What to Buy: Zargon Oil & Gas Ltd (TSX: ZAR, OTC: ZARFF) < CAD17.50, USD18

Why Now

Zargon Oil & Gas Ltd (TSX: ZAR, OTC: ZARFF)–a small but generally consistent oil and gas production company–has taken a hit this month and now yields 10 percent. The main reason is weakness in oil prices, which has hit share prices of all producers. In addition, flooding shut in a significant chunk of the company’s production base in the Williston Basin in the second quarter. That makes an otherwise pretty bar graph depicting slowly, steadily rising oil production look a little ugly. But the market has overreacted to what appears to be a short-term problem.

The big economic picture is messy right now, but it’s been so for almost half a decade. Energy prices have come down along with everything else this month. But they’ve bounced along with everything else too. Despite its production challenges, Zargon still covered its second-quarter distribution by a solid 1.07-to-1 margin. First-half coverage was much better at 1.54-to-1, and should improve much in the second half of 2011 as output returns to normal.

Meanwhile, management continues to transition its production mix further in favor of oil, pursuing acquisitions that fit its business model, managing its finances in a way that allows it to fund operations, paying a generous dividend and growing its asset base. Zargon has put itself in position to continue to benefit from oil prices that will remain well above what we became accustomed to during the long-ago 20th century.

The bet is a rebound in the stock price north of USD20 while it continues to pay monthly dividends at an annualized rate of more than 10 percent.

The Story

Last week the Big Yield Hunting crew thinned out its target list, shedding one double-digit winner, dropping one double-digit loser, while reanalyzing eight remaining open positions and offering updated advice on them. We created, in effect, a high-yield field bet for new money. But we’re here to offer another new pick.

And it’s as simple as this: The young gun couldn’t hold off. Once Zargon flashed a double-digit yield, David dashed off a quick text to Roger: “It’s time to move on Zargon…”

David: Like I said, it’s time to pull the trigger on Zargon Oil & Gas Ltd (TSX: ZAR, OTC: ZARFF).

Roger: There’s no question it’s a solid company. Zargon works for me. And like we said last week, the market is giving us another opportunity to lock in some great yields. It would be shame to waste it.

David: OK. But probably the most important reason to buy it is that it sounds like the name of a villain from a 1970s-era outer-space-or-near-future-set dystopian nightmare film.

Roger: No time for frivolities this week, although I’d love to hear William Shatner belt out “ZARRRRRRR-GONNNNNN!” just once. So tell me about this weather-related production decline in the second quarter.

David: The well-known story of wet western Canadian weather in May and June included Zargon and its operations in the Williston Basin, which straddles Saskatchewan, Manitoba and North Dakota. Rain and the seasonal melt caused serious flooding problems. Forest fires and pipeline outages didn’t hurt Zargon the way it hurt other oil and gas companies, but the second quarter was tough for Canadian energy producers all over.

Second-quarter shut-ins on Zargon leases in southeast Saskatchewan, southwest Manitoba and North Dakota reduced oil production by an average of 760 barrels of oil per day (bbl/d). Zargon’s oil and liquids production averaged 5,034 bbl/d, down 15 percent from the first quarter (5,893 bbl/d) and 12 percent from the second quarter of 2010 (5,741 bbl/d).

The weather has cleared, though, and management noted in its third-quarter presentation that conditions in the Williston had begun to dry out. As of Aug. 11 Zargon had brought most of the 760 bbl/d of shut-in production back on line; the remaining 150 should be back up, according to management’s timeline, by September. Overall production in August was above 8,700 barrels of oil equivalent per day (boe/d), about 5,150 bbl/d of oil and 21.3 million cubic feet per day (mmcf/d) of natural gas.

Total second quarter oil and gas production averaged 8,686 (boe/d), 9 percent lower than the 9,546 in the first quarter. Natural gas production averaged 21.91 mmcf/d, basically flat sequentially but down 15 percent year over year.

Roger: That sounds like we should expect third-quarter output to be inhibited as well, though sequentially better than the second quarter. By the way, the drop in natural gas output doesn’t bother me, though I think there’s opportunity in that market. Rather, it’s by design, part of Zargon’s now four-year-old “strategic shift to allocate capital to oil exploitation projects while permitting natural gas volumes to trend lower.” Oil was 58 percent of production, up from 42 percent in 2007, and would have been 61 percent but for the Williston shut-ins. And it’s an even higher percentage of cash flow.

As far as the bad second-quarter weather, the latest rig activity update from FirstEnergy Capital suggests things are getting back to normal all over the Canadian energy sector: 519 rigs, 64 percent of the total fleet, are working, up about 36 percent from a year ago. And it’s basically all about oil.

David: Zargon’s oil and gas sales in the second quarter were up 3 percent sequentially and 10 percent year over year, basically on better oil and gas prices for the company. Zargon realized CAD89.55 per barrel of oil, up 19 from the first quarter and 33 percent from the second quarter of 2010. The discount to the Edmonton par price also ticked up, from CAD12.68 in the first quarter to CAD13.54 in the second.

Realized natural gas prices were also higher, by 5 percent quarter-over-quarter and 1 percent year-over-year to CAD3.74 per thousand cubic feet.

Funds from operations for the quarter were CAD13.76 million, while Zargon paid out CAD10.47 million in cash dividends, or CAD0.42 per share. Declared dividends, including the company’s dividend reinvestment program, were CAD12.12 million, a payout ratio of 88 percent. On a cash basis it was 76 percent.

Debt net of working capital (excluding unrealized derivative assets/liabilities) was CAD102.12 million at the end of the second quarter, down 24 percent from CAD135.13 million as of Mar. 31, 2011. This was before the company sold two Williston properties producing 260 barrels of oil a day for CAD24 million.

Roger: The Jun. 30 balance is about 57 percent of the company’s CAD180 million credit facility, leaving it room to fund acquisitions.

I’m a little concerned about the royalties and costs numbers. Royalty expenses jumped 26 percent from the first quarter and 19 percent year over year, which is abnormal considering the company’s production declines. Management attributed the magnitude of the increase to changes in royalty and Saskatchewan Resource Surcharge estimates it recorded during the prior reporting periods.

Flooding in Williston also contributed to a rise in per-unit-of-production costs to CAD17.26 per barrel, excluding transportation costs. Management describes its cost structure as basically “fixed,” so whether it gets a barrel to market or not, it’s spending money.

Lower volumes hurt, as did the fact that management had to spend money beyond budget to get access to its flooded fields and get production up again. Electricity costs were higher, an accounting estimate change added to the total, and general costs in the field were higher. Transportation costs rose to CAD0.99 per barrel from CAD0.77 in the first quarter and CAD0.57 in the second quarter of 2010.

According to management, “The operating cost challenges in the second quarter of this year relating to flooding and surface access problems, production and transportation costs, combined, are expected to carryover into August, and combined production and transportation costs are not anticipated to return to our now targeted costs of $16.00 per barrel of oil equivalent until the 2011 fourth quarter.”

David: As a trust Zargon maintained a monthly distribution of CAD0.18 per unit for

62 months. During that time Zargon built up CAD346 million of tax pools that should help the company defer Canadian federal income tax until 2014 or later. The company’s reserve life index was 9.5 years at the end of 2010, up from 8.4 years in 2004, when it became a trust. It has 478,000 acres of net undeveloped land.

Zargon’s basic strategy is to focus on smaller, technically complex projects–but potentially highly profitable–that are overlooked by bigger E&Ps. It relies to a large degree on the ability of its people to understand complex well formations and design ways to extract oil from them. And as we saw in the second quarter significant weather events have what seems an exponential impact on such a small producer.

The company plans to drill 25 wells through the end of September. We’ve had nothing like the interruptions we saw in the second quarter.

Roger: One other thing that’s always impressed me about Zargon is the depth and quality of information they provide shareholders. Here you have a company with a market cap of only about USD500 million. Yet they have eight Bay Street firms following them. And management actually pre-warned about the production shortfall three weeks or so before announcing second-quarter earnings.

That’s incidentally when the stock took the hit, though like I said I think weaker oil prices definitely have had as much of an influence as anything else.

Another point we should make is Zargon is pretty much debt-phobic. In fact, bank debt as of the end of the second quarter was less than USD100 million. That was just 41 percent of equity. The debt-to-annualized cash flow number kind of blew up a bit to 1.65-to-1 in the first half. That was pretty much due to the interrupted production, however. And there are no maturities until mid-2012, when a couple of bank loans have to be rolled over or paid off.

If I can find fault in anything here, it’s that management has been too conservative with the dividend for my taste, pretty much dating back to 2004 when Zargon became an income trust. The company’s earnings base has grown steadily over that time. Yet when Zargon converted to a corporation, it took the dividend back down to the original monthly rate of 14 cents Canadian. That’s a lot better than, say, Penn West Petroleum Ltd (TSX: PWT, NYSE: PWE) did–I’m still scratching my head on why they cut their dividend so deeply when they have all that oil in the ground.

But I was still expecting Zargon to convert without cutting dividends, as Vermilion Energy Inc (TSX: VET, OTC: VEMTF) did. And I have been lukewarm on the company ever since in Canadian Edge.

That being said, the conservatism on the dividend is definitely a plus right now, with the markets in such a state of flux. You have a company with a rising production profile and focused on oil, giving it huge upside for cash flow going forward. And at the same time it has little debt and very strong and conservative dividend coverage.

The biggest risk here is the potential for lower oil prices should the global economy hit a recession. But then, that’s pretty much the same risk every recommendation in Big Yield Hunting faces. You can’t have a huge yield without taking on some risk. I should point out, however, that Zargon held its CAD0.18  per unit monthly dividend throughout the 2008-09 market crash/credit crunch/recession, despite a drop in oil prices from more than USD150 per barrel to less than USD30. That’s a pretty solid testimonial that this company is built to last.

Again, this looks precisely like the kind of opportunity that appears when panicky investors are dumping everything and running for the hills. Let’s do this thing.

David: OK, chief. But let’s take the buy target down a notch from where we have it for long-term investors in Canadian Edge, so readers can be sure to get a 10 percent dividend.

Roger: Good point. Let’s say buy up to CAD17.50 Canadian or USD18. That’s as cheap as anyone has bought this stock in the past two years. Thanks, David.

David: Thank you, Rog. Zargon Oil & Gas is a buy up to CAD17.50 on the Toronto Stock Exchange (TSX) or USD18 on the US over-the-counter (OTC) market.

Open Positions

• September 16, 2010: Avenex Energy Corp (TSX: AVF, OTC: AVNDF)–Buy < USD6
• October 22, 2010: Otelco (NYSE: OTT)–Buy < USD20
• December 16, 2010: Capital Product Partners LP (NSDQ: CPLP)–Buy < USD9
• March 17, 2011: Chorus Aviation Inc (TSX: CHR/A, OTC: CHRVF)–Buy < USD5.50
• April 21, 2011: Superior Plus Corp (TSX: SPB, OTC: SUUIF)–Buy < USD11.60
• May 19, 2011: The DATA Group Income Fund (TSX: DGI-U, OTC: DGPIF)–Buy < USD6
• June 16, 2011: FP Newspapers Inc (TSX: FP, OTC: FPNUF)–Buy < USD5.60
• July 22, 2011: France Telecom (France: FTE, NYSE: FTE)–Buy < EUR16, USD23
• August 31, 2011: Zargon Oil & Gas Ltd (TSX: ZAR, OTC: ZARFF)–Buy < CAD17.50, USD18

• August 19, 2010: New Flyer Industries (TSX: NFI-U, OTC: NFYIF)–SELL (06/16/11)
• November 18, 2010: Telstra Corp Ltd (Australia: TLS, OTC: TLSYY)–SELL (06/16/11)
• January 20, 2011: Cellcom Israel Ltd (Israel: CEL, NYSE: CEL)–SELL (08/18/11)
• February 22, 2011: DUET Group (Australia: DUE, OTC: DUETF)–SELL (08/18/11)