The Road Less Traveled

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Disclosure: The following represents my opinions only. I am long a lot of TAO.V (Image credit to Tom Podmore on Unsplash)

Sometimes I like to look back on what’s worked for me in the past in order to try to repeat it in the future. Two years ago, I wrote a note on Transglobe Energy in Egypt. At the time, it was apparent to me that the stock would eventually trade materially higher once the market realized the significance of its then-newly renegotiated contract terms, and I was right. I’d followed Transglobe for the better part of fifteen years at the time, so I was uniquely positioned to recognize Transglobe’s potential while it largely flew under the radar of the market due to its sub-$100 million market cap. The stock was $1.14 when I wrote a note like this one about it, and it was as high as $6.50 about 18 months later — eventually being taken out by Vaalco Energy (EGY.US, last at $5.20) for about $5 per share earlier this year. It was a great investment, even if I didn’t hold it until the end. All it took was for me to buy some stock and sit on my hands while the market digested (and appreciated) what Transglobe was saying. While the oil price tailwind didn’t hurt, I was sure about Transglobe’s value in pretty much any reasonable oil tape. I was sure because I knew the assets, I knew what they were worth, and I knew why it was cheap — it just needed some time for the market to realize what it would become.

So now, as I sit and ponder Tag Oil (TAO.V, last at $0.59), I can’t help but feel a little nostalgic. Since announcing the signing of its deal on the Badr oil field in Egypt in late September, TAO has 1) closed a $25 million 40-cent financing at the beginning of November, 2) released a resource report quantifying the company’s Abu Roash F (ARF) opportunity for the first time, and 3) is set to get active in the field in December. If TAO was slow to start, it’s making up for lost time now. While the stock is up 19 cents from the financing price, I’m of the view that TAO may have a lot farther to go.

I should be clear about the fact that my TAO investment is different from Transglobe in that Transglobe had producing reserves, while TAO has “2C development pending contingent resources“. The latter is a more speculative category. Those resources will convert into reserves only when their economic viability is proven by development. Fortunately, the folks at independent energy consultancy RPS Energy were kind enough to give an indication of what those contingent resources might ultimately be worth if TAO’s pilot development program proves the viability of the ARF play. RPS modelled 20 wells covering about one-third of TAO’s acreage, yielding 27 million barrels of recoverable oil (gross) with a risked net present value (NPV10) of US$339 million using an 80% chance of development (US$423 million unrisked). On the current share count, that’s about CDN$2.90/share risked and CDN$3.60/share unrisked… the stock closed today at 59 cents. The difference between the share price and RPS’ NPV numbers gives me some sense of what kind of reward might be on the table here at the start. Why italics on “at the start”? Remember that the report only covers about one-third of the 26,000-acre licence where the best well control is… and the implied ~400-acre spacing (i.e., 20 wells in ~8500 acres) is very conservative relative to what one would expect in a commercial development scenario. That means that those 20 well locations included by RPS could ultimately turn into 2-4x that number, with 2-4x the reserves, and a chunky bump up in the NPV, without even considering the other 2/3 of the license. Under that lens, I’m currently looking at the RPS report as more of a “starter kit”, and that’s what gets the speculator in me dreaming — seeing a potential five-bagger from a “starter kit” evaluation… and that’s even after I account for modest dilution along the way.

While I’ve been patient for two years to get to this point, fortunately I won’t have to wait much longer for some very key information from the Abu Roash F (ARF) horizon. TAO’s first operation, planned for December, involves re-entering an existing well, fracking it in the ARF, and then flowing the well back to get a sense of initial productivity and reservoir performance. As a general rule, a medium-length horizontal well could test at as much as 8-10x the rate of a vertical well in an unconventional resource play. So, when the results of TAO’s first vertical fracked well come back, it’s going to be very informative for anyone who’s been paying attention. I wouldn’t expect that TAO would release a flow rate for at least 30 days, which might put those numbers in the hands of the market by the end-of-January-ish. When those vertical test results come back, assuming they are positive, I think that will be the day that TAO will really catch attention. For now, with its $80 million market cap, TAO is below most institutional mandates and radars, but I think it’s going to draw a much larger audience with just a whiff of success given what is on the table; especially under this management team.

Even the best bets are still bets, but I know that if I want to make multi-bagger returns I need to be willing to go up the risk curve. I rationalize taking that risk by knowing that this kind of story is right in the middle of my sphere of knowledge — meaning that my view of risk can sometimes diverge from that of the market. In a sentence, based on every bit of information given to some of the brightest independent experts in unconventional reservoir evaluation, the prevailing technical view is that the ARF is a prime candidate for the same kind of unconventional resource development that we have been extensively employing in North America for the better part of two decades. The ARF is a proven source rock, having sourced most of the oil in this particular basin. It is 25-50 metres thick in the area, oil-prone, in the oil window, has porosity and permeability as good as the Eagle Ford with comparable (brittle/frackable) lithology/mineralogy, shows evidence of natural fracturing (good for flow and storage), and the zone appears to have very limited mobile water, with good boundary zones above and below for frack containment. Combine all of that with the fact that the ARF has historically tested oil from four vertical wells which were drilled for other conventional horizons within the area of interest — with two of those wells recovering 20,000 and 70,000 barrels of oil from the ARF via unfracked partial completions — and things start getting pretty interesting. There is good well control and seismic coverage, with all of the pipes and facilities needed for oil development and transportation already in place, aside from future infield tie-ins. Operating costs are expected to be around US$6/barrel, with wells costing US$5-6 million modelled to recover 1.35 million barrels each in a mid-case. To be sure, I could have less risk by waiting to see the vertical test result, but the spread between the share price and the RPS-calcuated NPVs is what draws me in, as I think my odds of success are better than what the market is implying (right now the market is implying a 20% chance). Usually, unlocking a big NPV — US$423 million in this case — requires a lot of capital , but RPS estimates just US$104mm of capital to develop the 27 mmbbls of gross reserves in their mid-case estimates. Low capital costs, short time to production, and everything you could ask for in terms of the kind of unconventional reservoir that you get to be the first one to test-drive. Will the ARF deliver as hoped when it’s hit with a frack? If the zone acts as it should, it will; but there’s only one way to remove that “if” — and that’s what TAO’s initial capex program is all about.

Two-and-a-half years ago you could go down just about any road and make a pile of money in the oils, but these days I think that making a big win will require heading down some roads less traveled. I’ve made my case — and my bet — and now it’s just about seeing where this one goes. With over $30 million in the trunk, TAO has enough cash to expand its drilling program if the initial vertical test and subsequent horizontal well(s) are encouraging. If that comes to pass, TAO will have no lack of access to capital and TAO’s pace of development could accelerate quickly. Dare to dream.

The Eagle Ford of Egypt. That’s the prize… and it may be a big one.

Happy hunting.