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On October 9th Zodiac Exploration, [ZEX.V / ZDEXF] announced a proposed, transformational acquisition of privately-held Muskwa Resources. Muskwa’s assets include 56,640 net acres (including optioned acres) in the light oil window of Alberta, Canada’s highly prospective Duvernay shale formation and 28,960 acres in the Nordegg shale. Amazingly, this property is located just 25-30 miles north of the primary Duvernay activity at Kaybob. Muskwa also contributes 2 conventional, low-risk, low-cost projects in Montana that could be cash flowing as soon as mid-2014.
Zodiac + Muskwa = Extremely Cheap Call Option on Progress in Key North American Shale Plays
After the closing of this all stock deal, Zodiac will still have an ample cash balance and zero debt. The new company, at a price of C$0.06 per share, would have an Enterprise Value, “EV” of just C$10 million, (based on a pro forma market cap of C$26.7 million and cash of $16.7 million on June 30th). To be conservative, let’s assume that cash after the proposed acquisition in November would be C$12.7 million, for an EV of C$14 million. Combined, Zodiac + Muskwa would have ~130k net acres in the Monterey shale in California and the Duvernay / Nordegg shales in Alberta, Canada. Thus, Zodiac is trading at a valuation of just ~$108/acre for its shale (only) assets.
That doesn’t include Muskwa’s 2 low-risk, low-cost, conventional projects in Montana or the Net Present Value, “NPV” of Zodiac’s tax pools. While it’s still early days in the Monterey, option value alone for Zodiac’s largely contiguous block of ~72k net acres should be $250-$500/acre today, and possibly 2x-3x that within 12-18 months.
The Duvernay and Nordegg shales are arguably less technically challenging and perhaps 1-2 years closer to maturity than the Monterey. I believe that within 12-18 months, Zodiac’s Duvernay and Nordegg properties could be worth $1,000-$2,000/acre, compared to peer transactions in Kaybob at valuations of $3,000-$9,000/acre. This winter’s active drilling season in Alberta and a conclusion of the strategic review of assets in California in the next few months are catalysts to drive Zodiac shares meaningfully higher. Importantly, third quarter earnings calls in coming weeks from a host of oil shale players could offer market moving news.
I continue to believe that Zodiac shares could reach C$0.20-C$0.30 next year. For example, if all 130k net shale acres (not including Montana) are sold for $1,000/acre, that $130 million, plus cash on the balance sheet, plus the NPV of tax pools, would equal about C$0.35 per Zodiac share, (assuming Muskwa deal closes as contemplated).
On a conference call on October 16th, Peter Haverson, CEO of Zodiac and Rick Jackson, CEO of Muskwa made a compelling case for the combined company. Also on the call John Newman, Zodiac’s CFO, provided an update on Zodiac’s California assets. Finally, Bob Cross, Chairman of Muskwa and a Director of Zodiac made some very interesting remarks about the Oil & Gas industry and the implications for Zodiac.
Update on Strategic Initiatives in California
Management provided an update of the ongoing process to farm-out, joint venture or otherwise monetize portions of Zodiac’s San Joaquin property. Recall that Zodiac has ~72k net acres in the deep part of the Monterey and Kreyenhagen shales in southern California. Management acknowledged that the process is taking longer than expected due to several multinational players requesting additional information to assess Zodiac’s holdings. Feedback from advisors retained to run the process indicates that interested parties love the technical aspects and are working on economic assessments. With realized prices near $110 per barrel in southern California, the economics should be robust! This key strategic initiative is now expected to come to fruition near the end of the year.
Why is the Muskwa Acquisition a Big Deal?
The proposed acquisition would greatly de-risk the Zodiac story, while maintaining very substantial upside. Like Zodiac’s San Joaquin (Monterey) acreage, Muskwa’s acreage in the Duvernay and Nordegg shales is in a potentially world-class basin. Importantly, Zodiac is prudently diversifying on multiple fronts, not just by jurisdiction. The combined company has diminished technology risk, as the Duvernay assets appear to be less technically challenging and the Montana assets are conventional low-risk, low-cost opportunities. Regulatory, environmental and political risk is diversified away from just California to Alberta and Montana. Time to initial cash flow is expected to be as soon as mid-2014.
This deal puts Zodiac on the maps of a larger universe of partners and suitors. There are many majors and super-majors in Canada that could also be interested in entering the Monterey, and likewise, plenty of U.S. players interested in the Duvernay. For example, Occidental Petroleum is the biggest player in the Monterey, but has no exposure to the Duvernay. Given OXY’s expertise in unconventional shale, it would make a lot of sense for OXY to take a shot in the Duvernay. XTO Energy, a unit of ExxonMobil, and Royal Dutch Shell are very active in both the Monterey and the Duvernay.
Zodiac is issuing 85.7 million shares in a 1-for-1 exchange, representing ~24% equity dilution to existing Zodiac shareholders. Muskwa’s shareholders have agreed to an 18-month escrow whereby 15% or ~12 million shares, will be free to trade upon the closing of the deal and an additional 15% every 3 months through mid-2015. A majority of the newly issued shares will go to 2 high net worth individuals who are also long-term, major shareholders in Zodiac. I strongly believe that these parties are not sellers of Zodiac stock anywhere near 6 cents per share.
Zodiac is effectively acquiring Muskwa’s property for approximately $115/acre. That figure includes property acquired in Montana which I discuss briefly below. I think this is a tremendous deal, especially as recent land deals have been done at valuations ranging from $3,000-$9,000 per acre. To be clear, those peer transactions were for property in the Kaybob area, the current heart of the Duvernay. However, Haverson and Jackson believe that Muskwa’s holdings have similar technical, geological and net pay characteristics to most of the Kaybob development projects.
The 2 Montana assets are not company makers like the California holdings or the Duvernay/Nordegg property. However, they are lower-risk, conventional projects that could begin cash flowing by mid-2014. Management has not given guidance for production from these two projects, but surrounding wells produce from 50 -500 barrels per day. Assuming an exit rate of 200 barrels per day at year end 2014, that suggests perhaps a few hundred thousand of cash flow per month. While not a homerun, it would extend the duration of the call option on the company’s shale plays. This toe-hold in Montana could become a stepping stone to bigger and better things in that area over time.
Why was Zodiac able to pick up Muskwa’s acres so cheap, i.e. why didn’t a major buy Muskwa? In speaking with Rick Jackson and other industry people, I believe the answer has 3 parts. First, majors like Chevron, Exxon & Encana already have decades worth of targets in Kaybob and areas south. Second, since Muskwa was tight on cash, potential suitors figured they could buy it cheaper by waiting them out. Finally, in new shale plays, the early capital chases liquids-rich production as gas moves through tight rock easier than oil does. In other words, capital flows first to lower risk development. As the play gets de-risked, initial players and new entrants look for riskier but potentially bigger payoffs. Rick Jackson believes that industry is quickly approaching the stage where commercial production of liquids-rich gas has been proven viable, kicking off a land rush in the light oil window of the Duvernay and Nordegg.
Conference Call Demonstrated High Conviction and Management Skill
An excellent corporate presentation describing the Muskwa acquisition can be found on Zodiac’s website. Zodiac has a clear and compelling game plan. A corporate strategy centered upon low-cost, high prospective value growth. Management is exploiting a rare opportunity to gain control of potentially world-class assets that are available due to hardships faced by capital-starved companies. Muskwa is the first step in that direction, there may be more to follow.
Rest assured, cash is still king at Zodiac. Further bolt-on acquisitions will only be contemplated if strong balance sheet cash liquidity can be maintained. Therefore, acquisitions will be somewhat dependent on what comes out of the strategic review of the Monterey assets. If another farm-out, like the one with Aera Energy is consummated, land payments of ~$2.5 million over the next 12 months could be largely avoided.
Further Detail on Muskwa Resources– All Roads Lead to Muskwa’s Snipe Lake!
Zodiac is opportunistically and cheaply stepping into Alberta at a great time. According to a recent article in the Calgary Herald, over $6 billion has been invested to date in the Duvernay. According to this informative article,
“Alberta’s early-stage Duvernay resource play has already absorbed $6 billion of investment and promises to be the subject of much more, analysts say, judging by recent activity and promising results. The Duvernay is arguably the most exciting emerging resource play in Canada. The Duvernay was the main driver of the record $3.2 billion spent at Alberta Crown drilling rights auctions in fiscal 2011-12.,” says a research report from TD Securities
Furthermore, from the same Calgary Herald article,
“The Duvernay has been much in the news this summer, with Chevron Canada buying an additional 27,000 hectares (67,500 acres) in the play earlier this month from Alta Energy Luxembourg. No purchase price was released but TD Securities said an affiliate on the selling side implied a price of $8,550/acre, in line with Encana’s metrics of ~$9,000/acre in its Duvernay joint venture with Petro-China signed in December 2012.”
The Duvernay is receiving a tremendous amount of attention. On Encana’s second quarter conference call, management stated, quote,
“On the Duvernay, we continue to be very, very pleased with our well up in Kaybob, where it’s currently producing 900 barrels a day of condensate, free condensate…and that’s a choked back rate… So we’re really, really encouraged with the results. We think we’ve cracked the technical nut with respect to the completions…we have a significant acreage in the Duvernay, currently just over 80,000 net acres. We continue to look to add to that 80,000.”
From Trilogy Energy’s 1st quarter conference call,
“And then we have $75 million targeting the Duvernay play. The strategy there is basically to drill…because it looks like it is a true world-class resource play that we may be exposed to. Well economics are very attractive, drilling, completing, tying in the wells for about $4 million per well. Wells with a range of between 210,000 and 330,000 barrels recoverable, (plus solution gas) or something like 336,000 to 495,000 barrels of oil equivalent.”
Referring to subsequent drill results from Trilogy Energy, Dundee Capital analyst Geoff Ready said,
“Based on these and other public production results, we believe payouts on some wells are under a year, a remarkable feat for a resource play in early stage development. Trilogy has about 80,000 net acres of Duvernay prospective lands in the volatile oil area and about 48,000 net acres in what is believed to be the gas condensate area of the play.”
The Duvernay, Nordegg and Montney in Alberta and BC Needed to Feed New LNG Projects
Another reason for the rapidly growing interest in the Duvernay and surrounding areas could be that LNG projects on the west coast are gaining momentum and will need to be supplied with natural gas. Super-majors are watching developments on the LNG front closely. According to a September 19, 2013 article in the Financial Post,
“It has been a long time since Chevron Corp., the second-largest U.S. oil major, was in growth mode in Canada, but that’s about to change. After missing out on the Oil Sands boom and selling many of its assets in Western Canada about a decade ago, Chevron is stepping back into its historic leadership role to build and run the first large Liquefied Natural Gas, “LNG” facility on the West Coast, while taking on the Duvernay shale gas play in Alberta.”
As infrastructure and logistics are developed to support development activities at Kaybob and an ever growing area around Kaybob, the value of the Muskwa property will become increasingly valuable. Given that several land deals in the past 6-12 months have been done at valuations of $3k-$9k/acre, Zodiac’s acquisition cost of just $115/acre for Muskwa’s acreage is outstanding. By no means do I suggest that Zodiac’s newly acquired acres are worth thousand(s)/acre today, but located just 25-30 miles from the heart of the Duvernay, these acres could easily be worth $1k-$2k within 12-18 months. That’s my opinion only, not necessarily that of management.
Importantly, the next six months could be telling. Winter in Canada is when a great deal of drilling gets done. The coming six months around Kaybob will the busiest ever with up to 100 wells planned to be spudded. The likelihood of further success stories is high. Each and every successful well supports the valuation of the Muskwa holdings. The truly exciting part of Zodiac’s Muskwa land is that 1) it’s only 25-30 miles from the heart of the fairway, 2) it has similar technical, geologic and net pay characteristics to the wells drilled at Kaybob, and 3) most of the property is on a large contiguous block. This suggests extraordinary blue-sky potential over time. Timing is the key, to be measured in months, not days or weeks. Significant new blocks of Crown land are no longer being auctioned, the only way for existing players and new entrants to get exposure is through M&A.
The proposed acquisition of Muskwa Resources is a great deal. The market expected the news to be something entirely different, a big announcement about Zodiac’s California assets. The stock price has fallen by about a third, on healthy trading volume, since the proposed acquisition was announced. While disappointing, the stock at just C$ 0.06 is very attractive. The strategic review in California is just a few months from being completed, and more than a dozen companies are de-risking the Monterey, Duvernay and Nordegg by the day. Third quarter earnings calls in coming weeks will provide valuable updates on the progress being made. Just today, October 23rd, Encana’s third quarter press release stated,
In the Duvernay play of west-central Alberta, the Company’s 8-5 well, which had an initial production rate of 1,400 bbls/d of field condensate and 4 MMcf/d of natural gas over its first 30 days, continues to exceed expectations producing at a rate of 350 bbls/d of condensate and 2 MMcf/d of natural gas after more than 160 days. To date, the well has produced over 100 thousand barrels of field condensate and 400 million cubic feet of natural gas. Overall, 12 horizontal wells have been completed in the play with 10 on production and two currently being tied in. Free condensate yield results remain strong with a range of 45 to 300 barrels per million cubic feet (bbls/MMcf).
Expanded Management & Board
Bob Cross, Chairman of Muskwa Resources, Director of Zodiac Exploration
Mr. Cross has more than 20 years experience as a Financier in the Mining / Oil & Gas sectors. He is a Co-Founder and Non-Executive Chairman of Bankers Petroleum Ltd., Non-Executive Chairman of B2Gold Corp., Co-Founder and Chairman of Petrodorado Energy Ltd., and until October 2007, Non-Executive Chairman of Northern Orion Resources. Between 1996 and 1998, Mr. Cross was Chairman and CEO of Yorkton Securities. From 1987 to 1994, he was a Partner, Investment Banking with Gordon Capital in Toronto. He has an Engineering Degree from the University of Waterloo, and received his MBA from Harvard Business School in 1987.
Peter Haverson, CEO Zodiac Exploration
Mr. Haverson has over 37 years experience in the oil industry, primarily relating to Exploration & Production operations. He has spent the latter few years working in foreign countries dealing with new-venture start-ups and foreign governments while maintaining the importance of good contractor relationships. He has extensive working knowledge of Drilling & Production as he has been involved in operations reaching all corners of the World. Most recently, Mr. Haverson was the General Manager at Suncor (formerly Petro-Canada) for International and Offshore Drilling & Completion Operations.
Rick Jackson, President & CEO Muskwa Resources
Mr. Jackson is a seasoned engineer and manager, with over 30 years experience. He spent 28 years with Chevron Canada managing operations with over 25,000 boe/d of production and annual operating budgets in excess of $40 million. He has hands on experience in Production, Completions, Facilities and Reservoir Evaluations. Mr. Jackson held key positions in Strategic Planning and New Ventures at Chevron. With these responsibilities, he identified, evaluated and closed several major initiatives. In his final years at Chevron, Mr. Jackson was the lead negotiator for divestiture of all of Chevron’s Canadian assets. Mr. Jackson later joined Enterra Energy as the Manager of Engineering. Among his achievements was the acquisition of a $250 million asset in the U.S. Mr. Jackson was a Founding Member of Muskwa, joining the Company in November, 2008.
Lee Pettigrew, Director of Muskwa Resources
Mr. Pettigrew is President and CEO of Mercari Capital Corp., a private merchant bank, and brings more than 20 years of senior investment banking and capital markets expertise to the Muskwa Board. Mr. Pettigrew began his career with the First Boston. After joining Gordon Capital, he moved to Calgary in 1992 to Co-Head Gordon’s Energy practice. In 1995, he became one of 9 Founding Partners of Newcrest Capital, where he headed the Energy Group and ran the Calgary office until the firm’s $250 million sale to TD Bank. After serving as a MD of TD Securities for 2 years, Mr. Pettigrew became a Founding Partner and largest shareholder of Orion Securities, and played a major part in the growth of the firm until its sale to Macquarie Bank. After serving as a MD of Macquarie for 2 years, he left to pursue early stage Energy merchant banking. Mr. Pettigrew is a graduate (with distinction) of the Richard Ivey School of Business Administration at the University of Western Ontario.