One place that a person can find very cheap assets is in the energy sector. The complication is that these very cheap assets are often cheap for a good reason. And that reason is the assets may belong to a company with a small amount of cash flow in relation to its debt load.

Consider Connacher Oil and Gas:

Connacher’s primary asset consists of 500 million barrels of proven and probable bitumen reserves near Fort McMurray Alberta.

Based on the company’s most recent presentation here is the value of what Connacher has:

· PV10 of proven and probable oil reserves - $3.1 billion

· Best estimate value of contingent reserves - $570 million

· Other assets - $140 million

· Total assets - $3.8 billion

· Less net debt - ($880 million)

· Net asset value, pre-tax - $2.9 billion

Value On a Per Share Basis:

On a pre-tax, per-share basis, this equals $6.54 per share.

On an after-tax, per-share basis, this equals $4.98 per share.

Excluding the contingent resources, this equals $3.71 per share.

The current share price is $0.78. A pretty severe discount.

A couple of weeks ago the discount was even larger. In fact the share price touched $0.23 in early October.

I’ve had my eye on Connacher. I don’t like the debt load and a pressing convertible debenture issue, but I do think they had a sensible plan to work through it.

The plan involves Connacher looking for a joint venture partner to fund a production expansion of 24,000 boe per day. The partner would pay the cost of development and receive an ownership in the property. This plan would obviously dilute the reserve value per share for Connacher shareholders, but would work towards deleveraging the balance sheet. Production and cash flow would increase, but the debt wouldn’t.

A Liquidity Enhancement

On November 28, 2011 Connacher made this move to improve its financial position:

Calgary, Alberta – Connacher Oil and Gas Limited (CLL – TSX) announced today that it has increased its cash balances to $120.3 million as of the close of business on Friday, November 25, 2011, principally as a result of the successful sale of its Latornell properties and its shares of Gran Tierra Energy Inc.

“With our increased cash balances and liquidity‐raising initiatives, we remain confident that we will meet all of our 2012 financial obligations, including the repayment of $100 million in convertible debentures due in June 2012,” said Richard

A. Gusella, Chairman and Chief Executive Officer. “Without diluting our existing shareholders we can reduce debt, deal with any adversities that might arise from weak general economic conditions and properly maintain our valuable oil sands, conventional and refining assets.”

“Connacher also continues to advance two other liquidity‐raising initiatives, a joint venture or sell‐down of our Great Divide oil sands project in Alberta and a farm‐out or sell‐down of our conventional crude oil and natural gas properties at Twining and Penhold, Alberta,” added Mr. Gusella. “On conclusion, which we anticipate will now occur next year, these initiatives could result in further debt reduction and an acceleration of growth activities on our assets.”

Things Get More Interesting

The liquidity enhancing sale of non-core properties was definitely good news, but certainly not enough to alleviate concerns over the debt. By early December Connacher’s share price was back up over $0.50 reflecting an increased level of confidence in the company’s plan.

Then on December 8 as I was scanning through my watch list I noticed that Connacher shares were up over 40% on the day, and I quickly found this press release from Connacher:

Calgary, Alberta – Connacher Oil and Gas Limited (CLL – TSX) today stated that it has been required by Investment Industry Regulatory Organization of Canada (IIROC) to provide a comment on the recent trading activity in Connacher’s common shares.

Connacher has recently advised capital markets of its improved liquidity and ongoing business plan, including in relation to its oil sands joint venture initiatives and its conventional activities. Furthermore, the Company notes that recently selling prices for bitumen have increased by over 50 percent above average levels received in the most recent reporting period.

Connacher also advises it has received a confidential, non-binding, unsolicited proposal to acquire all of the outstanding shares of the company. The proposal is conditional upon, among other things, due diligence, negotiation of all definitive documentation and approval of the Board of Directors of Connacher and of the interested party.

Consistent with its fiduciary duties and in consultation with its exclusive financial advisor, Goldman Sachs, and its legal counsel, Macleod Dixon LLP, the Board of Directors of Connacher is considering and evaluating the proposal. There can be no assurance that a formal offer or a transaction will result from this proposal.

Connacher Says Thanks But No Thanks

No offer price was disclosed, so it was interesting that Mr. Market took Connacher’s share price to just under $1.00. Why not $1.50? Why not $0.75? What did Mr. Market know?

Nonetheless, Connacher quickly announced that they did not find the offer (whatever the amount) attractive:

Calgary, Alberta – Connacher Oil and Gas Limited (CLL ‐ TSX and Alpha) announced today that its Board of Directors has determined not to pursue the unsolicited, non‐binding and conditional proposal received from a third party to acquire all of the outstanding shares of the company. The Board determined, upon extensive and thorough deliberation and following receipt of advice from its financial and legal advisors, that the proposal was not compelling.

Connacher continues to pursue its joint venture initiatives and to execute its previously enunciated business plan.

Connacher’s share price fell back to $0.75 on this.

So Where Does That Leave Us?

I find myself still somewhat interested in Connacher. The share price around $0.80 is still a steep discount to the PV10 value (after tax) of the reserves which is $4.98. To me it seems likely that this will play out one of two ways:

1) Connacher gets acquired in by the anonymous suitor which comes back with a better offer or takes its offer directly to shareholders. I would guess any acquisition would be for well over $1.00 representing considerable upside.

2) Connacher gets a joint venture deal done which alleviates the financing concerns and moves the share price higher.

But I’m also still a little scared of this one. Connacher’s oil is not the high netback light oil produced by Petrobakken or other players in the emerging unconventional game, so at lower prices Connacher’s production isn’t very economic/profitable. And if the world goes sideways again and capital markets freeze up joint venture and acquiring parties may close up their wallets for a while.

However, with oil over $90 and in my opinion likely headed higher in 2012 due to shrinking global inventories a fall in oil prices may not be a near term concern. Connacher shares have been as high as $1.60 this year, so minus the financing concerns the market could take the share price a lot higher.

I currently don’t own any shares at this point, but I may soon should I have a weak moment.