Drilling for information in energy sector

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Stephen Carter comes from a family of oil and gas drillers and explorers. His father, grandfather and great grandfather were all in the exploration business. He grew up in Dallas, where all his friends and neighbours were in the business. If it rains over there, it rains oil. So when he called me up in the middle of last year to tell me he was leaving his hedge fund, AndrewCarter, and starting a new hedge fund, Keyrock Energy, with hedge fund manager Hohman Finney, I wasn’t surprised. But I was a little annoyed.

“Stephen, I invested in AndrewCarter. You guys have made good money for me over the past two and a half years,” I told him. “What are you doing? This is a big risk also. There are 8,000 hedge funds out there. How are you going to compete?”

“I love this business,” he said. “I love the energy stocks. In the PIPE fund we were running we were looking at all sorts of microcaps but none of the large caps where there’s good value. In the energy business you can find opportunity all over right now. And you can come over and invest if you want.”

So I watched his initial efforts closely. He was up 24 per cent in the first few months in business. Not so bad. So I called him again.

Well, I said, tell me some of the stocks you like. Tell me what your edge is. It’ll be just between you and me. I promise. Scout’s honour.

He told me some of his plays:

“Parallel Petroleum is a great play,” he said. “They are an independent oil and gas exploration and production company located in Midland, Texas. Parallel has added natural gas resource plays to complement their oil project in the Permian Basin in West Texas. Parallel has shown the ability to acquire and execute production growth of 160 per cent and reserve growth at a 67 per cent compound annual growth rate. With the acquisition of acreage in the Barnett Shale and New Mexico Wolfcamp project they have given themselves a great reserve base and great upside potential with a successful drilling program. In their third quarter 2006 results, they gave operational data from their Wolfcamp project stating that two of the three operational areas seem to be outperforming what was anticipated of them initially.”

What’s your price target?, I asked. Again, just between you and me.

“Forty.”

Great. Tell me another.

“Petrosearch Energy Corporation is an independent exploration and production company focused on domestic resource plays in oil and gas, three main areas of focus being the Barnett Shale, Texas Panhandle and Wilcox Trend. The Barnett Shale Project is located in the Fort Worth basin of Texas and is arguably one of the most exciting plays to emerge in the lower 48 in the past decade. The project comprises a 2m-acre, eight-county contract area. Through a wholly owned subsidiary, Petrosearch owns a 5.54 per cent interest in a partnership along with ExxonMobil, who will direct the project, and other oil and gas companies. The partnership owns the leases, the wells and pipeline infrastructure. Price target five.”

Do you have any not in the energy space?

“Layne Christensen is an industrial goods company that supplies drilling and construction services and focuses on the water services and mineral exploration businesses. The water resources business focuses on a variety of things that include, portable water treatment facilities, well construction, pump selection, and pipeline construction. As the world finds itself short of clean water, Layne Christensen should be well-positioned to take advantage of this growing need. In the coming years there should be an ever growing need for water pipelines as well as water treatment facilities. This has been evidenced by Layne Christensen’s ability to grow revenues. In 2006 it reported revenues of $463m, which was far above its 2005 revenues of $343m. In 2007, it could do almost $700m in revenues, which should correlate to almost $1.50 a share in earnings. Layne Christensen operates in North and South America as well as Africa, which gives it the opportunity to capitalise on the need for clean water.”

One more?

“You should look at Contango Oil & Gas Company,” he said. “It just announced completion of a $30m secured term note. Contango updated production at its Dutch prospect off the Louisiana Coast. The Eugene Island well is flowing at approximately 20m cubic feet per day. The company’s third party engineer estimates the well to have 25bn cubic feet equivalent at the project. Also has interesting acreage in the Fayetteville Shale in Arkansas. Price target of 30.”

I asked him what their edge was in the energy space.

“Listen, James, in Dallas you walk down the street and you practically trip over energy deals. Hohman and I have an extensive network of people in the energy industry here including company management, analysts, petroleum engineers, land men, and other energy investors with specific expertise. Second would be our trading experience, which helps us mitigate risk. We reduce the risk of our long exposure by selling out of the money calls on energy ETFs such as OIH and XLE as well as owning puts on the same ETFs. We also sell short the same ETFs and go long puts on the underlying equities when we feel there is going to be near-term selling pressure or weakness.”

That’s great, Stephen, I told him. Good luck.

james@formulacapital.com

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