“Investors got full value out of Petrominerales [PetroBank's Latin-American play] and PetroBakken [Bakken and Cardium], but our 800-pound gorilla is THAI. It's frustrating for us to have all these operational issues, but one thing we know for sure is that it works.”
That was from Petrobank CEO John Wright about a year ago in this article in the Globe and Mail (http://m.theglobeandmail.com/report-on-business/managing/at-the-top/he-could-sit-tight-but-he-wants-a-tech-legacy/article1515427/?service=mobile).
After years of waiting to get a look at that 800 pound gorilla Petrobank shareholders may be on the cusp of a very rewarding trip to the zoo as Petrobank is now putting the first ever commercial development THAI wells on production.
It is interesting that Wright sees THAI as being Petrobank’s 800-pound gorilla, because the stock market assigns a negative value for it.
Petrobank CEO and Chairman John Wright
I’d first like to give you a bit of a background on Petrobank CEO John Wright.
Wright first started to get noticed becoming CEO of Pacalta Resources, a small junior Alberta Oil and Gas Company, in 1996. Wright quickly built and sold that company to Encana (ECA) for $973 million in 1999. After that success Wright formed a Merchant Bank with a group of former Pacalta managers. In March 2000, Wright and his group did a friendly takeover of Canadian junior natural gas producer Petrobank which at the time had a market cap of $40 million and a share price of $1.
In 2000 Petrobank Chairman John Tocher gave this as his reason for turning the company over to Wright:
“The new management team has demonstrated an outstanding record of achievement in developing a global company and creating significant shareholder value. Over a three-year period ending in 1999, they built Pacalta Resources Ltd. from a small Alberta junior oil and gas company into a company with an enterprise value of over one billion dollars. In the process, the management team set an example of how to conduct successful international operations.”
Link to report here:
In the same report John Wright wrote his first letter to shareholders and laid out his strategy for creating shareholder value. The most important elements in my mind being:
1) Focus on the best opportunities worldwide.
"We believe that there are numerous opportunities, both in Canada and internationally, which can generate superior returns for shareholders. By strictly applying the latest technical tools, carefully controlling all cost centers, and working to capitalize on our experience and strengths, we intend to invest in the most profitable projects on behalf of our shareholders. We recognize that there are specific local constraints and operating conditions that must be understood and respected; however, we do not believe that there are any artificial geographical limits that should be imposed on your Company’s operations."
2) Operate wherever and whenever possible.
"Acting as the designated operator for oil and natural gas exploitation and exploration projects allows us to control our destiny, particularly in the two cost areas that impact return on equity the most - capital invested, which is measured as finding and development cost, and operating/overhead expenses. Effectively controlling these cost centers will maximize return on equity throughout the life of each project and reduce the impact of the cyclical price movements that our industry experiences. In addition, operatorship brings with it responsibility for executing all decisions and investments, which ensures that all operating actions are implemented with the best interests of Petrobank shareholders in mind, and that errors or problems are dealt with and rectified immediately."
3) Act as shareholders.
We believe that your Company’s Board of Directors, management and employees should all be shareholders and/or have incentives to always act in the best interests of the shareholders. To this end, the Company’s executive group has personally made a significant financial investment in Petrobank. Moving forward, employee compensation will include share purchase options and incentive bonuses linked to share performance and long-term value creation for the shareholders.”
So how has he done?
After starting with a $1 stock price and a $40 million market cap ten years ago, today Petrobank trades for roughly $17 per share which is a market cap of $2.1 billion. And that excludes Petrobank’s 66% interest in Petrominerales which was spun out to shareholders at the end of 2010. Combine the value of the Petorminerales shares spun out and today that $40 million market cap would be worth $2 billion or $18.86 per Petrobank share.
Not bad. From $1 per share and a $40 mil market cap and in ten years turned it into roughly $36 per share and over $4 billion of market cap. This was a tiny natural gas company that he turned into two companies that are 90% weighted to oil. And it wasn’t as if Petrobank had hidden assets when he took it over that he could exploit. In fact Wright sold all of the assets that Petrobank owned when he took over within the first year. The current value of Petrobank and the current production of Petrobank come from assets acquired under Wright’s management over a 10 year span.
I think it is important in this case to understand that Mr. Wright must be a fairly bright fellow, because the stock market today would have you believe he is out to destroy value.
Here it is and it is pretty simple, especially subsequent to the spin out of Petrominerales to shareholders at the end of last year. Petrobank is made up of the following:
1) 109 million shares (62% ownership) of Petrobakken (a mid-sized Canadian light oil producer)
2) Whitesands Heavy Oil and Oil Sands Unit (holds Canadian heavy oil and oil sands assets)
3) Archon Technologies (holds the rights to Petrobank’s THAI technology)
The stock market assigns value to only the ownership of Petrobakken.
Petrobank valuation – 106 million shares at $17.40 = $1.844 billion (basically no net debt at the parent level)
Market Value of Petrobakken stake – 109 million shares @ $16.14 = $1.759 billion
Thus the value of No. 2 and No. 3 (Whitesands and Archon) implied by the stock market is $1.844 billion — $1.759 bil = $84 million.
Value of the Whitesands Unit
Let’s assume for now that Petrobakken is fairly valued by the stock market (I actually think it is quite undervalued). What are you getting for $84 million?
This unit has the following according to their third-party reserve auditors:
- 74 million net barrels of proved and probable heavy oil and bitumen reserves (at the Conklin and Kerrobert properties) with a PV10 value over $500 million according to the 2010 reserve report
- A best estimate 560 million barrels of contingent bitumen resources at the May River property with a PV10 value of $2 billion
- A Dawson property with 200 million barrels of potential oil in place and 80 million barrels of exploitable oil in place which is not in the reserve report
So the stock market values all of this at $84 million or about 80 cents per share. The third-party reserve engineers estimate a value of $500 million for the 2P reserves and $2 billion for the contingent resource which combined is $2.5 billion or $23.58 per Petrobank share (versus only 84 cents in the current share price).
Now don’t get excited, I’m not saying that tomorrow the stock market should value these undeveloped properties like this. But it certainly does look like an investor is paying nothing for a lot of oil in the ground.
You don’t have to use value of future production to try and estimate what the Whitesands reserves might be worth over time. Instead you can focus on what the oil in the ground around May River is worth today. Just last year the Thailand National oil company paid roughly $1.46 per barrel of contingent resource in the ground for a share of Statoil’s property that is right next to Petrobank’s May River. Applying that to the Petrobank property would suggest that today it could be sold for 560 million barrels @ $1.46 = $817 million. That alone is almost $8 per Petrobank share and ignores the value at Kerrobert and Dawson entirely. And that transaction happened when oil was $75, not $100.
I think what I would conclude is that a likely range of value for the Whitesands unit would be the $8 per Petrobank share (over $800 million) that is based on Statoil sale up to $20 per share based on the reserve engineer PV10 value.
One thing that I need to point out is that the PV10 value estimates from the reserve engineers is based on the assumption of development using SAGD. Petrobank has a different production method in mind.
Archon Technologies (THAI)
And now back to that 800-pound gorilla that I was mentioning before. The gorilla is named THAI. THAI stands for Toe to Heel Air Injection and is a new configuration of in-situ combustion that Petrobank believes could be a step change in production technology for heavy oil and oil sand reserves.
I’m not going to explain the technology; the best place for that is the Petrobank website starting with this video:
What I will do is try and explain the benefits of THAI if it performs as expected. And from an economic perspective a comparison with SAGD (Steam Assisted Gravity Drainage) which is the best current technology is needed.
From a production standpoint THAI is expected to outperform SAGD in two ways:
1) It stimulates 17% more of an oil reservoir than SAGD.
2) THAI has a 70% recovery factor of the reservoir that is impacted vs the 40% recovery factor of SAGD
So if you had a reservoir that SAGD stimulates 1 billion barrels of oil in THAI would stimulate 1.17 billion barrels. On top of that SAGD would recover 40% of 1 billion barrels (400 million barrels) while THAI would recover 70% of 1.17 billion barrels (819 million barrels a 105% increase).
So that is night and day really. And it is important to note that all of the reserve figures that were discussed above concerning Whitesands are assuming a SAGD development program. So if THAI works the 560 million barrels of contingent resources at May River are actually more like 1.12 billion barrels. And rather having a PV10 value of about $2 billion or $20 per Petrobank share the PV10 value under THAI would be more like $4 billion or higher which is $40 per Petrobank share.
But the amount of oil that is recoverable is not the only benefit of THAI. THAI also has the following benefits.
Superior Economics to SAGD
- Lower up front capital cost as there is no steam and water handling facilities and only 1 horizontal well
- Lower operating cost as it doesn’t require natural gas or water handling
- Oil produced is more valuable as it is partially upgraded due to heating (Kerrobert pilot has been receiving 10% premium to native oil)
- Faster project execution time
- No net impact on water resources, net water producer
- Smaller surface footprint
- Upgraded oil requires less refining
- 50% less greenhouse gas emission
- CO2 capture ready technology
THAI Sounds Like a Big Step Change but Does It Work?
The short answer is that the verdict is still out on that.
So far there have only been five THAI wells drilled by Petrobank. They were all designed as pilots as Petrobank tried to work through the process. Not surprisingly there have been challenges that were not anticipated in the laboratory as the science was applied in the field. And sensibly Petrobank has not spent a lot of capital on THAI as it has been in the testing phase over the past five years.
Until now that is.
Back to John Wright
And that brings me back again to John Wright.
I don’t know if THAI is going to work as advertised. But I think the actions of management can give me a pretty good idea what they are seeing behind the curtain. And I can combine that some information that is available externally. So here is a summary of the key pieces of info that I have about THAI as of today:
- For five years Petrobank has committed a small amount of capital towards THAI as they tested it through five pilot wells over that time. This year they are spending $90 million on a commercial development program at their Kerrobert property.
- Also this year their reserve engineers McDaniel have assigned reserves to this property assuming a development program using THAI instead of SAGD.
- Petrobank has made two recent property acquisitions near their Kerrobert property indicating an interest in expanding.
- Petrobank at the end of 2010 spun out their entire Petrominerales interest (worth $2 billion)to shareholders which would seem foolish if the Whitesands unit and THAI hadn’t made significant progress.
For me what it boils down to is common sense. Mr. Wright has had an incredible record of creating value over the past 15 years both at Petrobank and at Pacalta. He doesn’t need THAI to make him successful, he has already created multiple billions of dollars of value and is personally wealthy. So what then is his motivation to crank things up a notch and sink $90 million into a commercial THAI development this year unless they didn’t have information that gives him confidence to do so?
But even more importantly, the value of THAI in Petrobank’s share price today is zero. In fact I’d argue that it is more like negative $10 per share because the May River reserves themselves are worth close to $10 per share simply as oil in the ground today. And you pay nothing for them either. All you pay for is the market value of the Petrobakken ownership.
How then would I quantify the value of THAI?
I think the only way to do so is with a range of values.
The bottom of that range would be zero. The upper end of that range could be a lot.
When you consider that if THAI is proven to double the amount of oil that can be recovered, recover this oil at a much lower capital cost and do so in a more environmentally friendly manner, who isn’t going to want to use it to exploit their oil sands or heavy oil reserves?
And if someone wants to use it they are going to have to license it from Petrobank’s Archon Technology unit which has patented the technology all over the world. Petrobank recently signed an agreement with Pemex to explore the potential to use THAI to develop heavy oil assets that company has. The model for licensing THAI is to pay Petrobank both a royalty on the revenue from production and give them a share of the reserves in the ground.
One third party company that seems likely to embark on a THAI development in the next couple of years is former Petrobank subsidiary Petrominerales which has significant heavy oil accumulations in Columbia.
There are trillions of barrels of oil sands and heavy oil in the world for which THAI could be a huge step change in technology.
I have no idea what the upside to THAI could be, but I know it could certainly be in the billions. I also know I’m paying nothing for it in the current stock price.
My estimated range of value for THAI is therefore $0 to billions
Petrobakken represents all but about 80 cents of Petrobank’s current $17 to $18 share price.
In my mind Petrobakken is not the easiest company in the world to value. The reason is that a huge portion of its value resides in the vast amount of undeveloped land that it holds in the Bakken and Cardium resource plays in Western Canada.
The share price of Petrobakken over the past 18 months has been nothing less than awful. Since being created through the merger of Petrobank’s Canadian light oil unit and Tristar Oil and Gas in late 2009 the share price of Petrobakken has gone from $35 to under $17 today. The decrease in share price has been driven (in my opinion) by the big investment (over $1 billion) in undeveloped land in the Cardium that Petrobakken made (which the market didn’t like) and the lack of production growth.
I think Petrobakken is likely worth at least $25 and potentially quite a bit more. At just under $17 today it provides all of the value in the current Petrobank share price. At a very high level the value breaks down like this:
1,000 Cardium Locations with a PV10 of about $4 million = $4 billion in value
900 Bakken Locations with a PV10 of about $3 million = $3 billion in value
350 Conventional Locations with a PV10 of about $2 million = $700 million in value
Add all those up and you have $7.4 billion. Take out the net debt of about $1.6 billion and the value per share is $5.8 billion / 187 million shares = $31 per share
That overstates value because it is a pre-tax figure but also does not factor in any of the following:
- 400 drilling locations in the Montney and Horn River resource plays in British Columbia which could have over 1 TCF of natural gas.
- The fact that the PV10 figures above use $75 oil and not $100 oil
- 100,000 acres that Petrobakken has recently disclosed owning in emerging resource plays of Swan Hills, Duvernay and Nordegg
- Any likelihood that Petrobakken’s enhanced oil recovery plan involving natural gas injection will add any value (hard to imagine given that the pilot injection resulted in an immediate doubling of production in the impacted wells)
Where the value of Petrobakken specifically is I don’t know. I am very comfortable that it is over $20. I think it is likely closer to $30 and with the possibility of $100 oil, EOR success and new resource plays there may be significant value creation in the next few years as well. It is currently yielding almost 6%, trading at a discounted cash flow multiple to its peers and is growing production (they hit 43,000 barrels per day in March) so at worst a fair valuation seems likely.
And if you don’t believe me maybe the significant insider buying (and who one of those insiders was) of the past few months can provide some comfort. I wrote about it for GuruFocus:
A Range of Value Is What Makes Sense
I summarize what I think the valuation of Petrobank looks like with a range of values on each component.
1) Petrobakken – I don’t believe it is worth any less than the current $17 or so per Petrobank share that it trades at. And based on my valuation of the various properties and the potential for upside from enhanced oil recovery I think $30 could be the high end of that range.
2) Whitesands – There are 3 valuation figures for the Whitesands assets. The first is the $8 per Petrobank share that the May River oil currently sells for based on the Statoil transaction. The second is the $20 per share that is the PV10 value of the production of the oil under a SAGD development program. And the third is more like $40 per share assuming that the oil is produced using a THAI development plan which costs less and recovers twice as much oil.
3) Archon Technologies – The third leg of the stool is the most uncertain. I’d say the range is really from zero to something in the billions which could be $10 to who knows how much per Petrobank share.
I’ll let you play with the numbers, but the bottom of the range looks like this:
Petrobakken - $17 per Petrobank share
Whitesands - $8 per Petrobank share
Archon - $0 per Petrobank share
Which totals $25 per Petrobank share versus the current market price of $18.
The upper end of the range on the other hand:
Petrobakken - $30 per Petrobank share
Whitesands - $40 per Petrobank share (assuming a THAI development)
Archon/THAI – Pick a number in the billions or $10 per share plus
What got me so interested in Petrobank is that even at the low range of any sensible valuation it is very hard to get much less than the current share price. You could cut Petrobakken’s value in half and it plus the May River oil in the ground still combine together to equal the current Petrobank share price.
So the downside seems well protected and the upside through THAI and Whitesands could be huge.
And not only does Petrobank allow for the purchase of unappreciated assets, but also gives you a CEO who has an incredible track record for creating value over the past 15 years. CEO Wright has most of his net worth in Petrobank and is basically an owner/founder as he came in created the new Petrobank at the start of the last decade. He is financially and emotionally tied to this company.
My main concern is that for some reason Wright and his team have become so emotionally invested in THAI that they have lost their objectivity and aren’t able to see that pushing forward isn’t the right move. I don’t see a lot of downside here unless they just keep spending and spending on THAI when it is really not the best option, given that the reserve engineers have certified THAI, and when you look at Wright’s history that does seem highly unlikely.
A second major risk would be the price of oil. There is a direct relationship between the value of any oil assets and the price of oil obviously. Given my macro views that is a good thing, but if oil drops so does the value of the Petrobank assets.
A third risk would be any form of government ban on the fracking technology that is used with horizontal drilling by companies like Petrobakken. It seems unlikely to be an issue, but it does get a lot of headlines from environmental groups.
One thing is for sure and that is that within the next several months a lot more is going to be known about THAI. Petrobank is ramping up the first ever THAI development at their Kerrobert property with first oil expected this quarter. It will take about twelve months to ramp production up to maximum production rates, but the company should have some data soon.
I bought Petrobank because I thought it was likely to be a decent investment even if THAI is a complete bust. I still believe that. The fact that Wright and team are now taking the next step with THAI at Kerrobert by moving out of the pilot stage is exciting. I try and keep my focus on the value of Petrobakken and the May River oil in the ground. But occasionally I dream of the possibilities that THAI creates. There are twenty billion barrels of heavy oil just in Saskatchewan alone that THAI could make economic. Petrobank might have the only game in town for those resources. When you start to consider the rest of the world you are looking at trillions of barrels of heavy oil and oil sands reserves.
But focus on the downside and let the upside take care of itself.