The proverbial pendulum has swung for oil and gas exploration-and-production companies over the course of 2011. Stock prices of the oil and gas firms that we cover surpassed our fair value estimates early in the year, hitting a high price/fair value ratio of 121% on January 12, as oil prices climbed on fears of supply disruptions in the Middle East. Recently, however, spot oil prices have begun to fall due to the anticipated conclusion of the civil war in Libya.
The decline also has been spurred by speculation of lower global oil demand due to U.S. and European recession fears and lower oil import volumes in China, as the government there seeks to slow domestic GDP growth.
Despite concerns related to receding oil demand, we believe that prices for many of the firms we cover in the E&P sector are now at oversold levels. Furthermore, we think that natural gas prices continue to ride the bottom of a cyclical trough and that certain "gassy" producers are a strong contrarian opportunity for investors.
The running price/fair value ratio for the E&P sector in 2011 is shown below.
In evaluating E&P firms, we believe that the following characteristics produce outperformance in the long term:
Quality Reservoirs = Lower Costs
It's all about the rock. We assess reservoir quality through a number of factors, including the thickness of the rock formation (or "pay zone") as well as production rates from wells. With all else being equal, higher initial production rates lead to more rapid recovery of the upfront investment, and better economics (such as higher net present value). Higher production rates also indicate a greater volume of oil or gas that can be produced from the reservoir over the life of the well, which leads to lower finding-and-development (F&D) and lease-operating costs per unit of production for the firm over time. As a rule of thumb, the earliest operators in a play hold the lowest lease-acquisition costs, as they are able to scoop up the most prospective acreage before knowledge of a play is widespread. This first-mover advantage results in paying lower upfront lease bonuses and royalties than would otherwise be possible subsequent to a "land rush" that bids up lease costs. These cost levels are the key metrics we look at when we assess an E&P's moat. For gassy E&P firms, we also look for high liquids content in production volumes, which leads to greater average sales prices at the well.
Contiguous Acreage
Having large contiguous acreage positions enable a firm to minimise the number of days it takes to move a drilling rig between well locations. With, for example, North American unconventional rig rates running roughly $17,000-$25,000 per day, reducing the downtime between wells can lead to significant cost savings. Firms with contiguous acreage also make for better potential buyout candidates, and lead to cost savings in our next characteristic ...
Transportation Access
Favourable geology and phenomenal well rates do little good if a producer is unable to transport volumes to market. Gathering, processing (for natural gas), and pipeline access are critical infrastructure prerequisites successful development. Two destinations where this factor has proved to be particularly important are the Marcellus Shale in Pennsylvania and the Bakken in North Dakota, where new wells have greatly outpaced transportation infrastructure development, and many operators are now sitting on large inventories of wells awaiting a tie-in to a gathering system.
Capable Management
E&P management teams can take several forms. Some firms have great financial expertise that allows for savvy acquisition or divestiture deals and more favourable access to capital market--which is critical in times of credit market instability, such as we witnessed in 2008. Others contain strong backgrounds in geology and engineering, and specialise in developing solutions to better find and extract oil and gas reserves. Either approach can be successful, but we like to see management teams with a depth of experience measured in decades rather than years.
Morningstar's Star Rating for stocks can help you identify companies whose shares have been oversold, in our view. For an explanation of the Morningstar Stock Rating, and recent changes to our methodology, click here.
