Source: Chesapeake Energy Media Relations.
Three to five years ago, investing in the American shale boom
was pretty easy. You could print out a list of energy companies,
pin them to a wall, then throw darts blindfolded, and the
companies you landed on would likely trounce the
. Today, though, it's not as simple, and investors who want to
make good decisions in this space will need to do some more
Here's the nice part: Understanding an oil and gas producer
isn't that difficult. There are, of course, the financial metrics
we all know and love as well as stock valuations, but there are
some more specific keys you should consider when looking
specifically at independent oil & gas producers. Let's take a
deeper dive into this industry to find out how you can make
better basic investing decisions in the independent oil & gas
Who are we talking about, here?
Unlike integrated oil and gas companies, independents exclusively
produce oil and gas, That means no downstream assets like
refiners or retail arms. In some ways, it makes them much easier
to understand, because you don't have to sift through multiple
business segments to identify the primary driver of profitability
for the company.
The thing is, hundreds of independents are publicly listed on
major U.S. exchanges. They can vary in size from having a market
capitalization of only a couple million dollars all the way up to
, which today is valued close to $100 billion.Unlike other groups
within the energy space like
, there are simply too many companies to list them all, or even
pick a dozen or so without missing out on some great investing
Five key points to consider
In all honesty, there is a bunch of noise that can distract you
when trying to identify what is important. So many investors
today are worried if companies are in the top shale producing
regions, but what good does knowing which shale plays are the
best if a company has holdings in a poor part of that formation
that barely produces anything? At the same time, there are other
companies that don't even operate in shale that can be just as
lucrative investments. If you are looking to buy companies on a
truly long-term, buy-and-hold strategy, then you need to focus on
other keys that are much more important than geography.
To help filter out the noise, here are five key points you
should dig into when you are doing your homework. To mention
every company would be a little exhausting, so instead -- to give
you a little leg up on your research -- I will supply three
leaders and three laggards for each of the five points below that
have a market capitalizations of more than $500 million.
1. Production potential: Go beyond just proved reserves
One of the major misconceptions about the term "proved reserves"
is that many assume its the amount of oil in a reservoir.
Actually, it is the amount of oil & gas in that reservoir
that a company estimates can be extracted with a reasonable rate
of return based on prices set by the Securities and Exchange
Commission. This means the total proved reserves for a particular
formation can change as prices vary, or if technology makes it
cheaper to access that formation. Here is a great visual
explanation of this from the U.S. Energy Information
Source: U.S. Energy Information Admininstration.
To get a better understanding of how much resource potential a
company has, it's better to look at what is known as the 3P
resources. This means proved, probable, and possible resources.
This data gives a little more clarity to how much oil and gas a
company can extract if prices were to change, or if technology
improves. Not every company provides this information, but if
they do, it can be found in its 10-K.
Another thing to consider when looking at reserves -- and
production -- is how much of those reserves are in oil, gas, or
natural gas liquids. Generally speaking, companies that have
higher reserves and production in oil will generally have higher
profit margins, because oil has a greater value on the market,
but this isn't always the case.
2. Reserves to production ratio
The total amount of oil and gas that a company can access isn't
that valuable of information if not taken in context, though.
That is where the reserves to production ratio comes into play.
The reserves to production ratio is the total amount of reserves
a company has on its books divided by its total production, which
is typically measured in years.
This is a very crude metric because it assumes two things that
are highly unlikely: First, that current proved reserves will
remain constant, which also implies that oil and gas prices will
remain constant and no new technology will make more oil in place
attainable, and second, that production will remain constant over
this entire period. Any oil and gas produce worth their salt will
look to both increase reserves and production, so the
reserve-to-production ratio is only a snapshot of the current
situation. If you want to get a little more involved you can do
some quick calculations to compare production to 3P reserves or
technically recoverable resources as well.
Reserve to Production Ratio
% of Reserves That Are Oil/Liquids
Source: S&P Capital IQ, author's calculations.
3. Reserve replacement costs
One important factor to note is that not all reserves are created
equal. Certain sources of oil are simply more expensive to access
than others, and the ability to access these sources as cheaply
as possible can be a major determinant of the future
profitability of a producer. We can evaluate this by looking at
reserve replacement costs, which is defined as the amount spent
on exploration, development, and acquisitions (net of
divestitures) divided by the total amount of reserve revisions,
extensions, new finds, and acquisitions.
According to the most recent annual survey from
Ernst & Young
, the average reserve replacement cost in the industry was $20.30
per barrel of oil equivalent. As you can see in the table below,
these costs can be heavily influenced by whether a company is
bringing on reserves of oil or gas.
Reserve Replacement Costs
% of Reserve Additions That Was
Cabot Oil & Gas
Pioneer Natural Resources
Source: Ernst & Young.
4. Production costs vs. production mix
Not only does a company need to be able to secure its future on
the cheap, but investors like us want to find the great operators
that are able to produce oil and gas today at a decent price.
This is where production costs come into play. Production costs
are very similar to operational expenses on an income statement,
but without depletion and amortization expenses, since they are a
non-cash expense. Most companies will report their production
costs on a per barrel of oil equivalent or per thousand cubic
feet of gas equivalent for its total production.
Here's the catch when looking at these costs, though: The
value for oil is considerably higher than that of natural gas.
Looking at a survey of independent oil and gas producers, the
production cost per barrel compared to the percentage of
production that is oil looks a little something like this:
Source: Ernst & Young, Company 10-Ks and 40-Fs, and
S&P Capital IQ, author's calculations.
Therefore, a company that produces a higher amount of oil can
be forgiven for having higher production costs, but not too much.
So, when you are looking at production costs, be sure to take it
into context with the production mix. The companies in the table
below are rated and presented based on their production costs per
barrel, and the percentage of their production that was
Produciton Costs Per Barrel Equivalent
% Production That Was Oil/Liquids
Breitburn Energy Partners
Source: Ernst & Young, S&P Capital IQ, and Company
10-Ks and 40-Fs, author's calculations.
5. Operational cash flow coverage of capital expenditures
This last metric is becoming more and more important as the shale
boom isn't the fresh new thing it once was. Many of the companies
in this space have grown production by massive amounts in the
past couple of years, but very few have generated the operational
cash flow to cover their capital expenses and have been forced to
raise capital through debt and equity issuances or through asset
sales. According to the U.S. Energy Information Administration,
capital expenditures at oil and gas producers currently outpaces
operational cash flow by about $110 billion, and that number will
likely rise if
Source: U.S. Energy Information Administration.
Don't let anyone convince you otherwise -- this is an
unsustainable path for companies and should make investors worry
about the value of their shares. If this trend continues,
companies will be forced to continually issue new debt at higher
and higher interest rates, issue value-diluting shares, or be
forced to sell off assets that would likely be a part of a longer
For an individual investor, this doesn't have to be the case,
because we can pick the companies that are a much more solid
footing when it comes to cash generation. This is a very easy
thing to look for: Simply look at a company's cash flow -- on an
annualized basis to remove any seasonal swings -- and divide that
by the company's annual capital expenditures. Any figure greater
than 1 is a very good sign, because it is covering all of its
expenses with something left over for other needs such as future
plans, paying off debt, or even giving a little back to
Operational Cash Flow Coverage of Capital
Magnum Hunter Resources
Source: S&P Capital IQ, author's calculations.
What a Fool believes
The oil and gas industry has been a lucrative one for more than a
century now, and even though we are making great strides in
developing alternative energy, we will likely need oil and gas
for decades into the future. Oil and gas producers can be
incredibly lucrative investments to play this trend, and having a
better understanding of this industry will help you make better
stock choices. Looking into these five things won't guarantee you
will find the perfect stock for your portfolio, but it should
help you separate some of the wheat from the chaff when it comes
to independent oil & gas companies. Because unless we see
another boom like we have over the past few years, it will take
more than a dartboard to make a good investment.
Other subjects in the Energy Investing 101 series
Integrated oil & gas, aka Big Oil
Oil & gas royalty trusts
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Energy Investing 101: Identifying the Top
Independent Oil & Gas Stocks
originally appeared on Fool.com.
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