What to Buy: PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF) < CAD9.60, USD9.40

Why Now: PetroBakken Energy Ltd’s (TSX: PBN, OTC: PBKEF) problems may be easier to resolve than those of most rivals. Much of a production disappointment in the first half of 2011, for example, was due to exceptionally wet weather in 2010, which interfered with drilling conditions. The company also experienced some growing pains integrating some CAD1 billion in acquisitions, which management appears to have resolved. The biggest worry many seem to have is that PetroBakken’s technical capabilities are questionable. That has long-run implications that no one-off weather or short-term organizational dynamics issues can cover up. But that’s something that will only become apparent once we start to see results that can’t be blamed on weather.

The bet here is this much maligned company defies its skeptics and at last begins to produce up to the potential it promised when it initially went public roughly two years ago. If it can do that, it will hold its generous dividend and should recover much of the ground lost by its stock since its IPO. Alternatively, if oil prices do bounce as we think likely, we should have a winner even if the company continues to disappoint. This is a high risk/high reward play on energy, so treat it accordingly.

The Story

This light-oil-focused producer has been steadily falling since it debuted on the Toronto Stock Exchange (TSX), Oct. 6, 2009 at CAD34.60. It was a CAD22 stock as recently as Mar. 4, 2011, having hovered around that level for the better part of a year. Today, it appears to be leveling off in the mid-single-digits.

The stock’s most recent decline began following the release of fourth-quarter and full-year 2010 earnings in March 2011. The main reason was production growth failed to live up to company guidance. Less-than-expected output was again the catalyst for declines following the first-quarter 2011 announcement in early May.

Shortly thereafter John Wright was replaced as chairman of the board of directors. But it was hardly the kind of management shakeup that has investors thinking turnaround, as Wright remained chief executive office and kept his seat on the board and took on the role of president as well.

Having the word “Bakken” in its name alone likely created a lot of hype for this stock. The problem now is that it has consistently failed to live up to it with repeated disappointments. And the result is a cloud is hanging over its stock, made all the darker by the drop in oil prices since mid-summer.

The silver lining is there are now two potential catalysts for a PetroBakken revival. One is a rebound in oil prices in North America. The other is one or two quarters of consistent production gains that matches management guidance and establishes a comfort level for investors.

The latter is within the company’s power and depends on working through some logistical problems that are plaguing all producers operating in the Bakken region, both the US and in Canada. That will grow company cash flow, even if oil prices measured by West Texas Intermediate crude remain in the USD80 range.

David: What a difference a few weeks make. Last month, our problem was there were so many stocks yielding in double digits. I’m glad so many have rallied, including many previous Big Yield Hunting recommendations. But I’d be happy for some middle ground.

Roger: That’s the new reality of dividend-paying stocks. The old concept of them being interest-rate sensitive is dead. Now everything follows perception of risk, and with investors thankfully a little less worried now than last month prices are higher, which means yields are lower.

As we’ve been saying, as long as businesses stay healthy and keep paying dividends, they’re going to recover from whatever happens to them in the stock market now, no matter how bad things get. That’s what we’ve seen the first few weeks of October. And while there are certainly plenty of catalysts for selling to pick up again, I think we’re going to see more upside, as there’s still so much pessimism.

Of course as you point out, there are fewer options to buy really cheap stocks that are paying big yields just because of misperceived risks. But I’ll take that inconvenience any time.

David: So will I. I am a little concerned about Superior Plus Corp (TSX: SPB, OTC: SUUIF). It’s up a little bit but it’s still yielding 17 percent the last time I looked. That can’t be good.

Roger: I agree, and I really hope investors are following our advice not to average down in these stocks. This is an environment where companies that weaken can and will stumble, and losses can be huge.

Superior’s second-quarter numbers did support the dividend, and I think the payout has been set conservatively enough to hold this year, as management has maintained. But under the wrong circumstances any company can stumble. And the reason Superior is yielding so much is because it faces more challenges than most, from its construction materials, chemicals, energy-trading and propane distribution operations.

We’ll know more when we get the third quarter numbers. But for now, I would stick with positions but not add to them. And the same goes for any other Big Yield Hunting recommendations our readers have purchased.

David: I have found one, however, that I think you’re going to like. It’s a Canadian energy producer that’s oil-weighted and potentially has a great potential production profile but has repeatedly shot itself in the foot since going public in October 2009. We actually cover it in Canadian Edge under oil and gas producers: PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF).

Roger: Before you go on, I have to confess I thought this one was cheap at a somewhat higher level when we added it to our How They Rate table. They can blame at least some of the decline on the fear level in the wider market, but not all.

In fact, from what I can see the main reason it’s been beaten up is it’s repeatedly missed production targets. That always makes me nervous with an energy company. I’m willing to ride with a producer that can make its guidance for exploration and development but is suffering due to low energy prices.

I’m less willing to jump when a company isn’t doing well what’s it’s supposed to be best at–that’s getting accurate assessments of reserves and production costs and getting the stuff out of the ground and to market at a reasonable price.

David: I agree. This one is a stark contrast to another Big Yield Hunting pick we made some months ago, AvenEx Energy Corp (TSX: AVF, OTC: AVNDF). They’re a lot smaller than PetroBakken but they have executed well with their properties. You get the feeling they’re going to do very well if energy prices just stay where they are now.

The best with PetroBakken, though, is they get their act together and then benefit from what should be a big lift in energy prices.

Roger: I have to admit, the contrarian in me is having a hard time laying off energy stocks these days.

So many people seem to be expecting another 2008, and they’re really punishing the shares of producers–on expectation that we’re going to see $40 oil again. I just see extreme differences between now and 2008. And AvenEx is trading at a discount to the reserves it has in the ground–even using proven reserves that have a 90 percent or better chance of being produced. I believe PetroBakken is as well, even when reserves are very conservatively valued.

But I also think we’re going to see more dividend cuts in the energy patch because of the dip prices have already taken. You might recall we were holding Perpetual Energy Inc (TSX: PMT, OTC: PMGYF) as an aggressive bet on natural gas in Canadian Edge. This week the company eliminated its dividend indefinitely, and we’ve exited the stock. I’m willing to bet on PetroBakken, but anyone who buys it now should be prepared for a dividend cut if things don’t turn out as well as the company thinks, even though it should be doing better as a producer of primarily oil.

David: Again, I can’t argue with you. But if you’ll allow me, let me fill our readers in on the details. The company has 187,235,000 shares out as of Sept. 30, 2011. It pays a dividend of CAD0.08 per share per month, last confirmed this week. That’s a CAD15 million a month dividend nut to cover, CAD180 million annually, but cash flow has been covering it by better than two-to-one.

Market capitalization is adequate at CAD1.53 billion, though net debt is CAD1.15 billion and net debt-to-market cap is 75.16 percent.

Roger: I think I can see why it’s selling cheaply. Debt can be a real problem for producers if cash flow falls far enough. I guess we’ll know more in November when third-quarter earnings come out.

David: That’s definitely reflected in the split analyst opinion on this one. I checked out the “analyst rating” summary page on the good old Bloomberg terminal, and there’s a seven-seven-two buy-hold-sell line on Bay Street. The average target price is CAD12.50, but there’s a low price of CAD4 set by BMO Capital Markets, which has a “sell” on the stock. The high is CAD21 from CIBC World Markets, which just a short time ago was the actual trading range. That’s about as bullish a buy as anyone right now is willing to put on this stock, though a couple of analysts have set a high-teens price.

Roger: That looks a lot like some of the European stocks these days. Some analysts are willing to stick with them despite what’s going on there and the credit concerns. Others are practically predicting Armageddon. The funny thing is they’re looking at the same company numbers and often like what they see, but they just see things differently on how the economic and financial situation is going to play out in the Eurozone. It looks very similar here.

Some of these bearish analysts appear to be sold on PetroBakken’s prospects, but they’re not going to bet on it as long as they’re bearish on the macro situation.

David: I noticed that. But I think there’s more behind why the opinion on this thing is actually like Nuke LaLoosh: kinda all over the place.

PetroBakken declared its first dividend Oct. 5, 2009, and paid CAD0.08 per share the following Nov. 16. It just declared its 25th consecutive dividend at that amount, to be paid to shareholders of record as of Oct. 31, 2011, on Nov. 15, 2011. The ex-dividend date is Oct. 27. It earns some respect for consistency, though it hasn’t really done it for very long.

It also posted a payout ratio of 38.42 percent for the second quarter of 2011, which as you know is on the low end for the companies we cover in Canadian Edge. In fact, it’s good enough to earn a point under the revised CE Safety Rating System. But that’s the only time I’ll venture to mention “PetroBakken” and “safety” in the same sentence again. It clearly doesn’t get a point for earnings visibility, and that’s why I think the opinion is so split. People really don’t know if they’re going to live up to their stated production guidance, or if we’re going to see another quarter of disappointment.

Roger: And a lot of that’s due to oil prices, and where people think they’re headed. I do think the yield compensates for the uncertainty on that score, considering the low payout ratio. What can you tell me about debt?

David: There’s nothing coming due in 2011 or 2012, which is really positive. The company does have a convertible debenture that holders can put to the company in February 2013. But it has the option to repay any debentures that are put back in cash or shares.

There is something that really bothers me, however. There’s literally no cash showing up on the balance sheet, at least for what I’m seeing. Is that possible or am I looking at a bad figure?

Roger: It’s certainly possible. But keep in mind that a balance sheet basically gives you a snapshot of a moment in time for a company. I would say almost surely that there’s cash now, or at least there would have to be for it to continue to function. And keep in mind that it is continuing to pay dividends. You can’t fake that if you don’t have any cash. And I do like the fact that they have no debt maturities for the next couple years. Lenders can always call in their chits, but they’re a lot less likely to if nothing is coming due.

David: In that October 2011 presentation, management explicitly states that it is “pursuing options to increase liquidity, which potentially include…continued production growth…modifying our capital program…altering our dividend program and/or implementing a DRIP….” That would provide more cash than they’re getting now, if for no other reason than a dividend reinvestment program (DRIP) would allow shareholders to elect to receive the equivalent of a cash dividend in PetroBakken shares.

They’re also looking at an equity offering, issuing more debt securities or boosting its credit line, renegotiating its convertible debentures and selling assets.

Roger: All that is certainly possible, but things can get a lot tougher on the financing front when a company’s stock takes a hit. In fact, it can trigger what amounts to a margin call on the assets, if lenders get too worried they’ll be forced to loan more to keep the company solvent.

That’s what happened to Advantage Oil & Gas (TSX: AAV, NYSE: AAV) back in early 2009, and it was forced to eliminate its dividend. And it appears to be what happened to Perpetual Energy earlier this week. Again, it was the combination of shrinking cash flow, a falling stock price–which eliminated the ability to issue more equity–and tighter credit conditions that dealt the final blow. That’s why I never want to be in the position of owning a company that really depends on raising debt or equity capital to stay afloat. But that doesn’t appear to be the case with this one.

David: It looks to me like that guy with the CAD4 target is not only pricing in a dividend cut but a dividend elimination. Maybe he thinks there is a margin call on the horizon.

Roger: That would seem to be the downside for this security, though it does have one thing going for it that Advantage and Perpetual did not: It produces mainly oil. And oil prices haven’t crashed as natural gas did. Nor do I think they will.

If PetroBakken really has what it says it has in the ground, and finally proves to the world that it can get it out economically, no one is going to foreclose.

David: As long as that doesn’t happen, this should work out. Based on the production plan spelled out and illustrated in the company’s October 2011 presentation, PetroBakken is now moving for the first time into “surplus cash flow” territory. But the company’s capital payout/surplus cash flow assumption is based on a USD90 per barrel West Texas Intermediate oil price. The average spot WTI price for the third quarter was about USD89.

Roger: Keep in mind that they’ve probably hedged a great deal of future production at higher prices, so they’re not 100 percent exposed to a lower spot oil price. But again, we won’t know exactly how much until they report third-quarter results.

David: True, but at least based on the most current numbers, this doesn’t seem like a big deal to me either. And if the company can get the cash flow to sustain the dividend–as it again affirmed it would just a few days ago–I think the stock could take off. We may not get back to CAD21, but close enough to make it extremely interesting.

Roger: What I’m seeing here is a bar of expectations that’s very low and not much is going to disappoint. Even if what they report is less than optimal, it might be treated as bullish, and that means the stock price is going to go up.

I think you’re right that production is really the linchpin here. Second-quarter production was 35,300 barrels of oil equivalent per day (boe/d). That was 84 percent oil and liquids, 16 percent gas, which again is good for pricing. In fact, given where gas has been, cash flow is substantially more oil-weighted than production is.

David: Overall operating netback for the second quarter was CAD56.63. That’s selling prices less expenses. At the company’s flagship operation in the Bakken light-oil trend came in at CAD61.64 for the first half of the year, at an average WTI price of USD92.53. In 2010 that figure was CAD52.95 per barrel of oil equivalent (boe) at a WTI price of USD79.53 per barrel.

Roger: That would seem to indicate it’s paying more per barrel to produce more, kind of the opposite of economies of scale. But I guess as buyers we’re going to have to take management’s word that operating costs were higher than normal due to weather that reduced production volumes.

I do see that they only hedge about 25 percent of production, which would seem to make that netback more vulnerable to a drop in oil prices than say we would expect with a high-quality producer like Enerplus Corp (TSX: ERF, NYSE: ERF).

David: Yes, but Enerplus’ plans are to boost production 10 to 15 percent over the next two years. PetroBakken is much more ambitious. Average production at the end of September was greater than 43,000 boe/d, putting the company on course to get to its full-year 2011 target exit production range of 46,000 to 49,000 boe/d. Because most of its production is from wells drilled in the past 24 months, the base decline rate is estimated to be 40 percent for 2011.

Roger: Ambition doesn’t matter squat if you can’t deliver. And I think it’s clear Enerplus is a better Bakken production bet for conservative investors. So, too, is Crescent Point Energy Corp (TSX: CPG, OTC: CSCTF), for that matter.

But I agree that if they can execute their capital spending plans, they’re going to be in a lot better shape. And they have weighed most completion activity to the second half of the year, or right now, particularly light oil in the Cardium trend.

I think it probably comes down to how many of 75 wells slated to be brought on in the fourth quarter of 2011 meet management’s expectations. Anything approximating what they’re saying could bring some real blow-out numbers.

David: And if they fall well short, we’re going to get blown out of this trade, as will be anyone that follows us in.

Roger: That’s what this service is all about, delivering these kinds of trades that are well out on the risk spectrum. We play to win and I think we’ve got a winner here with PetroBakken. I also like the fact that we won’t have to wait long to see if things are going our way. That should be clear enough when third quarter earnings come out and we see management guidance for the all-important fourth quarter, which by the way now a quarter over.

David: All right let’s do it. Shall we say buy PetroBakken Energy up to CAD9.60 on the TSX and USD9.40 on the US over-the-counter (OTC) market?

• September 16, 2010: Avenex Energy Corp (TSX: AVF, OTC: AVNDF)–Buy < USD6
• October 22, 2010: Otelco (NYSE: OTT)–Buy < USD20
• December 16, 2010: Capital Product Partners LP (NSDQ: CPLP)–Buy < USD9
• March 17, 2011: Chorus Aviation Inc (TSX: CHR/A, OTC: CHRVF)–Buy < USD5.50
• April 21, 2011: Superior Plus Corp (TSX: SPB, OTC: SUUIF)–Buy < USD11.60
• May 19, 2011: The DATA Group Income Fund (TSX: DGI-U, OTC: DGPIF)–Buy < USD6
• June 16, 2011: FP Newspapers Inc (TSX: FP, OTC: FPNUF)–Buy < USD5.60
• July 22, 2011: France Telecom (France: FTE, NYSE: FTE)–Buy < EUR16, USD23
• August 31, 2011: Zargon Oil & Gas Ltd (TSX: ZAR, OTC: ZARFF)–Buy < CAD17.50, USD18
• September 15, 2011: Alaska Communications (NSDQ: ALSK)–Buy < USD8
• October 21, 2011: PetroBakken Energy (TSX: PBN, OTC: PBKEF)–Buy < CAD9.60, USD9.40

• August 19, 2010: New Flyer Industries (TSX: NFI-U, OTC: NFYIF)–SELL (06/16/11)
• November 18, 2010: Telstra Corp Ltd (Australia: TLS, OTC: TLSYY)–SELL (06/16/11)
• January 20, 2011: Cellcom Israel Ltd (Israel: CEL, NYSE: CEL)–SELL (08/18/11)
• February 22, 2011: DUET Group (Australia: DUE, OTC: DUETF)–SELL (08/18/11)