This is an opportunity to pay roughly $4 per boe of 2P natural gas reserves in politically stable Alberta, Canada. We are actually paying less than $1 per boe for the equity; the remainder reflects net debt. The latter has been cut in half over the past couple of years even as natural gas prices have remained dismally low. The debt appears manageable, especially in light of Compton's proven ability to sell portions of its large asset base at valuations far in excess of the market's valuation of the entire enterprise. Contrary to the apparent market consensus, we view the USD-denominated debt not as a problem but as a welcome upside "kicker" for the equity. In short, Compton appears to be in an excellent position to "muddle through" without equity dilution until natural gas prices recover. At such time, the operating and financial leverage should combine to create spectacular upside for shareholders, potentially making this a ten-bagger investment.

 

At a price of C$0.40 per share, we view Compton as one of the most compelling risk-reward opportunities out there. The share price has declined over the past several months even as management has improved the balance sheet, cut operating costs, and boosted production efficiency. The decline may be due to investors' general apprehension toward natural gas, Compton's voluntary delisting from the NYSE to save costs (the shares trade in Toronto), and selling by Centennial, the largest shareholder. It is not clear why Centennial is selling, but it may have little to do with Compton's future prospects. Centennial invested in Compton a few years ago when shares were trading above C$10 and subsequently took an activist position that ultimately failed to pay off.

 

While we are bullish on Compton, there is no guarantee that the upside will materialize or that the stock price will not go to zero. We own the shares in size but may sell at any time without informing you. Bottom line: Do your own work prior to investing.

 

 

Let's forget about the Street's fearful consensus on natural gas and think for a moment. Is the natural gas industry about to go the way of newspapers, video rental, or yellow pages? After all, we are talking about a major energy commodity here that has a clear relationship to crude oil in terms of the energy content: roughly 6,000 cubic feet (6 mcf) of natural gas are equivalent to one barrel of crude oil (1 boe). Natural gas is cleaner-burning than coal or oil. It also wins in terms of national security and the imperative to improve America's trade balance. There is ample natural gas in the U.S. to satisfy the country's energy needs and even start exporting (liquified) natural gas. Quite incredibly, one barrel of oil currently sells for roughly $90 while one boe of natural gas sells for roughly $25 in North America. If you had to generate six million BTUs of energy, would you pay $90 to do so with crude oil or $25 to do so with natural gas? (Nevermind that a significant chunk of the $90 would go to countries that are not exactly America's best friends.)

 

This brings us to argument one of the bears: On the demand side, it will take years to switch evergy consumption from oil to natural gas. Yes, but the incentive is clearly there, and it will only be eliminated if oil prices fall dramatically or natural gas prices increase dramatically. The latter would be just fine for our investment thesis. The former can be avoided by an investor via a short position in crude oil futures (though we would not advise such a position). So, if the incentive to switch from oil to gas is in place, what we have on the demand side of natural gas is a growth industry. Some power plants that can use multiple fuels as inputs may increase their usage of natural gas. More consumers may switch to gas from heating oil. A larger-than-normal portion of new energy users may choose natural gas. Some segments of the transportation industry, such as truck fleets or certain industrial vehicles, may start using natural gas. There are probably many other potential uses over time, but that is beside the point. You may be wondering when political lobbies and ordinary Americans will start pressuring Washington to embrace natural gas, and when politicians will see the light. Again, it may take years, but it sets up a long-term growth story (which strikes us as a lot better than the long-term growth story for oil or gold).

 

Now to argument two of the bears: On the supply side, shale gas is accelerating supply in a way that outstrips demand growth, keeping prices unbearably low for conventional gas producers such as Compton. Conceptually, this argument is scary for potential investors because it conjures up images of an unlimited flood of low-cost natural gas destined to keep returns on capital dismal for a long time to come. The truth is that shale gas still accounts for a small minority of overall natural gas production, and that overall supply is not growing quickly at all. Prices have been low recently due to economically-induced low demand, not an explosion in overall supply. Some have also pointed out the steep decline rates when drilling for shale gas, with fields getting depleted considerably faster than is the case with conventional gas. Some bears have argued that companies such as Chesapeake should never have been able to raise the financing they did, as true all-in returns on capital may be considerably lower than the major gas producers have led investors to believe. If true, this would add to the bullish thesis on natural gas, because prices would have to rise over time in order to bring true returns on capital to an acceptable level. Finally, a meaningful but temporary factor for the ongoing oversupply of gas appears to be the fact that many companies have to start drilling by certain dates in order to keep their leases, regardless of the prevailing price of natural gas. Will these companies enter into new leases that force them to drill at unacceptably low prices? Obviously not, but it takes time to work through the requirements of leases signed when higher gas prices prevailed. Shell Oil president Marvin Odum told Fortune in a December 15th interview, "There is a degree of [natural gas] drilling in the system right now that's oriented towards maintaining acreage for longer-term development--so there's additional production that doesn't look economically rational. A rational market would hold off from drilling some of those wells, but instead you get this aberration of drilling to hold acreage for a longer-term position. But I do think we'll see that play out certainly over the next two years, if not the next 18 months." [source]

 

In summary, we believe the natural gas industry is in a cyclical rather than a permanent downturn. Looking past the current doom, we can envision a Wall Street consensus that in a few years may sound something like this: "Natural gas is America's energy's commodity of choice. Cheaper, cleaner and more abundant domestically than crude oil, natural gas is at the beginning of a long-term growth trend!"

 

 

Why not just buy natural gas futures, UNG or Chesapeake as a way of investing in natural gas? Because there are issues with each of these alternatives: Futures generally require the rolling forward of positions, generating trading expenses and potential losses due to contango (upward sloping forward curve). UNG may trade at a premium to NAV, but mostly suffers from contango and potential front-running by those anticipating UNG's rolling-forward trades. Chesapeake has been much debated on VIC, and some very smart members have laid out a strong bear case there. Compton also has some winning attributes in its own right, including a vast asset base relative to enterprise value, a politically stable domicile, emerging oil plays that should help preserve value until natural gas price pick up, and management led by industry veteran Tim Granger. Granger joined in early 2009 and has so far delivered on his promises. He has minimized equity dilution by opting to reduce debt through a 5% overriding royalty sale and selected asset dispositions. An equity raise that took place in late 2009 was completed at roughly three times the recent market price, so in retrospect, it has been anti-dilutive (now there's an interesting concept).

 

We encourage you to view and listen to Tim Granger's recent presentation at an investor conference in Canada [view slides; listen to audio]. While Granger may not come across as the most polished speaker, the substance of his talk should speak volumes. You will hear him talk about a few big positives: First, the company intends to retire a recently issued $45 covert for cash in H1 2011. Second, the company believes it can lower production costs on the entire asset base so that it can earn a 20% ROC at gas prices of roughly $4 per mcf. Third, the company's large acreage includes some oil plays that have not been emphasized to date but that will be the focus on capex in 2011 due to the pricing differential between oil and gas. The company even has some Bakken acreage that it acquired a few years ago.

 

INVESTMENT HIGHLIGHTS

• Western Canadian natural gas producer. 88% of 126 million boe of year-end 2009 2P (proved and probable) reserves consist of natural gas. 61% of 2P reserves are proved; 83% of 1P are developed. These are long-life reserves offering low-risk, repeatable development, with low political risk.
• Completed recap in October, reducing debt to ~$400 million and extending maturities to 2017. The recap included cash from $150 million in July asset sales. Compton also issued a $45 million convert, which is redeemable for cash and should not dilute shareholders. According to CEO Granger, the convert "will be gone some time through [H1 2011] through a small disposition of an asset."
• Strategy of "living within cash flow" to minimize equity dilution while Compton waits for a recovery in gas prices and proves the value of its large assets.
• 138 million warrants no longer an issue. Compton raised $162 million at $1.25 per unit in October '09. Each unit consisted of one share and one warrant. The warrants will expire worthless if Compton trades below $1.55 per share by October 5, 2011.
• Sold 5% overriding royalty for $95 million in early 2010, implying a valuation significantly in excess of Compton's recent enterprise value. The buyer was respected industry insider Jim Kinnear, ex-CEO of Pengrowth Energy, which he co-founded in 1988 and built into a multi-billion dollar firm.
• EV per boe of 2P reserves is less than C$5, below comparable company valuations (average of C$13).
• Large tax pools would become valuable in rising natural gas price environment, as Compton has C$930 million available to offset future income.

INVESTMENT RISKS & CONCERNS

• Leverage remains high, but appears managable. Finance charges have been ~C$8 per boe, while recent field netback has been ~C16 per boe. The company may reduce debt further by selling assets.
• Dilution cannot be ruled out, though management appears committed to avoiding it. A C$750 million shelf filed in November 2009 is still in force, and a C$45 million convert as part of the recent recap.

SELECTED OPERATING DATA ¹

FYE December 31	2006	2007	2008	2009	YTD 9/30/10
Oil and gas reserves (net to Compton) (period end) (MMboe):
Proved developed	92	93	79	64	n/a
Total proved	120	121	101	77	n/a
Proved and probable	203	218	172	126	n/a
% natural gas	81%	86%	89%	88%	84%
Pretax reserve value (net to Compton) (forward pricing) (period end):
PV-10, 1P (C$mn)	1,907	1,810	1,635	1,127	n/a
PV-10, 2P (C$mn)	2,845	2,919	2,569	1,695	n/a
PV-0, 1P (C$mn)	4,393	4,275	4,370	3,015	n/a
PV-0, 2P (C$mn)	7,633	8,075	7,355	4,855	n/a
Net debt (C$mn)	892	818	817	626	426
Shares outstanding (mn)	129	129	126	264	264
PV-10, 1P (C$ per share)	7.90	7.68	6.50	1.90	n/a
PV-10, 2P (C$ per share)	15.20	16.27	13.93	4.06	n/a
PV-0, 1P (C$ per share)	27.24	26.78	28.25	9.06	n/a
PV-0, 2P (C$ per share)	52.46	56.21	51.99	16.05	n/a
change in proved dev. reserves 4	4%	1%	-15%	-19%	n/a
change in total proved reserves 4	14%	1%	-16%	-24%	n/a
change in production	13%	-6%	-9%	-27%	-15%
change in realized price 3	-14%	-2%	31%	-50%	19%
change in revenue 2	-2%	-3%	22%	-59%	-4%
Production ('000 boe per day)	33.2	31.3	28.7	20.9	18.3
Revenue, post-royalties (C$mn)	417	404	490	200	144
Selected items as % of revenue:
EBIT	44%	43%	8%	14%	-11%
Net income	31%	32%	-9%	-4%	-28%
DD&A	34%	38%	32%	67%	67%
Capex	118%	97%	66%	27%	18%
Realized average sales prices:
Natural gas (C$ per Mcf)	6.32	6.33	8.17	4.16	4.59
Total (C$ per boe)	44.65	43.56	57.26	28.90	33.46
Profitability (C$ per boe):
Field netback 6	28.17	26.99	34.26	18.35	18.83
Funds flow netback 7	21.53	18.84	25.49	7.15	7.79
Tang. equity / assets	34%	36%	38%	50%	53%
? shares out (avg) 8	2%	1%	0%	23%	110%

¹ In C$. cf=cubic feet; boe=barrels per oil equivalent; bls=barrels; B=billions; MM=millions; M=thousands.  ² Net of royalties.  ³ Before impact of hedging.

⁴ Developed reserves are estimated proved reserves recoverable via existing wells. Proved reserves also include undeveloped reserves (to be recovered via new wells on undrilled acreage or via existing wells where capex is required).

⁵ After-tax. Computed using year-end prices and costs excluding corporate overhead expenses and interest expense, discounted at 10% per annum.

⁶ Liquids and gas sales, incl. realized hedging gains, less royalties, operating and transportation costs.  ⁷ Field netback less administrative and interest costs.

⁸ On October 5, 2009, Compton raised net proceeds of $162 million by issuing 138 million units at $1.25 per unit. Each unit is comprised of one common share and one warrant exercisable at $1.55 per share through October 5, 2011.

OUR ESTIMATE OF THE EQUITY FAIR VALUE RANGE (view pdf version)

	Conservative	Base Case	Aggressive
Valuation methodology	Conservative valuation of proved reserves only	30% discount to enterprise valuation of peers based on 2P reserves 1	20% discount to pretax PV-10 at yearend 2009 2
Conservative case metrics:
Proved reserves, net, 12/31/09	77 million boe
Fair value "multiple"	C$7 per boe
Fair value of proved reserves	C$540 million
Base case metrics:
2P reserves, net, 12/31/09		126 million boe
EV "multiple" of select peers 1		C$13 per boe
Implied EV based on peer "multiple"		C$1.6 billion
Valution impact of 30% discount 3		-C$0.5 billion
Fair value		C$1.1 billion
Aggressive case metrics:
Pretax PV-10, 2P reserves, net (forward pricing), 12/31/09			C$1.7 billion
Valuation impact of 20% discount 4			-C$0.3 billion
Fair value			C$1.4 billion
Assumed value of tax pools 5	C$0	C$0	implicit in use of pretax PV-10
Minus: Net debt, 9/30/2010	-C$430 million	-C$430 million	-C$430 million
Estimated fair value of the equity of Compton	C$110 million	C$718 million	C$926 million
	C$0.40 per share	C$2.70 per share	C$3.50 per share
Implied price-to-tangible book value multiple	.1x	.8x	1.0x
Implied EV to 1P reserves net to Compton, 12/31/09	C$7 per boe	C$15 per boe	C$18 per boe
Implied EV to 2P reserves net to Compton, 12/31/09	C$4 per boe	C$9 per boe	C$11 per boe
LTM pre-capex cash flow to implied equity value 6	38%	6%	5%
2009 pre-capex cash flow to implied equity value 6	41%	6%	5%
2008 pre-capex cash flow to implied equity value 6	233%	36%	28%
2007 pre-capex cash flow to implied equity value 6	183%	28%	22%

 

Supplementary data:
Tangible book value, 9/30/2010	C$898 million
1P reserves, net, 12/31/2009	77 MMboe
2P reserves, net, 12/31/2009	126 MMboe
Cash flow, 2007	$201 million
Cash flow, 2008	$256 million
Cash flow, 2009	$45 million
Cash flow, LTM 9/30/2010	$42 million
Shares outstanding, 9/30/2010	264 million

¹ Peer valuation based on data for Celtic Exploration (Toronto: CLT; operates primarily in Alberta), Progress Energy Resources (Toronto: PRQ; focused on natural gas development in Western Canada), NuVista Energy (Toronto: NVA; based in Calgary, Alberta), Fairborne Energy (Toronto: FEL; based in Calgary, Alberta), and Birchcliff Energy (Toronto: BIR; based in Calgary, Alberta). Source: Compton Petroleum investor presentation dated November 17, 2010.

² Pretax PV-10 based on proved and probable reserves and forward pricing for natural gas, as of 12/31/2009. PV-10 does not reflect asset dispositions during 2010; net debt does not reflect proceeds from those assets dispositions.

³ Assumed discount takes into account Compton's leveraged balance sheet.

⁴ Assumed discount takes into account continued weakness in natural gas prices.

⁵ The company disclosed "tax pools" of ~C$930 million in an investor presentation dated November 17, 2010.

⁶ The company defines cash flow as cash from operating activities adjusted for changes in working capital. Cash flow is a pre-capex, post-interest measure.

 

Why not wait to buy Compton until natural gas prices start going up? Not to be glib, but when there is significant value in a situation, the stock price can and usually does go up some time before a key business driver goes up. All that's needed in Compton's case is for one large investor to make the judgment that natural gas price will not stay low forever, and that Compton will survive until then with roughly the same share count. Based on our analysis, we would be very surprise if this judgment wasn't made by at least one investor with some buying power. We'll see.

 

Now for the "catalysts":

1) End-of-year tax selling to subside in a couple of weeks?

2) The Centennial overhang will dissipate, either when Centennial is done selling, or when it becomes clear that the fund will hold onto some shares, or when Centennial buys back the shares it may have sold for tax-loss purposes.

3) Redemption for cash of a $45 million convert in H1 2011, following a likely small asset sale.

4) Rise in natural gas prices (even if only temporary).

5) Asset sale(s) at valuation(s) in excess of Compton's market valuation.

6) Continued reduction in net debt.