When I started investing, one of the books I read was Andre Kostolany's book about stock markets. He says that the market cap of a company is like a dog and his boss is the intrinsic value of that company. While the dog and his boss stroll out together, the dog goes back and forth and either it lags or walks ahead of his boss. A good investor has to know when the dog is behind his boss as one day it will catch his boss and they will return back home together.
I am a fundamentals-type of investor and this is why I always check the fundamentals, trying to not be disorientated either by any dot-com hype or by the social networking hype (FB, MEET, ZNGA etc.).
Canada has seen increased merger and acquisition (M&A) activity in 2012 as several foreign energy companies have acquired the Canadian ones which are considered more undervalued than their U.S.-based peers. The Montney formation of Canada has been the primary target for these foreign players during the last two years due to its abundant natural gas and oil liquids resources. The South African Sasol bought 54,000 net acres from Talisman (TLM) in 2011 and the Korean state-owned Kogas bought 77,000 net acres from Encana (ECA) in 2010. In addition, the Malaysian Petronas submitted an offer to acquire Progress Energy Resources (PRQ.TO) a couple of months ago, the Chinese giant CNOOC (CEO) submitted an offer to buy Nexen (NXY.TO) recently and Exxon Mobil (XOM) made an offer to purchase Celtic Exploration (CLT.TO) just few days ago. Both Progress and Celtic are natural gas weighted (84% and 76% respectively) and they also hold significant Montney land.
This is how I found Terra Energy (TFR): Its Montney land is adjacent to the Montney land of Progress and Celtic. Terra Energy trades at the main Toronto board and the OTC market of U.S. (TT.TO, TTRHF). It is a junior oil and gas corporation engaged in the exploration, development and production of natural gas and oil in Western Canada. Its production was almost 5,500 boepd (83% natural gas) in the second quarter of 2012. At over 500,000 net acres of undeveloped land, Terra is amongst the largest holders of undeveloped lands amongst its peers of Canadian junior oil and gas companies. The company holds an unconventional Montney resource of over 130,000 net acres whose full potential can only be pursued through the investment of significant amounts of capital. Based on the corporate presentation, at a conservative value of $3,000 per acre, Terra's Montney would be worth over $300 million.
Fundamental Analysis and the Upside Potential
The current market cap is $16 million while it was $65 million in early 2012. The long term debt/stockholder equity ratio is a decent 0.7 and the current pbv is as low as 0.13. The price has dropped significantly due to the low natural gas price which has impacted the company's cash flows, while the bank debt remains high. This made the company unable to propel its growth in 2012 and reduce its debt significantly. The company successfully closed the sale of a non-producing oil and gas property in the Wembley area of Alberta for gross proceeds of $6.1 million in the early third quarter of 2012. The net proceeds of this sale were used to reduce the lending facility from $94 million to $88 million.
The funds from operations (FFO) in the first and second quarter 2012 were negative meaning, obviously, the DCF ratio annualized (long term debt/FFO) was very problematic.
As a result of the low natural gas price, the company was also losing money in first and second quarter 2012, and I expect it to have lost money in third quarter 2012 as the natural gas price was at the early stages of its recovery during the July-Sep period. Therefore, I do not expect any major improvement at the quarterly funds from operations of third quarter 2012. However, we need to look ahead in order to project the future of this company instead of looking backwards.
Taking into account that the Enterprise Value (EV) = Market Cap + Long-Term Debt + Convertible Notes, the current enterprise value of the company is C$103 million. The 2P Reserves of the company grow consistently year over year and they stand at 33.9 MMboe as of today. Therefore, Terra trades for C$3 per Mboe which is the lowest per Mboe valuation of the industry. On a per-flowing-barrel valuation, Terra trades for $18,000/boepd which is also at the bottom of the industry's valuations. The Net Asset Value (NAV) per share is C$1.,78 per share according to the company's presentation.
The natural gas price is projected to rise by year end to C$4 per MMbtu (AECO), and some analysts say that it will hit C$5 per MMbtu (AECO) in 2013 if the winter is normal as the natural gas storage has dropped below average due to the shrinking number of natural gas rigs and an increased demand of gas instead of coal from the utilities during the summer months.
The price for the liquids (propane, butane, ethane) is also projected to rise further during the upcoming months. The propane prices have been rebounding lately and Mid-Continent Conway propane prices have risen by 17%, from an average of 74c/gallon in August to an average of 87c/gallon today. Meanwhile, Mont Belvieu propane prices have risen by 7.8%, from an average of 89c/gallon in August to 96c/gallon today. The future of the propane gets brighter and brighter as the demand for propane in several key markets (China, India) has risen more than expected while the supply from the traditional sources (Middle East, Iran, Venezuela) has been hit by several issues like operational problems and production disruptions according to Reuters. In addition, if the upcoming winter is normal, this will lead to a major increase in propane demand.
What is also of further interest for the pricing of the oil liquids is the upcoming major export expansions. DCP Midstream Partners (DPM) will activate its 150,000 natural gas liquids products pipeline from Conway to Mont Belvieu in Q2/2013, thus effectively linking the natural gas liquids to world demand, and away from the limited regional market we are stuck with for the time being. Not to forget that U.S. propane is trading at a discount of over 50% to international propane prices.
The oil price has also found a floor for the next months due to the upcoming winter, QE3 and the political tensions and the social unrest in Middle East. Although Terra does not produce much oil, the stabilization of the price in Q4 2012 at higher levels than the ones in Q2 2012, will strengthen further the quarterly funds from operations and eventually Terra's balance sheet.
However. the real remedy will come when the company sells one or even better all three of its marketed assets to pay off its debt and get the cash to fuel its growth through intensive drilling in its big and promising land. The company has initiated a sale process for 3 land packages (Montney land in British Columbia, Peace River Arch land and Duvernay land in Alberta) since early 2012 but the low natural gas price in Q1 and Q2 2012 along with the rather high management's expectations proved to be an obstacle for a quick deal. However the natural gas price has climbed a lot since then. The data room closed in early Oct. So now we expect to see the results of this sale process.
I must also point out that the Canadian International Oil company (private) hit a big Montney well of 4,000 boepd (predominantly oil) at Karr/Gold Creek in and around T66R3W6 location few days ago. A high rate liquids-rich well this far north in the basin would confirm that the liquids rich/oil window is continuous from Kakwa to Karr. Terra Energy has over 130,000 net acres of Montney land currently for sale and in addition the company has about 50,000 net acres in the townships surrounding this oily well with Montney and Duvernay rights. Terra has also three sections very close to this well.
According to the corporate presentation as shown at the corporate website, the insiders' ownership remains as high as 25% (approximately) which is a strong sign of confidence to the prospects of the company. The insiders have still a lot of skin in the game.
Perpetual Energy (PMT.TO) is another natural gas weighted intermediate producer which was in Terra's situation back in May 2012 due to its heavy debt. However Perpetual initiated an asset sale program back then and it has managed to sell several assets to reduce its debt significantly as of today. As a result, the price has recovered handsomely since May 2012 when it was at C$0,60 and it has yielded 150% thus far.
Let's see now some peers with a comparable natural gas portion out of their total production (higher than 75% nat gas out of the total production). Let's see some majors first which understandably could carry a premium:
Progress Energy Resources (PRQ.TO, PRQNF) produces 45,000 boepd (84% natural gas) and it was acquired for 110,000 boepd.
Peyto Exploration (PEY.TO, PEYUF) produces 41,400 boepd (90% natural gas) and it trades for 100,000 $/boepd.
and now let's see some small and intermediate natural gas weighted producers:
Painted Pony Petroleum (PPY.V, PDPYF) produces 5,700 boepd (76% natural gas) and it trades for 120,000 $/boepd. Painted Pony has a market cap of C$770 M currently. Painted Pony is another characteristic example of the undervaluation of Terra as both are junior producers with similar production but Painted Pony is debt free. However the potential of Terra once it pays off its debt thru an asset sale is obviously tremendous in my opinion.
Cequence Energy (CQE.TO, CEQXF) produces 8,700 boepd (75% natural gas) and it trades for 45,000 $/boepd.
Celtic Exploration (CLT.TO, CEXJF) produces 19,500 boepd (77% natural gas) and it was sold for 100,000 $/boepd.
Advantage (AAV, AAV.TO) produces 22,000 boepd (95% natural gas) and it trades for 40,000 $/boepd.
Birchcliff Energy (BIR.TO, BIREF) produces 22,000 boepd (76% natural gas) and it trades for 65,000 $/boepd.
If we applied the average valuation above per flowing barrel (65,000 $/boepd), Terra should have a market cap of C$270M and it should trade at C$2,70.
Despite the fact that Terra has a significant upside potential, Terra is an exploration company which carries the inherent risk of disappointing drilling results that applies to any oil exploration company. In addition, the sale process of the 3 land packages may fail completely. The share price is also below $1 currently. This puts Terra automatically in the penny stock category. As a result, investing in penny stocks carries a higher than average risk and consequently investors should not rely solely on the information presented. Rather, investors should use the information provided as a starting point for doing additional independent research on Terra Energy in order to form their own independent opinion.