Gear Energy, Raging River Exploration: Exchange With A Fund Manager

The following is a conversation between a fund manager and me regarding Gear Energy and Raging River Exploration. This fund manager wishes understandably to remain anonymous.

Both of us make interesting points on recent developments regarding Gear and Raging River. Here is the conversation.

Fund Manager: I was reading your recent Raging River article and I noticed you mentioned Gear was selling their Duvernay land position. I own a bunch of Gear and talk to Ingram every couple months and I didn’t even know they had any Duvernay!

I have a few questions for you about it. Why do you think they’d sell it instead of hold it or drill it? And how do you come to your estimate of C$15M to C$20M of value for it?

I’m kicking myself for not knowing about this and grateful for you uncovering it and writing about it.

I’m thinking about Raging River, but I haven’t even finished your article yet, so I’ll hold off asking about your take on it. I know a bunch of their competitors thought the stock was overvalued considering the high base decline rate.

Cadotte Capital Partners: I didn’t know either… Not until I searched for Gear and Duvernay.

I figured with under 7,000 acres you don’t really have the scale to develop a meaningful new growth play. Gear can already drill for light oil in Central Alberta. In all, better to sell it, especially with big operators near the acreage (Raging River and Vesta). Both could be very interested to add to their land position.

I obtained a total value of C$14M using a valuation of C$2,000 per acre. This number could be way too bullish in retrospect… Raging River values its Duvernay position at C$400 per acre. The bidding deadline is tomorrow. We’ll see soon enough.

FM: Well, 7,000 net acres could be a huge number of locations, and it looks like Gear is in or near one of the cores of the play. Vesta is ramping up drilling big time and Raging River is just to the north and the combined company will likely drill more up there too. I get why Gear would sell it, but if it were me I’d hold it or maybe even drill one well and see what I have.

I don’t think you’re off in terms of what they should be able to get for it. I should probably be bidding on it, below C$10M, unless there’s near term lease expiries or something, I’d buy it! And I’m a little worried because the obvious bidders, besides Vesta, are Raging River and Crescent Point Energy. Raging River is otherwise occupied, and Crescent Point just got new management and the executive who was responsible for the East Duvernay play left.

Also, I noticed in some of your articles you’re referencing the Montney offer as a dollar per acre comparison metric. I think liquids rich Montney is apples and oranges with Duvernay. Not guiding higher or lower on either of those, other than my thoughts on adjacent-to-core East Duvernay land value above. There are also specifics of land positions that can dramatically alter their dollar per acre value metrics.

The Raging River and Baytex Energy merger is thought provoking. I’m tempted to start buying Raging River given the large drop in share price and the arbitrage with Baytex. But… Raging River wasn’t cheap: Valued at about 4X PDP, high decline rate, rapidly burning through inventory, waterflood apparently isn’t working because the decline rate doesn’t seem to be falling, and finally the fact that its doing this deal means that this was the best deal they could find, which is troubling. It could probably mean their East Duvernay play isn’t working how they hoped. I guess the question is how much does the share price needs to fall for a higher bidder to come along or for the combined company to be cheap enough to offer enough upside to buy.

CCP: Yeah, drilling one well… Gear might as well concentrate on its own assets. As I say: Go big or go home. And those wells aren’t cheap either…

Gear is tiny compared to its neighbors. Could be one of the reasons Neil Roszell wanted to get bigger: He knew he would need to have size to develop Raging River’s massive acreage.

The high decline rate, the high valuation of flowing barrels: I see a lot of people claiming Raging River wasn’t trading cheaply. I disagree. The consensus EPS is C$0.62 in 2018 and C$0.76 per share in 2019. Of course I don’t have access to the models of the analysts so these numbers are to be taken with a grain of salt. But at first sight it seems like Raging River is trading at under 10X earnings.

And free cash flow was just around the corner. Higher oil prices will increase free cash flow exponentially. Yes, the decline rate is high. But I believe it all depends on earnings. If a high decline rate is met with low drilling costs, or higher oil recovery, or anything that increases earnings, then in the end, even though the oil flowing out is depleting quickly, you’ll still be making money. My thoughts anyway.

As for the waterflood, I can’t find anything mentioning the results aren’t encouraging. All the latest presentations (January, February and March 2018) pointed to a possible recovery factor of 25%. The recovery factor I usually see for waterflood is 20%.

It’s troubling Raging River couldn’t find a better alternative… Clearly I overestimated the sentiment in the Canadian oil patch. It isn’t bullish for Granite Oil, another small company I own. It also started a “review of strategic alternatives”.

I slowly bought some more shares of Raging River. I was barely in the red. Turns out my entry point wasn’t so bad after all.

The low end of my price range was C$7.25 per share: Upside is about 20% upside from current levels.

Probably the only good news in the short term is that Neil Roszell will become Chairman of the new company. Hope he really takes a very active role and improve governance. No need to tell you Baytex could use a little bit of that…

FM: Interesting. Thanks for sharing your thoughts.

CCM: Sure thing!

Disclosure: I am long GXE, RRX. Not for republication on Seeking Alpha.

Raging River: Endure The Pain

  • Raging River agreed to merge with Baytex for a small premium. After today’s selloff, the market is saying both are better at it alone.
  • Raging River is worth somewhere between C$7.25 and C$10.00 per share.
  • Baytex was trading at C$5.10 last Friday, which would value Raging River at C$6.94 per share, which is in the low end of the price range above.
  • Investing in Raging River is now like investing in Baytex: It’s a leveraged play to future oil prices.

Click here to read the entire article on Seeking Alpha.

Choosing The Best Leveraged Energy E&P From The TSX: Part 1

The basis of this investment is that the recovery of oil will happen sooner than later. I believe it is safe to say that the oil market will be balanced sometimes in 2017. Therefore, it could be interesting to find a leveraged energy E&P company that will still survive the current downturn and offer high upside once the recovery begins.

For the sake of stock picking, we have to find the one very best stock in the energy E&P sector. This is a gigantic task: this is one of the reason why I’ll separate the work in multiple parts. Let’s start with the initial screening of the TSX using these criteria:

  • Energy E&P sector.
  • Total Debt/Total Equity over 50%.
  • Market capitalization of over C$500M.

Let’s take a look at the tickers this search gave me. The tickers are sorted by current market cap.

Leveraged Energy E&P - TSX Screening - All Results

Company #TSX Tickers
1CNQ
2PEY
3VII
4VET
5ECA
6OER
7MEG
8ERF
9BIR
10PWT
11BNE
12BTE
13PGF
14POU

Source: Cadotte Capital Partners

Because betting on the recovery of oil using a leveraged company is a very risky business in itself, I want to concentrate the risk on the pricing of oil, and minimize any other potential risks such as geopolitical or legal for example. Therefore let’s remove all companies with operations outside of North America. It is also interesting to have companies with concentrated assets in one area.

Leveraged Energy E&P - TSX Screening - Concentrated North American Producers

Company #TSX Tickers
1PEY
2VII
3ECA
4MEG
5ERF
6BIR
7PWT
8BNE
9BTE
10PGF
11POU

Source: Cadotte Capital Partners

Let’s find the oil producers next. The production of selected companies should be at least 33% oil in their respective Q3 2015 MD&A. Therefore, a company with high liquids production but no oil production such as Seven Generation Energy was excluded from this list.

We now have the final selection of our leveraged oil producers operating in North America.

Leveraged Energy E&P - TSX Screening - Concentrated North American Oil Producers

Company #TSX Tickers
1ECA
2MEG
3ERF
4PWT
5BNE
6BTE
7PGF

Source: Cadotte Capital Partners

The next step is to analyze each company’s debt and cash level, debt maturities and cash flow from operations. This will lead us to Part 2.