What to Buy: PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF)

Why now: PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF) has fallen to a new 52-week low, despite management’s assurances that its distribution will be covered by better than a 3-to-1 margin with cash flow in 2013. The yield is now better than 10 percent.

Investors have driven down prices of Canadian oil and gas stocks in recent months, due in large part to worries about price differentials between Canadian-produced energy and benchmark West Texas Intermediate (WTI) crude.

The level of fear has been further augmented by dividend cuts at several of PetroBakken’s peers.

We more than doubled our money in a matter of weeks on a previous Big Yield Hunting recommendation of PetroBakken. With the stock back in single digits despite major advances in the company’s development, we’re expecting similar gains this time around. Buy under USD10.

The Story

The price discount between oil produced in Canada and benchmark West Texas Intermediate (WTI) crude has widened to historic levels. The cause is lesser access to markets at the same time crude output is surging throughout North America.

The result is a wave of worry that Canadian producers’ profits will suffer and that the dividend cuts we’ve seen in sector over the past year will become an epidemic. And prices of many sector stocks have plunged.

Not every producer, however, is equally at risk to this trend, which itself has already showed some signs of reversing. One company that appears well protected is this month’s Big Yield Hunting prey.

David: I guess you saw that last month’s pick, Bonavista Energy Corp (TSX: BNP, OTC: BNPUF), has already cut its monthly dividend–and by more than 40 percent.

That’s just a few weeks after management confirmed its intention to keep paying out at CAD0.12 a month. I guess I gave them too much credit.

Roger: What you neglect to mention is the stock is actually up by a pretty good margin since the company made that move.

Even though we thought they could maintain their dividend, Bonavista stock was already pricing in a pretty steep cut. All they had to do to make money for us was beat expectations, and they did that with the capital spending and production guidance they released at the same time.

David: Well, after the cut it’s not yielding more than 10 percent anymore.

Roger: True.

But let’s remind ourselves as well as our readers that our purpose with Big Yield Hunting has never been to find stocks that are going to pay safe dividends forever. It’s to find undervalued dividend-paying stocks that are going to beat what are abysmal expectations and make us some money.

And so far, despite some pretty major headwinds in the energy sector, Bonavista has done that.

I also think it can do more, which is why I want to keep it a hold. In fact, I have another pick this month in the energy sector along those lines that should do even better: PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF).

David: I’ve been watching that one as well. It really blew off the doors when we recommended it in October 2011, and readers who got in initially doubled their money.

But the stock has definitely had its head handed to it the past few weeks, and the company seems to be hit more than most by the widening discount between the price of Canadian oil and benchmark West Texas Intermediate (WTI) crude.

Bay Street opinion used to be almost universally bullish on the company. Now there are 10 “holds” and two “sell” recommendations, in addition to the 10 “buys.”

And this week the stock hit a new 52-week low.

Roger: The stock is also down by more than 10 percent this year and is trading for half of what it was in March. But the question is, do the concerns that are driving the stock down really signaling that something has changed in the company’s fortunes, or is this just another example of runaway momentum trumping value.

I definitely think it’s the latter. And I’m willing to bet it is by going back into PetroBakken.

David: You have recommended it our Canadian Edge service. And we’re currently sitting on a rather large loss for that position.

Does recommending it in Big Yield Hunting signal that PetroBakken has become a speculation and that other investors should avoid the stock?

Roger: This is one instance where a stock is suitable both as a bet on long-term appreciation and big short-term gains. But let’s focus on the latter, since that’s what this service is all about.

I think PetroBakken has gotten cheap again for three basic reasons. First, as you point out, the differential between what Canadian producers can get for their oil and WTI has really widened out.

Typically we’re looking at about a 5 percent discount to WTI. In December the spread widened out close to 15 percent. That’s a lot of dollars, and given that transportation difficulties continue to exist it’s no wonder a lot of people are expecting very negative things for Canadian oil producers’ earnings in 2013.

We’ve already seen several dividend cuts in the sector, most but not all by natural gas-focused companies. And the expectation built into the prices of these stocks is that there are going to be more.

The second factor results from PetroBakken’s recent separation from its former parent Petrobank Energy & Resources Ltd (TSX: PBG, OTC: PBEGF). Petrobank formerly owned 56 percent of PetroBakken. That ownership has now been dispersed to Petrobank shareholders, and I suspect more than a few of them are cashing out.

Finally, PetroBakken last week issued a capital spending plan for 2013 that funds only about 8 percent to 12 percent of annual production gains and will leave the company with basically flat exit-rate production.

Management, in its words, is taking a “fairly conservative” approach to spending, given the volatile energy prices and concern about differentials. And three analysts rating the stock immediately downgraded it in response.

David: That shift in analyst opinion could be viewed as worrisome. In addition, judging from several questions during the conference call accompanying the guidance there’s some concern about PetroBakken’s debt.

I see the company has CAD610 million drawn on a CAD1.4 billion credit line that matures June 2, 2015, as well as bond issues due in February 2016 (USD237 million) and in February 2020 (USD900 million).

The company has a B credit rating from Standard & Poor’s, nowhere near investment grade.

Isn’t this a reason why the company is cutting back capital spending?

Roger: Management didn’t explicitly spell that out, but there’s no question in my mind that they are concerned about debt, particularly with prices so volatile. But there are few other details here I think Bay Street is discounting.

First, as management points out, the company has only been around three years, and it’s been pouring a lot of capital into ramping up output in that time. This reduced capital spending reflects the success of earlier efforts as well as the fact that the company’s Bakken and Southeast Saskatchewan developments are now “cash-flow positive.”

The Cardium properties–the fastest-growing piece with the longest-lived, lowest-decline wells–are on track to be cash-flow positive this year. That basically means they generate enough revenue after expenses to fund their own development, and it’s a sign this company has greatly matured.

Second, comparing levels of capital spending in 2012 with 2013 is misleading, unless you take into account CAD100 million was essentially accelerated into the fourth quarter of 2012 rather than being spent in first quarter 2013 as initially expected.

It’s important to also note that PetroBakken paid off CAD239 million of convertible bonds put to it in December 2012 with cash rather than by issuing stock.

Management stated during the call that it wouldn’t pay down credit lines that cost on the order of 3 percent annually by issuing stock at a time when it yields 10 percent-plus. That should set at ease anyone who is worried about dilution.

So should the fact that the company has numerous properties throughout shale-rich areas of Canada such as Duvernay that it doesn’t intend to develop now but which other players are.

Management has proven time and again the ability to sell such property for a tidy profit, which comes in very handy funding development expenditures.

At a USD90 per barrel oil price on WTI and an average differential of 10 percent for 2013, the company funds all capital spending and dividends with cash flow.

And keep in mind there are no debt maturities for the next two and a half years.

David: It looks like at those assumptions they’ll cover the dividend with distributable cash flow by better than a 3-to-1 margin this year–with the first, third and fourth quarters more than overcoming lower output in the breakup-inhibited second quarter.

In fact, including the dividend reinvestment plan actual cash outlays are probably closer to 15 percent to 20 percent. That certainly backs up management’s support of the dividend.

Roger: Don’t forget they’re actually opening up the dividend reinvestment plan to their US investors as well.

I’m very interested in how the issue of all those shares to Petrobank shareholders will affect the accounting.

And of course they only hedge 25 percent or so of output, so what happens to oil prices will remain very important.

I actually think differentials could get a bit worse before they get better. But based on the numbers, it’s going to take a long series of unfortunate events to really put the dividend at risk, particularly since management has basically said it’s not interested in where the yield on its common stock goes in the stock market so long as earnings cover it.

David: It’s also worth pointing out that drilling costs are coming down in Canada, owing to reduced production plans. That suggests even if oil prices do fall more than we expect, there will be offsets.

Roger: When we recommended PetroBakken the first time, we said this was a bet on management improving the execution of its plans for the company’s development after a long string of disappointments following the initial public offering.

Since then we’ve seen what’s mostly been a string of successes, despite some difficult conditions in the energy market. But this is still basically the same play.

The bears are betting the wheels are coming off, and the stock price already reflects a crack-up.

But even though production in 2013 won’t be as high as some were apparently hoping, this company is still executing. Fourth-quarter output was in line with targets. And this new plan, if successfully executed, ensures profitability even if this year turns out to be challenging.

David: Some analysts appear to be disappointed management didn’t cut the dividend when it announced guidance, the way Bonavista did.

Roger: I think you’re absolutely right.

As we’ve noted before, one of the things we really like about Canada is the basic conservatism. Then again, one of the frustrating things about the country–and particularly its analyst community–is this same conservatism.

Anytime you have a company do something differently–like trying to pay a big dividend while growing the business–it’s going to run into a large number of detractors. And unfortunately many of these guys are extremely influential.

They just never got it with the income trusts, and they don’t really get it with the high-dividend-paying corporations that have replaced them.

That’s not to say that some of these high-yielding companies can’t stumble. And when it comes to oil and gas producers anything is possible. But PetroBakken does have a formula to boost production and pay a big dividend.

I don’t see anything in the numbers or this guidance that leads me to expect a dividend cut in 2013, barring a big drop in energy prices. And so long as they do execute their business plan, I think we’re going to get another big-time capital gain here.

David: So let’s head back into PetroBakken, which is a buy under USD10.

What about the other energy producers we still have as Open Positions?

Roger: Well, as I said above, I think we should stick with Bonavista, though maybe as a hold.

David: I agree, though I think management should have been a bit more up front last month about how energy prices could affect decisions on the dividend.

Roger: I won’t argue there, though this is a pretty good lesson to anyone who buys energy producers. They’re best conceived as high-cash-flow payers with dividends that vary with energy prices.

By the way, this also applies to BreitBurn Energy Partners LP (NSDQ: BBEP) and QR Energy LP (NYSE: QRE), though they’ve apparently done a more effective job of hedging future selling prices to keep distributions level.

BreitBurn should give us an 11th consecutive distribution boost this month.

QR is likely to hold its payout flat, but I really like their acquisition of USD145 million in oil properties in Florida this month. And the unit offering they did in December–while a bit more expensive than they preferred I’ll bet–raised funds that have kept their cost of debt capital cheap.

Both of these positions have had some ups and downs since we entered them. But I think they’re both very much on track to meet our profit goals. Both are up a solid amount this year as well.

David: I see BreitBurn is actually about 5 percent above our buy target. Should we raise it?

Roger: I’d say no. I like it, but QR Energy up to USD21 and PetroBakken up to USD10 are much better bargains.

David: I would say the same about the two coal plays Natural Resource Partners LP (NYSE: NRP) and Rhino Resource Partners LP (NYSE: RNO).

We’re actually back in the black on Natural Resource and nearly so with Rhino. That’s after being well underwater in both Positions in mid-November.

Roger: It may be that Nov. 15 is eventually viewed as coal-mining stocks’ nadir.

In retrospect, I wish we’d entered both of these then and not a couple months beforehand.

But I’m convinced we’re still going to make some real money in both of these trades. Miners are seeing some real life headwinds, mainly because low natural gas prices have cut into demand from US power companies.

But coal’s demise is greatly exaggerated, and these are financially solid companies backed by long-term contracts.

David: Those yields are still huge. But as you say, the numbers are still backing them up. Same buy targets I take it, USD22 for Natural Resource and USD16 for Rhino?

Roger: Sounds good. Anything new on our Australians, Aditya Birla Minerals Ltd (ASX: ABY, OTC: ABWAF) and Tabcorp Holdings Ltd (ASX: TAH, OTC: TABCF, ADR: TACBY)?

David: Aditya Birla is a pure play on copper. And copper prices are going to rise and fall with economic growth. The good news is the US housing market continues to show signs of gathering strength at its still-low levels. And China’s rebound looks more assured as more data comes out.

The key issue for the red metal is that although inventories are at low levels, there is a significant amount of new supply set to come to market over the next year.

The stock dipped to around USD0.40 in mid-November before rallying with global equities through the end of 2012 and into 2013.

Ten days after we recommended the stock Aditya management reported that earnings for the first half of 2013 declined 56.3 percent due to lower realized prices and lower sales volumes. But ore mined was up 37 percent, ore processed was up 33 percent and production was up 25 percent.

Management continues to focus on costs and keeping a handle on what it can control, and its two key assets continue to show solid long-term production potential.

I still like Aditya Birla Minerals as a bet on a global economic rebound up to USD0.50.

As for Tabcorp, the Australian gaming company got some good news in New South Wales, as a potential competitor dropped its legal challenge to the state government over a failed venture. Its license in NSW will come up for renewal this year, and this cost is not yet determined.

Still looming is a decision on recovery of lost revenue due to Victoria’s government changing the terms of its license to operate in that state.

Despite a challenging environment for consumers Down Under, Tabcorp reported a 3 percent increase in fiscal 2013 first-quarter revenue. Australians continue to find relatively inexpensive ways to entertain themselves despite a softening economy, or maybe because of it.

We’re up from where we entered Tabcorp, and the stock is above our recommended buy-under target of USD3.15 as of this writing. Australia’s economy will basically follow what happens in China and elsewhere in Asia, and the news seems to be improving.

I’m comfortable sticking with this one, too, as well as with our current advice. So Tabcorp remains a buy under USD3.15.

Roger: I’ve been getting a bit of feedback from new subscribers about the master limited partnership (MLP fund teased in one of the more recent promotions.

For anyone who’s interested, that’s Cushing MLP Total Return Fund (NYSE: SRV), the leveraged closed-end fund we first recommended in November.

Cushing MLP Total Return has been basically flat since then. Management has maintained the quarterly distribution, which is now good for a yield of nearly 12 percent. And the holdings are conservative, with more than 55 percent of the portfolio at last count invested in pipelines.

But investors need to be aware that the average yield of the holdings is only about 6.7 percent, while the annual expense ratio is 3.39 percent of assets. The only way the yield is maintained is the use of leverage, 36 percent at last count.

This is not a conservative income investment. It’s a bet the fund’s MLP holdings are undervalued and due to rebound this year.

I’m willing to make that bet in Big Yield Hunting and to recommend Cushing MLP Total Return a buy up to USD8 for anyone who shares that view.

David: And speaking of MLPs, Capital Product Partners LP (NSDQ: CPLP) is now our longest-standing Big Yield Hunting Position by almost a year. It’s also had a pretty incredible run so far in 2013 and is currently up by more than 21 percent since Jan. 1.

The catalyst appears to be the acquisition of two 8,000 Teu Container Vessels under contract into 2019 at preferable rates, which also involved reducing Capital’s debt by USD5.2 million. And CEO Ioannis Lazaridis also reaffirmed the current dividend and his intention to raise it going forward.

Roger: It doesn’t take a finance degree to see this one is cheap because of sector weakness, just as it was back in December 2010 when we first brought it to readers’ attention. That’s mainly the worry about a glut of ships, as new ones come on line and older ones keep operating longer than anticipated.

But so long as Capital has an average contract life of 4.1 years, it’s going to be in position to keep paying us to hold it. And sooner or later that glut dries up.

I don’t want to give anyone the impression this is a long-term service; Capital products is the exception, not the rule, as far as our holding period is concerned.

But after a big initial loss in this trade we’re now solidly in the black from the initial recommendation, and I’m hopeful for much more ahead.

Capital Products is still a buy up to USD9 for anyone who hasn’t yet bought it.

David: Well that about wraps things up.

I’ve noted that we’re seeing some upside in high-yielding stocks in early 2013. That’s certainly welcome after the turmoil of last year. But it’s also what we saw in the first weeks of 2012.

Roger: That’s certainly a good reason not to bet the farm on any Big Yield Hunting stock. These are speculations.

And if, say, our elected officials can’t agree to extend the debt ceiling and avoid a first-ever national default, these aren’t likely to be the kind of stocks that do the best job holding value.

Anyone who owns them needs to be aware that we’re taking risks for the greatest gains. Put them in a diversified and balanced portfolio dominated by high-quality stocks.

• December 16, 2010: Capital Product Partners LP (NSDQ: CPLP)–Buy < USD9
• November 18, 2011: BreitBurn Energy Partners LP (NSDQ: BBEP)–Buy < USD20
• April 20, 2012: QR Energy LP (NYSE: QRE)–Buy < USD21
• May 17, 2012: Tabcorp Holdings Ltd (ASX: TAH, OTC: TABCF, ADR: TACBY)–Buy < USD3.15
• June 22, 2012: Data Group Inc (TSX: DGI, OTC: DGPIF)–SELL
• July 20, 2012: CSR Ltd (ASX: CSR, OTC: CSRLF)–SELL
• August 24, 2012: Natural Resource Partners LP (NYSE: NRP)–Buy < USD22
• September 21, 2012: Rhino Resource Partners LP (NYSE: RNO)–Buy < USD16
• October 19, 2012: Aditya Birla Minerals Ltd (ASX: ABY, OTC: ABWAF)–Buy < USD0.50
• November 16, 2012: Cushing MLP Total Return Fund (NYSE: SRV)–Buy < USD8
• December 20, 2012: Bonavista Energy Corp (TSX: BNP, OTC: BNPUF)–Buy < USD15
• January 17, 2013: PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF)–Buy < USD10
  

• August 19, 2010: New Flyer Industries (TSX: NFI-U, OTC: NFYIF)–SELL (06/16/11)
• September 16, 2010: Avenex Energy Corp (TSX: AVF, OTC: AVNDF)–SELL (06/22/12)
• October 22, 2010: Otelco (NYSE: OTT)–SELL (09/21/12)
• 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)
• March 17, 2011: Chorus Aviation Inc (TSX: CHR/A, OTC: CHRVF)–SELL (12/16/11)
• May 19, 2011: The DATA Group Income Fund (TSX: DGI-U, OTC: DGPIF)–SELL (03/23/12)
• June 16, 2011: FP Newspapers Inc (TSX: FP, OTC: FPNUF)–SELL (12/16/11)
• August 31, 2011: Zargon Oil & Gas Ltd (TSX: ZAR, OTC: ZARFF)–SELL (12/16/11)
• September 15, 2011: Alaska Communications (NSDQ: ALSK)–SELL (12/16/11)
• October 21, 2011: PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF)–SELL (09/21/12)
• December 16, 2011: Telefonica SA (NYSE: TEF)–SELL (09/21/12)
• January 23, 2012: Inergy LP (NYSE: NRGY)–SELL (06/22/12)
• February 16, 2012: Arrium Ltd (ASX: ARI, OTC: ARRMF)–SELL (09/21/12)
• March 23, 2012: Capstone Infrastructure Corp (TSX: CSE, OTC: MCQPF)–SELL (06/22/12)
• April 21, 2011: Superior Plus Corp (TSX: SPB, OTC: SUUIF)–SELL (11/16/12)
• July 22, 2011: France Telecom (France: FTE, NYSE: FTE)–SELL (11/16/12)
• June 22, 2012: Data Group Inc (TSX: DGI, OTC: DGPIF)–SELL (11/16/12)
• July 20, 2012: CSR Ltd (ASX: CSR, OTC: CSRLF)–SELL (11/16/12)