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Nov 30

Out with the Old, In with the New: Arcan Resources and Reliable Energy

Updated: I mistakenly stated that Arcan had spent $40M on the Stimsol purchase. It was $24M. I got my original information from a Scotia report, which read: we note ~$40M of the uptick was associated with the purchase of StimSol and for land. I mistakenly read this as $40M for Stimsol. I also sleepily referred to Stimsol as a frac fluid producer when of course they produce acidizing chemicals and solvents for de-waxing.

On Monday in the mid afternoon Arcan released third quarter results that I was less than impressed with. I was lucky enough to receive a google alert on the earnings release before the market fully reacted. I quickly halved my stake in Arcan in my on-line portfolio.

As I wrote on the weekend, in my real portfolio I had already substantially sold down my position. With the release of the quarter I sold more, dropping it to a rather miniscule 1% weighting. With the stock is trading in the mid-4’s two days later it appears to have been the right thing to do.

Was the quarter that bad? On the face of it, the production numbers were ok. Arcan produced 3,680boe/d in the third quarter. This was somewhat disappointing since the company had stated as far back as July 20th that they were producing 4,400boe/d. Growth is trending upwards, but the company really needs hit their exit guidance of 6,000boe/d to prove to the market that they have built a solid base to grow off of.

And while the company provided 4th quarter guidance of between 4,600boe/d and 4,800boe/d and exit guidance of 6,000boe/d, they did not give an estimate of current production. I always wonder about this. While it is not necessary for a company to provide a current production number, you have to think that if they don’t it isn’t because they have good news to share.

Overshadowing the production figures were the 3rd quarter capital expenditures by the company. Arcan spent a rather extraordinary $87M in the quarter. This is far and above the already high levels of CAPEX that the company spent in the previous 2 quarters. It is also far and above its cash flow. Now $24M of this capital was spent buying Stimsol, a maker of the acidizing blend that Arcan uses. But even subtracting out that sale, Arcan still spent almost $63M of capital, or 5x its current cash flow.

Given the future capital expenditures alluded to in the quarters report (road building, a pipeline from Ethel, remediation of the existing pipeline at Morse Unit, waterflood at Ethel), one has to expect this trend to continue going forward. To be fair though, the recent debt and equity offering the company made does give them the money to fund these expenditures.

While CAPEX went up, netbacks came down. Netbacks in the quarter were $41.90, versus $55 in the second quarter. Of course much of this can be attributed to the Swan Hills fires in the summer (the company said this amounted to $10-$15/bbl) which was a one-time cost, but in addition at least some of the increase is attributable to Ethel production, which right now is being shipped by truck to the Morse Unit. The situation is explained by the company in the clip below, along with an ETA of the first quarter of 2012.

Arcan estimates a significant reduction in operating expenses in the first quarter of 2012 due to a number of activities which are currently underway. These activities include completion of the construction of a high grade road system that connects the DM2 through Arcan’s Ethel property into Morse River, the commencement of pipeline infrastructure along the new road system backbone that will allow production in Ethel to flow to the DM2 oil facility, and the construction of pipeline infrastructure to facilitate water injection in the Ethel area. Arcan is also working on resolving issues with the clean oil pipeline which flows from the DM2.

Arcan is still on the right path, they are just moving more slowly down it than I would like to see. The problem with moving more slowly is that Arcan is valued quite highly compared to its peers, so slower than expected growth leaves lots of room for downside questioning.

All flowing boe numbers are based on the latest production estimate provided by the company.

With some of the proceeds of Arcan I bought a position in Reliable Energy.

Reliable Energy released their 3rd quarter results on Tuesday morning. While Arcan produced a decent production increase while spending a lot of capital, Reliable showed similar production increases (production has almost doubled since the 3rd quarter), while spending more closely in line with their means.

Moreover, a look at cash flow shows that Reliable will be more able to spend within their means in the coming quarters. Reliable generated $3.8M of cash flow in the 3rd quarter with a netback of $65/bbl. As of their latest production estimate they are now producing about 500bbl/d more than they averaged in Q3. At $60/bbl netback that would work out to about $3M additional per quarter in cash flow. That puts the yearly cash flow somewhere around (maybe slightly above) the $25M per year range. The capex budget for 2011 is $25M.

Midway, Arcan and others have had to spend well beyond their means to grow production. In some environments that is not a deterrent. In our current liquidity strained environment, it is. Reliable looks to be in a better position to do that, at least in the short term.

The other important consideration with Reliable is that they are beginning to ramp up into the 2nd of 3 consecutive quarters of drilling. Reliable basically moves to the sidelines during spring break up, and so they tend to see decent production gains through the winter months as they spend a disporportionate amount of their yearly CAPEX budget during that time. The drilling and completions in Q3 is responsible for the production increases so far in the 4th quarter. With a little luck it will continue going forward.

The company trades at about half of what Arcan does on a flowing basis. At $47,000/flowing boe (see the above chart where I compared flowing boe numbers for a number of juniors) the company is reasonably cheap compared to its peers, especially considering they are producing high netback light oil. On a reserves basis the company trades at close to its 2010 NPV10 of $0.19.

I suspect when their 2011 reserves report comes out (likely not until late in the first quarter) it will show a significant increase over the 2010 reserves. The 2010 reserve report (available on Sedar) gave them 800,000bbl of undeveloped reserves and 400,000 of developed producing reserves. The 400,000bbl was likely entirely vertical drills. The undeveloped works out to the equivalent of about 8-10 horizontal locations depending on the evaluators productivity per well guess. In the next report that number should go up pretty substantially. Up to the end of the 3rd quarter Reliable had drilled 10 successful hz wells this year so offsets alone should double that number.

In all, Reliable Energy looks to me like a better bet for near term price appreciation than Arcan does.

Nov 28

Week 21: Getting Worried Again

(current positions shown at end of post)

The benchmarks that I compare my portfolio performance to have begun to trend ominously down. I am a little concerned about what the market will do next week now that Thanksgiving is over and investors are looking more soberly at a pictrue of Europe that really should perhaps not be viewed without a good bottle of scotch. Of course the rumor making the rounds tonight is that the IMF is going to set up a massive bailout fund for Italy and that has the market soaring. Count me a skeptic here. Morgan Stanley put out the following note on the subject:

The Italian newspaper La Stampa reported over the weekend that the IMF is preparing a €400-600bn loan at a 4-5% interest rate for Italy. We would view this report skeptically, as even a credit line amounting to the lower end of the reported range would eat up the entirety of the IMF’s available $385bn (as of Sept ’11) forward commitment capacity. The only workaround would involve substantial IMF quota increases, a measure that would require the support of the US Congress.

The bottomline is that while stocks may be rising on the news, yields in Italy have hardly fallen this morning, an German yields are actually up. There simply is no easy Sunday night fix for this crisis.

Europe Still Dictates my Decisions

What worries me is that in the end it is the ECB that has to step up and fill the void and there is more than a little evidence out there that the ECB has no intention of coming to the rescue of profligate governments. There is a very good article in the NYT this weekend called As Crisis Mounts, Europe’s Central Bank Stands Back. The article explains the ECB position. Printing money to buy the bonds of countries facing funding problems does not solve the underlying issue. And the ECB is not necessarily going to step in. Witness the following:

“I think markets are going up a blind alley thinking there’s going to be a common euro bond or thinking that the E.C.B. is going to act as a lender of last resort,” Norman Lamont, the former British finance minister, told Bloomberg on Friday. “I think Germany would rather leave the euro than see the E.C.B.’s integrity affected.”

Instead, the E.C.B. insists, euro area governments must amend their errant ways. “Governments need to ensure, under any circumstances, the achievement of announced fiscal targets and deliver the envisaged institutional and structural reform programs,” Mr. González-Páramo said in London on Friday.

This is true. However what printing money does do is it avoids a full scale banking crisis and the commiserate deflationary recession brought on by the insolvency of Italy or Spain that results from the funding problems.

If the ECB chooses not to engage in significant bond buying, and to stand aside as Italian and Spanish yields march higher, markets will rightly conclude that a deflationary recession must be priced in. And this isn’t going to be goo for any asset, save perhaps US treasury bonds. It isn’t even going to be good for gold.

It is with that line of reasoning that I remain 50% cash, and while I am not allowed to short in my online portfolio, I am 50% hedged with shorts against my long positions. My long positions remain significantly skewed towards the gold stocks.

Portfolio Moves:

I didn’t buy or sell any stocks this last week in my online portfolio. This was not entirely the case however for my actual portfolio. In particular, I sold some Arcan early in the week this week. My overall exposure to Arcan in my online portfolio is about 5%. In my actual portfolio it is now only 2%. In addition to Arcan, I have a small position in Midway (about 1%) that is not represented here. Let’s talk for a second about the problem with these stocks.

Why you should be Wary the Oil Juniors:

Both Midway and Arcan are junior oil producers. Arcan has a large (96,000 acre) position in the heart of Swan Hills. I have written extensively on the company here. Midway has a fairly large (33,000 acre) position in the Garrington Cardium and a reasonably sized position (23,000 acres) on the fringes of Swan Hills.

Both Arcan and Midway show strong growth in production, as witnessed below:

Based on their growth both companies look like great investments. And they are… in the right environment. The problem comes with the particular environment we find ourselves in. We live in a credit constrained world. Based on events of the last few months, most notably of late the escalating problem that even the Germans are having trying to raise money, and one has to wonder how well companies that are not self-financing are going to do.

The downfall of Arcan and Midway is that they are anything but self-financing.

With European banks teetering on the brink it just doesn’t seem like a great time to be taking much of a chance on companies that need cash. I have reduced my exposure to Arcan and have decided to leave my exposure to Midway at its current level unless we see some sort of resolution across the ocean (as if). I likely will wish that I had done the same steps here online. Unfortunately Arcan fell rather substantially last week and I am reluctant to reduce the position now at below $5/share.

New Short Position in Deutsche Bank:

The other move that I made that is not expressed in the online portfolio is that I add a short position to Deutsche Bank. I have been trying to add a short position in this stock for months. Its hard to get the shares to short with. I finally had some luck and shorted it at $34. I have been reading about the company regularly in FT. This is one leveraged bank. The tangible assets to equity ratio is 60:1. To compare, when researching the regionals, I wouldn’t look twice at a regional bank that had a ratio above 10:1, and many of the one’s I found most attractive (Home Federal Bank of Louisiana for one) had ratios of less than 5:1. This makes DB the most underfunded bank in the EU.

Secondly, DB relies on wholesale funding for short-term liquidity to a greater degree than most. Below is how Deutsche Bank stands in comparison to other EU banks with regard to the Net Stable Funding Ratio (NSFR), which is often used as a proxy for determining a banks reliance on wholesale funding.

It seems to me that the combination of high leverage and reliance on less than stable sources of funding are a recipe for a liquidity squeeze for DB as Europe continues to get worse.

Current Portfolio:

Nov 24

5 Comments

Stepping through the NAV of Aurizon Mines

The following post, originally published on November 23rd, 2011, has been updated to reflect the calculation of NPV after tax rather than being limited to before tax treatment only, as was the case before.

A couple of days ago I looked at the current cashflow generation capacity of Aurizon Mines. Contrary to popular market opinion (Aurizon continues to drop as though it would be bankrupt at $1500 gold), from my analysis I concluded the following:

…about 20% of Aurizon’s market cap is in the form of cash on the balance sheet. The enterprise value of the company is only $740M after subtracting this cash. Annualizing the last four quarters, the company is trading at about 9x its free cash flow generated. That would be using an average gold price of about $1500/oz.
Looking at the company on the basis of free cashflow, if you annualize the third quarter, where the realized gold price for Aurizon was $1695/oz, the company is generating free cash at a rate of $104M a year. This puts the company valuation at a little less than 7.5x free cash flow.
On an operating cash flow basis, in the last four quarters (when there has been an average gold price of $1500) Aurizon generated $111M of operating cash flow This gives the company a 6.6x EV/opcf multiple for the ttm. If you annualize the third quarter operating cash flow alone you get $136M, which leads to an EV/opcf multiple of 5.4x.

So those are some basic conclusions that can be drawn based on production, revenues and costs. Now I want to expand the analysis to look at what net asset value of the company.

To look at the NAV I am going to sum up all the parts of the company, subtract any liabilities and debts and then divide by the shares outstanding to estimate the value of the assets on a per share basis.

Let’s start with Casa Berardi.

Casa Berardi

Casa Berardi is Aurizon’s single producing mine. Casa Berardi has been a steady producer over the last number of year, both in terms of produced ounces and costs.

In the current environment which has been wrought with gold companies missing cost estimates, it is particularly impressive that Aurizon has been able to actually reduce costs for the last two quarters.

Casa Berardi has the following reserves and resources

Note that some of the resource is open-pittable. The expectation is that the open pit production will begin near the end of the underground mine life when the underground is no longer supplying sufficient ore to the mill.

On March 31st Aurizon filed an updated technical report on Casa Berardi that looked specifically at the feasibility and economics of the open pit. That report can be found on Sedar. I have used the data in that report extensively to come up with my own estimates.

In the report the evaluators, Roscoe Postle, only considered mineral reserves for both the underground and open pit when determining the production schedule. I believe this is too conservative. I have instead incorporated 70% of the measured and indicated resource in my production profile. I have included none of the inferred resource. I believe that I am being conservative in these assumptions.

The inferred and M+I resource that I did not include in the production profile will be added to the Aurizon NAV based on a $/oz valuation. These ounces will have a lower value than those included in the production model, but still have some value assigned to them.

Because some of the M+I resource was added to the production profile, the profile I used is not the same as what was used by Roscoe Postle. I basically spread out the open pit production over twice as long of the period, and overlapped the production with a reduced but extended production profile from the underground. The specifics of how Aurizon eventually will sequence the underground and the open pit are a guess to me, but I don’t think that they will dramatically effect the result I am trying to achieve, which is to understand the NAV of the company.

I determined the following after tax (AT) value for Casa Berardi:

The details of the spreadsheet I used to come up with the estimates is provided below. The cost and processing assumptions are almost exclusively based on the Roscoe Postive report. The grades of the underground are based on the grades expected from the mine sequencing of the current reserves, and the stated grade of the M+I resource. Open pit grades are from Roscoe. Taxes are determined based on a 30% tax rate (includes provincial and federal tax) with depreciation deducted from the before tax income.

Joanna

Aurizon has an advanced stage development project called Joanna. The company is completing a feasibility study on Joanna as we speak. The feasibility study has taken a bit longer than anticipated because it was originally expected thta Joanna would mine the ore, form a concentrate, and then ship the ore to Casa Berardi for final processing. Aurizon got about half done the feasibility study using this assumption before the drilling results at Joanna forced them to re-evaluate. The company is now producing a feasibility study that includes full mill and processing circuit on-site.

My analysis tries to incorporate this new on-site milling. The mining and base milling assumptions were determined from the pre-feasibility study that was done for Joanna December 22nd 2009. However I updated a number of the capital and operating cost numbers to better reflect both the cost increases, the mill on-site, and to add some conservativeness. The differences are listed below:

I am probably being conservative with all these assumptions. I’ve hiked the numbers rather substantially.

My analysis assumes ultimate production of 1.4Moz of in-situ gold (pre-recovery). This compares with the following estimate of gold resource at Joanna.

Clearly I am being conservative in basing my work on a 10 year mine life and 8,000t/d. There appears to have at least 2Moz and potentially 3Moz of gold in-situ. And the deposit remains open to more exploration.

As with Casa Berardi, any M+I or inferred resource not included in the production profile will be given a valuation based on a per ounce estimate.

Like Casa Berardi, I looked at 3 gold price scenarios; the trailing four quarter gold price ($1500/oz), the current gold price $1800/oz, and a future possible rise in the gold price ($2100/oz). Below is the before tax NPV of Joanna under each scenario.

The details of the spreadsheet I used to come up with the estimates is provided below.

Other Projects

Aurizon is involved in a number of other much earlier stage development projects. There of these already have legitimate (albeit small) deposits. There is exploration work being done on all three of these projects to increase the resources. I am not going to include any of the potential in the NAV calculation, but I will include the current resource value.

Because these projects are still years away from a feasibility type study, and because they represent a very small value in comparison to Casa Berardi and Joanna, I have chosen to value them on a very simple $/oz basis. In the case of Marban, as part of the earn in Aurizon has to pay $30/oz M+I and $20/oz inferred for 50% of the ounces defined in the final NI 43-101. That is why I have assigned a lower value to ounces in the Marban-Norlartic deposits.

The total value to Aurizon of these projects is about $12M.

At this point we will value the ounces that were not included in the production profile at Casa Berardi and Joanna. The value of each ounce is somewhat arbitrary. It really represents a risked value of what the NPV10 of that ounce would be if produced. M+I resource is worthe more than Inferred resource. Similarly, Casa Berardi ounces would need to be worth more than Joanna, because with a mill already built on-site and a mine in production, the risk profile of an ounce at Casa is less than at Joanna. Another consideration is the price of gold that ounce is being valued at. In the table below I have considered all 3 variables in my determination of the value of each ounce.

There are a number of sources that can be used to determined the average value of an ounce in the ground. All are bound to be wrought with error bars. One such study, performed by Edison Investment Research, drew the following conclusions:

we have been able to determine that the average value of a ‘measured’ resource ounce globally is US$340/oz, while that of an ‘indicated’ ounce is US$159/oz and that of an ‘inferred’ ounce is US$34/oz

Another study, published by Casey Research, determined some slightly lower numbers, though I suspect this was because the CaseyResearch team was mostly focused on junior exploration and development companies, or in other words companies that do not yet have a mine built, and where therefore the value of each ounce should be expected to be somewhat less:

1. Inferred: US$61.20 per ounce (up 179.5% from Dec 2010)

2. M&I: US$69.30 per ounce (up 56.4% from Dec 2010)

3. P&P: US$232.70 per ounce (up 1% from Dec 2010)

My estimates are quite conservative. They can be seen below as a function of the gold price they are being evaluated at.

Adding it all up

The last piece of the puzzle before we add up the numbers is corporate expense. This has been fairly consistent for Aurizon at around $15M. I assumed a continuation of the $15M expense going forward over the 11 year mine life of the production profile I developed for Casa and Joanna.

I did not include the NPV of any exploration expenses that Aurizon will incur in the future. I did not think it was correct to include these expenses without being able to estimate the offsetting assets they create. Obviously we can’t hope to know what the drilling may find, so I decided to leave this expense out of the calculation entirely.

As noted above, Casa Berardi and Joanna production profiles all assume a 30% tax rate to net mining profits. No tax rate has been assigned to the valuation of “other ounces”. It is assumed that the $/oz number that is used for those ounces implies the value of the ounce after tax.

The individual parts can now be added up to determine the net present value of the company at various gold price scenarios. This is shown in the two tables below, first discounted at 10% and then discounted at 5%.

A couple observations about the final result:

The valuation of the company is quite dependent on the price of gold. The net asset value of the company varies by almost 50% depending on whether the valuation is done at $1500 gold or $1800 gold. Perhaps the violent swings in the share price with each $10 move in the price of gold are not as unwarranted as I have thought?
The numbers vary significantly with the discount rate. There is a 20% swing depending on whether you want to discount at 5% or 10%. I think what this really puts in perspective more than anything is just how subjective the valuation can be.
Based on my assumptions, Joanna isn’t worth that much at $1500 gold. But my asumptions are likely wildly conservative compared to what Aurzion’s upcoming feasibility study will show. Why? My production profile for Joanna did not include about 2Moz of resource. I ended up valuing those ounces separately at a much lower amount. If you add them to the production profile the value of Joanna would rise by 40-50%.
Aurizon is fairly priced in the $6-$8 range if you believe in $1500/oz gold for the long term. Aurizon needs to move well into the double digits to begin to price in $2000/oz plus gold.

Overall, the work gives me confidence that there is unrealized value with Aurizon, and that if and when a gold price of $1800/oz begins to get accepted as a sustainable one, the price of the stock should move up significantly to reflect that.

Nov 21

Week 20: Back into Gramercy, Adding to OceanaGold

This week I finally got my order filled for Gramercy Capital at $2.75. Plan Maestro had another excellent write-up on Gramercy last month. CDO-2005 did relapse and fail its over-collateralization test. This may have something do to with the weakness in the stock. Still, the stock has a net asset value somewhere north of $5. And Bloomberg has had two articles in the past two months commenting on the likely sale of the company to private equity. I feel comfortable holding shares bought at this level and waiting for such a buyout.

While on the subject of US real estate, I began to review some of the regional and community banks this week. Community Bankers Trust, which released Q3 results last week, appears to be on the upswing. The stock remains extremely cheap based on tangible book value or earnings potential. I do not own any regional banks shares at the moment but it may be something worth looking at in the next (inevitable) downdraft.

I added to my position in OceanaGold on Friday. I have had a standing bid in for OGC.to at $2.21, and it was filled. This stock seems range bound between about $2.20 and $2.70. I’m not sure why it cannot break higher. I posted Sunday about the cash generation capabilities of Aurizon Mines. I could have just as easily written about OceanaGold. The only difference between Aurizon and OceanaGold is that Aurizon can continue to generate cash at lower gold prices. In addition, OceanaGold’s costs get misinterpreted to be higher than they actually are because

so much of them are being expensed right now, as opposed to capitalized.
They are in NZD, which has been perhaps the strongest currency in the world this year

Absent these two factors, the first of which is really just smoke and mirrors, and the stock would be trading substantially higher. As it is I am picking up a company with growing production, likely lower costs (the NZD is down from 83 to 78 so far this quarter), and doing it at the lower end of the trading range.

The last trade I made did not show up in the practice account but will next week. On Friday I sold 1/3 of my position in Arcan and planto use the proceeds to buy Midway. I have nothing negative to say about Arcan. They appear on-track. Nevertheless, Midway is a cheaper stock right now, especially after the recent steep drop. Midway also appears to be a good takeover candidate to me, so I don’t mind being diversified in case of such an event.