Mike Kachanovsky is a regular contributor to Investor’s Digest of Canada. He specializes in ferreting out junior resource and technology stocks on the cusp of becoming growth stocks whose value will grow at a much more rapid rate than that of the overall market.
With a rich endowment of natural resources, Mexico has been able to leverage its economic growth ambitions on export revenue from crude oil. Mexico remains one of the largest foreign sources of oil for the United States.
However, as large, low-cost oil basins slid down the depletion curve, alarm bells started ringing. Oil exports have been in steady decline since the former heydays and domestic demand within Mexico has been rising.
Linear thinkers have concluded that the Mexican energy bonanza is ending, and some have even suggested that the country will become a failed state as it loses this critical export revenue, so necessary to support other economic obligations that keep the country running. Sometimes it is only under the threat of perilous challenges that important change can take place.
Until very recently, all energy resources in Mexico had been nationalized under the control of the state-owned energy giant Petróleos Mexicanos (Pemex). The centralized management of oil exploration and production worked while the low-hanging fruit was still easy to access, but as the large developed reservoirs run dry, efficient production can be more effectively achieved using a smaller-scale approach.
The decision was made to gradually privatize the energy sector, opening the door to foreign companies to participate. This initiative promises to inject much-needed capital and technology, while expanding total energy production potential to offset depletion rates. It represents the proverbial win-win opportunity, since smaller energy companies have the chance to earn a slice of a bigger pie.
This approach is not new. It was successfully implemented in the late 1970s with the Mexican mining sector, and Mexico rapidly saw mining output increase. A wave of new money and technology overcame the stagnation that prompted the privatization in the first place.
Mexican energy sector transformation
A similar virtuous cycle is sure to play out now as Mexico’s energy sector goes through its transformation.
This has created the opportunity for an emerging Canadian junior oil producer to secure a quantum leap in its growth objectives. International Frontier Resources Corp. (TSXV—IFR) chose to participate in the bidding process for development rights and has become the first Alberta-based junior energy company to gain access to Mexican oil production.
To do so, the company created a Mexican subsidiary, Petro Frontera, to partner with Grupo Idesa, one of the largest petrochemical companies in Mexico.
Grupo Idesa produces, markets, and distributes petrochemicals, and has a large market presence.
The experience and connections of a billion-dollar domestic partner go a long way to improve the odds for success when establishing operations in a foreign country. The partnership operates under the name Tonalli Energia in a 50-50 joint venture partnership arrangement.
Tonalli Energia has secured its beachhead in Mexico with a successful bid to gain control of the Tecolutla block in Veracruz, a world-class petroleum-producing region.
The terms of the transaction are favourable, as the authorities did not require any upfront payment to win this licence contract. Instead, the company pledged to fund a minimum work program estimated at $8 million in capital spending, and a royalty payable to Mexico on any subsequent production.
This is an ideal framework for a junior oil stock. It has secured access to a proven oilfield without having to pay high lease fees just to gain entry.
The purchase price alone for a similar-quality block of property in Canada or the U.S. may have amounted to tens of millions of dollars.
The Tecolutla block comprises an area of 7.2 square kilometres. Seven wells were drilled within the project area by Pemex, three of which were significant producers, and historic production peaked at 900 barrels of oil per day in 1972.
New kid on the block
IFR formally assumed ownership of the block in November and is now advancing its strategy to restore production.
There are a number of positive factors that will contribute towards a successful outcome to this partnership.
First and foremost, the Tecolutla block is part of an established basin with past production and an extensive 3-D seismic database. It is a much lower-risk proposition to optimize production capacity from an underutilized producing field than it would be to initiate production from a totally unknown exploration prospect.
In addition, IFR will have the ability to deploy new technology and enhanced recovery techniques in order to restore production from existing wells. This is much cheaper than drilling a new well from the surface.
Consider that this basin is already served by extensive infrastructure, including roads, nearby pipeline access, and a refinery within trucking distance. This represents an advantage that will reduce production costs, and also shorten the timeline to bring new wells online.
Another positive factor is that production from Mexico earns a higher selling price than in Canada. The combination of projected lower costs and higher sales revenues will contribute to a higher overall netback on production.
An extensive geotechnical database from prior operations lent a head start to the partnership to punch new wells that may optimize the extraction for the basin and increase total output.
The process is already bearing fruit. IFR has identified parts of the reservoir that are thicker than previous interpretations had suggested, and these areas had been overlooked prior to the review. The company plans to drill the first new well into the formation in the first half of 2017.
Other expansion opportunities may come from re-completing existing wells, deploying secondary extraction technology to extract a higher percentage of the remaining oil in place, and directional drilling to access underexploited areas of the basin.
In addition, IFR will participate in the bidding process to acquire additional licence contracts elsewhere in Mexico.
A growth stock with international ambitions
I am attracted to micro-cap stories with macro growth ambitions. This company is off to a very good start with its international growth ambitions.
Trading at a market cap in the range of $25 million today, it has already set up a beachhead to participate in one of the largest energy growth opportunities in the Western Hemisphere. The company is well-positioned to accumulate additional holdings for Tonalli Energia. And any success that is achieved on the production from this early stage will contribute organic cash flow to underwrite further expansion.
Thus, International Frontier Resources has the potential to evolve into a mid-tier producer with a much higher share price.
Mike Kachanovsky is a freelance writer specializing in resource and technology companies. Besides being a founding partner of the website smartinvestment.ca, he’s a regular contributor to several newsletters and blogs. He also does consulting for institutional blogs and evaluation of mining projects.
This is an edited version of an article that was originally published for subscribers in the January 6, 2017, issue of The Investor’s Digest of Canada. You can profit from the award-winning advice subscribers receive regularly in The Investor’s Digest of Canada.
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