The Globe and Mail

  The bridge over the Little Bow


Friday, August 2, 2013

Contra the Heard is an investment letter for the independent investor. That means we share the ins and outs of our investment decisions with our subscribers and they apply it to their own portfolios as they see fit. One advantage of this business model is that many subscribers are sophisticated, so the ideas flow in both directions. We appreciate that very much.

One reader asked for an opinion on Zargon Oil and Gas (ZAR-T) and offered to introduce us to CEO Craig Hansen. As it turns out, ZAR has been on the Contra VP watch list for a few years. Besides sharing a name with a wickedly cool Cyclops from 1980s era Dungeons and Dragons, the Calgary-based oil and gas junior made it to the list in the wake of the income trust bust. The stock has a nasty looking chart dropping from a high of $34.75 during the income trust madness and being almost quartered since 2011, but the carnage has decelerated lately and the current price of $6.30 is a short distance from its 100-day moving average. This is a signal that the prospect deserves a closer look.

We had grave doubts about the suitability of the small petroleum producers for the trust model right from the beginning. Sure, they generate lots of cash flow to fund distributions, but the problem is that money is needed to develop new properties to offset decline rates from established wells. For many years, Zargon eluded this thorny issue, far better than most, with astute management and efficient growth. However, it too eventually hit the sustainability wall when the natural gas part of the business couldn't come close to covering its share of payouts to shareholders.

Facing the possibility of the company falling into a death spiral, Hansen adopted an ambitious plan to move from a conventional approach to a tertiary recovery business. There are really only two ways to get more oil out of the ground, either find it through exploration or squeeze more out of a known reservoir. Various techniques to coax petroleum out of stubborn rock have been used for decades. Hydraulic fracturing, or fracking, is the best known due to its pervasive use in the shale boom. Less familiar is ASP flooding, a methodology that combines three injection types, alkaline, surfactant and polymer.

Zargon is in the midst of building an ASP recovery system at its Little Bow property in southern Alberta. The idea is to flush the reservoir with ASP for a couple of years, then switch to polymer only, and finally just water. The main advantage is a significant boost to the portion of oil that can be recovered and a slow decline rate, making for an asset with a long, productive life. The main downside is the high upfront capital cost and the chemical mixture is expensive, working out to about $10-$15 per barrel of oil extracted. In the long term, once chemicals are no longer needed, margins should improve. So far Zargon has spent about $20 million on the project.

From 2006 through 2010, Zargon paid a distribution that worked out to $2.16 per year. That was slashed to $1.20 and more recently to $0.72, but even that rate looks overly generous and is boxing Hansen into a corner. It is critical to bridge the funding gap to advance the ASP venture to the point where it becomes cash flow positive. Another $25 million is expected to be taken from the credit line, and a similar amount is anticipated from sales of conventional assets. That should be sufficient to complete the first phase of the project.

Investors smell risk, and for good reason. ASP is a relatively new technology that has been used only eight times in Canada. Earlier implementations had problems with a precipitate clogging the wellbore tubulars and pipelines when the alkalinity of the produced fluids reached a threshold level. This can be mitigated with inhibitors, but that adds to the cost of chemicals. Also critical is an accurate understanding of the Little Bow field. Reservoir flow dynamics is a demanding science and there's probably a bit of art thrown in, too. Though the potential is clear, these uncertainties make it very difficult to assign a value to an incomplete project.

One thing we like to see in the stocks we own is insiders with the confidence to buy shares in the open market. Hansen has been exemplary in this regard, buying $3.8 million worth of shares over the past 12 months. Evidently he is betting heavily on the efficacy of his plan.

Our main sticking point is the insistence by large shareholders to be paid handsomely while they wait for Little Bow to become a producer. We love our dividends too, but we expect them to be paid out of profit. Starving a company of capital, or worse, using the bank to fund the dividend makes no sense to us. If the payout could be suspended for 18 months or so, it would slap an extra girder on that bridge over the funding gap. As that option is currently off the table, we will continue to sit on the sidelines and keep an eye on progress at Little Bow.