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An Energy Pick By Portfolio Manager Daniel Cheng of Matco Financial Energy Fund

Following up on the interview with Daniel Cheng of Matco Financial, I now present one of Daniel’s top picks in the energy sector.


Daniel Cheng, CFA is Vice President and Portfolio Manager at Matco Financial

Daniel Cheng, CFA is Vice President and Portfolio Manager at Matco Financial

Q: Can you tell us a little bit about the company, the economics of the industry/sector and anything else you think is important to get an overview of the company?

A: Blackpearl Resources (PXX:TSX) is currently one of the largest holdings in the MFi Energy Fund and we purchased it in early 2009. One of the main reasons that I like this company and have liked this company is that there are basically only a handful of oil weighted junior and intermediate companies in Canada and they are one of them. They are a heavy oil focused company with both conventional heavy oil as well as SAGD potential. The company has three core properties, Mooney, Onion Lake and Blackrod of which they have high working interest in all and are the operator of all three. The companies production is 95% weighted to oil, which given current oil prices is a great place to be. Heavy oil differentials have narrowed dramatically over the past two years due to a number of factors including increased refinery demand for heavier barrels, increased access to key refining markets and decreased production from Venezuela and Mexico and I expect that this differential will remain tighter than historical in the medium term (~15-20%). Current production is over 7,000 boe/d and they are looking to reach 11,000 – 13,000 boe/d by the end of 2011 and ultimately be producing more than 50,000 boe/d+. Production growth is expected to be >35% this year and production per share growth >35%. They have a high working interest in their three core properties and very large resource potential (739 mmboe of contingent resource) on their properties to support their future growth plans. At Onion Lake they are drilling more than 200 wells over the next few years for primary development and longer term SAGD potential exists which would increase recovery factors. At Mooney they are working on commercialization of a polymer flood which they received approval for last year. The Blackrod property has the largest future potential (619 mmboe of contingent resource) for the company through a SAGD project. There is no current production from the area and they are drilling the first pilot well pair here and will begin steaming in the next few months.

Q: What about valuation? How does this company compare to its peers? Also, what does the company’s balance sheet look like? Do you have a target price?

A: With respect to valuation, Blackpearl currently trades at the upper end of valuation metrics on all conventional metrics compared to its peers at ~17x 2011 EV/DACF and ~10x 2012 EV/DACF vs. the mid cap average of 11.1x 2011 EV/DACF and 8.0x 2012 EV/DACF. However, there are very few true peers to Blackpearl in terms of production mix, market cap etc. so it is difficult to do a broad peer analysis. Many gas weighted intermediate companies are actually trading at similar valuation metrics to PXX, which is difficult to justify I believe given where gas prices are compared to oil. With respect to the oil sands comparables, many of them don’t currently have any production and associated cash flow or earnings so conventional metrics are difficult to apply here as well. But as discussed above, the metrics that we look at when investing focus on the underlying asset value and go forward net asset value of the companies resource and future production profile. In the case of Blackpearl when we made our investment the company was trading well below its net asset value and was trading at 5.0x EV/DACF. We continue to think the company is trading under its go forward net asset value based on the its resource potential in the ground which we believe is in the $10 range with room for upside based on deliverability and continued delineation. I believe Blackpearl will be able to trade at a premium valuation given the visibility on its production profile and long life resource base. Lastly, another reason I like this company is that they have no debt, so positive working capital which is definitely not the norm for a junior/mid cap energy company. They are self funding which eliminates a key risk factor that has hampered many energy companies.

Q: What catalysts do you see that could move the stock?

A: The company has a material resource and the business plan is to increase production on its core properties and prove up its resource base with continued delineation drilling. This is something that I like, a more measured approach to development as opposed to potentially binary outcomes of some exploration companies so it offers diversification from that perspective. Catalysts for the stock going forward here include higher oil prices, improved recoveries, results from the first phase of its polymer flood at Mooney beginning in Q2 and results from the drilling program at Onion Lake this year which could lead to resource estimates being revised upwards. They also received regulatory approval for their pilot at Blackrod with first steam injection planned for March of this year and results from the pilot expected early next year. Plans are to file a commercial development application in early 2012. The company is expecting to grow production to 11,000 – 13,000 boe/d by the end of the year, up from 8,000 boe/d at the end of 2010.

Q: What is your opinion of the company’s management, Dan? How have they performed leading up to this point? Have they delivered on their promises? Do they have prior experience running a company like this?

A: Blackpearl is run by a very experienced management team lead by Mr. John Festival and senior executives who previously ran Blackrock Ventures. Blackpearl in its current state was created in early 2009 with the acquisition of BlackCore Resources which brought Mr. Festival and his team. Blackrock, managements previous company was another heavy oil focused junior producing in the Seal area of Alberta. The management team grew production from 0 to 16,000 boe/d and reserves from 11 mmb to 195 mmb in roughly three years and BlackRock was ultimately sold to Shell in 2006 for $2.4 billion cash. Blackpearl is a very similar company to BlackRock given its heavy oil focus, large resource in place and longer term development plan. Management has executed their plan well delineating and proving up their resource base and taking their core properties to commercial scale development all while maintaining a conservative financial position. In 2010 they exceeded our production estimates and hit the expected exit rate of 8,000 boe/d. Management also owns ~10% of the shares outstanding.

Q: Lastly, what are some potential risks associated with this stock that could hamper your investment thesis?

A: If oil prices were to fall dramatically, which I don’t forsee happening at this point, Blackpearl will trade lower given its 95% weighting to oil production. If heavy oil differentials were to widen dramatically they would also be impacted given their exposure to heavy oil. As with all energy companies, ultimately well performance and capital efficiencies are also potential risks. Other risks would be related to regulatory issues or timing delays for its projects that would impact the realization of its production.

Thank You, Daniel!

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