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How To Invest in Oil & Gas Stocks

ENERGY INVESTING 101

Dear OGIB Reader,

Investing in oil and gas stocks is actually quite simple.

Investors have two basic choices when starting out:

1) Do I want to get a stockbroker who specializes in oil & gas (probably based in Calgary or Texas) and do what (s)he tells me; or 2) Do my own research and stock-picking?

If your answer is 2), then you may find useful the Top 20 Answers I try to determine in my first round of research I am doing on oil and gas companies. This is hardly an exhaustive list. But I’ve tried to use simple language to help even the most novice oil and gas investor understand what questions and answers will help them decide on the potential of an energy company.

Where do you go to find these answers?

In order, I suggest:

A) Corporate Presentation on the company website

B) Call management directly (though the bigger the company the harder this is, and few energy companies have investor relations people)

C) Read the quarterly financial statements ± the numbers and the notes (the more you get into it, the more you will find that most good information is in the notes and the management discussion)

Before reading these starting points, also consider ± what type of investor are you? Do you want to invest in large stable companies with a long history and strong cash flow? Or can you tolerate higher risk, and want to look for more leverage in the junior stocks, where a discovery could either give you a multiple return or lose most of your investment?

THE TOP 20 ANSWERS YOU NEED TO KNOW:

How much of their production is oil and how much is natural gas? (gas prices are very low right now and doesn’t produce much, if any, cash flow for companies)

1) How many barrels of oil per day (bopd, or “boe” for natural gas – barrels of oil equivalent) is the company producing, and how quickly have they grown production in each of the last 3 quarters.

2) How much net cash or net debt do they have? This industry uses a lot of debt, so if a company actually has net cash, they could grow more quickly because they have an entire untapped line of credit waiting to go drilling, and grow the business. And of course no debt means no debt payments and flexibility in doing business.

3) Where are the properties? Investors give North American assets a slight premium, unless the company is either growing very fast or has a management team that has built and sold an oil & gas company. Political risk shows up in the stock price.

4) How many wells will the company be drilling in the coming nine months? This will give you an idea of how fast they may grow. Companies usually say in their presentation how many wells they will drill property by property, but don’t often give an overall number in one slide. Odd but true.

5) How much will all this drilling cost, and do they have the money or cash flow to do it? Most companies have a slide in their corporate presentation that shows their estimated cash flow for this year or next, along with their estimated capex, or capital expenditure,
which is their drilling budget. Or do they have to raise money in the market to do the drilling they want? (This is not good when the market smells a financing coming, it drives the stock lower.)

6) Are these wells higher risk exploration wells or lower risk development stage wells? Development wells are just filling in an already discovered oil field. It means these wells will almost certainly repeat the success of the discovery well; the oil or gas formation is large and drilling success is “repeatable”. The market loves certainty, and most companies go out of their way to crow about their “undeveloped land acreage” and “X year drilling inventory”; the number of wells they could drill on this development-stage land.

As an example, the new, big shale formations in North America are very “repeatable.” The Bakken oil field in Saskatchewan is “repeatable” in large scale, i.e. it could support many wells.

7) If the company is doing exploration drilling, what has been the company’s success rate in each of the last two years? HINT: if it’s not on the PowerPoint, guess what… There is new technology called 3D seismic that allows companies to see the producing oil/gas formations much better and now means a much higher success rate for exploration. Anything under 70% success in raw exploration and I get nervous.

8) What has management done in the past? Have they ever built and sold a producing energy company?

9) How many research analysts follow the story? If the answer is 3 or less, why hasn’t management been able to secure more coverage? There is a reason. It might be because your target investment is small. It might be that it is just not a compelling growth story as you think. Or it might be just be because management doesn’t raise money much, i.e. rarely (if ever) issues equity. Analysts get partly compensated on the business they can bring into their brokerage firm. If they cover a producer who will never raises money, they’ll never get paid, so who cares?

10) Without analyst coverage there is no institutional money flow in the stock. And without institutional support, your stock will need A LOT of drilling success to move up, and will likely always trade at a big discount to its peer group.

11) Decline rates are something management teams don’t really hide, but don’t really talk about either. Every well has declining production until it’s uneconomic. The new shale gas plays often have 85% decline in production in the first year. Tight oil plays (shale gas and shale oil) have 75% initial decline rates. Decline rates are increasing over time now as the industry drills deeper and tighter plays. Ask management what the initial decline rate is, both company wide, and specifically on their main, big play that they believe will be the growth engine of the company. Then ask what the decline rate flattens out to – it’s usually 20-30%. This is called the “long tail” of production.

Why is this important? Because many investors, when forecasting growth, use the only public numbers given for a well the ones in the press release. Most companies have a production decline graph in their PowerPoint, but few actually say what the production levels in the wells in the area flatten out at (and many research reports from analysts don’t either)

12) If the company is operating in a foreign country, what kind of political connections do they have? Who from that country is in management or on the board of directors?

13) What is the break even cost, companywide, and in their main play, in terms of price per barrel? Management should have a very good ballpark number at hand.

14) How much does it cost them to bring up a barrel of producing oil? Costs can range from $8000 per flowing barrel to over $30,000. Obviously, the lower the better, as this will be more profitable. Then you compare it to what companies are being bought out for. If a company can produce a barrel of oil for $10,000, and the stocks are being bought or merged at valuations of $70,000 per barrel, that’s a very accretive oil or gas play! Again, management should be able to answer that question on the phone.

15) What is the recycle ratio – both overall corporately and specifically on their main play – that will be the growth engine for the company? The recycle ratio is a key measure of profitability for an energy company. It’s a fairly simple calculation, and many companies put it in their quarterly and a few even put it in their PowerPoint. Management will know this number off the top of their head like they know their wife’s name, so don’t be afraid to ask.

The recycle ratio is the profit per barrel (called the “netback”) divided over the cost of finding that Barrel – ”F&D”– Finding and Development Costs. Both the netback and the F&D costs are in all the quarterlies, usually broken out in simple charts and language in the notes. The higher the recycle ratio, the better. Anything over 3 is great, 2 is really good and under 2 can still be OK if it’s a big field and lots of wells can be drilled. Different companies report differently so not all recycle ratios are equal, but it will give you a general idea. The higher the recycle ratio, the higher the valuation should be.

16) How much of their own infrastructure do they own? And are they the operator of their plays? Infrastructure includes things like local or regional pipelines, storage facilities, processing facilities. If they don’t own them, they have to pay charges to use them, and are subject to somebody else’s maintenance and upkeep. And the market often pays a lot less for a non-operating interest in a play, as the operator gets to call the shots most of the time.

17) Ask management what kind of discount or premium they get for their production, from quoted prices like WTI crude or Brent Crude and why that is. For example, heavy oil gets a discount up to 50% from the WTI price or Brent crude price that is always quoted in the media. Maybe their oil or gas has a high sulphur content (which would also give them a tougher time with environmental permits). A company may say they are producing 10,000 bopd, but if their price is much lower than world price, their future cash flow could be much lower than you think.

18) How much stock does management own? Which people on management are the largest shareholders in the group? And how much hard cash – not stock options – does management have in the company?

19) Look at the stock chart – Is the stock moving up or down? Ask management – what is the market missing in terms of appreciating the company and stock?

20) And lastly, ask open-ended questions, like what else is there about your company that you want to tell me? Where do you want to improve the most over the next 2-3 quarters?

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