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Given volatility in the price of crude oil, exploration & production stocks have taken investors on a bumpy ride lately. In light of recent weakness, investors need to be careful about how they play the E&P arena.

Since hitting its peak above $78 in July, the price of crude oil fell to a six-month low just under $60 on September 25, amid a mild hurricane season and fading investor concern over Iran. Although, at $63, the price of oil has rebounded slightly, it remains well off of its high. Not surprisingly, shares of oil companies have also suffered. Over the last four weeks, the average stock price in the oil & gas operations industry has slid nearly 7 percent. By comparison, the S&P 500 index is up nearly 2.7 percent over this period.

The question then becomes how to identify potential investment opportunities in the exploration & production (E&P) arena while also being mindful of the volatility arising from fluctuations in oil and gas prices.

We started with the list of companies from the oil & gas operations industry that also appeared on at least one Reuters Select stock screen. We then sifted out companies that focus on oil & gas transportation, refining or marketing, in addition to property trusts. This left us with a list of eight firms that focus on exploration & production (E&P) activities, though some are also involved in other areas as well. (Click here for an Excel sheet comparing these eight oil companies.)

Since we wanted companies with stocks that appear to hold up better during adverse market conditions, we filtered for stocks that have outperformed the average of the oil & gas operations industry in either the last month or quarter. This left us with three names.

A problem with focusing on companies where stocks have outperformed their peers is that there is potential for stocks to be priced at significant premiums, which could make them more susceptible to get hit in the event of a market downturn in the future. Thus, while we can allow a slight premium, we need to make sure that a stock isn't priced too far above the industry norm. While there can much debate about what exactly is meant by "too far," we are going to use an upper limit of just five percent above the peer norm for price to earnings (P/E). All three passed this test.

We then used the same criteria for another valuation metric, price to sales. Here, Talisman Energy, Inc. (NYSE:TLM) stood out from the others.



Its relatively attractive P/E and P/Sales ratios enabled Talisman to register on the Reuters Select value screen for Relative Value, which seeks companies that have reasonable price tags when stacked against their industry peers. The screen focuses on companies that have P/E, P/Sales and P/Cash Flow ratios that are no more than 10 percent above the industry mean. Talisman's P/CF ratio is 5.53 versus the industry's reading of 7.68.

While these requirements go a long way in highlighting companies that are priced reasonably, it does not tell us anything about the quality of the company. At this point on the screen, it is just as possible that a company has experienced declines in both its stock price and its revenue, earnings and cash flow, as it is that the firm has experienced improvements in these areas. As such, we need some supporting tests to ensure that we are highlighting companies that are performing relatively well. To accomplish this, the screen requires that a company's earnings-per-share [EPS] growth during the trailing 12-month [TTM] period must be at least 25 percent better than the industry's pace. As indicated below, the magnitude of Talisman's outperformance is closer to 53 percent. And it has continued to outpace its peers in the most recent quarter [MRQ].


Learn about Growth Rate Ratios

There are many factors explaining why a company's earnings growth pace might be faster than its revenue pace, as we see above. A key contributor to Talisman's performance is its profit margins. As indicated below, in the TTM time frame Talisman has improved upon its already industry-leading five-year average margins. This has laid the foundation for Talisman to also appear on the Reuters Select stock screen for Strong Operating Margins.


Learn about Profit Margin Ratios

The Strong Operating Margins screen requires that a company have both TTM and five-year operating margins that are wider than the industry average. It also requires that a company's own TTM margin must be at least 25 percent wider than its five-year figure. As indicated above, Talisman easily satisfies these constraints.

A key benefit of Talisman's profit margins is that they also provide a buffer during periods of falling commodity prices. This is particularly important given the recent downtrend in the price of oil. Wider profit margins suggest that a company could be better able to weather a decline in revenue than a company with slimmer margins. Similarly, wider margins also allow more of those top-line gains to boost earnings during periods of rising oil prices. And these are factors that need to be considered carefully, particularly when one considers the volatility of oil prices, especially against the backdrop of mixed signals we are getting from different types of oil traders, as Marc Gerstein discussed in a recent article on oil spot and futures prices.

At the time of publication, Erik Dellith did not directly own puts or calls or shares of any company mentioned in this article. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.

Note: This is independent investment and analysis from the Reuters.com investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by Reuters.com.

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Source: Talisman: An Exceptional Exploration and Production Play