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Bottom of the Barrel: Drilling Into Real Resources

Christopher Edmonds

CALGARY -- On the freezing Alberta tundra, oil and gas drilling season is well under way. One way to play the oil and gas markets may be with Canadian small-cap Real Resources (RER:Toronto).

This Calgary-based exploration and production company has growth aspirations and an emerging focus on natural gas. As natural gas production and storage levels continue to decline, investors will probably keep a close watch on companies with meaningful growth potential. Although it's quite small, this company could make for a high-risk, yet high-potential, natural gas exploration play. Combined with its oil balance, Real Resources is positioned to benefit from a turn in the energy markets.

Growing in Alberta

The company has produced a significant amount of crude oil in recent years, but it recently turned its attention to natural gas, specifically to production in Alberta, where it has a significant land position.

"The company now has over 200,000 net acres in west central Alberta, southern Alberta and the Greater Provost area, and is well positioned to capitalize on this expansive undeveloped land base," says Andrew Boland, director of research at Peters & Co., a Calgary energy investment boutique. "Our fiscal year 2003 [production] forecast of 6,733 BOE/D [barrels of oil equivalent per day] ... is predicated on a risked capital program of $38 million. This forecast would equate to 36% growth in production per share growth year over year." Boland rates the stock an outperform, and his firm has not provided banking for Real Resources.

Real Resources (RER:Toronto)
Current Price (CAN)	$4.98
52-week range	$5.19-$3.10
P/E Ratio*	24.9
Market Cap	$97.94 million
Average Daily Volume	72,742
Inst. Ownership	NA
Dividend Yield	Nil
Beta	0.737
Company Web Site	www.realres.com
*Based on 2003 estimates; all dollar amounts Canadian Source: Bloomberg, Peters & Co., Company Reports

That number may prove conservative, as the company has become one of the most active small, independent drillers in Alberta. In 2002, the company drilled more than 110 wells -- up from just 53 the year before -- with an 80% success rate. It now anticipates spending about $50 million in capital this year, aiming to average nearly 7,000 BOE/D of production in 2003. Real Resources' land position gives it plenty of drilling prospects for at least the next three to five years.

"The present management team took over in 1997, when Real Resources was producing 400 b/d," wrote Josef Schachter of Calgary's Schachter Asset Management in early January. "Real is looking to grow the company to the 10,000 b/d level in the next two to three years and may then move to maximize shareholder value." He also rates the stock outperform and has not provided banking services to Real Resources.

That strategy has been successful for several smaller Canadian E&P companies. For example, Canadian Hunter started out small, grew its production and then sold to a large producer, reaping nice profits for shareholders. Although Real Resources is a much smaller company, the concept remains the same: It has focused production in gas-rich Alberta precisely when natural gas supply is dwindling, and its management team appears to have the long-term goal of creating shareholder value.

Rapid Pace

Its rate of production could increase more quickly than even the optimists expect. Real Resources expects to drill about the same number of wells as last year -- 110 to 120 -- and it has a better understanding of its land plays. As a result, the company may find better oil and gas yields with each prospect.

Although history is no guarantee of future results in the oil and gas business, 80% drilling success doesn't happen by luck. Real Resources appears to have a good exploration and drilling team that can choose high-potential prospects and execute. If wells continue to go its way, production of 7,500 BOE/D by the end of 2003 is not out of the question.

That would translate into cash flow of about C$2.00 per share, even assuming oil and gas prices decline to the mid-$3.00 range and oil prices to the low $20s. At today's prices, cash flow could be nearly $3.00 per share at a 7,500 BOE/D run rate.

With a conservative multiple for the cash flow results, the stock could trade close to C$6.00 per share, compared to Wednesday's closing price of C$4.98.

Canadian Concerns

As with any oil and gas exploration company, risks include the failure to find anything during exploration, the potential for commodity-price declines that make production less profitable and the possibility of technical delays in a drilling program.

Moreover, Real Resources only trades on the Toronto Stock Exchange, making it slightly more challenging for a U.S. investor to buy. It has a market cap of just under C$100 million and trades only about 30,000 shares per day. Therefore, building a position can be difficult and the stock will undoubtedly be choppy.

I give it two barrels and place it in the special situations portfolio. (For an explanation of our barrel rating system, see our description.)

Stampede

It isn't summer, so there was no Calgary Stampede, but 16 RealMoney subscribers showed up for happy hour this week during my visit to this energetic city. We had a fabulous time discussing oil and gas markets, among other topics. Thanks to those who attended and to Peters & Co. for their hospitality this week.