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In the investment world, there are few sectors that offer as many binary outcomes as the oil and gas business. A potentially high-impact well either hits or it doesn't. In this business, well results move stock prices far more than do quarterly earnings statements.

This is kind of appealing, in a way. Companies that live and die by beating the Wall Street consensus earnings-per-share number each quarter are far more inclined to fudge their numbers. Accounting chicanery is something I don't spend a lot of time worrying about when I invest in E&P companies.

Of course, there are plenty of other things to worry about:

  • Hurricanes and other natural disasters.
  • Expropriation by foreign governments.
  • Rig explosions.
  • Permitting challenges following said explosions.

Then, of course, there's the more run-of-the-mill concern that a new exploratory play will come up dry. If a company has a lot riding on a play, this can really hurt. We saw what happened to Delta Petroleum (Nasdaq: DPTR) shares when the company's highly anticipated Gray well in Washington state turned out to be a duster.

On the flip side, a successful well result can set shares alight. We saw that yesterday with Credo Petroleum (Nasdaq: CRED) and the results of its third Bakken well. The well tested at a 24-hour rate of 1,367 barrels of oil equivalent per day. This initial rate was actually lower than those reported at Credo's prior two Bakken wells, but this one was choked back to a greater degree, implying strong potential. Credo also has a much larger working interest in this well than in the prior two, which should translate to a more material increase in production, cash flow, and net asset value. The shares are up over 20% as I write.

Credo is drilling in the Fort Berthold Indian Reservation in Dunn County, North Dakota -- the same area that Williams (NYSE: WMB) paid a pretty penny to enter back in November, and where Kodiak Oil & Gas (AMEX: KOG) is also making headway. The Bakken play is making a lot of people a lot of money. Credo shareholders are just the latest to catch the wave.

Now, as for my thoughts on investing in so-called "drill hole plays," where you've got that binary outcome in full effect: This is often not a great deal different than putting it all on black at the tables in Vegas. That's not to say you can't tilt the odds in your favor, though.

E&Ps can trade down to incredibly pessimistic valuations as a result of disappointment or boredom. Over in the U.K., an explorer called EnCore Oil had been all but abandoned by investors in early 2010, following a year that saw no drilling activity. Despite the team's track record of past discoveries, and a collection of interesting prospects, EnCore shares traded for roughly the value of net cash on hand. After hitting a few successes, the company's shares are up tenfold. I only uncovered this situation after all the fireworks, but it's the sort of asymmetric bet that I look for constantly as an investor.

In short, you can take a lot of the risk out of even the most speculative realms of investing. The less you pay up for potential upside, and the more downside protection you have in the form of cash or other tangible assets that are unlikely to be frittered away, the less speculative the activity becomes.

Disclosure: No positions

Source: E&P Stocks: What a Difference a Well Makes