Is Painted Pony Petroleum A Painted Bubble Filled With Natural Gas?

Nathan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Any successful investor must separate the hype from the fundamentals. The dot-com and the housing bubbles remind us how detrimental a bubble can be for our portfolios. However, a speculative investor is free to gamble on any stock. An analyst can also be bullish on grossly overvalued stocks for several reasons which are not always for the retail investor's benefit.  

As a fundamentalist investor, I don't buy Painted Pony Petroleum (TSXV: PPY) at $9.50. Painted Pony is a gas weighted producer who is grossly overvalued for the same reasons Africa Oil was grossly overvalued at $10.70 two months ago when I analyzed it in my article. The comments from Africa Oil's bulls are at the bottom of that article. However, the fundamentals always prevail and the precipitous fall occurred. It's very difficult to move opposite to the mass but it's highly rewarding.

The Fundamental Approach 

1) Natural Gas Glut: EOG Resources' (NYSE: EOG) CEO Mark Papa believes that the natural gas prices will not rebound  soon, but he sees them depressed for the next years. This is why, he is shifting his company away from gas and towards oil. This glut hurts the netbacks of the producers and this winter doesn't seem to be cold enough to push the gas price significantly higher. Painted Pony is heavily exposed to gas. 

2) Lack Of Oily Acreage: Despite this pessimistic outlook, the company keeps increasing the gas percentage of its total production. The production was 75% gas weighted in Q2 2012 and it is 77% gas weighted currently. Thus, the company keeps adding on the wrong side of the equation instead of adding on the oily part. This implies that its land isn't oily which is strengthened by: 

A) The company finished operations recently on its first exploratory well targeting Viking light oil. This well failed to produce commercial volumes of oil and instead flowed gas. 

B)  The ROR (Rate of Return) for its Bakken wells is as low as 41%. 

C) Although the company provides numerous details about its gassy Montney acreage, it doesn't provide any details (decline rate, IP rates etc.) about its Bakken and Mississippian light oil projects. 

D) The company said last summer that it completed drilling operations on an exploratory test at Flat Lake with prospective zones in several formations. The completion operations were expected to commence by August 2012. However, it hasn't released any update on this well so far although seven months have passed. If the results were good, the company would let investors know. 

These are clear indicators that the company is lacking oily acreage and this must concern any buyer. If it wants to become oilier, it has to acquire an undervalued oil-weighted junior like Second Wave Petroleum or Arcan Resources (TSXV: ARN) that own the oil-rich Beaverhill Lake formation. After Crescent Point Energy's purchase in 2012, Petrobakken Energy also bought recently a significant stake in Arcan Resources targeting Arcan's oil-rich acreage in Swan Hills. 

3) Let The Numbers Speak: Painted Pony has been losing money. The Enterprise Value (EV) is $850M and the estimated annual Funds from operations (FFO) are 40$M at best. The production is 8,100 boepd (77% gas). 

So it trades for a staggering $105,000/boepd and 21x the FFO. Both ratios are whopping for any gas weighted player let alone a junior one. The company has also 149 MMboe 2P Reserves (December 2011) which means a fair $5.7/boe for such overly gassy reserves (80% gas).

4) Peers: Advantage (TSX: AAV) has also exposure to Montney holding 80 net sections and produces 16,000 boepd (100% gas). After the latest disposition, Advantage's EV is $690 million currently, the production is 16,000 boepd and 2P Reserves are 165 MMboe (December 2011). Thus, it trades for $43,000/boepd and $4.18/boe. 

5) Montney Transactions: ExxonMobil acquired Celtic recently. Excluding the part of Celtic that wasn't sold to Exxon, Exxon paid $2,92 billion for 26,600 boepd (2012 exit production) that were gas weighted (75% gas). Thus, Exxon paid $109,700/boepd (75% gas) to buy Celtic with 867 net sections in the Montney play. 

Crew Energy (TSX: CR) paid recently only $22 million to Terra Energy for 56 net sections of liquids rich Montney rights that were producing 52 boepd. Obviously Exxon was generous but few other companies have equally deep pockets. 

Painted Pony owns 187 net sections on the Montney play. Most of this acreage is undeveloped. Assuming that 120 net sections are undeveloped, their value can't be more than $50 million. This estimate is supported by the fact that Crew has retained an option to purchase from Terra Energy an additional 140 sections of Montney land, total proved reserves of 1,850 mboe and 2P reserves of 9,970 mboe for $56 million on the option lands. 

The Speculative Approach

1) Buyout: If the company's buyout was a baby, it would be three years old today. The takeover rumor emerged in 2009 for the first time, based on the company's Montney acreage. However, a potential buyer has to know that Painted Pony is far from owning the largest Montney position. There are almost 20 companies with significant Montney exposure, whose acreage is also well-situated on the Canadian map. This is why any acquisition scenario due to the company's Montney rights is highly speculative.

2) LNG Project: The CEO of the company has been touting the West Coast LNG project for long. Some analysts have been also following this strategy for more than one year. The company's presentation is also centered on this speculation noting that it is "Positioned to be a leading supplier of gas to Canada’s West Coast LNG projects". 

Painted Pony wasn't selected as a supplier for this highly touted project finally. However, the shareholders are free to keep living their myth with this company, aren't they? 

It is also worth mentioning that the earliest start-up of the first LNG project is estimated to occur by the end of 2015 although the delays are likely due to the nature of these projects. At best, the first results on a supplier's balance sheet will show up in 2016.

Conclusion

If I buy Painted Pony at $9.50, I take a huge risk to lose a big part of my capital. As a fundamentally-driven investor, I steer clear of this company looking elsewhere for undervalued stocks.


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