MGM Energy MGM
March 14, 2011 - 2:13am EST by
2011 2012
Price: 0.22 EPS $0.00 $0.00
Shares Out. (in M): 315 P/E 0.0x 0.0x
Market Cap (in $M): 67 P/FCF 0.0x 0.0x
Net Debt (in $M): 6 EBIT 0 0
TEV ($): 73 TEV/EBIT 0.0x 0.0x

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MGM Energy is a fascinating little company on a Don Quixote-type of quest to develop natural gas resources in the farthest reaches of Arctic Northern Canada where conditions are so poor that drilling can only be done for a few months each year. Despite the considerable risks, the company's valuation is such that investors have the opportunity to make many multiples of their money in an upside case and a likely prospect of getting their capital back in a base case.

MGM is owned just under 50% by Clay Riddell and his company, Paramount Resources. Clay Riddell is one of Canada's most successful oil and gas men, building up Paramount from the ground-up over decades to be a multi-billion dollar enterprise. His focus is entirely on shareholder value creation and has tracked his progress over the decades on a book value per share basis not unlike Berkshire Hathaway and Leucadia. There is an excellent write-up on Paramount on VIC with additional background, his early involvement in the Canadian oil sands play, etc.

For our purposes, Clay Riddell has a strong track record of success and shareholder value creation, and he has a nose for unconventional assets that turn out to be multi-baggers (reference the VIC write-up). Paramount spun out MGM in the middle of the decade, and the company subsequently raised hundreds of millions of dollars to acquire further assets and conduct exploration/development.

MGM's assets in the Arctic are in an area known as the Mackenzie Delta in the hinterlands of northern Canada. The area is a prolific natural gas play and Conoco, Exxon, etc. all have large land positions there. As part of the spin-off and in subsequent acquisitions/exploration, MGM has developed one of the largest resource blocks in the Delta totaling nearly 900 Bcf of contingent and prospective resources with an NPV of over $1 billion present value at a $5 natural gas price assumption and dramatically higher levels at higher gas prices. In addition, the company has a large amount of exploration acreage that could increase the resource estimate considerably, not to mention a database of 2-D and 3-D seismic data that would be worth in the hundreds of millions (per MGM management) if the MacKenzie Delta became an active area of development. While contingent resources are not the same as proved developed resources that are producing (e.g. there is risk in a contingent resource estimate being accurate), the geology of the Delta is such that industry experts have little doubt that massive quantities of gas is there.

I am not focusing too heavily on the valuation of the resource, as the issue is that virtually all of MGM's assets have no practical value if there is no way of getting the gas to the pipeline infrastructure system in Canada which then connects with the United States. Imperial Oil, a subsidiary of Exxon, is taking the lead on developing a pipeline to connect the Delta, and in late December 2010, the pipeline was approved by the Canadian government after 4+ years of review. However, during the review process, the price of natural gas sank and right now Imperial is publicly stating that there it is not economic to both develop the Delta resources and build the pipeline when there is prolific natural gas in shale plays in North America. The government has given Imperial until 2013 to decide whether or not they are going to move forward with construction, and it's likely Imperial will take until 2012-2013 until the end of this option period to decide what to do unless natural gas spikes up in 2011.

Now given the pipeline will take several years to build and the Delta is a major long-term asset, the price Imperial will use in their final analysis is their long-term view of natural gas prices. Furthermore, Imperial has a strong incentive to publicly proclaim the pipeline as economically nonsensical as Imperial is currently negotiating with the Canadian government for incentives to develop the pipeline. The government strongly wants the pipeline as it connects an underdeveloped part of the country, creates a substantial amount of jobs, and allows Canada to monetize one of its great natural resource areas.

Nonetheless, most industry followers view the pipeline at current natural gas spot prices as pretty much dead. As such, MGM could be viewed as a long-term, out-of-the-money option on natural gas prices and an option valuation methodology could theoretically be used.

However, there is potentially a harder valuation approach available. On literally the same week Canada approved Imperial's pipeline proposal, MGM also announced it has sold 12% of its ~ 900 BCF to Kogas, the Korean government's state-controlled energy entity and one of the largest LNG developers and importers in the world. In speaking with MGM management, two things are important to note about this transaction. First, that the sold acreage is representative of the entire portfolio. Secondly, that the purchase was consummated prior to the announcement of the pipeline approval. The price Kogas paid was $30M, but $20M is due at closing and $10M upon Imperial's go-forward decision to construct the pipeline. A $20M valuation implies a nearly $200M valuation for MGM prior to any other assets outside of the contingent+ prospective resource base.

Why would Kogas do this deal if the Imperial pipeline is widely considered to be a dead deal? And why would they do it even before the pipeline was approved by the government? I would argue two reasons. First, this is a third-party validation of the significant option value to MGM, and a foreign country with a burgeoning economy that has no intrinsic energy assets has a strategic need to be a player in recognized major energy plays such as the MacKenzie Delta. Indeed, Kogas is acquiring exploration assets all over the world, as are other Asian governments. Secondly, and more specific to Kogas, if one reads their annual reports their clear purpose is developing LNG assets. LNG would be an alternative way to get gas out of the Delta without having to build a pipeline. In a statement by the South Korean ministry on January 20th, 2011 (see Google, type in South Korea and Arctic), South Korea stated that the Arctic would be a major strategic area for Kogas and that they expected to be producing gas from the region by 2020. The ministry also stated that the MGM purchase was just a beachhead for a promising and strategic new area for Kogas. To my mind, while nothing formal has been announced, Kogas may be planning to build a position in the Delta and then develop LNG infrastructure to get the gas out of the Delta and to Korea. If this happens, it will realize the value for MGM's portfolio.

Showing the utter obscurity of MGM, both the Canadian government announcement and the Kogas deal happened in the same week, and the share price did not move. I think the Kogas deal is crucial, as it provides a third-party downside value based on optionality and strategic interest alone. The pipeline is widely considered to be a very low probability event, and Kogas still implicitly valued MGM at ~ $200M vs. today's market cap of ~ $70M. Furthermore, there are multiple ways to win big. First, the Kogas deal suggests an alternate route beyond the pipeline of making many multiples on your money - that Kogas will take the lead on developing LNG infrastructure in the Delta similar to what Kogas has done in many other parts of the world. Secondly, natural gas could spike and the pipeline gets built. Third, the Canadian government could offer a very generous incentive deal, and the pipeline gets built.

Clay Riddell, the highly successful CEO of Paramount (and Chairman of MGM), clearly likes the risk-reward, and he personally has been the largest participant in a series of private placements MGM has done over the last few years to offset its $6M per year annual cash burn. Note that with the sale to Kogas, MGM has enough cash to fund the cash burn for at least the next two years. By this time, the company hopes that there will be further progress on the pipeline and they can raise capital at a significantly higher valuation.

One last final twist. As the company has sunk several hundred million into acquiring and exploring in the Delta, there is a ~ $300M NOL available to offset future income from either the oil well or the gas assets should either come to fruition. If neither happens, this NOL still has some value as Paramount/Riddell could theoretically transfer producing assets from Paramount to MGM and utilize the MGM NOL. While this would take Paramount/Riddell over the 50% threshold for an NOL change in control, I asked the company about this and was told they created a new class of shares called ‘flow-through shares' that have no voting rights. In Canada, this is an allowed structure and would allow Paramount/Riddell to own more than 50% and MGM would still keep the NOL. I am not a tax expert and haven't verified this with counsel, but if you value the NOL even very cheaply, it gives you some more protection on your downside.


Announcements on the pipeline from the Canadian government and/or Imperial
Natural gas prices 
Any LNG announcements in the MacKenzie Delta from Kogas
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