Paramount Resources POU
December 23, 2007 - 7:31pm EST by
roc924
2007 2008
Price: 13.56 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 921 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Paramount Resources
Summary of investment positives
  • Discounted valuation due to hidden assets; stock worth >$20
  • Likely catalysts to unlock hidden value
    • Carbonates resource evaluation
    • North Dakota production ramp
    • Further stock buybacks
    • Smaller than expected impact from Alberta royalty rate change
    • Tax loss selling pressure lifts
  • Strong management with track record of value creation
All $ figures are in Canadian dollars.
Paramount (POU, $13.56) is an energy exploration and production company (current production: 70% gas, 30% oil) majority owned by a management team with a track record of strong value creation. Book value has grown at a 25% annual rate in the past ten years, treating spin offs as if the company sold the assets instead.
The company has an NAV of at least $20 and at the current price of $13.56, investors can buy Paramount’s current production at a discount and receive the company’s heavy oil carbonates and light oil North Dakota program for free. Catalysts are forthcoming to realize the value of these assets with a carbonate resource study in 2008 and the ramp of North Dakota production (the company was successful with its first well, which began producing in early 4Q07). Longer term, Paramount’s substantial undeveloped acreage position should result in additional shareholder value creation. The stock was written up in 2005 -- please refer to that write up for additional information.
The stock has been under pressure this year due to a string of production disappointments, guidance reductions, strong Canadian dollar, and changes to Alberta oil and gas royalty rates. Looking to the future, analyst estimates for 2008 production finally look reasonable and the stock has probably over reacted to recent changes in the Alberta oil and gas royalty rates. The Canadian dollar is a wild card, but investor can hedge this risk.
Loss of permanent capital from today’s price appears unlikely given management’s value creation track record and the stock’s large discount to fair value. The company’s recent buy-back of almost 5% of the stock around $14 suggests the timing is right. Clearly the Riddels, who own half the company, see an undervalued stock.

Valuation



Asset
Value (millions, $CAD)
Notes



Trilogy Energy Trust ( TSX: TET.UN)
102
Market value of 15.4m shares; In LT investments on balance sheet
MGM Energy Corp (TSX: MGX)
43
Market value of 21.5m shares; In LT investments on balance sheet
Rigs
20
2/3 of construction cost (built in 2007)
MEG shares
152
Cost; In LT investments on balance sheet
MEG debenture
75
Cost; In ST investments on balance sheet
Cash net of debt
-106
Sep07 cash of $105 plus $119 ST investments less $75m MEG debenture less LT debt less retirement liability plus non-cash working capital deficit less $20m for repurchase of 1.4m shares subsequent to 9/30/07
Carbonates
300
$0.30 per recoverable barrels of 1B (low end of estimated recoverable 1-2B barrels)
North Dakota
192
DCF value using $65 oil; also $6.4/bbl likely reserves and $30k/bbl/day average production
Current production
600
6x 2008 cash flow; $43k/boe.day production of 14mboe/day of conventional (non-North Dakota) assets
Other undeveloped acreage
0
2.2m net acres December 2006
NAV
1377

Per share
20.24
68m fully diluted shares at $21 (67.7m outstanding today)
Current price
13.56

Discount
-33%




Downside case
$13
See below for assumptions
Downside
<5%




Upside case
$30+
See below for assumptions
Discount
>50%


There are several components of the table above explained in more detail below:
  1. Current production and the Alberta royalty change
  2. Carbonates
  3. North Dakota
  4. Downside case
  5. Upside case
1. Current Production and the Alberta Royalty Change
October 25th Alberta announced increases to gas and oil royalty rates that will take effect January 2009 for production in Alberta. Management estimates less than a 3% impact to Paramount’s PV-10 as a result of the royalty changes. Royalty rates will range from 5 to 50% instead of 5 to 35% under the old rate structure. Low volume wells or deep wells receive lower rates than high volume or shallow wells.
http://www.energy.gov.ab.ca/About_Us/1293.asp
The uncertainty of how the royalty change will affect company values has led investors to sell the group en mass. However, the impact varies greatly across companies, depending on a variety of factors. The impact of the new Alberta royalty rates is likely less than 3% on Paramount’s PV-10, which was $970m as of December 2006. The bulk of the company’s reserves are either low volume wells or deep, both of which receive lower royalty rates under the new rate system.
Assuming the same oil and gas prices as last year, this year’s PV-10 should be very roughly $800m, reflecting 2007 production, a decline for the Alberta royalty change and disappointments at its Kaibob and Liard areas. $800m compares to production value of $600m in the base case valuation and does not include reserves for North Dakota or the Carbonates
Paramount should have 2008 production of 16,500+ bbl/day and cash flow of $135m assuming $80 oil and $7 gas. Current analyst estimates finally appear to be realistic after being too high for over a year.

2. Carbonates
Paramount has 125,000 acres in the Grosmont Carbonate Bitumen Trend adjacent or near Shell, Husky, Laricina and Osum acreage. Paramount’s investor presentation has a map of its acreage position. Using recent valuations placed on Osum’s recoverable barrels values Paramount’s carbonates at $300-1,200 million.
The carbonate opportunity is not unlike the oil sands opportunity in 1999 and 2000. Then, investor skepticism was high that Paramount would generate value in the oil sands. Recently, Paramount sold its oil sands properties for $1B after investing less than $200m from 1999 through 2006.
Paramount is likely to commission a resource evaluation by GLJ in 2008. The company likely has 5B barrels of original bitumen in place, of which 1-2B are recoverable.
Recovery techniques are still in the early development stages, but the company believes recovery will be easier and more economic than most expect. Paramount believes its patents for steam generation and CO2 sequestration techniques will be valuable in the development of the carbonates. Unocal pilot wells flowed at 400 bbl/day in the 1970s using cyclic steam. Shell is producing oil from carbonates in Oman and purchased 89,000 acres in the Grosmont formation in 2006. Osum and Laricina plan pilots in 2008-2009.
GLJ valued Osum’s recoverable resources at 63c/bbl in a May 2007 resource study. An August 2007 financing valued the company at about $500m. Applying half of GLJ’s 63c per barrel to the low end of Paramount’s 1-2B barrels of recoverable resources results in a $300m valuation for Paramount’s Carbonates.

Osum Resource Valuation
NPV-8% GLJ evaluation
Recoverable resources
$/bbl
Marie Lake
$ 305
252
$ 1.21
Carbonates
$ 372
591
$ 0.63
Total
$ 677
843


3. North Dakota
Several years ago Paramount established an acreage position in North Dakota. The company had two rigs built to drill the deep play at a cost of $30m. After about a year long delay in rig construction, the rigs finally began drilling in 3Q07. Well one is producing at 130bbl/day; 2 and 3 are being completed and the company is drilling 4 and 5. The company sees the play as low risk and having the following potential:

North Dakota Economics

Wells
100-200
Recoverable per well
200,000 bbl
Total recoverable
20-40 million bbl
Production per well
100-200 bbl/day first year
Drilling, tie-in, etc. cost per well
$3m
Cash operating cost
$10-12/bbl
Royalties
18%
A DCF shows an after tax NPV at 8% of $192m, assuming $65 oil in year one and 3% inflation thereafter, 150 wells drilled, 80% success rate, 150 bbl/day year 1, 70 bbl/day year two, 50 year three, 40 year four, …10 year nine (I used a decline curve from a Paramount presentation.) An NPV of $192m is about $6.40 per barrel of likely reserves and $30,000/bbl.day using average production over the first six years. Both metrics are probably far too low considering the well economics, but I was conservative on a variety of assumptions. Using $85 oil results in an NPV of $374m, all else unchanged.

The company believes its North Dakota wells will be economic down to $35/bbl.

4. Downside case
Odds of a permanent impairment of capital appear low, even assigning zero value to carbonates and North Dakota. In the unrealistic case of assigning no value to both of these assets, NAV is $13 even conservatively assuming a value of $600m for the combination of current production and the company’s large undeveloped acreage position. The largest risks are a sharp decline in energy prices or significant appreciation of the Canadian dollar.

5. Upside case
The DCF for the North Dakota program assumes $65 oil today and 3% annual inflation. Assuming $85 and 3% inflation increases the after tax present value by $182m. Adds $2.60 to NAV.
Using the top end of estimated recoverable Carbonate barrels of 2B (instead of the base case 1B) increases the Carbonate valuation to $600m. Adds $4.30 to NAV.
Paramount’s current production is probably worth $800m instead of $600m. As uncertainty lifts regarding the impact of the new royalty, the market may be willing to assign this higher valuation. This would add another $2.90 to NAV.
Using these assumptions, NAV is about $30.

Value Creation Track Record
A quick look at Paramount’s financial statements does not reveal the value creation at Paramount due to spin outs. Paramount spun out Paramount Energy Trust in 2003, Trilogy Energy Trust in 2005 and MGM Energy in 2007 with a combined market value at spin of $1.6B. Had Paramount sold or IPO’d these assets instead of spinning them out to shareholders, book value per share would be approximately $34, a 25% annual growth rate from $3.76 in 1997. Past free cash flow of course would have been significantly higher since Paramount spun off its highest cash generating assets.
The Riddells were early to see the oil sands potential. They bought oil sands acreage in the late 1990s and early 2000s when few wanted it and most were skeptical of oil sands economics. This year Paramount sold its oil sands interests for about $1B, after investing less than $200m in the properties in the past ten years. Most of this investment occurred recently, such that the IRR for Paramount’s oil sands investment was extraordinary.

Risks
Sharp decline in natural gas prices (company is not hedged)
Further appreciation of $CAD
Production decline rates are faster than expected

Catalyst

Publication of Carbonate resource estimate. Successful North Dakota drilling. Realization that the royalty change won’t impact POU as much as currently feared. Additional stock buybacks. Accretive acquisitions
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