Madalena Energy Drills Where It Chills

Madalena Energy (Canadian ticker MDN.V, US ticker MDLNF) caught my eye back in 2014. They're based in Canada and they drill for oil and gas there too, but they also drill in Argentina. I have long been skeptical of the chances for junior exploration companies who locate their offices in North America but chase properties in developing countries. Raising capital in the easiest markets isn't the same as successfully drilling in difficult markets.

I always check the company's management team first. The current CEO was educated as a petroleum engineer but spent a lot of time in consulting and investment banking. I usually like it when company leaders have degrees in their sector but successful field work has to flesh that out. Companies in the business of finding and pumping oil must have leaders who have successfully done that for their entire careers. I am similarly unimpressed with other senior team members who had undefined positions with other companies, some of which no longer exist. I can't judge their abilities if I don't know what they did or why their former employer isn't around anymore.

The company's four Canadian properties must get pretty darn cold in the winter. Three of them are producing. The Argentina properties are a slightly different story. Some of the properties appear to be in production but it's hard to tell from the website's descriptions. I did not find any NI 51-101 reports anywhere on the Madalena Energy website, so it is impossible for me to verify each property's potential.

Geopolitical risk is always worth noting. Canada ranks 10th on Transparency International's Corruption Perceptions Index and 6th on the Heritage Foundation's Index of Economic Freedom. Meanwhile, Argentina ranks 107th for corruption and 169th for economic freedom. That is a huge delta in risk for investors from other countries. Argentina may start moving in the right direction after its recent political changes. International investors will be watching for progress.

I downloaded Madalena's quarterly financial statements and MD+A dated September 30, 2015. There's no pretty picture here. The accumulated deficit in shareholder's equity (or what we Americans typically call negative retained earnings) is now at -CAD$115M. Inexperienced investors need to recognize this type of negative figure as the amount of invested capital earlier investors have put into a company that has not yet earned it back. The company has $11M in cash on hand and swung to a $14M profit after losing money in much of 2014, so they are above what would otherwise be a burn rate for now.

The weakness of Canadian and Argentinian currencies against the US dollar probably helps this company's bottom line. Argentina recently relaxed its currency controls, devaluing the Argentinian peso against the US dollar. Note 2 in the company's quarterly financial statement says their Argentinian invoices have been in US dollars and their planned capex for Argentina is weighted to US dollar denominated expenditures. Argentina's currency devaluation means financing in US dollars and spending against a falling Argentinian peso will make Madalena's capex in the country less expensive. This is good news given the company's negative free cash flow for most of 2015.

Madalena deserves kudos for actually producing oil and gas, something many junior resource companies never do. The company's fortunes in Argentina may improve if the new government there takes reform seriously. One big problem facing the entire oil and gas sector is the continuing weakness in world oil prices. Bearish oil markets will challenge Madalena's ability to sustain the success it experienced in late 2015.

Full disclosure: No position in Madalena Energy at this time.

The Haiku of Finance for 03/11/14

Mature pumping well
Not some older gal dancing
Rework oil and gas

The Limerick of Finance for 11/03/13

Fracking boom may not last very long
Must drill more if production's not strong
Those decline curves are steep
Drilling wells is not cheap
Selling smiles to investors is wrong

Dubai Won't Work

Dubai is building an airport that will be as big as a city.  The first passengers have started arriving.  I hope they take lots of pictures of the endless glass and steel towers in the middle of nowhere.  Those things will be derelict hulks and piles of recycling material within one generation.  There is no way Dubai's civic boom can be sustained.

Dubai is a city-state built on sand.  Anything built with sand or on sand will crumble but the rich Arabs building wild projects in Duabi never figured that out.  Developers built island resorts in Dubai that are crumbling into the sea due to natural erosion.  There aren't enough clueless rich people in the world to pay for perpetual sand maintenance on artificial islands.  

Dubai built its skyscrapers with imported slave labor.  The workers live in squalor and make next to nothing.  No one told these workers that they would be working for starvation wages under dangerous conditions.  When some of them finally got sick of their dire straits, they went on strike and now face mass deportation.  Dubai's major construction contractors are eventually going to make the country subject to a host of WTO sanctions that will make the country economically uncompetitive.

Dubai has no real competitive advantage, and its artificial advantages like low labor costs are temporary.  Dubai's historical role as a crossroads for Persian trade means little in modern times.  Geographically isolated city-states need to be about something to have longevity.  Singapore and Hong Kong are about seaborne trade and their natural deep harbors are excellent gateways to mainland Asian markets.  Dubai has no such natural advantage.  Even comparing it to Las Vegas is meaningless.  Las Vegas has an indefinite supply of fresh water and energy thanks to Hoover Dam, assuming the US government can manage demand from the dam's other customers.  Dubai has no such resource.  Hydrocarbon energy is a small and declining share of Dubai's GDP.  The city's physical size, population, and economy will contract to match its energy resources.

Dubai is a physical and financial impossibility.  The world's traveling classes will eventually tire of subsiding this high-cost, high-entropy boondoggle with their vacation dollars.  The world has plenty of financial hubs and tourist traps that aren't slipping into the sea.  

Alfidi Capital Attends IPAA OGIS San Francisco 2013

I'm not a member of the Independent Petroleum Association of America but their events have great value for me as a market analyst and commentator.  I attender their annual Oil and Gas Investment Symposium (OGIS) San Francisco last week.  I'll address each of the presenting companies in future blog articles.  This particular article is about concepts that apply to the entire energy sector.  The OGIS participants use these ideas frequently.  Understanding these ideas enables understanding of a company's value.

First of all, IPAA has some phenomenal statistics available for free.  I had previously relied on the Energy Information Administration's data but the IPAA data sets are excellent companion pieces.  IPAA also advocates maintaining tax breaks for oil and gas exploration on its Energy Tax Facts site.  I'd prefer to eliminate any and all tax breaks for energy exploration because the market needs to price the all-in cost of energy production.  I would also eliminate breaks for renewable energy because its costs have pretty much reached grid parity.  Eliminating both severance taxes and depletion allowances would make the non-renewable energy sector's project economics more transparent.

Let's talk about hedging for a moment.  Lots of hydrocarbon producers like to hedge the price of oil with futures contracts.  Exploration and production (E&P) companies in the upstream sector hedge against declines in the price of West Texas Intermediate (WTI) crude because a price drop will hurt their revenue.  I can see how operators who have committed free cash flow to a capex program would not want to see their drilling interrupted by commodity price swings.  Hedging makes a bit less sense for operators who have committed to a perpetually rising common stock dividend.  That kind of corporate policy can hamstring management and set investors up for disappointment if the hedging strategy cannot sufficiently protect earnings.  Most E&Ps hedge most of their projected production.  Swaps seem to be the most popular instrument but some companies use costless collars.  That's my anecdotal impression, anyway.

Energy REITs and MLPs also hedge prices (again, to support their expected dividend) and some of them even hedge interest rates because they borrow to acquire new producing properties.  They hedge prices to make their payouts more predictable.  Investors have to live with that predilection, but it makes less sense to me than producers who hedge prices.  Do E&Ps hedge interest rates as well as prices?  They certainly borrow for capex.

I'm agnostic on whether North American oil producers should hedge their production against WTI prices or Brent prices.  It may depend on where the companies market their crude.  Crude shipments to the Americas are often priced in WTI quotes while production in Asia and the Middle East is priced in Brent.  The Brent-WTI spread matters to investment banks, hedge funds, and energy traders whose arbitrageurs play the price differential.  Bloomberg has a decent rundown of common energy prices; arbitrage away, hedgies.  The CME Group has the most transparent energy derivative prices I could find, including contracts for both WTI and Brent.  Futures and other derivatives have enormous risks and I've never used them in my own portfolio.  I would rather leave them to energy supermajors who have complex value chains to hedge.

MLPs have it easier than E&Ps.  Older wells with long, slow decline curves fit MLPs very well because they need little additional capex other than basic maintenance.  That's why MLPs use debt to acquire existing wells rather than putting in capex.  I agree with the common MLP claim that low barrel per day (bpd) producing wells are ideal for their structures.  I've heard some MLPs describe their avoidance of incentive distribution rights (IDRs) as a selling point to the investing public.  I really think MLPs will have a field day buying low-producing shale wells at cheap prices once the Bakken boom fades away.

Some E&P companies tout their natural gas liquids (NGL) production.  Investors need to remember that NGLs are more difficult to hedge because they require longer futures contracts (about 12-18 months).  A web search for "NGL derivatives" did not reveal any central exchange for them that I could find, but some energy trading firms specialize in constructing private swaps for NGLs.  The lack of liquidity for these financial derivatives means NGL swap prices can easily affect real-world NGL prices.

Energy MLPs do have to worry about Unrelated Business Income Tax (UBTI) and they report this on the K-1 form they send to their investors.  I had previously thought that holding a high-yielding MLP in a tax-advantaged retirement account would be a smart move until I realized that UBTI may trigger a tax liability.  Index funds and ETFs that invest in MLPs do not have this UBTI drawback for an IRA.  An MLP that produces zero or negative UBTI poses no apparent problem for an IRA.  It pays to know the rules in IRS Pub 598 and it pays to read an MLP's documents.  I am not a tax advisor, so don't ask me what to do.

If you're sick of hearing about fracking and horizontal drilling, there's a new drilling technique called "down spacing" coming along.  Drillers down space by decreasing the space between wells in an area, which is slightly different from the "pad drilling" concept that erects more than one well on a given land plot.  These two approaches fly in the face of one of shale gas's selling points, namely that one drill rig per pad enables the minimum possible surface disturbance.  Increasing the rig count on a project also accelerates a field's decline rate.  Shale producers need to think hard about how much they can spend on additional engineering to expand recoverable deposits before they go hog wild into down spacing and pad drilling.  We're all going to hear a lot more about enhanced oil recovery (EOR) techniques and ways to minimize sub-surface non-productive time (NPT) as more shale plays hit their very steep decline curves.

I don't worry about whether producers have drill-to-earn, produce-to-earn, or shoot-to-earn clauses in their farm-out agreements.  Either they produce or they don't.  I'm interested in bottom-line results.  I don't worry about land value capture because the financing of infrastructure servicing oil/gas fields is less important than whether said fields are economically recoverable.  Held by production clauses are good to have if the producer doesn't know how long it will take to bring a greenfield project to maturity.

I'm agnostic as to whether a producer owns a working interest or the entire property; their job is to spend capex on production and someone has to pay the costs of owning wells.  I do care about MLPs that focus on royalty interests (especially overriding ones) because that limits their lifetime capex commitment.

Geologists analyze a project's porosity, resistivity, lithology, total organic carbon (TOC), permeability, and isopach subsurface data.  I don't look at those things because I'm not a geologist.  I'm a finance guy and I need to see financial data.  All of the eyewash on soil engineering that energy companies put into their investor relations pitches means nothing if they don't have a budget to turn exploration into production.  Geological characteristics will determine the amount of stock tank original oil in place (STOOIP) and its estimated ultimate recovery (EUR).

The EUR of a project deserves a special.discussion.  EUR is a mix of oil, gas, and NGLs that is always measured in BOE.  Proven reserves includes several engineering terms that do not necessarily comport with financial terms allowed by US securities regulators.  Progressing from 1P (proven) to 2P (probable) to 3P (possible) reserves may impress some investors but it does not impress regulators.  The SEC has very definite rules for what can and cannot be included in reserves reported in financial statements.  This is why producers break down their 1P reserves into proved developed producing (PDP), proved developed non-producing (PDNP), and proved undeveloped (PUD).  Using estimates of proven reserves only is the most conservative way to calculate a project's valuation.  That's why I read the 43-101 reports of junior resource companies that are registered in Canada.  The 43-101 regime allows for "proven and probable" (2P) reserves that I can use to find a valuation.

It's good to know the Baker Hughes US rig count to track the energy sector's health.  Producers need to know the day rates of rigs in their region.  Analysts track the recycle ratio of an energy company, which the companies themselves often quote as the netback.  I have not yet used a recycle ratio in my analysis of energy companies but I will try to apply it in the future.  It may even apply to renewable energy companies if it can be measured in kilowatt hours.

I shake my head at shale oil producers who allow their natural gas production to flare off instead of trying to capture it.  That is literally money going up in smoke.  Producers who care about maximizing ROI on their projects should be willing to spend the capex needed to install temporary pipelines and storage systems that will enable them to capture gas that would otherwise flare off.  Orphan gas gets plenty of attention in the midstream sector.  Too many shale producers have their eye on the steeply declining production curve and want to get a cash return as quickly as possible.  They need to to think more about how capturing extra gas production from a shale play will increase a project's long-term value when it's ready to be sold to an MLP.  Don't ask me to figure the difference between wet gas and dry gas; that's a problem for petroleum engineers.

The great thing about reading my blog is that all of the knowledge I gain at conferences and investment seminars is here for free.  You people should be entertained by my discussions.  I'll take my bow, thank you very much.  The next set of IPAA events will give me more opportunities to show off my knowledge.  

The Haiku of Finance for 10/03/13

Continue shutdown
No oil/gas drilling permits
End energy boom

The Haiku of Finance for 07/19/13

Frack gas and clean coal
Bring on future energy
Plenty in the ground

The Haiku of Finance for 02/21/13

Oil and gas pitch man
Ought to be an engineer
Make it credible

The Haiku of Finance for 10/16/12

Drill for oil and gas
Wildcatters crowdfunding wells
More penny stock fraud

The Haiku of Finance for 08/08/12

Giant Chevron fire
Gas prices going up soon
Let's see if stock tanks

Legend Oil And Gas (LOGL) Has Legendary Losses

I got a teaser mailer from some outfit called the McShane Letter, attesting to the stock-picking prowess of one Don McShane with help from some unattributed factoids.  The object of this pumping missive is Legend Oil and Gas (LOGL), a Seattle-based explorer that used to be known as SIN Holdings.  The disclaimer inside the mailer says Legend paid $850,000 for this promotional material, $24,000 of which went directly to Don McShane.  None of that matters to me.

What does matter is the company's performance.  Legend hasn't just managed to lose money every year since 2009.  Their net losses have actually multiplied.  I haven't seen anything like that after reviewing and trashing multiple penny stock pumper mailings.

Normally I'd stop right there, but sometimes I just don't know when to quit.  I have to fill this article with something.  Their management team has just one geologist but he appears to be running things.  I suppose a guy with "diamond" and "gold" in his surname is in the right career.  Everybody else at HQ has corporate finance backgrounds but little apparent experience in the mining sector.

Reviewing SEC filings is a must for serious investors.  Check out their amended annual report dated May 10, 2012.  They forgot to check the box indicating they're not a shell company.  Now that we've got that straight, check out the annual report itself from March 2012.  Legend had a deadline of today to raise an equity offering sufficient to pay off part of their outstanding credit facility.  It looks like the equity commitment they received from Lincoln Park Capital Fund on May 18, 2012 is legally sufficient to meet that obligation.  I also noticed that two separate inside holders filed Statements of Beneficial Changes in Ownership in April 2012 in which they disposed of some of their shares.  Folks, company insiders who are confident of a bright future for the firm they help run would be buying shares, not selling them.  Read the Risk Factors section of their 10-K.  The loss of two key executives would materially harm their business, and those are the same two gentlemen who sold shares in April.

I've pulled back the covers far enough on this one.  It's not for me, and neither are the wondrous musings of Mr. McShane in his newsletter.

Full disclosure:  No position in LOGL at this time.  

France Defeats Itself With Stupid Fracking Ban

Frenchies are hilarious.  Their banks bought billions of euros worth of worthless Greek debt and can't admit the massive losses they're about to take.  Meanwhile their government is very concerned about the mostly imaginary environmental hazards of fracking in oil exploration.  France's new ban on hydraulic fracturing ensures that Frenchies' energy needs will be held hostage to instability in Libya and elsewhere indefinitely.  This is just too darn bad.  The Paris Basin's geology resembles that of the U.S.'s oil-rich Bakken Formation and may hold very large amounts of shale oil.  Frenchies are handcuffing themselves by eliminating a very successful exploration method. 

The U.S. isn't that dumb (not yet anyway, although arguably we can give the rest of the world a run for its money in other categories of stupidity).  The Niobrara Formation has plenty of shale oil and natural gas.  Fracking is the only way to get at it.  Explorers are plenty busy in Wyoming to bring this trapped energy to you and me.  If I owned some shale-rich land I'd love to let wildcatters go fracking all over it in search of oil.