Philip McPherson: Rising Oil Prices Make E&P
Source: George Mack of
The Energy Report
Why look for value in energy exploration and production when
you can get growth? For Global Hunter Securities' Senior Analyst
Philip McPherson, the story is first about taking advantage of
supply and demand fundamentals in the critical industry of
E&P, and then getting a deal on oil in the ground. In this
exclusive interview with
The Energy Report,
Philip outlines the characteristics he looks for in companies
and where his growth thesis can pay off for investors.
The Energy Report:
Your area of coverage is exploration and production. Do small
caps and large caps trade similarly? Do they follow similar
Yes. In the exploration and production (E&P) space as a
whole, it's a pretty simple business model. The size of the
company is basically a reflection of the ability to accelerate
that business model. And your ability to execute and meet
timelines usually has just as much of an impact on your market
cap as the success or the failure of the actual oil and gas
(O&G) play. I'm covering many California companies, including
Berry Petroleum (
Plains Exploration & Production (
and this small oil producer that I stumbled across,
NiMin Energy Corp. (
. I think they all have the same type of idea. But in terms of
how they trade, every company is in some ways going to trade as
does the commodity. So you're going to go up and down on certain
days because oil's up and oil's down. I used to joke with people
that you could announce the best well in the world, but if oil
prices are down, your stock is going to go down. A small cap of
$100 million to $500 million trades more on the net asset value
(NAV) or the value of the perceived potential of your properties.
When you get to that $500 million- $2 billion area, you start
looking at a multiple of EBITDA (earnings before interest, taxes,
depreciation and amortization) or cash flow multiples. When you
get to be large cap, you're really more of an earnings story;
then you start thinking about P/E ratios and cash flow
Do inflationary pressures point towards higher oil prices?
With the economy recovering, and as more people feel that the
double-dip recession is not going to happen, oil prices are
tending to stay stronger. However, it seems to me the tail is
wagging the dog right now, with the U.S. dollar going down and
the price of bonds being up, and the yield being extremely low.
To me, it has more to do with the price of oil than necessarily
the pure supply and demand fundamentals, because we still have
excess supply of oil via OPEC. If you're bullish on oil or
bullish on the economy, then you use those dips as opportunities
to gain more exposure.
What about inflationary effects on margins?
The biggest inflationary costs we're seeing right now are on
unconventional completion services, like fracking crews,
cementing and pressure pumping. But as with any business, when
the demand is there and the visibility is there, entrepreneurs
rise up to the challenge because they know they can make money. I
think you're going to be surprised that in 2011 the likes of
Halliburton Co. (
Schlumberger Ltd. (
, as well as lot of other smaller companies, are going to have
more crews out working. There's going to be enough demand there.
It's all a function of oil prices, and as long as they are in
this relative range, people are going to continue to drill these
wells. I don't think margin makes as much of an impact as the NAV
that you can grow with these companies via drilling these wells
and growing reserves.
I know it's not your area, but would you expect the vertically
integrated oil companies and the oil field service providers to
benefit more from an inflationary environment than the E&P
I think the oil field service guys will definitely benefit
because they're going to put more crews to work. They're going to
hire more people. They're going to be able to generate more
revenues and thus make more money. I've always stayed away from
the vertically integrated guys. The old joke in the oil patch is
that you never make any money on refining. That business has a
very weird dichotomy, and it just doesn't seem like these guys
really ever make that much money. So I don't know if it really
affects them as much, but they can pass higher prices along to
Phil, do investors have more leverage with E&Ps than they do
with these other kinds of companies?
I've always believed that they do. The argument against that
concept used to be that if you're a service company, you don't
have the volatility of oil and gas prices to deal with, and you
therefore don't get hurt as much. I would argue that now they
trade together. When oil prices go up everybody goes up, and when
they come down everybody comes down. Where the real difference
is, I think, is in value creation. That means an oil company can
literally go out and change the value of the entire company in
one day with one wellbore. It can make one discovery in one
field, and set in motion something that can last for 10 years.
You don't get that type of a big upside surprise from a service
company overnight, but an E&P company can really hit a home
run and change the fates of the company and the shareholders
But the risk is greater in E&P.
Well, for that perceived dry hole risk. Or if they're betting
everything on one well, but I think we've gotten away from that.
I would say 90% of companies right now are involved in more than
one type of project. You might be in the Bakken and the Eagle
Ford and the Niobrara Formation or whatever. So you don't have
that one-trick pony. There are still some that are pure plays,
and I'm looking at one now. Now, in general, it seems like the
unconventional plays have taken out some of that old-time
wildcatter spirit-where you're going to be either hero or zero.
Some of the offshore guys like the McMoRan's (
McMoRan Exploration Co. (MMR)
) of the world, with their deep shelf stuff, are kind of unique.
But all in all, I don't think there is as much of that kind of
mentality as there used to be.
What is the minimum dollar price per barrel that oil has to
maintain for a small-cap E&P company to make money?
That's not going to be necessarily dependent upon a company's
market cap. It's really going to be about the project. You have
certain fixed costs, like your general and administrative
(G&A), but it's really more on a project-by-project basis.
The highest cost oil in the world right now is probably the tar
sands, where you probably need $50/barrel to break even. If
you're in the deepwater Gulf of Mexico, there are barriers
because of the economics of infrastructure, and you're not going
to develop a small discovery there, so your threshold for
commerciality is much higher. I've seen companies with $150
million market caps that have better margins than companies with
$6 billion market caps. It just depends on the amount of leverage
a company has and what play it's in. Right now you can be in an
oil play and your margins are going to be much higher. But the
gas guys are really hurting right now. At $4 per thousand cubic
feet equivalent (Mcfe), it's pretty hard to be making any money;
and, in a lot of cases, you're actually destroying shareholder
value by continuing to drill.
Phil, when you're doing due diligence on a new company that you
might add to your coverage universe, what's the first thing you
look at? Give me an example or an anecdote.
If something new pops up on the screen, like a brand-new company,
probably the first thing I'm going to do before I call anybody is
see what the capital structure of the company looks like. That's
because I think we've all learned, coming through this last
couple of years, with the credit markets tightening and things of
that nature, is that no matter how great a company looks, or what
it has, or however great the management team is, if it's not set
up properly to succeed, then it's already put on its own
I've always been kind of a stock picker, and I know that
capital structure and how your operations are funded are
sometimes more important than the operations you're going to
fund. An example would be NiMin Energy, which I recently
initiated coverage on. When it went public, it didn't raise as
much money as was desired. The company was eventually able to get
a term loan to replace some of their short-term debt. It now has
a five-year window of opportunity to take that money and go out
and execute, grow production, grow reserves, grow value. Now it
doesn't have any short-term financing needs, so if the [debt or
equity] market's not there, the company won't be backed up
against a wall. I think people have learned that you don't want
to be a victim of the markets. You want to be able to pick and
choose when you raise capital, and raise it on your terms, versus
letting the market dictate it. I believe that is one thing that
most people overlook. Right now, I can buy NiMin's proved
reserves for around $9 or $10/barrel in the ground. Oil's trading
at $90, and there's obviously a huge gap between those two
numbers. If you take into account inflation and the declining
dollar, you have a unique way to think of resources. It's almost
like buying gold, but you're actually buying a company's reserves
at an attractive price.
What other small-cap companies have a proper capital structure
I'll just stick with the California theme and then go elsewhere.
One of the more interesting names now, and possibly in 2011, that
will have a lot of people scratching their heads is
Venoco, Inc. (VQ)
. A Denver-based independent, but all its assets are based in
California. It's 50% oil, 50% natural gas. But it has this
emerging play called the Monterey Shale. The Monterey Shale is
the source rock in California for a lot of the legacy properties.
The founder of that company believes he can use horizontal
drilling and modern-day completion technologies to unlock a lot
of hidden reservoirs in California.
That's just a hard way to get oil, isn't it?
California is actually pretty fortunate in that our rock quality
out here is very good. Although the formation is called is the
Monterey Shale, the word \"shale\" is in quotation marks because
the porosity and permeability of the rock are 10-15 times better
than the Bakken Shale. So, rather than having to do these long
laterals with 30- or 40-stage fracks, which cost millions of
dollars, you can do a long lateral into this better rock and
you're going to get more oil out of it. The analogy I use is that
it's like pulling the tab on a shaken Pepsi or Coke can. Once the
hole is opened, the oil flows out naturally as it's under
pressure; so, when you pull that tab, it should flow relatively
naturally through the wellbore and back up the wellbore. Then,
once the initial pressure drops, you can pump that oil out of the
What would be a market-moving event for Venoco?
The company stubbed its toe a little bit. Its first Monterey
Shale well encountered a water zone, and it watered out. The
stock went from $21 to $15 and is starting to recover here again.
Its second horizontal well is done, and is in production. The
company hasn't released any results on it. Its third horizontal
well has just finished drilling, and the fourth one is getting
ready to start drilling. So, by the first quarter of 2011 when
they report year-end reserves, you should also have data on two
or three more wells. I think as people see the data and start to
believe in it, the floodgates will open and the stock will move
materially higher. To put things in perspective, right now when
we talk about buying a barrels in the ground, Venoco's proved
reserves are valued at about $16-$16.50/barrel in the ground. We
talked about NiMin being at $9/barrel, which is probably one of
the lowest valuations I can find in my group and one of the
reasons I like it. Venoco at $16.50 is in the middle of, or still
slightly below, the group. The group right now is trading at
north of $24/barrel in the ground from an oil-weighted
perspective. The point being, investors are not paying a lot for
the upside potential in the Monterey Shale. The company has
amassed 150,000 acres. The fully undiscounted value of the
Monterey could be a multiple of Venoco's current stock price. I
like that type of risk reward and I think it should serve
investors well in 2011.
One thing that may give Venoco legs is that OXY (
Occidental Petroleum Corp. (OXY)
), the 800-pound gorilla out here in California, is running 10
rigs targeting the Monterey Shale in 2011. The company has
actually gone so far as to say they think shale oil will be a
top-10 business unit for OXY in the next 10 years. For a
$70-billion dollar company to say that is a pretty bold
statement. The last time I checked, OXY had zero debt and was
buying back stock. A lot of people don't realize that OXY is one
of the largest oil producers in California and in Texas. So while
news from Venoco will move its stock, news from OXY also could
move Venoco's stock, because from a small-cap investor's
standpoint, you're not going to buy OXY to make 5% or 10% of your
money. You'd buy Venoco, which could potentially provide a two-,
three- or four-bagger.
Was there another one that had the right characteristics?
Yes, there's one company that I recently downgraded. You know,
the life of an analyst is interesting because you have to make
long-term decisions and you also have to have short-term
impactful calls. So, in January this year (2010), I actually
initiated on a company called
Magnum Hunter Resources Corp. (NYSE.A:MHR)
, which is a second reincarnation of Magnum Hunter, at $2 a
share, and it recently hit my price target of $6 a share. It went
all the way almost to $6.50. So I downgraded it from a buy to a
neutral on valuation, stating that the stock had made a great
move this year. We made investors a lot of money and at this
price, I wouldn't commit new capital to it. West Virginia is a
very natural resource favorable environment, with all the coal
and drilling that's been going on there for hundreds of years.
Magnum Hunter is in the West Virginia window of the Marcellus
Shale. It's one I'd be looking at buying on a dip.
Magnum Hunter is up about 250% over the past year.
Congratulations on that one.
Yeah. Not bad. Thank you.
So, what other characteristics suit your investment
My newest foray has been looking at more international
opportunities. I cover
Houston American Energy Corp. (NYSE.A:HUSA)
, a company that is getting ready to drill some pretty
high-impact exploration wells in Colombia, of all places. I
initiated that one at around $3.50 or $4, and it's at $17 today.
It's been a solid performer though we're waiting for drilling
results. The company is going to start drilling in the first
quarter. Houston American is like the old analogy that you can
buy the smallest house in the best neighborhood and the price of
your house will go up, right? Well, it's got this block in
Colombia and it's surrounded by all the big boys. A Canadian
company has been drilling wells that have had initial production
rates in excess of 10,000 barrels a day. For onshore exploration,
you haven't seen anything like that in the United States in 50
years. We say this is like being in Texas 50 years ago when
people first started to drill some of the
stuff and things like that. It's just the fact that Colombia was
such a bad place to be for the better part of the 20th
You see this company as low hanging fruit?
Yes, because there haven't been a lot of wells drilled. People
were scared they were going to get kidnapped. Now, in the last
seven or eight years the country has had a democratic president
that pushed the terrorist FARC out of the country, improved the
fiscal regime and improved the oil and gas business. This guy
came in and formed an entirely new division of the oil and gas
ministry and stopped all the automatic back ends (royalties).
There's a public company now, called
Ecopetrol S.A. (NYSE:EC; TSX:ECP)
, that has to compete in the licensing rounds along with
everybody else. The entrepreneurial spirit has been brought
You have an accumulate rating on
Rosetta Resources Inc. (ROSE)
. You said in a note that it is divesting nine core assets that
would ultimately impact operating margins in a positive way. It
is converting from a natural gas to an oil company. What does
this portend for investors?
They used to be just a conventional player, mostly in natural
gas. A new CEO, Randy Limbacher, came in about two years ago from
Burlington Resources' exploration group, and he brought in a lot
of his old guys from Burlington-good old-fashioned oil and gas
guys. The company started looking at basins and places where they
wanted to be. They ended up in the Eagle Ford Shale, and they
were one of the first to drill a well there. They acquired big
blocks of acreage, the major one being the Gates Ranch, which is
about 29,500 net acres. So, now they've got 10 years of drilling
inventory just in that one property.
We've mostly been talking about growth stories. Are there any
deep value plays in your universe?
Well, you know, I don't look for companies that are just deep
value. They need to have a little bit of growth. But the one that
pops up to me is an offshore company called
W&T Offshore Inc. (WTI)
. It's only grown maybe 10% or 15% per year. But at $16 a share
right now, the company is trading at less than two and one-half
times cash flow. So that's relatively cheap. I would call that a
value story. They're looking at taking advantage of this
post-Macondo operating environment, buying more assets in the
Gulf if they can get them at attractive prices. They are
acquiring and exploiting them, and they continue to generate huge
amounts of cash-flow.
There was one more story on your coverage list that was
Evolution Petroleum Corporation (EPM)
Yes, that would be a sort of deep-value company, and it's
basically a play on oil. But its primary asset is a revisionary
working interest in an override on the Delhi Field. It bought
this field all-in for about $6 or $7 million, and sold it to
Denbury Resources Inc. (DNR)
for $50 million. So Evolution got six or seven for one on its
money there, and then kept a 7.2% overriding royalty on a 25%
backend working interest. Denbury had to build a $200 million
pipeline to start injecting CO2, which it started doing in the
beginning of 2010. Now we're getting first response, and those
reserves are booked as proved. This company has an enterprise
value of $160 million. In the Delhi Field alone, there are about
12 million barrels. So it's about $13/barrel to own this company
with zero debt and 90% oil.
Is there anything you'd like to leave with our readers today?
My closing thought is that what always amazes me about investors,
particularly in the oil space, is how scared they can get when
oil goes down. They feel like Chicken Little, like the sky is
falling. To me, if you believe in the global economy and you
understand the supply and demand dynamics with China and India,
and that their economies are growing at such rapid paces, it's
very hard to poke holes in the oil thesis. Maybe oil prices won't
go to $100 or $150 overnight; but, over the longer term, they're
going to continue to trend higher. My advice has always been that
when some unemployment number or something comes out and scares
the market, and oil's down $2 or $3, those are the best days to
sharpen your pencil and buy your best companies.
Phil, I've enjoyed talking with you. Thank you.
Philip McPherson joined
Global Hunter Securities
in June of 2007 as a senior equity research analyst in the
firm's energy group. Prior to joining GHS, Mr. McPherson was
director of research at C. K. Cooper & Company, a boutique
investment-banking firm located in Irvine, California, which
focused exclusively on small-cap exploration and production
companies. In his role at C. K. Cooper, Mr. McPherson was
responsible for new initiations of E&P companies;
additionally, he generated the firm's macroeconomic analysis in
relation to oil and natural gas price forecasts, which
generated the firm's price decks. Mr. McPherson was rated a
five-star analyst by Zacks in 2002, 2003, 2005 and 2006. Prior
to joining C. K. Cooper, Mr. McPherson was a partner in Mission
Capital, which was acquired by C. K. Cooper in 2001. Mr.
McPherson began his career in the securities industry at
Mission Capital in March of 1998 as a retail stock broker. He
graduated from East Carolina University with a BA in
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1.) George Mack of The Energy Report conducted this interview. He
personally and/or his family owns shares of the following
companies mentioned in this interview: None.
2.) The following companies mentioned in the interview are
sponsors of The Energy Report: None.
3.) Philip McPherson: I personally and/or my family own shares of
the following companies mentioned in this interview: Venoco and
Evolution Petroleum. I personally and/or my family am paid by the
following companies mentioned in this interview: None.
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