

CM: It's the third largest oil producer on the shelf. It is taking advantage of its footprint in the area and its expertise of the geology in the basin to pursue some deeper exploration targets, not necessarily the ultra deep. We should get some results into 2014 from the company.

You mentioned it being a consolidator. Both Energy Partners and Energy XXI have become consolidators on the shelf. Looking into 2014, we wouldn't be surprised to see Energy XXI target some larger objectives internationally, specifically in Malaysia, which offers a nice analog field to what we've seen in the Gulf of Mexico, but with larger scale.

TER: Energy XXI also just initiated a share buyback program and raised the dividend. Is that part of a trend?

CM: It's a representation of its confidence in the stock and in its performance, its belief that shares are undervalued and its willingness to buy back shares at levels it feels are too low.

TER: Smart capital allocation has been a differentiator for some of these companies in 2013. How are successful companies better using their resources?

CM: Since we've seen commodity prices somewhat range-bound with a lot of the land grab more or less over, investors will be even more willing to reward companies that demonstrate effective and efficient operations in 2014.

TER: Companies have been trying to create some new catalysts and value, and derisk their new projects. Is that paying off?

CM: Yes. We've seen that across the board in terms of drilling efficiencies. As companies have migrated away from acreage capture to development mode in their core resource plays, we've seen rig productivity increase fairly dramatically. That's been an area where companies have been able to deliver meaningful cost savings while, at the same time, enhancing their drilling and completion techniques, essentially making bigger wells and increasing their IRRs in these plays. Downspacing has also been a catalyst in a lot of these plays and, looking into 2014 in some of the more developed plays, whether it's the Bakken, the Eagle Ford or the Niobrara, additional downspacing results will be a major catalyst for a number of companies.

TER: Can you leave us with some advice for investors in the space as they prepare for 2014?

CM: Stock selection will be more important than ever looking into 2014. While this is a group that historically has a high correlation to oil and gas prices, it's becoming more of a stock picker's market. As we look into 2014, we're more focused than ever on company specific fundamentals and relative performance indicators that should help pick the outperformers into next year.

TER: Thanks for joining us today.

CM: Thanks for having me.

Chad Mabry is an analyst in MLV's Energy and Natural Resources Research Department. Bringing over 10 years of experience in the oil and gas industry, he primarily focuses on small- and mid-cap companies in the Exploration Production sector. Prior to joining MLV, Mr. Mabry was a senior analyst with KLR Group and Rodman Renshaw, and an associate analyst with Pritchard Capital Partners. Mr. Mabry holds an M.A. in Accounting and a B.A. in Philosophy from the University of Texas at Austin.

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The Energy Report: Micro-Cap Oil Stocks that Hit the Jackpot

The Energy Report: With oil prices firming up over the past couple of months and the spread between West Texas Intermediate (WTI) and Brent Crude narrowing, what are your price expectations for the remainder of 2013 and into next year?

Phil Juskowicz: While I don't spend a lot of time predicting commodity prices, I personally see relatively stable short-term oil prices. Intermediate or long-term prices may weaken, assuming no supply disruptions arise from political upheavals, while gas prices may strengthen based on supply/demand fundamentals. We've seen continued oil supply growth and the short term market seems to be pretty range bound, having developed a good base around the $100 per barrel ($100/bbl) level.

TER: Where do you see some of the best investment opportunities in the oil and gas business?


PJ: Micro-cap exploration and production (EP) stocks have severely underperformed the SP Small Cap EP Index since the second half of 2011 (H2/11). However, the definition of "small cap" depends on who you're talking to. The Small Cap EP Index consists of companies around the billion-dollar range like Approach Resources Inc. (AREX:NASDAQ) and Northern Oil Gas Inc. (NOG:NYSE). Casimir has a micro-cap EP index, which is comprised of companies with market caps up to $500 million ($500M) with some names under $100M. That index level started to diverge in H2/11. Both of these groups consist of relatively equal gas/oil weightings, so the performance should not, in our opinion, be attributed to the relative strength of oil prices over gas that commenced around that time. As a result, we believe that there are attractive investment opportunities in the micro-cap EP universe.

Casimir Micro-Cap EP Index (White) vs. SP Small-Cap EP Index (Yellow)


Casimir Micro-Cap EP Index composed of: AMZG, ANFC, CAK, CPE, CXPO, EGY, EEG, ENRJ, ENSV, FEEC, FXEN, GMET, GNE, HDY, HNR, IFNY, IVAN, LEI, MCEP, MILL, MPET, MPO, OEDV, PHX, PNRG, PSTR, RDMP, SARA, SSN, STTX, TAT, TENG, TGC, TPLM, USEG, WRES, ZAZA
Source: Bloomberg; Casimir Capital

TER: How do you choose the companies in your coverage list?

PJ: We look for small companies that have largely flown "under the radar screen" and are underfollowed. The companies we cover have strong management teams and operate in premier areas with good assets that have substantial cash flow potential.

TER: Do you cover any service companies?

PJ: Enservco Corp. (OTCBB:ENSV) is on our "watch list". The company is the only nationwide provider of hot oiling, well acidizing and frack heating services generally used to coax oil out of the ground, for example to counter paraffin buildups. Enservco experienced healthy margins in Q2/13 despite it typically being a seasonally weak time for heating services. The company continues having to turn customers away in some areas while it builds out its fleet. Management, in our opinion, has a track record of building successful companies and its regional staff has strong relationships with EPs. The company is also expanding into other basins and successfully tapping into new revenue sources.

TER: Why aren't competitors seeing the opportunity here and moving in to get a piece of the action?

PJ: There are regional pockets of mom and pop shops that will do some of these services, but, a nationwide company like a Noble Energy Inc. (NBL:NYSE) might turn to Enservco because it already has a reliable relationship with Enservco's staff in different areas. Enservco's services account for a very low percentage of total well drilling and completion costs (it might cost around $100,000 to service a $7M well) so customers are not as likely to conduct competitive bidding processes. Instead, they choose to use a company with which the frontline managers already have existing relationships.

TER: So it has developed a national reputation, which is its competitive strength.

PJ: And it's building out the capacity as we speak. Enservco is expanding its already large presence in the Marcellus Formation. In its Q2/13 conference call, management said they were starting to see the Utica play out a little bit. The Utica underlies the Marcellus in a lot of areas and Enservco gets some economics of scale there. [See map] Furthermore, management has been getting the word out more and also may be contemplating a reverse stock split and listing on another exchange.


Source: Marcellus Coalition

TER: What EP names on your coverage list look interesting?

PJ: We like Miller Energy Resources (MILL:NYSE; MILL:NASDAQ), which, in late 2009, captured former Pacific Energy Resources Ltd. assets out of bankruptcy that were valued at $500M for an outstanding $4.5M. Miller's entire enterprise value, meanwhile, is just $240M. Moreover, its infrastructure assets were valued by third parties on behalf of its lender at $190M. What makes these assets most attractive is the fact that recent well results indicate that original estimates by Forest Oil (which sold the properties to Pacific in 2007) may in fact be correct, which would mean that these Alaskan assets could contain 100200 million barrels (MMbbl) of recoverable oil reserves. Proved oil reserves presently stand at 8.61 MMbbl.

TER: How was Miller able to buy $500M worth of assets for less than 1% of their value? Even in bankruptcy, you'd think that there'd be buyers willing to pay more than that.

PJ: David Hall, a Miller Energy executive who had worked on the assets even before Pacific bought them from Forest Oil in 2007, was following the Alaskan bankruptcy proceedings. He got in touch with the CEO of Miller, Scott Boruff, and told him about these assets that were becoming available.

TER: Why does Miller believe that the original estimates of recoverable oil reserves may, in fact, be correct?

PJ: The thesis is that Forest Oil used the wrong completion techniques, which is why well performances had dropped off. The completion techniques Forest Oil used were in fact different from techniques used for other assets on the McArthur Trend. David Hall believed that workovers on existing wells, for example, replacing some electric submersible pumps and making changes to completion techniques on new wells, could improve production. Low and behold, that's exactly what's happened.
In addition, Miller just started doing sidetracks of some of these old wells. It posted a 21-day production test of its RU-2A well several weeks ago at 1,314 barrels per day, which would indicate that that the oil's there and it's recoverable. Management has been doing a good job of utilizing preferred equity to have substantial capital expenditure programs without diluting the common shareholders. To top it off, it has about 600,000 undeveloped acres that it's just starting exploration on as well.
TER: What other names look interesting?

PJ: I like Trans Energy Inc. (TENG:OTCBB), which is a pure play in the Marcellus Shale. The company holds about 20,000 net acres in the Marcellus, a substantial portion of which are in the core, liquids-rich part of the play. Operators, including Range Resources Corp. (RRC:NYSE), EQT Corp. (EQT:NYSE) and Gastar Exploration Ltd. (GST:NYSE), continue to increase their return assumptions for acreage adjacent to Trans Energy's. The company's production is set to ramp up as soon as Williams Companies Inc. completes the construction of certain infrastructure. Trans Energy's acreage is in northeast West Virginia, on the southwest Pennsylvania border. There's been a lot of success coming out of that area.

TER: What sort of strategy would you suggest our readers consider?

PJ: I think the micro-cap space, in general, is less correlated to the market's vagaries. Perceived changes in foreign interest rates, for example, have a larger effect on large-cap names. Micro-cap pricing is determined more by company-specific dynamics, such as anticipated future cash flows. Plus, a lot of micro-cap names and EPs in general seem to be more active on hedging, and therefore should be less susceptible to changes in commodity prices. As a result, investors that exercise due diligence should be rewarded for accurate cash flow predictions. If you want to find companies where your hard work can actually pay off, then the micro-cap space is a good place to look.

Micro caps seem to be getting more active in reaching new investors, and some of the management teams have regrouped from previous lives and are starting up very successful new companies. I think Bonanza Creek Energy Inc. (BCEI:NYSE) is a great example of management hailing from one company and getting back together and starting all over again.

TER: Thanks for talking with us today and giving us some interesting input, Phil.

PJ: I appreciate the opportunity.

Philip Juskowicz, CFA is a managing director in the research department at Casimir Capital, a boutique investment bank specializing in the Natural Resource industry. Juskowicz began his career at Standard Poor's in 1998, where he was one of the first analysts to recommend Mitchell Energy, credited with discovering the Barnett Shale. From 2001-2005, He worked with a former geologist in equity research at both First Albany Corp. and Buckingham Research. At Buckingham, Juskowicz was promoted to a senior oilfield service analyst position, leveraging his extensive knowledge of the EP space. From 2006-2010, he was an insider to the oil and gas industry, serving as a credit analyst at WestLB, a German investment bank. In this capacity, Juskowicz was responsible for $500M of loans to energy companies and projects. He earned a Master of Science in finance from the University of Baltimore.

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