A Blueprint For Small Cap Oil and Gas Investment Success – Part 1
You only make Big Money on mis-understood investments.
And now that the oil price has collapsed to the point where there is almost no meaningful cash flow, mis-understood investments are easier to find.
That’s because the Market has divided oil stocks into two groups—those that can thrive at $65 oil and those that can’t.
Some go bankrupt, like the operating subsidiary for junior Bakken producer American Eagle did on May 11, and some just survive as zombie stocks—the walking dead who make enough cash flow to stay alive but not to grow.
But there’s actually a few—and these would be the less followed, smaller companies—that actually have quite good economics in Canada, given
- The lower Canadian dollar
- 15-25% reduction in service costs
- Continued improvements in fracking technology that is lowering costs per barrel—sometimes as much as 20% just since last summer!
You just have to use the right process to find them; your research has to quickly weed out the zombies.
There is so much leverage for investors in the junior oil sector now as valuations have been crushed—if you find one of the few that has stellar economics and a good team at the helm…you can make a lot of money right now.
With the right process, you not only increase reward but reduce risk in your investments. I’ll give you my process right here, and the stock that it has led me to:
Box #1 – Proven Management Team With Real Skin In The Game
Management is so important in oil and gas production. A good team thrives in bull markets and does more than survive in bear markets. A good management team has the respect of analyst and investment banking community which opens deal flow and allows for low cost access to capital (i.e. higher stock prices).
Do the bios for top management and the Board of Directors show a past track record of successfully building companies? And how many shares did each of them own? You want management to be both skilled and motivated by having significant skin in the game.
If management doesn’t have a great track record AND own a significant number of shares toss the company back on the zombie pile and look for another.
If that box is ticked proceed to the next boxes.
Box #2 – Low to No Debt–A Pristine Balance Sheet
Once you have an “A” Team with skin-in-the-game—look at the balance sheet.
I’ve watched companies like Legacy Oil and Gas that has a Tier 1 management team just slowly add on too much debt…and fall out of favour. The team at Lightstream took Petrobank to $60 and Petrominerales to over $30 and were market darlings. But now that team has one of the lowest valuations on the Street—all because of debt.
In Canada, the Market is very clear: lower debt levels get higher valuations—even though debt is essentially free, and makes a lot of business sense. High growth, high debt companies can be very tempting in a bull market. But it was the more highly leveraged oil stocks that fell 70-90% in late 2014 as oil prices collapsed.
So now the field of possible investments narrows. The overleveraged companies are weeded out. This is good—it should narrow, at every step in the process. If your company has less than 1.5x debt-to-cash-flow, then your investment idea is ready for the next step.
Box #3 – Low Finding And Development Costs
Ok—now you have a proven team with a good balance sheet that is ready to drill baby drill…..but as an investor you better be very sure that what they are drilling is a top quality asset.
A good management team and good balance sheet can both get ruined by hitching their wagon to the wrong property. The team at Pinecrest Energy are a Tier 1 group, and were the toast of the town for their high netback Slave Point play. Everyone expected it to be the Next BIG Winner, and the Market gave it a huge valuation.
But this young asset never met expectations with unexpectedly high decline rates, and the stock went from just under $4 to just over four pennies.
The issue here for investors—Slave Point was not a proven play—you want a proven play with Top Tier Finding Costs.
At $100 oil these resource plays can make some money for junior producers. Today, they are really only a good fit for larger companies.
Few resource plays (read: tight oil, shale oil) can recycle cash very quickly for a producer through rapid payouts. I’m looking 18 month payouts now and at higher prices it’s 12 months.
Small companies have a limited amount of cash and typically don’t have an underlying base of low-decline production. That is why these fast paybacks are so crucial.
I think this low oil price will bring back a lot of low-cost conventional vertical plays. Wells are cheaper for juniors, and they can still have fast payouts and much lower decline rates. That provides a much more stable base of production and cash flow which means less investment is required to maintain production and makes growth easier to achieve.
The company’s with the lowest cost are able to generate positive cash flows and drill profitable new wells even today. When oil prices are high these best in industry assets are like owning a license to print money.
By now, a few more candidate stocks have fallen off the table. My list grows shorter. On to the next step:
Trait #4 – A Multi-Year Inventory of Low Risk Development Drilling
So now you have a company with a proven management team, solid balance sheet and an asset proven to be low-cost and highly economic, even at today’s commodity prices.
But you still need more……you need a visible path to future production and cash flow growth.
Look at RMP Resources (RMP-TSX)—they have the single most profitable play in all of Western Canada, IMHO—their Coquina formation wells paid out in weeks when oil was up at $100. They have a well respected team. But that asset is only proven on 6-8 sections, with a 1-3 year drilling horizon. The Market is just not willing to reward them for a long inventory yet, despite almost all the boxes being checked there.
To be a really great investment a small producer needs growth, and lots of it.
I’m looking for companies that have at least a five year inventory of low risk development drilling locations in a “de-risked” conventional play. These are wells where I know what cash flow I’m getting.
Box #5 – Few Shares Issued; Low Float
The best small cap oil and gas opportunities are also found in companies with tight share structures. Americans use more debt and Canadians use more equity (shares) to grow. I want a small share count where I have leverage to the future success of this great management team.
I also think a low share count is a sign of respect by management to their shareholders. If they’re not willing to dilute a lot, there’s a much better chance they own a lot of stock (see Box #1).
This criteria often narrows the field dramatically, so I keep it close to the end.
Box #6 – An Attractive Valuation
Valuation is likely the least important of the six criteria—a) because I’m not afraid of expensive stocks. They tend to stay expensive…until they don’t meet one of the above criteria. And b) all the companies on the zombie pile are cheap now.
If a company is dirt cheap–it is usually dirt cheap for a very good reason. Either the assets are sub-par and the market is starting to figure this out or the company balance sheet is stretched.
A really great small producer might look expensive on the surface, but the rates of growth that these companies are able to achieve quickly make that valuation look incredibly cheap in hindsight.
A lot of companies have most of my boxes checked…but few have all of them. (And I already own most of them—they’re The Leaders).
Proven Management Team That Owns A Lot of Stock
Great Balance Sheet
Proven Play with Low Finding And Development Costs
Years Of Growth via Development Drilling
Tight Share Structure
Attractive Valuation
The work is finding these companies lying in the Market’s zombie pile. But unlike zombies, these stocks do exist today.
There is one at the Top of My List right now. I did my research, and went through all the boxes. They all got checked off. Just as a hint, management has sold three companies for a total of more than $1 billion—yet this stock trades so cheaply right now.
This one has the type of low risk, high reward combination that only can be found in the midst of an oil crash. This baby has been thrown out with the bath water for absolutely no good reason.
That’s what makes it mis-understood. And that’s where the Big Gains are—especially if oil stays here or goes higher.
More to come in Part 2 when I show you exactly how this company ticks all of these boxes……
-Keith
