North American light oil production is booming, thanks to horizontal drilling and hydraulic fracturing.
One of the places that’s happening is the Swan Hills reef complex, which is located 200 kilometers northwest of Edmonton Alberta. The play is more than 80 kilometers long and has long been recognized as a “giant” oil field. It is estimated to contain more than seven billion barrels of light sweet crude oil.
But that initial enthusiasm turned into something else in 2012. Shares of those Swan Hills focused companies crashed as management teams of both did a terrible job of managing growth and balance sheet leverage. Even the bigger players in the play like Crescent Point Energy went radio silent on the region.
It left many wondering if Swan Hills was a bust.
Then, in March 2014, after very quietly commencing drilling in the play, Lightstream Resources (OTC: LSTMF) revealed the results from its first year of activity in Swan Hills. Perhaps surprisingly, they look really good.
Through the first six months, Lightstream’s wells produced 17,000 barrels… 43% more than expected. As you can see in this chart from a Lightstream presentation in June:
In fact, the firm was able to more than pay back the capital that had been invested in it, in just one year. Put simply, from that point all future production from that well is a profit. Those fast paybacks are what make for a successful horizontal oil play.
Just look at what has happened to Lightstream shares since word got out about the firm's 2013 success:
These superior well results are due to a unique fracture and completion combination that the company has introduced. This is good news not just for Lightstream, but for everyone else with acreage in the Swan Hills play, most notably Arcan Resources (OTC: ARNBF) which has huge leverage to it.
Arcan has 110,000 acres in the Swan Hills play which the company believes contain almost 285 drilling locations and 700 million barrels of oil in place. With the implementation of a secondary recovery effort (waterflooding), Arcan has suggested that 40% of that oil can be recovered.
That 40% recovery figure on Arcan’s 700 million barrels of oil would mean that the company has control of 280 million barrels of recoverable oil.
Arcan has an enterprise value today of only $285 million, which means that at the current share price investors are paying basically $1 per barrel of recoverable reserves.
That seems like an enticing proposition in a world of $100 per barrel oil, and if history repeats Arcan -- whose shares were clobbered in 2012 just like Lightstream's -- could see equally sharp gains.
Sounds like a no-brainer, right?
But while its Swan Hills land position has always been appealing to investors, Arcan has backed itself into a corner where it’s pinned down by debt and may be unable to grow out of it.
With $240 million of debt and expected 2014 cash flow of $40 million, Arcan has a debt to cash flow ratio of a staggering 6 times.
Normally, I wouldn’t touch such an indebted company with a ten foot pole. A big debt load almost always greatly increases the risk involved in owning shares of a company.
However, that big debt load also usually results in a discounted price for the overleveraged company’s shares. Such a discounted share price in the right circumstance can mean opportunity.
I think that could be the case with Arcan. Plus, Arcan brings with it a unique safety net for investors...
Nearly 40% of the common shares are owned by larger producers Crescent Point Energy (which owns 20%) and the previously mentioned Lightstream (the other 20%).
More encouraging, Crescent Point purchased its Arcan shares at prices in the $5 to $5.40 range which is more than ten times the current share price! Lightstream purchased its shares at around $0.90 which is a lot lower, but still nearly twice the current share price.
Both of these purchase prices provide very good evidence of the potential upside in Arcan’s share price should the concern over the debt be removed.
It seems highly unlikely to me that either of these larger companies would let their equity interest in Arcan expire worthless. That would mean that despite its high debt load, any downside for Arcan investors might be cancelled out by what either Crescent Point or Lightstream is willing to pay for full control of the company.
That potential downside protection is very intriguing. Also intriguing is that Crescent Point is a very knowledgeable party when it comes to valuing oil and gas assets, and it was willing to pay ten times the current share price for Arcan.
Despite the leveraged balance sheet, I like the risk relative to reward offered by Arcan at the current share price of $0.53. The high level of debt certainly elevates the risk profile here, but I believe that getting these assets for a fraction of what they are worth at the current share price could be a worthy addition to a diversified portfolio.
Risks to Consider: This company has far too much debt and if one of these companies doesn’t acquire Arcan, it's a good possibility that there won’t be much good to happen for a long time. I believe that Lightstream and Crescent Point owning 40% of Arcan makes this opportunity less risky, but that doesn’t mean there still isn’t a considerable amount of risk.
Action to Take --> Buy shares of Arcan Resources for the opportunity to see Lightstream-like gains or profit from a takeover by Crescent Point or Lightstream.