Free NPV

Petrobank (PBG) announced this week that they will be spinning out their ownership in Petrobakken to their shareholders in a tax free move on December 31st. Each share of PBG currently entitles you to 1.1 shares of Petrobakken and the THAI assets that are currently producing in small quantities. PBG rallied on the news, but only to a value of 1.1 times Petrobakken. The shares are still pricing in $0.00 value for the stubco on the spinout.

The stubco will begin trading with $100 million in cash, no debt, and some assets producing oil using THAI. With roughly 100 mm shares on PBG outstanding, and the market giving no value to THAI, it should still trade at $1 on Jan 1st. So there is still time to put the trade on and make a small risk free gain over the next 2 months.

PBG held a conference call to discuss the spinout and at the same time updated the progress at their Kerrobert THAI oilfield. Current production was extremely disappointing, coming in around 300boe/d over the last few weeks, after peaking at 400 in early august. However, in the Q&A session of the call, they said they expect it to reach 1000boe/d in well under 6 months. The wells have never shown the ability to produce near those levels after 1 year, but management has always claimed that they were taking it extremely slow. If they can gte to those rates by February, the stubco will have to reflect that production into its price. A rough calculation is to value flowing barrels with decent reserves around $80,000 per barrel. This would be another .80 for the stubco, giving it a value of about $2. So im still recommending the trade, even after the first $2 part of the move was closed this week.

Petrobakken (PBN), the company that each shae of Petrobank enetiles you to 1.03 shares of, reported numbers this week. Im following petrobakken more closely now because I took off my hedge some time in September, due to PBN becoming ridiculously cheap. Market rumors about a dividend cut and an analyst report that highlighted the risk of a large cash payment coming due in February 2013 drove the price down to a low of $6.

I doubt petrobakken will cut the dividend unless they absolutely have no other choice, because this is where petrobank gets all their funding from, and management still believes in petrobank. PBN would rather cut some grow capex or sell off some undeveloped assets instead. However, they would obviously prefer to grow their way out of this problem.

This seems to be the case. While production numbers for Q3 were crappy, again due to a late spring breakup and flooding in Saskatchewan, the early look at Q4 seems to be amazing. They managed to get october production to average above 46k BOE/D and indicated early November is already above 47.5k BOE/D. Thus they increased their exit guidance to over 49k BOE/D, which was their previous high end of the range. This means they their wells are producing at high rates, their drilling program is progressing well, and there are no more screwups occurring. Further, their netback in Q3 was quite high, meaning from an Opex side, they are executing well.

If petrobakken can exit at 49K +, and continues to perform moderately well in 2012, there is virtually no chance of a dividend cut or an asset sale. It would be a $20 stock again, which is double from where it is now.

I might reinstate my long petrobank short petrobakken hedge if the spread gets any more negative but for now im happy to have the positive exposure to petrobakken. Management has a proven track record and is now finally starting to show it. If the street regains confidence in this name again it will be a very profitable story indeed.

Heres a link to the quick 7 page earnings report. It contains some oil industry terms but I suggest you read it and google what you don’t understand. http://www.petrobakken.com/wp-content/uploads/2011/11/PBN-2011-11-08-PressRelease.pdf

Petrobank (PBG) filed its yearend report this week, as did its 59% owned holding Petrobakken. Both shares were down sharply on the week, primarily as a result of the poor Petrobakken earnings. The investment suggested here back on December 31st was to isolate the cheap PBG stand alone unit by going long PBG stock and shorting the correct amount of Petrobakken. If this approachwas followed, the decline in PBG’s shareprice this week should have been offset by the Petrobakken short.

Petrobank reported mixed results for its standalone HBU unit, the one we are interested in. Some of their wells did not show the improvement that was hoped for in their daily production rates. As well, the construction of some new wells was delayed due to bad weather. However these wells should open sometime in Q2 and begin producing shortly thereafter.

The good news is that for their operating wells, McDaniels consultants were able to recognize reserves based on THAI technology. They assigned a 10% premium to these reserves due to the THAI process. PBG believes this premium will increase over time as the THAI process becomes move proven.This is an important first step in getting THAI recognized as a superior extraction technology and hopefully will lead to licensing agreements down the road.

So while PBG as a standalone unit is coming along, the valuation remains quite low. As of now, the HBU unit is being valued at roughly $1.29 a share or 20 cents per barrel of reserves. This is far below the historical transaction price of .50- 1.00 for similar quality barrels and does not reflect the upside of the THAI technology. A catalyst for the market to see the true value of the isolated unit might be when these new wells begin production later this year and when THAI reserves are afforded more of a premium to the other reserves being extracted under the conventional method. A risk to PBG might be the continued underperformance of Petrobakken. While you should be hedged out from changes in Petrobakken stock price changes, PBG depends on the dividend to fund their capex needs. The current amounts should still be ample for PBG to accomplish their goals, however.

Here is an interesting play that my friend Greg tipped me off to about a month ago. It involves a complicated ownership structure which has resulted in a really cheap valuation on an oil company.

Petrobank (PBG.to) is a Canadian oil sands company that trades on the TSX. It is a large company, however the vast majority of its value is from its majority ownership of Petrobakken (PBN.to). This week it also distributed its shares of Petrominerales to shareholders. This transaction resulted in some strange price action which made Petrobank quite cheap.

PBG as a standalone company (or HBU unit) owns the rights to a few oil sands projects and the rights to a new extraction method they invented called THAI (Toe Heel Air Injection). They have proven reserves of 670 million barrels along with some properties that have yet to get a reliable estimate. As well, the THAI technology can increase yields from 60% using the older SAGD technology to 70% – 80%. If this technology works and is successful, PBG can lease it out to other oil sands companies. Here is a link to the Wikipedia page the discusses the oil sands and the THAI extraction process.

According to some sellside research, past transactions (mostly in the last year) have valued oil sands oil, under the assumption that it will be extracted using the old SAGD technology, between .50 and 1$ per barrel. The median price was .63$ per barrel. This would give PBG’s reserves a value of 422$ million. If THAI works as well as PBG believes then you need to apply a 25% premium to the amount of known reserves which increases the valuation to $527 million.

Here is where it gets interesting. A share of Petrobank entitles you to 100% of the Petrobank HBU unit and their properties and 1.04 shares of Petrobakken. Based on the closing prices today, you can buy Petrobank and short Petrobakken in the correct ratio to isolate the Petrobank properties at 2.07$ a share for a total market cap of 220 million. This is substantially below the worst case scenario (670 million barrels priced at the low end of the range still equates to a valuation of $335 million).

A downside risk would be if the price of oil drops substantially, since oil sands oil is much more expensive to extract. According to Wikipedia and a Canadian government institution, it costs between $36-40 to extract a barrel of oil sands oil when taking all the refining costs into account. With oil currently trading around $90 a barrel, the risk of a price drop that far seems minimal

This company seems extremely cheap based on the comparables and can have a lot of positive surprises. If PBG’s other properties start producing, or THAI works as well as PBG management believes it will, the standalone HBU unit could trade up to $500-600 million. This investment has a lot of potential upside with very limited downside risk.

For an explanation of the spinoff and remaining ownership of Petrobakken from PBG management, click here