Another interesting stock I’ve come across during my recent screening exercise is Toronto-listed Calvalley Petroleum, an oil explorer whose main producing asset is in Yemen. Clearly, country risk is a big issue here. No wonder, the stock has given shareholders a bumpy ride in the past (see stock chart below).
The stock reached its high during the 07/08 oil craze and hit a bottom during the financial crisis at around 1 CAD per share. It traded up due to QE and was hit hard by the 2011 events in the arab world, when security risks increased dramatically as a result of the arab spring. It is currently trading at around 1.5 CAD per share. As discussed below, the security/political risk is real for Calvalley and can be considered the biggest risk for the company.
The stock has a tiny market capitalisation of USD 120 million and looks cheap with a trailing PE of 5 and PB of 0.6. Calvalley is not only debt free but has USD 84 million of cash and cash equivalents parked in a Canadian Bank, i.e. almost 2/3 of the market value are supported by net cash not subject to country risk! Although not a classic Ben-Graham-type of net-net play I still consider it to have some margin of safety since a typical net-net usually doesn’t have highly profitable operating assets: in 2013 the company had a Free Cash Flow to equity of USD 20 million (operating income – less capex). I would say the potential loss is limited by the Cash at the Canadian bank. It is also good to see management owning 25 percent of the company, with the bulk owned by the CEO and his family trust.
As already mentioned, security risks are real in Yemen. In its shareholder letters, Management mentions frequent supply disruptions and problems with bringing product to market due to a lack of infrastructure. The extreme natural and political climate hit the company in Q1 2014: Calvalley had a negative quarter as it could not sell any of its oil due interruptions of transportation to its pipline (by truck) that started at the end of 2013. The company even had to shut down production as it ran out of capacity to store oil. As a consequence, inventory (68,000 barrels) is up almost 100 percent from the 37,000 barrels recorded at the end of Q1 2013.
As the saying goes, you cannot have good news and a cheap stock. Over the years the market has derated Calvalley substantially as evidenced by the historic evolution of the various multiples in the table below.
The attitude of the market towards the company has changed dramatically: whereas in 2007 the market assigned an enterprise value (EV) of 77 USD per barrel of reserves for the assets of the company, it is currently valuing the barrel of oil in the sand at 11 USD. (Note: For EV calculations I have not deducted the cash on the balance sheet, as a large cash pile is clearly necessary from an operating perspective due to the huge operational risk) – despite the fact that management has been able to increase reserves by 40 percent over this timeframe. Interestingly, the current valuation is only somewhat higher than the 9 USD per barrel recorded at the end of 2008, in the midst of the financial crisis, a time when Brent oil was trading below 50 USD per barrel – compared to 110 USD now – and credit spreads on investment-grade debt were higher than junk-bond spreads today. In some sense, therefore, it can be said that the market prices Yemen-risk higher than systemic risk at the end of 2008.
Calvalley is a high risk/high reward investment. As a consequence of the low valuation I consider the risk to be largely priced in. Even without figuring in its growth potential, the stock can double from here over the next five years. Due to the recent disruptions however, negative price performance in the short term is highly likely. In a world of central-bank-depressed risk premiums an asset where risk is fully priced in is rare and attractive. Therefore I have initiated a small position for my portfolio. As always, this is not a recomendation to buy or sell stock. Do your own research!