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Getting Your Arms Around an Unconventional Play

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Taking profit is never a bad thing...

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Back in early October, I highlighted one of my favorite unconventional energy plays, The Exploration Company (TXCO). Since then the stock has moved from the mid-9's to about $13/share. Taking profit is never a bad thing so I certainly understand the argument for letting a little go here (near all-time highs) as I imagine many are doing.

TXCO has three different unconventional plays (I like to think of them as embedded call options) that are still getting little value. The entire market cap is just north of $400 mln at $13/share. At $60 oil, I think its Glenrose porosity asset (where the bulk of the company's production comes from) is worth about $9/share. That leaves $4/share (or about $120 mln) in value for the three early-stage unconventional assets.

For now, I will ignore the Marfa and the Pearsall plays and just focus on the San Miguel Tar Sand play. Based on information that TXCO and its partner Pearl Exploration (PXX.CN) have put out in the public domain, I come up with an "unrisked" valuation of several billion dollars for its piece of the tar sands JV with Pearl. I would also note that is entirely possible that the company has additional acreage outside the AMI (area of mutual interest) with Pearl...possibly much more acreage.

I expect results from TXCO's San Miguel (tar sand) pilot wells by 1Q at the latest (and perhaps by the end of the year). What the market will be looking for is the pricing provided to TXCO by Valero (VLO) for its heavy oil. Remember, Valero has about 80% of the heavy oil refining capacity within 150 miles of the San Miguel Tar sands. Also, at some point TXCO will make public its acreage position to let us shareholders know where and how much tar sands it has. Up until this point, the company has been very quiet about its tar sands play as the last leases in the area are being snatched up. Once all the land is leased, I expect to see some sort of map of what TXCO has.

If the results from Valero come back positive (on the price Valero is willing to pay for TXCO's heavy oil), I expect TXCO to be revalued by the market rather quickly. Currently, only a couple of smaller sell-side shops cover TXCO. Over the past few months, TXCO has presented at several energy conferences and the rooms have been packed, so I would not be surprised to see additional (large) sellside shops pick the stock up in the near-term.

I will also note that Encana (ECA) and Conoco (COP) signed a heavy oil JV about a month ago. Encana will contribute some of its heavy oil assets in Canada and Conoco will provide heavy oil refining as part of the 50/50 JV. Both Encana and Conoco are in the Maverick basin and are very familiar with TXCO's San Miguel asset. Perhaps we will see a similar deal structure with Valero (another San Antonio-based company)? Or maybe the Conoco/Encana JV needs another partner? It's all speculation on my part at this point, but if the San Miguel works, there are many attractive options for TXCO to contemplate.

So what is the stock worth? That is the hard part about putting a valuation on an unconventional play…it's kinda like getting your arms around a smokestack. If the San Miguel works, it's worth several multiples of the entire market cap of the company at today's price in my opinion…but only time will tell.
Position in TXCO

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