Aroway Energy: Minimal Debt, Trading At 2 Times Cash Flow, Significant Growth Potential

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1 Aroway Energy: Minimal Debt, Trading At 2 Times Cash Flow, Significant Growth Potential! Mar.!6,!2014!8:59!AM!ET!!!! Devon!Shire,!Canadian!Value!Investor!! Long!only,!newsletter!provider,!oil!&!gas,!smallJcap! Profile!Send!Message!Follow!(2,282)!!!! Disclosure: I am long ARWJF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Summary Aroway!energy!(arwjf)!is!on!off!the!radar!oil!producer!with!hidden!value!in!a! new!heavy!oil!development!property.!!! The!company!has!a!very!conservative!balance!sheet!and!trades!at!less!than!3! times!expected!april!2014!cash!flow.!

2 The potential catalyst for aroway shares is the conclusion of water disposal drilling at one property and the start of production at another. If the circle of companies that you focus on is exclusively mid to large caps, chances are that you aren't going to find many extreme bargains except in times of full on market panic. If a large company appears extraordinarily cheap it is almost always because there is a very valid concern about the company itself or the industry it operates in. If you want to find stocks that are seriously mispriced but don't have major problems you need to be looking at smaller companies. Investing in smaller companies brings with it some less desirable things to be sure. The stocks are less liquid and harder to trade in and out of and the share prices are guaranteed to be more volatile. It takes some stomach and some patience to ride out the volatility involved in owning smaller companies, but it can often be worth it. One small company that I think today is worthy of further investigation is Canadian oil producer Aroway Energy (OTCQX:ARWJF). This company ticks several boxes that I find appealing: - High level of insider ownership 22% (interests are aligned with shareholders) - A very clean balance sheet (only $1.4 million in debt) - Focused on very profitable oil and not natural gas (90% oil) - Involved in plays with well costs that are appropriate for a junior producer - The valuation is very compelling (Trading at 2.2 times cash flow) - There is a high impact new asset that the market isn't aware of Aroway Energy - Properties One thing I like about investing in smaller oil and gas producers is that you can get your head around all of the assets of the company. With larger producers it is often hard to get a clear picture of how each operating area is performing. It is also much easier for a smaller producer to generate a step change in growth by adding a modest amount of new production. Since production and the resulting cash flow tend to drive producer share prices, a production increase can be a major catalyst. Aroway has four small properties in the Western Canadian provinces of Alberta and Saskatchewan.

3 Currently on those four properties Aroway has fewer than 7 net wells producing. Having a well count that small creates both opportunity and risk. The opportunity is that adding only a couple of wells is going to rapidly grow production. The risk is that every well, particularly newer wells with higher rates of production are very important and mistakes hurt. Before I get to the details of the specific properties I want to point out the fact that none of these properties are tight oil or shale plays. Most of the drilling being done in North America today is directed at shale and tight oil (resource plays). These unconventional resource plays have been wonderful for the oil and gas industry, but they do not work well for a smaller producer like Aroway. Unconventional wells have high drilling costs and extremely steep decline curves. It requires a big balance sheet and source of cash flow to develop these plays.

4 Aroway has intentionally focused on conventional oil plays that have much lower well costs and more manageable decline curves. These assets are the right size for a company like Aroway, as they allow the companies to recycle their cash much quicker than the unconventional plays. Aroway Energy Property 1 - West Hazel Saskatchewan (100% Operated) In November 2012, Aroway acquired from a private company, the West Hazel Property, which is an oil producing asset in Western Saskatchewan. The acquisition included production of 265 barrels of oil per day, the wells and all surface facilities on 200 acres of land. The purchase price for the producing assets was $2,769,000. This was an opportunistic acquisition as you might be able to tell by the price paid per flowing barrel ($2.76 mil / 265 barrels) of $10,075. That is extremely low even for a heavy oil property. Since acquiring the property Aroway hasn't drilled any wells, but has indentified at least 6 future development drilling locations targeting three productive Mannville zones per well. Aroway plans to drill two of those wells in What investors may not be appreciating about the West Hazel property is that there is some potential to greatly reduce operating costs and boost both production and cash flows. Water is something that is part of the business when operating a heavy oil property. During 2013 Aroway was spending $150,000 per month on water trucking and disposal costs at its West Hazel

5 property. Aroway is currently in the process of drilling a water disposal well and building a facility at West Hazel. This will not just serve to reduce operating costs (the $150,000 of costs will be gone completely), but also significantly extend the property's reserve life. Additionally there are two currently shut in wells that can be restarted with better water handling capabilities and a new well to be drilled into the existing producing formation To pay for the cost of the water disposal well, Aroway struck a deal with two private companies which will see the cost of the $1.4 million water disposal well and facility paid for out of the reduced operating costs. The two restarted wells and the new well along with the existing producers and reduced operating costs will basically cover this cost in about a year or less. Once the disposal well is complete, production at West Hazel should increase from 240 barrels per day to up to 400 barrels per day. That is expected to be done by mid to the end of March of Aroway's new well on this property should have the following characteristics: Initial production rate: 80 barrels per day Operating Costs: $9.30 per barrel Netbacks: $38.00 (assuming $72 per barrel heavy oil) Recoverable reserves: 75,000 barrels Reserve life: 15 years After tax PV10: $1.348 million These wells have attractive economics and at $450,000 a pop are the appropriate size for Aroway allowing the Company to recycle its cash quickly. Aroway Energy Property 2 - Kirkpatrick Lake (100% Operated)

6 Also in 2012 Aroway purchased the Kirkpatrick Lake property. This deal was done in September 2012 with a private oil company. Aroway acquired oil and gas properties in the Kirkpatrick Lake area of Alberta consisting of 1.25 sections of land for $500,000. At the time of acquisition this property was not producing. Two successful wells have since been drilled on the property. The second well was completed in December That second well is currently producing at a restricted rate of approximately 100 barrels per day. Total production at Kirkpatrick is 300 barrels per day as the first well continues to produce at about 200 boe/day with the operating costs being very low and the Company realizing netbacks of over $65 per barrel at current prices.

7 In early 2013 the first Kirkpatrick Lake well came on production and actually took Aroway's production briefly over 1,000 barrels per day. That was a major, albeit temporary milestone for the company. Because this well related to a new discovery, Aroway was required by the Alberta Energy regulators to file a GPP (good production practice) application. While this application was being prepared Aroway was forced (by the regulators) to restrict the flow on this 600 barrel per day well to 50 barrels per day. This restriction meant that Aroway had more than half of its 2013 production and cash flow shut off. The regulators took three months processing this application during 2013 and you can see from the chart below what happened to Aroway's share price as a result of the big deferral of production in May of 2013.

8 When the regulators eventually concluded their review they told Aroway that the maximum rate this well (and future Kirkpatrick Lake wells in the same pool) could be produced was 240 barrels per day. Aroway believes it has another 2 wells that can be drilled at Kirkpatrick Lake. Aroway Energy Property 3 - Peace River Arch / Worsley Non-operated The Worsley Property is located in northwest Alberta, Canada, north of the city of Grand Prairie, Alberta. Aroway owns between 18.2% and 50% working interest in fifteen gas wells and seventeen oil

9 wells. Most of the gas wells are shut-in due to low gas prices. Currently eight wells are producing of which 7 are oil wells and one is a gas well. The majority of the remaining shut-in oil wells require recompletions in the shallower zones. Presently, due to the low gas price and uneconomic netbacks, the Worsley property is only producing somewhere around 40 boe/day. This is a very large block of land of which Aroway owns 50%. There is potential on this property for several resource plays, but for now Aroway has decided to focus on its 100% owned and operated properties. The Worsely property won't be playing an important role for Aroway in the near or likely even mid-term. Once cash flow gets ramped up on the controlled properties it is possible that Aroway could start allocating more capital back here. It is also possible that this asset could be monetized. Aroway Energy Property 4 - Kerrobert Saskatchewan Six months ago this property was not a part of Aroway's asset base. Looking forward six months this could very well be the dominant asset for Aroway. Management spent a considerable amount of time examining this property and negotiating on deals to bring together a contiguous land package. What management believes it has here is something very similar to a property producing 2,500 barrels per day directly to the south. The first piece of this Kerrobert property was acquired in September 2013 when Aroway acquired from a private company a 100% interest in 5,760 acres in exchange for a 12% gross overriding royalty. When this property was acquired Aroway's CEO referred to the property as being a potential "company maker". Aroway followed up on the September purchase in January 2014 with this announcement: CALGARY, ALBERTA--(Marketwired - Jan. 16, 2014) - AROWAY ENERGY INC. is pleased to announce that it has executed a seismic option agreement with a major independent oil Company on 18 sections or portions of sections of freehold land (approximately 8,800 acres) adjoining Aroway's existing land base of 15 sections (9,600 acres) in the Kerrobert area of central Saskatchewan. Pursuant to the Agreement, Aroway has committed to shoot, process and interpret approximately 21 sections of 3D seismic over the option lands. Upon completion of the seismic program, Aroway can elect to acquire the freehold leases for a fee payment for a 2 year term subject to a gross overriding royalty. If Aroway elects to acquire the leases, Aroway is then committed to drill a test well on the option lands, with requirements to

10 continue to drill to keep the leases, and will have the option in certain circumstances to extend the term of the leases. Almost immediately after, Aroway commenced the required seismic work. A little investigative work using the location of the property reveals that the second acquisition was with Devon Canada (NYSE:DVN). This deal basically doubles the land position that Aroway has at Kerrobert and fills in pieces of land that Aroway didn't own. With a little help from Google, I was able to track down an interview with CEO Cooper that was done subsequent to this acquisition. In the interview Cooper laid out his expectations for this new property. Cooper believes that the property should be able to support production of up to 2,500 barrels per day and that Aroway could get production ramped up to that by sometime in 2016 if the Company is successful in proving that the oil can flow from their targeted formation. This is a pure exploration play! After the current seismic is done Aroway expects that it will drill its first Kerrobert well in June or July, after spring break-up. That well will obviously be one that Aroway shareholders should be watching keenly. If it produces as expected it likely means that Aroway has a property that can pretty much quadruple production over

11 the next 18 months or so. It is important to note that although Aroway is clearly very bullish on this property, it is still exploratory in nature. Aroway Energy - Balance Sheet / Finances During 2013 Aroway's management made the conscious decision to tighten up its balance sheet. The trigger for this action was seeing other small competitors start to get into trouble with their banks. Back in 2012 Aroway made its West Hazel acquisition using bank debt at which time Aroway's total debt peaked at $4.7 million. Since then Aroway has been using cash flow to slowly reduce debt outstanding and it is now down to only $1.4 million. Monthly cash flow is currently $700,000 to $800,000 per month (When West Hazel is producing) which means the Aroway's debt to cash flow ratio is extremely conservative. By July of 2014 Aroway should become completely debt free, if they continue to pay down the debt at a rate of $300,000 per month. The plan for Aroway is to live within cash flow when it comes to capital spending in 2014 and beyond. With decline rates (company estimates) of roughly 18% at West Hazel and 15% at Kirkpatrick Lake, Aroway looks to be well positioned to be able to grow through internally generated cash flow. That is a welcome change from many of the resource play focused companies I see that struggle to grow from cash flow alone because of the high decline rates they fight. Aroway Energy - Valuation How you choose to value Aroway is really going to depend on what you assume about the new Kerrobert property. Six months ago Aroway did not even own this property. Now it appears that this property is going to be the main asset of the company going forward.

12 Current production for Aroway is 300 barrels per day. That is with the West Hazel production shut in pending completion of the water disposal work. Once that work is done production should be up to at least 750 barrels per day. At the current share price, with 750 barrels per day of production Aroway is trading at $27,000 per flowing barrel. That is very cheap for an oil producer (Aroway is over 90% oil). On an enterprise value to cash flow metric Aroway also looks very inexpensive. With the current cash flow run rate of $750,000 per month Aroway is trading at only 2.2 times enterprise value to cash flow. Aroway could grow production by drilling additional wells at West Hazel (6 wells remaining) and Kirkpatrick Lake (2 wells remaining), but it appears that Kerrobert is going to be the focus. Aroway has indicated that it thinks that Kerrobert could be producing 2,500 barrels at some point in 2016, assuming their exploratory drilling is successful. If that is true, then the production ramp up for Aroway could look something like this: Property Current Name Production Production Production Production Comment 18% decline West Hazel rate 15% decline Kirkpatrick rate Worsely Kerrobert ,500 2, ,580 2,108 3,006 A conservative $40,000 per flowing barrel multiple on 3,000 barrels of production would value this company at $120 million, or $1.94 per share. I wouldn't want to bet the farm on production ramping up that quickly, but even if half that level was achieved we are talking about big upside from the current share price. The risk is that the Kerrobert property doesn't perform as expected. If that is the case Aroway is still a company that is producing great cash flow with litte debt and the ability to sustain and grow that production with Kirkpatrick Lake, West Hazel and potentially even Worsely if capital was directed there. My point being that even without Kerrobert which could be a "company maker" there doesn't seem to be a lot of downside risk at the current share price considering the company is trading at $26,000 per flowing barrel, 2.2 times cash flow and has basically no debt. For information the outstanding options and recent share prices and trading volumes are presented below.

13 Aroway Energy - Management / Directors

14 Aroway Energy - Risks Aroway brings with it all of the normal risks involved in trading in shares of a small company. The shares are illiquid and they are apt to be volatile. Additionally as an oil and gas producer Aroway is exposed to commodity prices (mainly oil) but also heavy oil differentials which have at times gotten quite wide for Canadian producers over the past couple of years. Company specific risks would include the fact that Aroway has very few producing wells, so an unexpected problem with one of the larger ones could really impact cash flow. And the Kerrobert property which figures to be so important going forward is completely unproven at this point. Aroway Energy - Catalysts There are a few things that could be quite positive in the coming months for Aroway shareholders. The first is the completion of the water disposal work at West Hazel which will immediately bump total company production from 300 to almost 750 barrels of oil per day. That is a big percentage increase in production. After that it is possible that production at Kirkpatrick Lake could also increase as the second well is currently being brought on very slowly. The company did not want any unexpected problems with this well while West Hazel was off line for the water disposal work. The following catalyst would be the drilling of an infill West Hazel well which will now be possible with the better water handling capability. And then the big catalyst would be the drilling of the first Kerrobert exploration well. If that goes well, Aroway could really be off to the races.

15 Aroway'Energy','Final'Thoughts! I!don't!think!it!is!a!stretch!to!say!that!Aroway!looks!like!a!compelling!opportunity.! The!numbers!tell!the!story!for!me.! The!best!part!of!the!Aroway!story!though!is!what!the!market!can't!see.!The! Kerrobert!property!could!take!Aroway's!property!to!2,500!barrels!per!day!over!a! relatively!short!period!of!time.! There!is!still!exploration!risk!attached!to!Kerrobert,!but!with!basically!no!debt!and!a! very!low!valuation!it!is!hard!to!see!much!downside!risk!here!even!if!the!kerrobert! property!doesn't!pan!out.! ****!! Read!the!article!at!!!