Will Annual Reserve Report Hurt Natural Gas Stocks?

 |  Includes: GXOCF, OEXFF, ONRGF
by: Oil and Gas Investments Bulletin

Over the next few weeks, oil and gas companies are going through a special sort of reporting period … and it’s going to have some important ramifications for stock prices — especially for junior gas producers.

Here’s why:

At the end of each calendar year, every single junior energy producer is obliged to prepare an independent reserves report — essentially a snapshot of the value of their inventory of oil and gas in the ground as of Dec. 31.

Oil and gas companies produce away their main asset each year –- reserves — and have to replace them or eventually go out of business. It’s a fact of life. Valuations, debt lines and ultimately stock prices flow from this single piece of paper, which is how you figure out profitability.

The oil and gas business is not about how fast you can get it out of the ground. Big IP (Initial Production) rates can give a stock a quick pop, but the real money wants big reserves that they can rely on to provide longterm cash flow that provides funds for reinvestment. The market will pay more for bigger, less profitable reserves than smaller, highly profitable reserves.

This is important for a few reasons, but especially because it gives a glimpse into a company’s finding and development costs, or F&D as the industry calls it. This measures a company’s ability to replace production at low cost. How good is management at finding oil or gas? And how good is it at getting it out cheaply, so there’s lots of profit left for shareholders?

The reserve report is also the first clue into a key valuation tool called the Recycle Ratio – which is profit per barrel (the industry calls this the “netback”) divided by costs per barrel – the F&D.

If you spend $20 to get a barrel of oil out of the ground, and get $60 profit for that barrel after all costs, then you are recycling your money 3:1 – hence the term "recycle ratio."

The Recycle Ratio is only easy to find if you know where to look. It’s usually in the middle of the quarterly financial document called the MD&A – Management Discussion and Analysis.

Most junior producers in Canada are gas-weighted, so this year there’s a lot to chew on. The release of year-end reserve reports will highlight the growing chasm between the oily haves and the gassy have-nots ... especially considering gas prices fell by 20 per cent in 2010, on top of a 25 per cent drop the year before.

According to Dundee Capital, lower gas prices means that several gas-weighted juniors could see their reserves reduced. Reserves by definition have to be economic at a certain gas price, and obviously reserves will be less with a lower gas price.

Just this week, junior gas weighted producer Orleans Energy (OTCPK:OEXFF) dropped 1.34 million boe in reserves because of low gas prices, adding that its reserves dropped 35% year over year. It also announced it was selling its deep mineral rights for $10 million on the same day. The stock fell off a cliff, dropping 17%.

Energy producers use a lot of debt, and the banks will lend them money against their assets – their reserves. Lower reserves will mean a lower credit line – but what if their debt is already above their newly reduced credit line?

It’s like having the value of your home be worth less than the mortgage – your asset value is less than your debt. Then the bank forces you to get enough collateral by selling assets or raising equity to pay down debt (which dilutes net asset value per share) or go out of business.

Because the reserves value is calculated at year-end, which just happens to be the coldest part of the winter heating season, the gas guys have been lucky the past couple years. But not even the coldest winter in a decade could help them this year – the going rate for gas at Dec. 31 was barely four bucks and change.

This only serves to highlight what a tough game the gas business has become. At the end of the day, abundant cheap supplies are definitely good for consumers, and probably the economy as a whole.

But for producers, it’s a tough way to make a living.

You can still make money in gas, but it means you have to be the lowest cost producer. He who adds the most reserves the cheapest will probably weather the storm and come out better for it. That which doesn’t kill you definitely makes you stronger.

Dundee says names to watch (and possibly avoid, depending on your point of view) include top ranked picks like Orleans Energy Ltd. (good call, Dundee) and Open Range Energy Corp. (OTC:ONRGF) that face the greatest risk of having credit lines slashed. Terra Energy Corp. and DeeThree Exploration Ltd. (DTHRF.PK) are two more names with attractive assets that have wound up on Dundee’s watch list.

All these companies are desperately trying to shift to oil prospects, and rightly so, because they’re the most gas-levered names in the business. The oil industry is a fashion industry for investors, after all. But it’s tough to turn on a dime and by the time the gas market breaks it might be too late to prevent these guys from being bought out – cheap.

We say pay close attention, because these are the names that are going to be the prey for consolidators. Encana’s (NYSE:ECA) multi-billion dollar deal with PetroChina (NYSE:PTR) shows even dry gas assets still have substantial long-term value, but markets can stay irrational longer than you can stay solvent.

This is a nice way of saying that any gas-levered company operating in Western Canada is ripe for takeover, especially for deep-pocketed majors with time — and money — on their side.

Open Range, DeeThree and Orleans (until this week) have all been relatively strong performers, especially given where gas prices have been. But the trend is always your friend or worst enemy.

As always, timing is the key for investors trying to get ahead of a company sale/buy-out. Get it right and you could be looking at some attractive capital gains relative to (the newly reduced) net asset values when the predators start looking for some easy pickings. But beware. Jump in too early and you could be riding a slippery slope to the downside; wait too long and you could miss out all together.

But the reserve report will be the first clue.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Keith Schaefer owns DeeThree.