The Energy Report: How do you choose the energy names in your coverage list?

Mike Breard: I look for managers with great track records. For example, I attended the annual meeting ofMatador Resources Co. (MTDR:NYSE), and there were 150 people there. Normally, only maybe 20 people attend the annual meetings of the junior energy companies, but these folks had been investing with the current managers of Matador in private deals for 30 years. They were so eager to get in on the newest venture of these guys that Matador stock has tripled during the past year.

TER: What is driving Matador’s success?

MB: Attention to detail. Matador does not control the most acreage in a play; they want the best acreage. The company studies an area for quite a while before deciding what leases to go after. Then, it does all kinds of additional technical studies on the leasehold before drilling—such as microspectrometry, which is taking pictures of the cores under a strong microscope to identify channels that will allow the oil to flow. It is drilling now in the Eagle Ford and the Delaware Basin portion of the Permian Basin.

Frankly, I do not care for small firms that invest in a dozen different plays all over the country—stretching their assets and manpower too thin. I prefer companies that stay in two or three regions and concentrate on developing the assets on hand.

TER: How is Matador stock doing?

MB: It was under $8.00 last March then hit a high of $24.25 in late November. When the price of oil dropped, the stock went down to $16. Recently it was over $25 and it could go a lot higher as people get used to thinking about oil staying in the high-$90s/low $100s. Matador has a lot of gas in the core area of the Haynesville. As gas prices rise, Matador could drill some profitable wells there too.

TER: How important are factors like debt:equity ratios and other types of metrics when you decide whether or not to invest in a junior energy firm?

MB: In the last few years, those metrics have not been as important. Large investors are just throwing money at the oil business. A company will announce a $500M debt offering and two days later, they sell $750MM. Money is the easiest thing to get in the energy industry right now. Of course, I do look closely at the debt situation, and I want a firm to have enough liquidity to drill wells and make acquisitions. But there are different ways of doing this. Take Comstock Resources Inc. (CRK:NYSE), for instance: it has not sold any new stock in years. It treats its shares as a precious commodity, while some companies do a stock or bond offering every year or two.

TER: Why is money so free right now?

MB: Cash is nearly worthless in terms of getting a return. Investors are seeing the large profits flowing from the Bakken, the Eagle Ford, the Permian, etc. Investors want in on that seemingly easy money. Energy is a growth industry.

TER: What are the top oil and gas plays in the U.S. for 2014?

MB: The Permian Basin is the hottest area right now. Drillers have been active here since the Santa Rita No. 1 well began producing in 1923, and numerous formations are productive. The Bakken, the Eagle Ford, the Marcellus, the Wattenberg, the Mississippi Lime, etc. are all good areas. More drilling is being done in the Utica and the Tuscaloosa Marine Shale, and these areas could blossom in 2014—2015.

One issue to consider, however, is that in some of the older plays, the core areas have been identified and firms are exploring the fringe portions. Now, as far as Wall Street is concerned, the older regions do not have much glamour left. Some hedge funds are insisting on a minimum leasehold of 100,000 acres and 1,000-barrel-a-day (bbl/d) wells or they are not interested. Size is not the only factor though. The reality of it is that if a firm drills a well for $0.5M and produces 50 bbl/d, the well can pay out in a few months, and the rest is pure profit. Those types of small, profitable operations are running well below the radar on The Street—which can make them good buys.

The oil stocks can be volatile, not based on what they are actually doing, but based upon the perceived price of oil and Wall Street’s cyclical fears. In November, many on Wall Street became convinced that the price of oil was going to fall to maybe $60/bbl. Oil stocks dropped substantially—even though the price of oil did not plummet. Now, many of these Wall Street seers are thinking “Oil is $100! We missed out; it is time to start buying!”

TER: What other firms do you like in the junior space?

MB: EPL Oil & Gas Inc. (EPL: NYSE) is now being managed by Gary Hannah, who has been in the business for 30 years. EPL was formerly called Energy Partners Ltd. Gary studied its assets, took over the company and paid off the notes in 2009. He is working in the shallow waters offshore in the Gulf. EPL made a big acquisition several years ago. It spent $15 million ($15M) the first year on technical studies, and $150M the next year on drilling and tripled the reserves. This is its business model. EPL is in the giant shallow water fields that were discovered 40 years ago, when we did not have the advanced seismic technology to properly assess the true potential. Now, EPL is finding all kinds of smaller reserves around these old fields and there is plenty of infrastructure in place. Zones between 12,000 and 20,000 feet have rarely been drilled. EPL has begun a $45M Full Azimuth Nodal seismic program to better understand the deeper water formations.

TER: Is there a lack of competition in the shallow basin area?

MB: There is a lack of interest. People are putting their money into the shale areas onshore and are shying away from the shallow waters. But the Gulf has ample production facilities and pipelines in place, and it really does not cost that much more to drill a shallow water well than it does to drill a Bakken well.

EPL is conducting studies and making acquisitions in this space. In 2012, EPL bought Hilcorp assets for $550M. They spent 2013 studying the prospect and will spend over $100M this year to explore and develop.

TER: How is the EPL share price performing?

MB: EPL’s high was about $43 last fall. When energy stocks generally declined, it dropped down. Then there was a storm in the Gulf that shut down some high producing wells. When EPL tried to bring them back on, it did not get production back as high as it was, which was disappointing. The stock fell to around $25 and has recently been back up over $30.

TER: What other juniors are you focused on?

MB: Comstock Resources Inc. was a big gas producer in the Haynesville when that region was hot. When the gas price fell, Comstock went looking for oil on property that it already owned in the Eagle Ford. It also bought property in the Permian Basin. But when it came time to drill the development wells, gas was at $2 per thousand cubic feet ($2/Mcf). Comstock realized that it could not afford to develop both properties. It sold the Permian Basin properties for $824M, which was a $231M profit in about a year. Then it paid down debt, started to buy back stock and began to pay a dividend, which is very rare for a small producer. The yield is now 2.5%.

Comstock then put $100M into exploring the East Texas Eagle Ford, primarily in Burleson County. It plans to drill 10 wells there this year on 21,000 net acres. It also bought 51,000 net acres in the Tuscaloosa Marine Shale, where the wells cost quite a bit more to drill. Comstock management plans to drill a couple of wells there in 2014, but it is waiting to follow the lead of nearby producers before stepping up drilling in 2015.

TER: Do you buy all these types of stocks on a short-term basis or are you a long-term holder?

MB: We have held some stocks for four or five years. It depends on how they perform. If a stock doubles in a week, we may sell it. If something bad happens, we may also sell it. But, generally, we’re looking for the longer-term plays.

TER: What other picks do you have for us today?

MB: Torchlight Energy Resources Inc. (TRCH:NASDAQ) is a small company with a property in the Eagle Ford that provides cash flow. It plans to sell that asset, if it can get a high enough price, because it is going more into the Hunton play in Central Oklahoma with a private operator, Husky Ventures Inc. Husky has drilled 35—40 wells in the Hunton after spending a lot of money on technical work to find the right spots to drill and has been very successful. Torchlight has four areas of mutual interest with Husky. Torchlight has two other properties in Kansas, where it can drill low-cost, low-risk oil wells. Torchlight is currently drilling in one Kansas play with Ring Energy Inc. (REI:NYSE).

Not too many people have heard of Ring, but it is run by the same managers that built Arena Resources and sold it to SandRidge Energy (SD: NYSE) for $1.6 billion ($1.6B). Arena drilled 850 shallow, low-cost wells with high rates of return in the Central Basin Platform of the Permian Basin. Ring is drilling the same type of wells in the Central Basin, but it also got into a similar shallow oil play in Kasnas. These wells will cost around $0.65M to drill and the payout can come in less than a year.

TER: How is Torchlight financing these activities?

MB: It sold $7M in equity recently. It is also looking at a mezzanine financing package or a line of credit. It has already set aside $6M to gain a half-interest in the Ring Energy play in Kansas and has put up its share for at least two more months of drilling with Husky.

TER: Do you have an interest in international energy sectors?

MB: We buy blue chips, including BP Plc (BP:NYSE; BP:LSE) and Exxon Mobil Corp. (XOM:NYSE). They pay decent dividends.

TER: Do you have any interests in the alternative energy sector?

MB: I have all I can handle with following conventional energy. I have, however, talked with managers at wind turbine companies. They have gas generators on the side to supply electricity when the wind dies down. Ironically, the alternative energy sector has created additional demand for natural gas.

TER: Do you have any other companies that you want to talk about today?

MB: Helmerich & Payne Inc. (HP:NYSE) is a drilling company that was the first to build modern AC rigs that they called FlexRigs. These are not like the old mechanical rigs with the dirty, dangerous drilling floor. In a computerized FlexRig, the operator sits high up in an air-conditioned cockpit guiding the drill bit while looking at computer screens that tell him the weight on the bit, how fast it is turning, etc.

A decade ago, the company’s competitors laughed, claiming that no one was going to pay extra for such a fancy rig. Now, HP has half the AC rig market share. The rigs are super efficient and made for pad drilling. The footage rate has increased by 10% in each of the last two years. While an average rig may drill a well in 30 days, an HP rig can drill it in 18–20. It charges more per day, but it is cheaper per well because the wells are drilled faster.

The company can build its rigs for $1–2M less than the competition and can charge 15% more. This provides a superior profit margin. It has been building two new rigs per month, and is going to three per month in April. And it is well-managed. The Helmerich family has been running the company since it was started in 1920. Hans Helmerich has just stepped down as CEO but he will still chair the board.

TER: Is the stock cheap?

MB: HP stock has been hitting all-time highs lately, and it has raised its dividend quite a bit. It is yielding 2.5%. It has the potential to go higher. Building three new rigs a month should add around $0.90/share on an annual basis.

In general, offshore drilling stocks have been way oversold, and they will likely be good performers later this year.

TER: Thank you very much for your time, Mike.

MB: Cheers.

Mike Breard graduated from Rice University in 1963 and got an MBA from Stanford in 1965. His first job was with Standard & Poor’s in New York. He later worked with Goodbody and Walston in NYC before moving back to Dallas. He worked for several brokerage houses in Dallas, including Eppler, Guerin & Turner and Schneider, Bernet & Hickman, as an energy analyst and institutional salesman before joining Hodges Capital in 1997.

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DISCLOSURE: 
1) Peter Byrne conducted this interview for The Energy Report and provides services to The Energy Report as an independent contractor. He or his family own shares of the following companies mentioned in this interview: Torchlight Energy Resources Inc.
2) The following companies mentioned in the interview are sponsors of The Energy Report: Torchlight Energy Resources. Streetwise Reports does not accept stock in exchange for its services or as sponsorship payment.
3) Mike Breard: I or my family own shares of the following companies mentioned in this interview: CKR, EPL, HP, MTDR, TRCH I personally am or my family is paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: BP, CKR, HP, MTDR, TRCH, XOM. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
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