West Energy WTL.TO W
July 04, 2006 - 6:55am EST by
2006 2007
Price: 4.13 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 277 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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West Energy (WTL.TO) is a Canadian junior energy exploration company strictly focusing on the prolific light oil Pembina Nisku reef fairway in west central Alberta. West is unique because it’s a fast growing domestic light oil producer (whereas natural gas and heavy oil make up the majority of the production growth of Canadian juniors these days). West is set to gain nearly 100% in share price by year end even after assuming a fall in the price of oil and conservative expense & decline rates. It is the only small company remaining in a region where three other companies of similar size and scope were acquired within the last year.

West is special among Canadian juniors because a single successful well is capable of dramatically increasing cashflow. West’s track record for hitting these special wells is slightly above the industry average (West claims 75% vs. 63% industry average however it appears the really good hits only occur 50% of the time, similar to others in the area). West has got a net inventory 46 such targets on land it controls.

Last year West issued equity at $6 and again at $8 per share in private placements (all prices in Canadian dollar unless otherwise noted). The funds it raised were used to build infrastructure. It appears they overbuilt infrastructure at the expense of drilling and existing well tie-ins. The contributing investors would’ve liked to see West get production on stream but instead they got a plant and pipelines leading to satellite facilities. West’s management has vowed to fund ongoing expansion out of cashflow and debt instead of more equity offerings. They’re focusing on shorter cycles, getting production on stream and on posting near term results.

A little more history: West established a core position in this Pembina Nisku play in 2003 before it gained popularity. From inception this area was their focus. In 2004, this area gained industry attention because of its “hellacious wells” capable of up to 3000 barrels per day of production. Oil flowed up naturally 3000 meters to the surface without pumps. Following these discoveries, the auctions for land mineral rights hit all time records for Alberta. However, the area also has had problems: Sour gas, well licensing issues, competitive bidding on adjacent lands, and technical problems stemming from the complicated drilling required to access pools (all discussed below).

The basic economics behind West’s “core prospect target”, a Nisku well, are as follows:

It costs $2.5 - $3.5 million to drill a single well. The wells are moderately deep (around 10k feet) and take a month to drill. If a well is successful it can cost an additional $1 million to tie-in the well. There is potential for an uphole surprise (usually sweet gas discovered on the way down to target depth).

An average successful well is capable of producing between 500k to 1,500k barrels per day from just the Nisku region. After royalties, operating costs, g&a expenses and interest expense, this nets the company $33.75/barrel in cash (based on today’s oil & gas prices). Most important to the economics of this play is the rate at which each well produce. West’s existing wells have stabilized around 750 barrels/day. Thus, at current oil prices the payback period for a successful well is less than half a year. Theoretically, these wells could last 9+ years. Some of West’s early wells have shown no decline in production whatsoever. West has spread its formula for unlocking this type of resource and developing potential targets over three different areas along this trend. West has recently expanded into a 4th area with exploration results pending.

Wells tend to produce light oil (80%), gas (15%) and natural gas liquids (5%). Lighter oil trades at a premium to heavier oil because fewer refineries accept heavy oil. Light oil is used to make higher value products like gasoline, diesel and kerosene (vs. heavy oil being used for asphalt, residual oil, bunker c). The production from these wells is sour, meaning it has to go through an additional process to be sweetened (removing H2S) before it can be sold… As I mentioned, the expensive infrastructure is already built to sweeten and transport the oil.

The worst problems are behind:

(1) West spent most of it’s capex in 2005 developing capacity to handle the sour oil & gas. It raised capital twice in 2005 at $6 and $8 per share to pay for this plant, satellites and pipelines. The plant gives them significant capacity (9000 barrels per day for West). West was forced to shift its capex balance in 2005 towards infrastructure and away from drilling because the regulators weren’t granting drilling licenses to operators in the region due to concerns over sour gas… which leads to number 2.
(2) The plants that process the sour oil and gas were declared “Critical Sour” because of their high concentration of deadly H2S. Sour wells, especially ones like these under extreme pressure, require extensive licensing and environmental compliance procedures to get a drilling permit. In 2005 local residents (rural farmers) complained about the potential dangers. The entire well licensing process was halted. West and the other operators in the area set up a safety plan for dealing with landowners. This problem appears to have been solved as evidence by the recent granting of drilling licenses to West. The landowners (who don’t have mineral rights) must actually sign the license. West has 6 well licenses in hand. They are expecting 2 more any day.
(3) Production from one pool of oil in their first core area, Violet Grove, is starting to lose pressure. They were expecting this. As a pool depletes, pressure loss takes the pool to the "bubble point" where dissolved natural gas starts to come out of oil. It creates the equivalent of a gas line "vapor lock". If this loss of pressure is allowed to go unchecked it can cause permanent loss of permeability, meaning lower ultimate recovery of the oil. The solution is to inject water to maintain the pressure. They’re leading other operators in addressing the problem (others share the same pool of oil). Thousands of wells in N. America and even the famous Ghawar field in Saudi Arabia, undergo pressure maintenance. It doesn't mean the pool is empty. Until the system gets implemented at Violet Grove, the production has been curtailed by AEUB (Alberta energy regulators). Regardless, West gets production from multiple pools of oil, spread over three distinct areas along this trend. Only 1 pool is experiencing this lack of pressure and being temporarily curtailed. It expects this pool to be back online in October and will result in a net increase of 2000 barrels per day.

Because of the issues above, West has gone from trading at the top end of the market cashflow multiple for high growth juniors to something in the middle of the pack. It is currently trading at the lowest multiple in its short history as a company. Current multiple is 7.14x annualized cashflow per share based on the operations update it posted on June 16 and current energy prices. Compare that to its quarterly annualized history beginning when it went public on 9/30/2004; 12.2x, 24.2x, 27.9x, 18.3x, 21.3x, 20.4x, and 16.6x.

Revenue per barrel based on today’s prices quoted in Cad$ based on 93% of Edmonton Light ($82.90) and 109% of AECO spot gas ($5.21), which is an approximation of what they receive for their product.

Revenue per barrel:
Oil - $77.09
N. Gas - $5.69

Current production per day: 3150 (as of june 16)
Production mix, 79% oil, 21% gas

Royalties per barrel - $17.02 (~25%, historical range is between 20% – 27%)
Operating costs per barrel - $12.50 (historical range between $6.96 and $14.52)
G&A and interest expense per barrel = $4.80 (historical range between $4.40 and $5.50)

Corporate Netback = $33.75 per barrel
Cashflow per fully diluted share = $.58
Annualized Cashflow multiple = 7.14x

There are significant, unrelated catalysts that could drastically increase the share price. Any or all of them could occur. One is all you will need to make money on this idea. It would be highly unlikely for none to occur.

(1) Faster turnaround of routine exploration & development in their core areas. In the past West has done a poor job of balancing drilling and infrastructure capex. Wells would be drilled and tested but they could never get the production to market. As of March 16, with their newest Battery coming online, they arguably have too much infrastructure for the first time in their existence. West now only has the fun part ahead of them. Currently, West is producing 3150 barrels/day. Prior to the recent curtailment of Violet Grove for pressure maintenance, they were around 5000 barrels/day. They have all that is necessary (targets defined by seismic, signed licenses, leased rigs and funds available) to drill 6 more targets before the end of the year. If 50% are successful, and they turn into average producers (750 barrels/day), then West’s production at year end will be 5085 barrels/day. This production target assumes a margin of safety of a 10% decline in existing production. From that we arrive at an annualized cashflow of $.74/share (assuming 15% lower price of oil and conservative operating, g&a and royalty expenses). At West’s current multiple (which is the lowest it has traded at since West began trading, and 1/3 the multiple it traded at during their peak) that would put the share price at $5.31, a 29% gain.

(2) Results of recent drilling successes. On June 16, WTL announced preliminary drilling success that could lead to a single, big production gain. The number they released was the length of the oil column from the well log. This preliminary data is not always an accurate reflection of the well quality. Flow tests are what comes next to actually see what kind of production the well is capable of. However, the preliminary news indicates it is the largest Nisku oil column they have yet to discover (32 meters vs their previous discoveries of between 10 and 20 meters). This gives me some confidence in their drilling inventory (prospects getting bigger). Their inventory of potential well sites is one of their most important assets, yet it very difficult to value. If you assume they get a minimum 750 barrels/day then that alone would increase annualized cashflow by $.14/share if all else remained the same, and the resulting share price by $.98 (using current depressed multiple), resulting in a year end price of $5.11, a 24% gain.

(3) Return of Violet Grove production in October. If management can get just 75% of the production they once had back then that will mean an additional $.27/share in annual cashflow, or a $1.97 increase in share price all else remaining constant, using current depressed multiple.

(4) Extra Margin of Safety: Acquisition by Highpine Oil & Gas. Highpine has acquired 3 other operators of similar size and capacity as West in the exact same area. Highpine’s strategy is to grow partly by acquisition. Highpine’s CEO used to be a board member at West. Past acquisitions by Highpine have been expensive when you look at cashflow multiples or premium to nav. Highpine explained these premiums by the value in the following 5 things relating to this Pembina Nisku fairway: (1) acreage (2) infrastructure (3) drilling targets (4) expertise and (5) licenses. Here’s a quick comparison of Highpine’s previous acquisitions followed by West. To value the acreage, I’m using the published “record sales” number that happened in an auction in 2005. This is not really a fair estimate but it is a number that one of the operators actually paid for some land, and I applied it evenly to all the comps. Once a discovery is made on one section, depending on the seismic data, the neighboring sections becomes more valuable (likely those were the sections that got the big money). My calculation of NAV premium is only part of the picture because it only includes proven plus probable oil & gas reserves at year end net of debt. It doesn’t include plants, pipelines, land or anything else.

Vaquero acquired by Highpine on April 6, 2005:

Premium to NAV: 236%
Premium to book: 601%
Percent of production that is oil vs. gas: 56% (higher oil % is more desirable)
Cashflow multiple: 11.3x
Cost per flowing barrel: $112,105
Amount of net acres at Pembina: 14,000
Value of acreage based on 2005 auction prices: $116 million
Net land (all areas total): 66,200
Sour oil facilities: ~5000 barrels/day net capacity
Pembina Nisku drilling targets: 6.6 net
Pembina Nisku drilling licenses: unknown, getting licenses wasn’t an issue at the time. The controversy over sour oil didn’t occur until mid-2005.

White Fire acquired by Highpine on Dec 12, 2005

Premium to NAV 248%
Premium to book: 222%
Percent of production that is oil vs. gas: 30%
Cashflow multiple: 26.4x
Cost per flowing barrel: $261,702
Amount of net acres at Pembina: 2500
Value of acreage based on 2005 auction prices: $20.8 million
Net land (all areas total): small
Sour oil facilities: none
Pembina Nisku drilling targets: few
Pembina Nisku drilling licenses in hand: 3

Kick Energy acquired by Highpine on June 1, 2006:

Premium to NAV 179%
Premium to book: 429%
Percent of production that is oil vs. gas: 6.7%*
Cashflow multiple: 6.8x
Cost per flowing barrel: $84,694
Amount of net acres at Pembina: 10,759 acres
Value of acreage based on 2005 auction prices: $89.6 million
Net land (all areas total): 52,000
Sour oil facilities: none
Pembina Nisku drilling targets: 24 net
Pembina Nisku drilling licenses in hand: 3

*Note the gas weighting. Also, the NAV was calculated based on year end reserve audit when natural gas prices were 80% higher in Canada. Kick’s area of focus was at the southern end of the fairway which is gas weighted and much less valuable. There are many prolific natural gas regions in Canada, but only a few prolific light oil regions. For that reason, Kick is not a good comparison.

West Energy, as of June 16, for comparison (not yet acquired by Highpine)

Premium to NAV 248%
Premium to book: 197%
Percent of production that is oil vs. gas: 79% (higher oil% is more valuable)
Cashflow multiple: 7.14x
Cost per flowing barrel: $87,976
Amount of net acres at Pembina: 32,731
Value of acreage based on 2005 auction prices: $272.8 million
Net land (all areas total): selling other non-operated areas for $10 million
Sour oil facilities: 9000 barrel/day capacity
Pembina Nisku drilling targets: 44 net
Pembina Nisku drilling licenses in hand: 6 (plus 2 in process)

West management/insiders owns 18% of the shares outstanding. Highpine and West have competed fiercely in the past for neighboring land and licenses. West is thought to have some of the best land in the region and was a steps ahead of Highpine at a time when the area was less known (and cheap). Highpine’s CEO is an industry veteran and intends to grow an intermediate sized company, vs. royalty trust exit. He is quoted as saying this area is one of the most dramatic things he has seen in 30 years of exploration.

If things go reasonably well for West in 2006 and they meet management’s expectations, they should see $7.66/share. This assumes historical success rate on ongoing drilling, 750 barrels/day from recent drilling success and just partial restoration of Violet Grove production. It prices in a 15% decline in the price of oil, no decline in the price of natural gas, and 10% decline in existing production. The above scenario would put their facilities at 81% of capacity. Cashflow would be $1.07 per fully diluted share. I’m assuming their multiple of 7.14x cashflow holds (in reality, it would likely increase given they increased their production by 300%).

In summary, West established a land base in a prolific area at a time when the land was selling for a fraction of it’s peak price. West has raised significant capital (at much higher share prices) and put it work in a way that effectively front loaded expenses. In 2005, it only spent 24% of that capital on actual exploration. Most companies this size spend over 50% of capex on drilling and carefully manage their growth so they don’t end up in West’s shoes. This year, they can focus their capex on drilling to fully make use of their expensive infrastructure.

Is this a value investment? These short-lived junior energy producers trading at double their accounting book value, with wimpy earnings and limited histories, seem very flakey. However, they will eventually sell out to a royalty trust trading at a similar cashflow multiple. The acquiring royalty trust will distribute pre-tax cashflows to investors and manage commodity price volatility with hedges. Depending on your outlook for commodity price futures, peak oil, etc., these royalty trust payouts can be valued using conservative dividend discount models despite their thin accounting earnings. Royalty trusts have survived past commodity price cycles. They have gained widespread acceptance in the U.S. Many trade on the NYSE and receive analyst coverage from U.S. brokers/banks. Royalty trusts depend on acquisitions of innovative companies like West to replace production as very few royalty can do it organically. An experienced management teams with a good land base can grow a junior E&P company from 300 barrels to 10k barrels per day in production in a few years. This is what is happening with West.

A couple of extra tidbits & a wildcard:

Burlington/Concoco was a minority partner at their recent big hit mentioned in catalyst 2. I’m not sure this is the right way to interpret this partnership, but it gives me a bit of confidence that smart money is putting capital into this area with West at the helm. I don't remember ever seeing major oil companies taking positions with small, landlocked Alberta companies like West (I've seen it with higher impact offshore and overseas projects). It underscores the potential for this area.

West and Highpine had a dispute over who was the first in a pool of oil. The Alberta EUB handled the dispute. The outcome was positive for West. It appears that the impact for West will be a slightly lower royalty rate, vs. higher for Highpine on production from this pool. The net result won’t mean much for the valuation/catalysts of this idea as I have constructed it but the testimony is interesting. It adds color to many of the topics I mentioned, and touchs on the fierce competition between West and the much larger company, Highpine, in this area: http://www.eub.ca/docs/documents/decisions/2006/2006-058.pdf

The Wildcard: West announced in late 2005 that they’re exploring in a 4th region, Crossfire. It is north east of the current areas and still part of the Pembina Nisku play. They’ve shot seismic 3d, acquired land and drilled the first 2 exploration wells. They put the wells on “tight hole” status which means they don’t have to make the results public for a while (all geophysical data is public in Canada unless it gets tight hole status), thus preventing competition from bidding up nearby land. West is 3 for 3 in coming into new areas and making a significant discovery on this Pembina Nisku trend. They are the only company with seismic over this new area. They believe they could generate 20 potential targets here. It is thought to be a gassier weighting than their other 3 areas. I didn’t include upside from this in my valuation. Many times a company will say they will not raise capital from equity offerings (like West said) only to come back to the market and say, “we’re raising capital for this new area/project, see how great it is.”

There you have it. It’s the 4th of July and the U.S. markets are closed, so consider this idea on the Toronto Exchange.


-Faster turnaround on routine E&P activity because of newly commissioned infrastructure.

-Recent drilling success is brought on stream.

-Violet Grove is brought back on stream on Oct. 1.

- Acquisition by Highpine.
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