Xavier Grunauer: Small oil and gas companies are rising stars in Latin America

Xavier Grunauer: We realized that over the last five years, global investors have mostly associated the Latin American oil and gas space with Colombia and Brazil. They think of Petrobras (PBR:NYSE; PETR3:BOVESPA) and gigantic oil fields that have attracted global oil companies to Brazil’s offshore basins.

When we took a fresh look at investment opportunities in the region, we found smaller, independent oil and gas companies that have outperformed Petrobras, Ecopetrol S.A. (EC:NYSE; ECP:TSX) and OGX Petróleo e Gás Participações S.A. (OGXP3:BZ). Most of these smaller companies are traded on Toronto, New York and U.K. exchanges, and are bringing North American oil and gas experience and technology not only to Colombia, but also to Argentina, Peru, Brazil and Chile. This technology transfer has been successfully implemented in Colombia, and we think that success could be repeated in Argentina, Chile, Peru, Trinidad, Paraguay and onshore Brazil.

Our investment report outlines 18 independent oil and gas companies that operate in Latin America and are listed in New York, Toronto and the U.K., and breaks them down by risk level, current operations, opportunities and where we see them going forward.

TER: Does the report focus solely on South America?

XG: Also included in this report is Trinidad, which has a long history of oil and gas production. We find Trinidad has been encouraging smaller companies to come to its mature onshore basins that were previously drilled using older technology. Several independent oil companies are already operating in Trinidad using modern methods to increase production. Recently, Trinidad has announced a move to lower taxes, which is quite encouraging, given that taxation can be a significant hurdle in Trinidad.

TER: How do you compare what’s happening in South America with what has happened in North America? I’m thinking, for example, of the use of hydraulic fracturing (fracking).

XG: We’re all learning as we go, but it is worth noting that the more successful companies in the North American shale boom have been smaller companies with technical knowledge and local know-how, first-movers who picked off the choicest acreage. We expect similar outcomes in Latin America.

TER: Is the political risk worth the reward in Latin America?

XG: I think so. Risk is always part of the equation when it comes to oil and gas production, regardless of where operations are based, and it can come in unexpected forms, such as environmental issues, the shutdown of fracking activities or a proposed key infrastructure asset not getting government approval. But there are also big rewards. The risks we see in Latin America as a whole are not new. Companies will continue to prosper in this part of the world. Those who choose to participate will reap bigger rewards than those that never participated at all.

TER: Argentina nationalized some oil and gas a couple years ago. Should investors be weary of wading back into those waters?

XG: Argentina devalued its currency in 2002 and has been involved in legal battles with investors since then. The point here echoes what I said earlier: Smaller independent oil companies do not attempt to have a monopoly hold on a national asset. Instead, we see independent oil companies operating in Argentina, companies that are keen on technology transfer and the development of conventional and unconventional assets—while realizing fair market value for their oil and gas production. We remain of the opinion that over the next two years, as President Cristina Fernández de Kirchner enters her last term, there will be change in Argentina.

TER: In mid-October, the U.S. was producing 7.9 million barrels of oil per day (7.9 MMbbl/d)—the most since 1989. Record-high crude oil supplies and weak U.S. economic data point toward even lower oil prices. Do oil and gas prices influence your investment thesis for Latin American oil and gas equities?

XG: First off, I would point out that Edison doesn’t publish buy, hold, sell recommendations. We find net asset value (NAV), which we realize making use of discounted cash flow models. We use an $80/bbl oil price, which we think is quite neutral, if not conservative. This removes the overlay of a top-down call on oil, and allows us look at the rocks, drilling programs and the proposed sequence of events, which then leads us to our published NAVs.

TER: You make a distinction between bottom-up and top-down knowledge. Can you tell our readers more about that concept?

XG: Largely over the last 10–15 years, equity investments in Latin America have been top-down driven. By that I mean choosing an investment was largely influenced by local economies and top-down metrics. What investors need to look for now is more bottom-up metrics: Who operates in these basins? What is management’s experience? Who are their partners? What have their results been to date? Where does the experience come from? I am of the opinion that all 18 companies highlighted in our report are worth taking a look at.

TER: Tell us about some of the companies in your report that have compelling stories.

XG: The main story thus far has taken place in Colombia. The Pacific Rubiales Energy Corp. (PRE:TSX; PREC:BVC) merger with Petrominerales Ltd. (PMG:TSX) could be a sign of more consolidation to come. The big story though, and what most people are looking to medium term, is the southern cone, and in particular the unconventional oil and gas potential of Argentina. I would point to three companies in our report: Madalena Energy Inc. (MVN:TSX.V), Americas Petrogas Inc. (BOE:TSX.V) and Crown Point Ventures Ltd. (CWV:TSX.V).

American Petrogas recently hired a large investment bank to look at its operations with an eye toward joint ventures or merger and acquisition. Americas Petrogas’ story has risks, and a lot of potential, should it be able to monetize its below-ground potential.

Madalena Energy is in a similar situation in Argentina, and has an added advantage of producing assets in Alberta. The Alberta assets can help support the company’s day-to-day cash flow and operations while Madalena continues to develop its large asset base in the southern cone.

TER: Crown Point also has some assets in the Neuquén Basin and Tierra del Fuego. Where is the company-maker asset in that mix?

XG: Crown Point’s production is currently focused on low-risk conventional oil and gas in Tierra del Fuego. The company is looking to increase netbacks and drill more conventional wells in 2014, and in the process will get a “free look” at the unconventional potential.

TER: Do you have other stories you’d like to discuss?

XG: Edison covers President Energy Plc (PPC:LSE), which operates in Paraguay. Some of the same basins that run in Argentina stretch into Paraguay. President Energy has recently signed a contract with Schlumberger Ltd. (SLB:NYSE) to drill exploration wells. The International Monetary Fund is also quite interested in these developments and is helping companies like President grow a sustainable business in Paraguay.

TER: You mentioned the opportunity for investors to position themselves in select equities now, in anticipation of a potential breakout. How far off is that?

XG: It’s always difficult to time these events. You have to be realistic about catalysts.

The North American shale gas boom wasn’t built overnight. In Latin America, especially in Argentina, there are political uncertainties, at least until the outcome of presidential elections are known in 2015. But if you wait until 2015 to invest, it will be a little late.

TER: Can you leave us with one more thought about investing in the explorer and producer space in Latin America?

XG: Independent oil companies are expected to continue playing a larger role in Latin America’s next wave of oil and gas production. The days of bringing financing to the table as your main contribution are behind us in Latin America. Increasingly, we will see national oil companies reaching out to smaller companies for joint ventures, technical expertise and know-how. Knowing more about these independent oil companies is a must, and could prove quite profitable for investors.

TER: Xavier, thank you for your time and insights.

Xavier Grunauer has more than 15 years of experience as an oil and gas analyst. He has spent the last six years working for Nomura, and prior to this worked for Dresdner Kleinwort Benson and ING Barings. His oil and gas coverage has focused on emerging markets and has included companies operating in Latin America, Eastern Europe, South Africa, China and Australia. Grunauer is a chartered financial analyst and has an engineering degree from the University of Toronto.

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