Rocky Mountain Energy RME CN
February 08, 2004 - 11:57pm EST by
2004 2005
Price: 5.30 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 36 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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In a nutshell, this fast growing, undiscovered E&P company is simple, shareholder friendly, and gosh darn cheap. Liquidity is pretty good (for a stock this size). Plus there’s a decent catalyst in place.

Calgary, Alberta-based RME has been drilling for natural gas and oil around the Princess area of Southern Alberta. They’ve been finding plenty of both (roughly 50/40 natgas/oil) at about $5.30/BOE (industry average is about $11.50/BOE) and have consequently grown reserves and production tremendously. Growth has been funded largely through internal cash flow, along with reasonable use of bank debt. Since they see their main skill as exploration, they will most probably grow for a couple more years and then sell the company. With growth like this, I think there’s a good chance that a sell-side outfit will initiate coverage on these guys, but up until now there has been none. Actually, there isn’t even a message board on the stock(!)

When I say cheap, I mean selling below break-up value, defined as the NAV of proven reserves. Actually, I think it’s probably at a sizeable discount to that. You get the probable reserves and a call on future exploration for free. I think both these items have significant value. (More on valuation below).

By shareholder friendly, I mean that management owns 25% of the shares, and their stake is now worth quite a bit in relation to payroll (incl. option grants). Per the annual report: “Management’s number one objective is to enhance shareholder value … this objective is best accomplished through the drill bit and low overhead.” I haven’t noticed them exercising any options and shares outstanding have stayed pretty flat, despite a large run-up in price (and NAV). Let’s face it – a lot of E&P companies have destroyed value by unprofitable drilling or overpaying for properties. I think that risk is greatly lessened when management has a big stake.

OK – before I get into the numbers, let me humbly admit that I am somewhat new to this sector, which means that I could be making some obvious mistake here. I am indeed looking for feedback. But look, this situation is pretty simple. If there’s a flaw in my logic, you E&P types should find it easily.

On Jan 31, 2003, RME’s reserve auditor estimated the NAV of proven reserves to be CAD 28M at a 10% discount rate. Spot prices back then were very similar to today’s spot prices. (By the way, the reserve auditor is Grant Trimble Engineering of Calgary, Alberta). Over the year, I estimate they produced 21% of these proven reserves. Over this same period, they added 10.7 net wells to the 12 net wells they had at Jan 31, 2003. I suppose the average new well could be significantly less valuable than the average old well, but I doubt it. This new drilling has all been in basically the same area, and test results on the new wells look comparable. If you make this assumption and crunch some numbers, I estimate that NAV grew 68%, which would put break up value at almost $7/share. All I’m saying is that proven NAV is probably not below the current price.

As for the probable reserves, I’ll note that they were about 80% of proven reserves as of one year ago. You can make your own assumptions what % of these will turn into proven. I certainly don’t know how much the exploration value is worth, but when you’re finding reserves at $5.30/BOE, you’re beating your cost of capital by a longshot.

Of course, no E&P thesis would be complete without at least a cursory mention of future oil/natgas prices. As usual, the very near term is anyone’s guess. But over a timeframe relevant to this analysis, I suspect that prices will not decline much, and may increase. The natgas situation has been widely reported and I suspect most of you have already drawn your own conclusions. But basically, the US has built a huge natgas powered energy infrastructure, the sheer size of which lessens the risk of further “demand destruction.” Demand for energy is a steady 2-3% grower, and company’s drilling results have been pathetic for a while now. (EIA-reported drilling results are much rosier, but who you gonna believe?) New supply from pipelines and LNG is expensive and will take much time to implement. For oil, the outlook is probably tougher to predict, but drilling results have been likewise weak for a long time. Demand is growing. Improvements in finding/drilling technology have bailed us out in the past, but spending on this tech has yielded diminishing returns for some time now.

Finally, if none of the above has excited you, I’ll just add that this company is the sponsor of the bull riding event at the annual Patricia Rodeo in Patricia, AB. Gotta love that.

Ps – when I talk about the catalyst here, I’m basing my statements on an interview with the CEO that appeared in the Wall Street Transcript about a year ago.


Sale of company in a couple years
Initiation of sell side coverage
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