The Barrett Edge

Hunting For Energy Stocks

One of the key things I’ve learned from my mentor Dave Anderson at Palo Alto Investors is how to find Undervalued  Oil and Gas stocks  as well as how to figure out a way to monetize on their hidden value. Rule number one in the stock market is- have a GOOD MENTOR. So I share with you one of the most important lessons that I have learned from my mentor.
The most important element that Dave always looks for when evaluating an investment in an oil and gas exploration and production (E&P) company, is the ability to economically replace reserves at a rate of over 200% of annual production. That is, for every barrel a company produces, they should be able to replace that barrel with two more barrels. It’s important to make sure that these funds are generated from internal cash flow without raising capital and diluting investors. For example, if someone told you to give him  $1 and he will return $2 you will think he is an alchemist as he promises to create money. The same concept applies to energy, it’s important to find the right companies that can realistically generate a sufficient Internal Rate of Return.

Dave uses a classic example that if you are a producer that can find a barrel (Bbl) of oil for $20, produce it for $10 and sell it for $50, you’d be pretty happy. This mathematical model allows for growth in reserves and production and a positive return on capital. As you recall, an E&P company needs to at least replace each unit of oil it produces with a like unit, otherwise it is just depleting its existing asset base. Therefore, the sale of each unit must generate enough excess cash flow to replace that unit at a cost equal to or below that excess cash flow. As an example, let’s say that your operating metrics look something like this:

1) Drilling and completion cost of your latest well: $6,000,000
2) Size of new reserve from this well: 300,000 Bbls
3) Finding cost per Bbl: $6,000,000 / 300,000 = $20.00 per Bbl
4) Producing life (expected reserve life) of well: 10 years (note that production is not linear, that it comes on at the highest rate it will acheive and will decline over time due to reservoir and pressure depletion)
5) Lease Operating Cost per unit (to flow it from well, maintain well ops, etc): $10.00 per Bbl
6) Sale price per Bbl: $50.00


Based on the metrics above, each unit produced will generate cash flow of $50.00 minus $10.00 in lease operating costs, or $40.00 per unit. But now you have depleted your asset base by 1 barrel, so what do you do? You take your $40.00 in cash flow and go invest it into a new drilling program. Since your finding costs are $20.00 per Bbl for a 300,000 Bbl well (assuming that you have a repeatable drilling program), you have the ability to replace your one unit produced with two more. Note that another way to look at it is that the $50 -$10 – $20 finding costs provide you with an excess of $20, which is “full cycle” free cash flow that allows you to create one new barrel through drilling. So don’t be fooled by the $50 – $10 calculation. At first glance you might imagine I was ignoring finding costs. Full Cycle cash flow must be no less than zero to stay flat in reserves, or be positive to grow the company.

So…using the FASB 69 supplemental disclosures at the back of every public E&P 10-K:

1) look at annual finding costs (total capital expenditures for drilling / total change in reserves, adjusted for prior period changes)
2) Calculate operational cash flow per barrel produced (Rev – Op Cost) and full-cycle cash flow (Rev – Op Cost – Finding Cost). Compare Op Cash flow to Avg Finding Costs to determine CF per Bbl
3) Look at total reserve replacement (total new reserves / total production)
4) Compare across companies and over rolling 5-year periods (one year isn’t a fair assessment period for a growing E&P company) and you will find significant differences that can lead you to asking the right questions about a company’s value and ability to grow. Of course, history doesn’t predict the future, but positive trends in a company’s costs over time should tell you something about the type of reserves the company is chasing and how they are managing their growth. Consistent reserve replacement should be a sign of strength while highly volatile results may be cause for further investigation.

Of course it sounds easier than it is but this is a good start in the hunt for lucrative E&P stocks. I will continue to write about energy stocks and share some of the articles that Dave has written about as well. In my opinion, this is one of the most lucrative sectors on Wall Street.

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