₪ David Pescod's Late Edition September 5, 2006
AN INTERVIEW WITH MONTY BOWERSPRESIDENT OF CAPITOL ENERGY (CPX.TO)
(From August 23, 2006)
David Pescod: We are here with the dynamic team that’s running Capitol Energy and they represent one of the favorite stock picks of Jim Welykochy, an analyst we have followed for some time. What is very interesting about Capitol Energy is that shortly, they should be working on a water flood and that’s something most retail investors just don’t understand. In almost baby-talk Monty, how would you describe it?
Monty Bowers: Water floods are required when you remove oil and gas from a reservoir depleting the natural pressure in the reservoir resulting in a natural production rate decline. What a water flood does by injecting water, a noncompressible fluid, is maintain the pressure in the reservoir and thereby maintain higher production rates for a longer period of time. That’s the first benefit of a water flood.
The second benefit of a water flood is that oil is swept through the reservoir. Water and oil do not mix with each other and so the water will push the oil ahead of it towards the producer. Through production a pressure sink is created at the producing well. Through water injection in an offsetting water injection well, a pressure high is created. The result is water moves from the high pressure water injector towards the lower pressure producing well flushing oil ahead of the water moving it towards the producer. Those are the two key components to a water flood.
On primary production without a water flood, the particular formation we are talking about on average in the basin recovers 10% of the original oil in place even though the technology that’s being applied in other reservoirs is actually a little bit different that what we are doing. The median on water floods is an incremental 7 ½% recovery which considering both primary and water flood is 17 ½% of the oil in place.
D.P: Now this is quite a big discovery that you are working on as well. So the numbers involved could be large?
M.B: Yes. There are three different reserve categories. From highest to lowest confidence you go from proved reserves (1P) to the proved plus probable reserves (2P) and then to the proved plus probable plus possible reserves (3P). On a 3P basis, this reservoir currently has a little over 200 million barrels of oil in place recognized and we ultimately believe that with water flood, you will recover 20% to 30% of the oil in place or 40 to 60 million barrels of recoverable oil. That is the target here. The question in our minds isn’t whether or not we will recover the oil, more so, the time frame that it will get recognized and then how does that get tied into the share price ultimately?
D.P: Now back-stepping a bit, physically just how do you actually do this water flood?
M.B: Well the first step is that we are currently developing the Dixonville Monteny “C” pool on a primary basis. The way we are doing that is we are drilling horizontal producing wells, which basically means a well is drilled vertically 800 to 900 meters straight down and then we go horizontal for about another 1000 meters, plus or minus. Basically what you do is develop a pool on a primary basis and then, in this case, you convert every second or third well to water injection. The water moves from the horizontal water injector to the horizontal oil producer. We have applied for approval to do a water flood pilot which is a sub-set of the whole pool and we expect approval towards the end of this month or early September. Once we’ve got that, within weeks, we will be injecting water. We expect to get early indications of response anywhere from a month to 12 months and then peak production in the offsetting oil producer will likely occur within one year, plus or minus six months.
D.P: When you mention the word water flood, one thing that does make some people nervous - are there implications for water in general?
M.B: One of the big issues for water floods in Alberta has been the use of surface water. It’s become a big issue in the Province of Alberta anywhere people want to use surface water. i.e.: take water out of rivers, lakes or shallow fresh water acquifers and inject the water into the reservoir. Capitol is sourcing the water out of a non potable water bearing formation that is very close to the producing formation which will have none of the impacts alluded to above. That is, there is no impact to any fresh water acquifers nor will we be using surface water that is used for other purposes.
D.P: Is there precedent for what we are doing?
M.B: In terms of water floods, the primary issue is that the majority of the pools in the same formation, the Montney Formation, are deeper in the basin and the technology that has been used to develop those pools is different. They are developed by drilling vertical wells with productivity enhanced through fracture stimulation. The same process is used on the water injection wells. In our case we are drilling, producing and injecting into horizontal wells. There is no really good analogy within the formation itself for what we are about to do. There are, however, analogies in other formations with one particularly good analogy with similar rock characteristics and similar fluid characteristics. We’ve done everything technically feasible to mitigate the risks. We started with lab work where we confirmed the reservoir is an excellent candidate to water flood. We then took the results of the lab work and all of the available geological and fluid data and did a field wide reservoir simulation which supported the lab work and confirmed the viability of doing a water flood. For people who aren’t familiar with reservoir simulation, think of it this way – a lot of people have cars today where your car (based on your historical driving characteristics) will predict how many miles you’ve got before you run out of gas. So a reservoir simulation is really no different from that. You take the historical production data and then you predict how many barrels of oil will be produced. As in the car analogy where you can change performance by changing the driving habits, we can change the operating conditions, that is without water flood, with water flood etc. and see what happens. So we’ve done a full field reservoir simulation and then we’ve taken that and narrowed it down to two sections or so, a subset of the whole pool, where we are going to implement a pilot water flood. The reservoir simulation suggests that we should get 20% to 30% recovery. The analog pool that is developed on exactly the same basis that is horizontal oil producers, horizontal water injectors is ultimately going to recover 12% of the original oil in place on primary and an incremental 24% with water flood for a total of 36% recovery. The performance is better than what we modeled within our simulation so quite frankly we believe there may be more upside. All of this said, ultimately what is recovered will be what is produced over decades of time and that may be different than what is predicted, either higher or lower.
D.P: What would be your guess as to the ballpark percentage of water flood projects that work and what is it that could go wrong?
M.B: The biggest reserve additions in the Province of Alberta in recent years has been through water flood, not through exploration and development. It’s a very common reservoir development tool that people utilize to maximize ultimate oil recovery. Quite frankly, the EUB and the government actually encourage people to look into water floods because if we don’t as an industry we end up leaving oil behind. There are examples of pools where industry didn’t put water floods in early enough and ultimately the pools did not recover as much of the hydrocarbon as they could have. Of course industry has to consider whether there are positive economics associated with the water flood projects. In this particular case though, the economics are very good as the incremental reserves that can be recovered easily support the incremental capital investment.
D.P: But back to the question, if you had to say 60% of water floods are successful, 80%, etc?
M.B: Every water flood gives you some incremental benefit in terms of recovery so I would have to say virtually 100%. You will always recover some additional oil. At the end of the day, the question should be how much will be recovered and is it economic to do so? In our case, quite frankly, the water flood is great for ultimate recovery, has costs which generate a good return for the company and should translate into a significant appreciation in the share price.
D.P: You are currently producing shy of 3000 barrels. Where do you hope to be a year or two from now with the water flood?
M.B: If you look at our last quarter, we were producing around 2860 barrels of oil equivalent (boe) per day and the 4000 we are referring to is for exit 2006. Our 2006 exit production guidance is between 3950 and 4350 boe per day. We think ultimately, corporately we are going to get to minimum peak production of 6500 boe per day.
D.P: Now some of this would have a longer reserve life than most companies?
M.B: Actually, we already have one of the longest reserve lives for our peer group. One of the benefits of the water flood is that because you are not having to spend many dollars to get the incremental barrels, you can extend out your reserve life with the water flood because the production stays flat and you are adding reserves as you water flood and the reserves are recognized through production performance. So literally the reserve life index can stay high and constant for a period of time.
D.P: With this reserve life, does this not make it an obvious target for a trust, and is that possibly the exit plan, if there is one?
M.B: We’ve been very clear that ultimately this asset will belong in a trust and the only question is whether we merge with somebody else to become a trust or simply sell the company to a trust. If you go to our corporate presentation, you’ll see that we think that happens in the latter part of 2007 for several reasons. (Go to www.capitolenergy.ca and on the right hand side, view latest presentation)
D.P: Wow! That would be nice. The knock of course might be that the company is becoming a one-trick pony.
M.B: I’m not going to deny that would be a knock on our company, just like you prefer to invest in a number of different companies to diversify your risk exposure, we would prefer to have a number of different assets. However, with this particular asset, you’ll find that it has been very, very predictable in terms of its performance. We have an expression on our side of the business that good pools get better and bad pools get worse. This is a pool that has continually performed well and exceeded our expectations.
D.P: Anything else you would like to add?
M.B: What I would say to your retail people is – Jim Welykochy has done an absolutely terrific job of describing what a water flood is about and so I would certainly refer them to his research. In addition, there are five other firms out there with independent research and unique perspectives. The bottom line though is all of them believe Capitol is valued more or less on our primary production with very little value for the water flood and if the water flood works it has the potential to drive the share price to significantly higher values from where we are today. So I would encourage people to read the research.
D.P: Thank you very much Monty!
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