When I analyze stocks I look for two things: an industry that I believe will thrive over the long-term and value. I don’t have models to predict the future prices of oil and natural gas, and even if I did, I doubt they would be very accurate; however, I do believe in the long-term viability of the industry or I wouldn’t have bothered starting this blog nearly three months ago. When looking for value in oil and gas stocks, I first look at how investors are valuing each play. The easiest way to do this is to look at reserve and production multiples.
The trouble with valuing an individual play is that there aren’t a lot of “pure-play” companies in the oil & gas industry. Most companies have operations in various plays across the U.S. and abroad, so their reserves and production valuations have several different plays factored in. Companies like Kodiak (KOG) in the Bakken and Concho (CXO) in the Permian are great examples of pure-plays that make analysis easy. A play like the Eagle Ford is more difficult to value, not only because it’s so new, but because it has attracted companies from all over the globe, most of which had existing production and were looking for oil and liquids rich assets.
At first glance, Sanchez Energy (SN) is the perfect Eagle Ford comparable. It’s an Eagle Ford pure-play, but it’s an early stage company that the market is expecting significant reserve and production growth from over the next several years. Because of these expectations, its multiples are high which throws off my Eagle Ford valuation. I did consider throwing SN out of the analysis, but I had a tough time justifying this because their core acreage is in Gonzales County where two Bakken companies, EOG Resources (EOG) and Magnum Hunter (MHR), have been drilling gushers and I want to get a sense for the valuation of that acreage.
While SN may bloat my Eagle Ford valuations some, keep in mind that Marathon (MRO) spent $3.5 billion purchasing 141k net acres (~25k/acre) from Hilcorp a little over a year ago. By year-end 2011, the acreage was expected to have 46 wells on it producing 12,000 net BOEPD (80% oil and liquids) giving us a valuation of $291,667 per flowing BOEPD, 22% less than the $355,234 per flowing I calculated based on my peer group.
See valuations by basin/play below to get sense for how the market is valuing each play:
The first point to make here is the “well duh” observation: the gassier the basin, the lower the valuation. It should be no surprise that the North Dakota Bakken is receiving the industry’s best reserve valuations, because the play is in more advanced stages (thus less risky) than the Eagle Ford, DJ and Permian, and more oily than the Marcellus. While the Eagle Ford is more gassy than the Bakken, it’s downspacing potential has led EOG to nearly double its reserve estimates. In addition, the play has several resource windows and the potential for stacked pay zones which is undoubtedly driving up valuations. The DJ and Permian Basins also have stacked pay zones, which has led to a revival of both Basins in recent years.
Companies are now going back into these Basins using updated completion techniques (horizontal drilling, fracking, etc) to exploit the previously unrecoverable resources. Large cap E&Ps Noble Energy (NBL) and Anadarko (APC) aren’t spending billions in the Niobrara over the next several years for no reason. With valuations in the Bakken and Eagle Ford extremely high, I think it’s worth looking at these other plays for value. Below are the peer groups I used in my valuations by play above.
1: SYRG reserves based on 8/31/2011 year-end
The companies used in the analysis above are either pure-plays in a specific basin/play or have current operations focused in a certain play. Aside from SN, KOG is another company whose valuations are outliers. KOG is an early stage company that has several years on SN. KOG’s production has done what SN’s investors are hoping its production will do: explode. And when I say explode, I mean increase nearly 5-fold from May 31, 2011 to May 31, 2012.
SM is an established operator, producing in a premier shale play, but with a low production valuation. Why might this be? Its reserve life (reserves divided by annual production) is only 5.5 years versus the peer group average of 17.39. The market isn’t buying that SM will be able to replace its reserves quickly enough to maintain production. The company is in the process of shifting assets from the Cotton Valley and Wyoming gas Basins to invest nearly a billion dollars in 2012 drilling in the Eagle Ford and Bakken-Three Forks. The company has over 200k net acres in each of these plays, so if you believe in the acreage, the present could represent an opportunity to buy SM on the cheap.
Based on pure value, we should all be buying Marcellus companies right? EQT’s stock price has increased 20% from its lows this spring when natural gas prices dropped below $2 per Mcf. EQT has the largest reserve base in this analysis, located in one of the most economic plays on the planet. The economics of the Marcellus are so good that the company boasts 25% IRRs at $3.00 gas and 50% at $4.00 gas. On an energy equivalent basis, those numbers blow the Bakken out of the water.