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15 drillers to fuel your portfolio
Natural-gas exploration is still a crapshoot, but the stakes have grown tantalizingly higher. Back the right stock and both of you emerge big winners.
By Jon D. Markman
For investors interested in intellectually-advantaged speculation seasoned with a dash of geopolitical gaming, it may be time to step on the gas.
The broad-brush reasons for taking positions in small-cap North American energy exploration companies has been in place for some time, as China has emerged as a voracious devourer of energy, Saudi Arabian turmoil has intensified (See "Sauds royal house of cards"), U.S. state governments have demanded wider use of clean-burning fuels by power plants and environmental laws have tightened supplies.
Early-bird speculators have therefore pushed up prices of some of the best little explorers, such as Ultra Petroleum (UPL, news, msgs) and Callon Petroleum (CPE, news, msgs) by as much as 100% over the past 10 months. But most of these stocks have cooled recently, providing a new entry point for a second wave of investors and traders seeking a hedge against overseas uncertainty.
To be sure, drillers defile the landscape of some of the most gorgeous places on earth like filthy rows of steel stinkbugs. Yet they are a necessary evil, angels disguised as devils, and their ugliness masks opportunity.
Natural gas increasing value
Big picture first: Back in the 1940s, natural gas was worth virtually nothing. Drillers burned it off in the process of exploring for petroleum. As new uses were discovered, it became increasingly valuable, rising from $2 per 1,000 cubic feet on average during the 1990s to $10 in 2000. The price collapsed in 2001 back to $2, but it has steadily risen since -- spiking above $10 at the start of last years war in Iraq before settling back to around $5.25, where it is now.
The price of natural gas always jumps during winter cold snaps, which accounted for its most recent foray above $5.75, but its unlikely to collapse below its current trading range again because theres not enough drilling being done to satisfy demand due to tough environment laws. Federal Reserve Chairman Alan Greenspan told Congress back in June that tight supply threatened the U.S. economy.
An all or nothing world
All gas drillers are not equal, and it pays to understand the industrys superstructure, risks and leverage points. Just as technology investors are accustomed to learning about the varied makers of semiconductors, disk drives and switches that make components for popular consumer electronics devices and determining which offer the most oomph at various points in the economic cycle, energy investors must learn about the complex, high-risk way gas is discovered and distributed.
Lesson No. 1, though, is how truly speculative some of these guys are. The companies are usually run by cagy industry veterans -- some with checkered pasts -- who suspect they can use new high-tech 3-D seismic imaging tools to find gas formations in properties abandoned by much larger drillers, such as Exxon Mobil (XOM, news, msgs) or ChevronTexaco (CVX, news, msgs). At the start of new projects, observers are skeptical that the driller will even find financing to start the project. Then, they're skeptical theyll persuade an oil-services company to lease them a drilling rig. Then, theyre skeptical that drilling will ever actually start. Then, theyre skeptical that the project will ever be completed. And then -- and lastly, they wait anxiously to learn whether gas is discovered or not.
Drilling is thus a crapshoot of probability distributions, and as each critical hurdle is cleared, energy speculators become more interested, adding to their positions and pushing up stock prices. The big moment comes when the company announces whether it has hit pay dirt or come up dry. The final press release announcing the success or failure of a new well is like the one that is published when a biotech company tells the world whether the U.S. Food and Drug Administration has approved its cure for cancer. Its all or nothing, hero or goat.
Canadian Superior Energy
Canadian Superior Energy (SNG, news, msgs) is typical of this high-risk/high-reward world. The company, which already owned leases to drill in Trinidad and western Canada, obtained four offshore exploration licenses totaling 933,000 acres in relatively shallow water off Nova Scotia a few years ago. In April last year, it announced it had teamed with gas pipeline giant El Paso (EP, news, msgs) to drill an extremely deep well -- about 18,000 feet -- in a property off Halifax known as Mariner Prospect. In June, Canadian Superior cleared a big hurdle by announcing that El Paso would provide half the projects $30 million cost for half the profits, and in November it cleared further hurdles by completing a $14 million private placement, securing a drilling rig from Rowan (RDC, news, msgs) and started to drill. The stock over this period went from 80 cents to $3.03; its now around $2.65.
The largest institutional shareholder of the stock, at 6.5% of the outstanding shares, is Palo Alto Investors (PAI), a private, value-oriented hedge fund in Northern California. David Anderson, the analyst on the hook for the investment at PAI, says he believes the value of the companys other properties in Western Canada provide the bedrock for the share price today, and the Nova Scotia project could add $5 to $8 if the company meets its goal of drilling into the middle of a formation with 1 trillion cubic feet of gas. As a value player, we see a lot of optionality, he said, meaning that the stock is like a call option on the Mariner project.
Two weeks ago, Anderson flew out to the rig on a helicopter in 60 mph winds and hung around for a while despite 30-foot seas. He said he learned Canadian had 4,000 more feet to drill, that the drilling personnel were fantastic and that there have been gas shows along the way. But he said that neither he, the crew bosses nor company executives had any idea yet whether the project would be successful. Its sort of like the swordsman who lives to fight another day, he said. Every day they drill without doing anything wrong removes a little uncertainty, but until they get to 18,000 feet and do some expensive tests there, its still just a speculation.
Cheap, strong explorers
The day of truth will come in about three weeks. In the meantime, Anderson, whose hedge fund was up 90% last year and has compounded returns of 25% over the past 14 years, has been quietly investing in several other exploration ventures that he declined to reveal. He primarily buys drillers with high recycle ratios. Its a simple concept: Find companies with proven ability to replace the oil or gas theyre extracting from the ground for much less than the production costs and the expected future commodity price. If you can sell gas for $5.50 that costs $1.50 to find and make, you can use some of the profits to explore for more. The key thing is to replace your depleted asset at low costs, and if you can provably do that repeatedly -- fantastic, Anderson said. And, he added, all the information necessary to make such judgments can be found in the footnotes of explorers annual 10K filings with the U.S. Securities and Exchange Commission.
Not including the ones hes currently buying, Anderson said he believes the strongest, least expensive explorers at this time are small caps PetroQuest Energy (PQUE, news, msgs), Patina Oil & Gas (POG, news, msgs), Wiser Oil (WZR, news, msgs), Harvest Natural Resources (HNR, news, msgs), Callon Petroleum and Meridian Resources (TMR, news, msgs); and midcaps Ultra Petroleum, XTO Energy (XTO, news, msgs), Evergreen Resources (EVG, news, msgs), Newfield Exploration (NFX, news, msgs) and Pogo Producing (PPP, news, msgs).
Ultra Petroleum is a good example. Although it has properties in Pennsylvania and China, Ultras main asset is in the Pinedale Anticline of Wyoming, located southeast of Jackson Hole. A company typically does great if it hits oil in half the wells it sinks, but Ultra is virtually 100 for 100 in Wyoming and has more than 700 drilling prospects left. That makes it a reserves growth story that Anderson believes is worth $30 to $40 -- about 50% more than the current price. (His firm owns 1 million shares.) Likewise, Harvest Natural Resources is a low-cost producer off the coast of Venezuela that might be undervalued because of political risk stemming from the unstable regime of President Hugo Chavez. Anderson considers Chief Executive Peter Hill one of the industrys best.
Side bets abound. Consider drilling technology provider Carbo Ceramics (CRR, news, msgs), a small-cap maker of little clay balls that are used to prop open fractured rock underground, increasing oilfield yield. Or Golar LNG (GLNG, news, msgs) a fast-growing, profitable but inexpensive Norwegian shipping company that specializes in transporting liquefied natural gas. For returns less subject to the whims of commodity prices, check out large-caps Halliburton (HAL, news, msgs) and Schlumberger (SLB, news, msgs), without whose oilfield management and services expertise worldwide drilling would come to a standstill.
Over the rest of the year, Ill explore the industry further and visit some rigs for a more personal account. Initial ideas are listed in the table below.
| Natural gas exploration picks | | Company | Market cap | Chg. 2003 | Scouter rating | 2/17 price | | PetroQuest Energy (PQUE, news, msgs) | $114 million | -13.8% | 4 | $2.84 | | Canadian Superior Energy (SNG, news, msgs) | $233 million | 149.5% | 5 | $2.56 | | Meridian Resource (TMR, news, msgs) | $333 million | 318.5% | 4 | $5.58 | | Wiser Oil (WZR, news, msgs) | $126 million | 141.1% | 6 | $8.17 | | Harvest Natural Resources (HNR, news, msgs) | $393 million | 73.7% | 5 | $11.58 | | Golar LNG (GLNG, news, msgs) | $977 million | 188.4% | NA | $16.19 | | Ultra Petroleum (UPL, news, msgs) | $1.7 billion | 140.2% | 6 | $25.84 | | XTO Energy (XTO, news, msgs) | $4.8 billion | 43.4% | 9 | $28.53 | | Halliburton (HAL, news, msgs) | $13 billion | 57.0% | 10 | $31.79 | | Evergreen Resources (EVG, news, msgs). | $1.2 billion | 49.4% | 8 | $35.10 | | Pogo Producing (PPP, news, msgs) | $2.6 billion | 12.7% | 8 | $44.83 | | Patina Oil & Gas (POG, news, msgs) | $1.5 billion | 68.6% | 8 | $49.46 | | Newfield Exploration (NFX, news, msgs) | $2.6 billion | 42.4% | 8 | $46.38 | | Carbo Ceramics (CRR, news, msgs) | $911 million | 77.1% | 7 | $59.55 | | Schlumberger (SLB, news, msgs) | $35 billion | 63.2% | 8 | $64.07 |
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Jon D. Markman is publisher of StockTactics Advisor, an independent weekly investment newsletter, as well as senior strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jdm68@lycos.com. At the time of publication, Markman did not have positions in any securities mentioned in this column. His newsletter described Canadian Superior in its Dec. 3, 2003 issue.
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