Strategic Oil & Gas is a $220mm market cap E&P traded on the Toronto Venture Exchange under ticker SOG.  There is $75mm of net debt so the enterprise value is $300mm (ignoring, for now, the $200mm of tax pools).  With the TSX Venture down over 60% since its peak in March 2011, there are lots of undervalued Canadian natural resource related stocks to choose from.  While at face value Strategic may not be the cheapest, I believe it has among the best risk/reward given the pairing of Tom Claugus, a very successful and deep-pocketed backer who through his hedge fund GMT Capital owns a quarter of the shares and serves as the Board chair, with a very large and highly prospective asset base controlled by the company with a 100% working interest.

Strategic’s primary asset is 441,000 acres in the Greater Steen River area of Northwest Alberta.  This is an exceedingly large land package for a company of this size to hold in a block that is largely contiguous, which makes a big difference in leveraging infrastructure, and in an established oil and gas producing area as opposed to an emerging or frontier basin.  The company has effectively been built around a thesis that a large asteroid strike approximately 100 million years ago created a crater system known as an Astrobleme, charged with light oil and gas.  Over the last several years, Strategic used seismic imaging to identify a series of hydrocarbon charged zones throughout much of the acreage with an estimated one billion barrels of original oil in place.  During the last two years, the company has dramatically advanced the original thesis by drilling two of the most attractive of these zones based on the estimated recovery factor and cost, known as the Keg River and the Muskeg.  At this point, the results are very encouraging, and while it is inaccurate to extrapolate the results across the entire land package or to assume that the other zones the company will be going after will also be successful, it is equally inaccurate to value the company solely on the basis of the proved and probable reserves it has booked on a small portion of its lands and only in the Keg River and Muskeg targets.

The Keg River opportunity is the easiest to value so let’s start there.  The company has about 24 wells on production and these are relatively inexpensive ($1.7mm to drill and complete), conventional vertical wells.  Therefore the type-curve is fairly robust at this point.  The estimated net present value of the average or type-curve Keg River well using a 10% discount rate is $5.6 million using $94 oil and $3.85 AECO gas price.  The return of capital happens in 7 months and the IRR is over 200%.  The company has currently identified 45 Keg River locations to drill though I expect that they will continue to restock the inventory of development locations for Keg wells as they develop the extensive land package.  Using the 45 locations and $5.6mm PV-10, this equates to $250 million in value.  This assumes that all  45 wells are drilled tomorrow, which obviously will not be the case, but it gives a sense of the order of magnitude value attributed to what is the most easily identifiable source of high ROI investment opportunity for the company at Steen River.

The Muskeg type curve is less developed since the company has only drilled a handful of these more expensive horizontal wells ($3.mm to drill and complete including multi-stage frac).  However, it was a major milestone that the independent reserve engineer McDaniel & Associates recently included the Muskeg stack on a portion of the company’s Steen lands, allotting 3.6 million barrels of oil and gas (on a barrel of oil equivalent basis) in the proved and probable resource category on 25% of the Steen land base that was evaluated.  This represents the discoveries the company has made on this portion of their Steen land.  The McDaniel’s report estimates the prospective resource on the sections they evaluated at 19.4 mm barrels of oil equivalent including likely discoveries based on seismic.  All this does is to lend a stamp of independent approval on the Muskeg as a valid target across their large land base.  As far as the actual live results, they have been encouraging thus far, though somewhat gassier than originally forecast.  The company estimates a present value at 10% discount rate of $4.3mm per well, which yields a payout in less than one year and an IRR over 100%.  What is important about the Muskeg is that this is an unconventional resource play (unlike the Keg River light oil pools) so that it is possible to drill hundreds of these wells over the land package as the company refines its drilling and completion methodology and incorporates the data from more horizontal wells.  As it stands, the company has identified 400 potential locations for Muskeg wells.  Again, these 400 high NPV wells will take time to drill and the company would need to continue to expand its oil handling infrastructure to keep pace with the growing oil and gas production should they dramatically ramp up the pace of Mukeg production.  Still, the fact that this small company has 100% working interest in a project with this degree of potential is fairly unique.

There is significant blue sky from the Muskeg opportunity at Steen River.  There is also additional upside from the potential for Sulphur Point oil production, which is shallower than the Muskeg and is likely to be targeted once the Muskeg play has been more fully developed.  Despite this, the stock is relatively inexpensive even on a current production basis.  Using $95 oil price and $3.75 AECO gas and including the hedges in place, the expected cash flow at the expected year end exit rate of 5,000 barrels of oil equivalent (80% of which will be oil) is $16 million.    The EV multiple to this cash flow stream on an annualized basis is 4.7x.  This is in line with small-cap E&P peers with nowhere near the inventory of drilling locations.  Management estimates 2014 and 2015 average production rates of 5,700 and 7,700 BOEs, respectively.  This would yield cash flow of $85mm to $115mm at a pace of 20 to 30 Muskeg and Keg River wells drilled at Steen each year, which leaves plenty of running room to continue is production growth from there.  It is worth noting that management is also excited about the potential for Sulphur Point wells at Steen River, which may look at lot like shallower versions of the Muskeg. 

The pace of drilling up the different opportunities at Steen River will depend on the results as well as the availability and price of debt and equity capital.  Many small-cap E&Ps mess up the process either on the capital allocation side (often by overly accelerating drilling to satisfy market demand for production growth) or on the capital structure side with poorly timed equity raises or excessive reliance on debt.  What attracted me to Strategic in the first place was the involvement of  Tom Claugus, who is the non-executive Chairman and through his GMT Capital / Bay Resource Partners group of hedge funds, controls a quarter of the stock.  GMT is an Atlanta based long/short fund with approximately $5 billion under management and an incredible 20 year performance record.  Tom is also the principal  sponsor of GMT Exploration, a private E&P business which has been very successful across different oil and gas basins in the lower 48 as well as Alaska, where they are partnered with Repsol on what looks to be a major light oil discovery in the North Slope.  I know Tom and his team to be excellent long-term value creators in the energy business and would be surprised to see Strategic make too many mistakes either with capital allocation or financing.  Certainly his involvement is no guarantee of success and many may not have heard of Tom or his firm, given that they maintain a relatively low profile and are based in Atlanta, but for me it is an important facet of the investment case and I wanted to at least mention it.

To recap, Strategic has a very large and 100% owned/operated asset base at Steen River with several  gas and light oil targets to develop.  The stock is reasonably priced on its current modest production with little credit afforded to the hundreds of development locations they have identified in the Keg River and Muskeg targets alone.  The involvement of Tom Claugus and GMT Capital lowers the risk of unforced errors in the process of de-risking its acreage through drilling.