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Penn West’s shares have been battered of late, but the upside remains intriguing

On the Money: Land Lords

Jody Chudley is the author of The Punchcard Portfolio, a value-oriented newsletter with a focus on Canadian oil and gas stocks

Jan 15, 2013

by Jody Chudley

When you buy a share of a publicly traded company, you are not buying a piece of paper. You’re buying an ownership interest in a company, and the value of most businesses changes very little from one day to the next. The price, however, of a publicly traded share of that exact same business often swings wildly from one day to the next. The price is what you pay. The value is what you get.

That disconnect between how much the actual value of a business changes and how much the related stock price changes is what creates opportunity for investors. When the price of a publicly traded share of a company drops well below the actual business value of that same company, an attractive investment opportunity presents itself. My job as an investor is to find those opportunities. And my job, as Alberta Venture magazine’s new stock picker, is to help you find them as well.

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With that in mind, let’s dive right into the most interesting opportunity I see today: Penn West Energy. That probably sounds crazy, given the way the stock has been beaten up of late, but bear with me while I explain. It’s no secret that the North American energy industry has had a rebirth through the evolution of horizontal drilling and multi-stage fracturing. These techniques have made both oil and natural gas resources that were previously uneconomic or impossible to develop commercially viable.

This unconventional revolution has changed the modus operandi of energy companies in North America, and made the exploration and production model a thing of the past. In its place is what I call an accumulate-and-exploit model. Now, more than ever before, land matters.

Strangely, though, the share price of the single company that should be the biggest beneficiary of the unconventional revolution in Canada has actually performed very poorly over the past five years. It is hard to believe that in a world where oil has been consistently over $80 per barrel, Penn West has had its stock price drop from over $40 per share in 2006 and 2007 to barely $10 today.

What happened? I believe it is a combination of low natural gas prices, poor execution and investors simply running out of patience. In the first nine months of 2012 Penn West added $800 million in debt but only increased production by 1.5 per cent. That calls the efficiency of the company’s operations into question, and is why – along with the persistently low price of natural gas and the deceptively low netbacks the company gets on its oil – a large swath of its head office received their pink slips in early November.

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But while execution issues and commodity prices have impacted this year’s results, I don’t think the long-term value of Penn West’s vast asset base has changed much. And there’s the catch: as a result of its disappointing performance of late, the price that we as investors can now pay for Penn West’s extraordinary asset base has gotten much more attractive.

With a share price of $10.50 Penn West has an enterprise value of $8.8 billion. That means Penn West is selling for $54,000 per flowing barrel of oil equivalent (boe) and just over $12 per boe of proven and probable reserves. Even with consideration given to recent operational issues, I think those are very attractive metrics for a producer whose production is weighted 65 per cent towards liquids.

But what really gets me excited about the company is the untapped value that lies in its huge portfolio of unconventional oil acreage – value the market isn’t currently pricing in. With six million acres of western Canadian land and 7,000 identified drilling location targets under its control, Penn West has more exposure to unconventional oil than any other company in the country.

Here’s the catch: Every year, the energy industry improves the horizontal drilling and multi-stage fracturing techniques used to develop unconventional resources. Every year, the industry learns to extract more oil from these plays more efficiently. Remember, these techniques have really only been applied on a large scale over the last decade. There is plenty of room for improvement.

As the amount of oil being extracted increases and the cost to do so decreases, the profitability of horizontal production gets considerably better. And as the profitability of the production improves, the value of the land where these resources can be found increases in lockstep. The biggest beneficiary in Canada of these improvements to unconventional production techniques is the company with the most unconventional acreage. That company is Penn West.

It is almost as if Penn West owns a bunch of land 10 kilometres from city limits. Right now the land is worth a certain amount, but five years from now when the city limits reach where that land is situated, its value increases significantly. All the owner of the land has to do is sit and wait for the city to come to him. It might take a while for the value of Penn West’s acreage to be realized, and that is why Mr. Market isn’t interested in Penn West today. Mr. Market is not known for his patience. But for the investor who can sit on his or her hands and wait, Penn West could represent a compelling long-term opportunity.

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