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by Mike McDermott

This report was sent to subscribers on July 27, 2011.

EXECUTIVE SUMMARY:

• Institutional investors are brushing macro risks aside and looking for stable growth areas for capital allocations.

• Peak oil concerns are still in play as new reserves require expensive exploration – meanwhile, OPEC has an incentive to keep oil prices high.

• Cash-flush major Exploration & Production (E&P) companies provide an underlying M&A bid as they seek to acquire attractive reserves.

• Three oil and gas producers look especially attractive due to quality reserves and a market cap that makes a takeover offer possible.

  • Energy XXI Ltd. (NASDAQ:EXXI)
  • Brigham Exploration (BEXP)
  • W&T Offshore Inc. (NYSE:WTI)

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As we work our way through another season of earnings reports, one investment concept is becoming clear… The macro risks simply don’t matter to investors right now.

Sure, the United States faces downgrades on its debt as Congress bickers and the debt ceiling looms. Sure, the situation in Europe is disturbing as even the latest funding stop-gaps are only expected to last for a couple of years. Sure, the growth story in China is in question, the marginal US consumer is weak, the housing market is still slumping, and inflation measures are picking up.

But none of that matters… Instead, investors (both individual investors as well as professionals) have been conditioned to expect everything to be OK. And so far, they have been right.

Government bailout programs and stimulus measures around the world have helped to prop up the global economy. And if the latest round of “solutions” in Europe are any indication, the bullish train could keep on chugging.

With potential threats being at least temporarily averted (and this will likely happen again with the US debt ceiling), investor sentiment has an opportunity to improve, which means more capital allocated to equities.

Institutional investors typically have a mandate to remain fully invested (or nearly fully invested) at all times. So as capital allocations toward equities, ETFs and mutual funds, managers are likely to continue plowing capital into stocks with perceived opportunity along with stability.

The oil and gas industry fits that bill perfectly…

Increased Allocations to Energy

There is a good argument for institutional investors overweighting allocations to energy stocks. Typically there are three key arguments for increasing exposure to this area:

  • Emerging Market Demand – Consumers in key EM countries like China and India are increasing their energy demand on a per-capita basis. Considering the huge population in these two countries alone, that represents tremendous future demand for oil and gas reserves.
  • Fears of Inflation – With fiat currencies still in question, investors are looking for exposure to hard and soft assets. Gold spot prices are the first place most investors look at, but purchasing oil and gas reserves is also an excellent inflation hedge.
  • Peak Oil Speculation – The world has a finite supply of oil. Conflicting reports from different agencies make the supply details a bit murky, but the bottom line is that it is becoming more expensive to find and produce new energy reserves. Higher production costs ultimately act as a price support for oil and natural gas prices.

It’s true that technology continues to support drillers and find new ways of creating alternative energy. Shale “fracking” in the US has been instrumental in accessing huge natural gas reserves and sending spot prices lower.

But it now appears that a floor has been established for natural gas, and as demand continues to grow, spot prices could increase. Companies with access to significant natural gas reserves could see the value of their assets increase, and most of these properties have at least some exposure to the price of oil as well.

Cash Balances Lead to a M&A Underlying Bid

It’s no secret that US corporate balance sheets are flush with cash. Because of the uncertain economic outlook, companies have been more comfortable stockpiling cash than trying to spend capital on expansion opportunities.

For the oil and gas industry, this effect is compounded by increasing expenses for drilling, along with the fact that there are fewer untapped resources that are worth pursuing. It’s difficult to justify the exploration and initial drilling expenses if the costs make it difficult to realize an attractive rate of return.

An interesting paradox, is that it makes much more sense for smaller E&P companies to engage in speculative drilling opportunities. For these smaller firms, the risk of “doing nothing” is about the same as the risk of exploring and coming up empty. Either way, they’re out of business.

So a number of “junior” E&P companies have been active in developing oil and gas reserves, and several of them have become very successful.

Here’s where the major cash balances come in…

Large-cap energy companies can keep a close eye on these smaller drilling projects, and monitor the risks in play. When it becomes clear that a smaller company’s energy assets are attractive, Big Brother can then swoop in and buy out the smaller company and use its capital to develop the resources more quickly.

An acquisition like this can actually be set up to benefit everyone… The smaller company may not have the capital resources to roll out a large-scale drilling program. On the other hand, the larger companies are looking for more reserves. A merger solves both of these problems.

For example, take a look at the recent acquisition agreement between PetroHawk Energy Corp. (NYSE:HK) and BHP Billiton (NYSE:BHP). In this case, BHP bought out HK for a huge premium to gain access to the company’s natural gas resources. BHP brings plenty of capital to the table and will be able to develop these resources more quickly. HK shareholders received a huge jump in their share price – an attractive return overnight!

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Major oil companies are flush with cash and are increasingly willing to put it to use if it means capturing reserves that can be exploited.

  • BP plc (NYSE:BP) holds $18.6 billion in cash
  • Chevron Corp. (NYSE:CVX) holds $13.1 billion in cash
  • Exxon Mobile (NYSE:XOM) holds $8.5 billion in cash

As deals like HK / BHP are announced and investors realize the acquisition potential, small energy companies could see share prices rise in anticipation of potential M&A transactions. Here are three names we’re tracking in the area…

Energy XXI Ltd. (EXXI)

• The #3 oil producer in the Gulf of Mexico shelf with 125 million barrels in reserves and 46,000 barrels / day in production.

• Has grown reserves by 27% annually over the last five years.

• Debt metrics attractive compared to both reserves and capitalization.

• Stock has established a positive trend, with recent consolidation offering an attractive entry point.

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Energy XXI has been on its own acquisition spree since the company began operations in 2005. Over the past six years, the company has spent roughly $2.5 billion dollars to acquire drilling rights to various oil fields.

The results have been quite impressive. EXXI now has a profitable operation which produces 46,000 BOE (barrels of oil equivalent) each day and has 125 million barrels in reserves. At a current price of $100 per barrel, that represents about $12.5 billion dollars before production expenses.

The company has an interesting approach to building its business. EXXI focuses on mature oilfields in coastal and offshore Louisiana. “Mature” fields simply means that the resources are already actively producing. Energy XXI is able to economically continue the exploration and development process with less overall risk to the company.

At this point, EXXI is the #3 oil producer in the Gulf of Mexico shelf with 447 active wells in 60 different production areas. While the company does have exposure to natural gas, 63% of their production is oil. With oil prices in a true bullish trend, this “oil heavy” production is much more attractive to a potential suitor.

Throug a combination of acquisitions and additional exploration activities, the company has managed 27% annualized growth for their base of reserves, even while growing their production levels and generating profit growth.

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This reserve growth not only points to future profits for the company, but also makes EXXI an attractive takeover candidate for large-cap oil companies looking for an opportunity to build their own reserve base.

To acquire these reserves, it was necessary for Energy XXI to take on a significant amount of debt. But the company has been working on reducing its liabilities and long-term debt has dropped from $1.14 billion in June of 2008 to roughly $772 million as of the end of June.

More importantly, the company’s debt per barrel of reserves has dropped to $9.55. So it would be easy for an acquiring company to agree to assume EXXI’s debt given the ample and growing level of reserves.

The stock price for EXXI has been on a bit of a roller coaster over the last few years. When the price of oil took a hit in late 2008 / early 2009, the company’s profitability took a hit. The company lost $1.31 per share in 2009 and the stock price hit a low of $1.25 – in danger of being delisted.

But as the price of oil has turned higher, EXXI’s stock price has followed suit. The stock currently sits near $34 after consolidating gains from 2010 and the first quarter of this year. A new breakout above $35.00 would represent a bullish inflection point and should result in a resumption of the bullish trend.

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Brigham Exploration (BEXP)

• Healthy inventory of un-tapped well opportunities, translating to strong long-term value.

• Accelerating levels of drilling and production leads to increasing profits.

• Plenty of liquidity to fund development of assets.

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Brigham Exploration is a perfect example of an attractive takeover candidate. The company has been very active in testing its resource base and measuring its drilling opportunities. After doing its homework, management now believes that they have 1,283 potential well location – each with a net present value (NPV) of $10.9 million.

Usually when a small to mid-tier producer identifies this many drilling locations, the primary challenge becomes how to fund the actual drilling process. While BEXP won’t be able to hit all of these locations at once, management has noted that there is plenty of financing available for accelerating their development program.

The firm currently has $812 million in available liquidity. Just over half of this is pure cash, with $325 available as part of a credit facility.

Investors should realize that the credit facility is not completely guaranteed to be available. In the last financial crisis, lines like this were pulled, leaving some companies in a difficult bind. But unless we have another severe disruption in the financial system, BEXP should have access to all of this capital.

The capital is particularly helpful – even when considering a potential merger – because of the flexibility that it gives management. If BHP stepped in and made an offer for BEXP, management could evaluate the proposal objectively. If they didn’t like the terms, they could simply tell BHP to take a hike and continue to ramp production themselves.

Potential acquirers realize this and will be more likely to offer a premium price given BEXP’s strength at the negotiating table.

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The company has been growing its production tremendously over the last two years, and the expansion is translating directly to the bottom line. Analysts expect EPS to increase by 141% this year to $1.42, and in 2012 the company is expected to earn $2.42.

Of course the true company value is based much more on the level of reserves which is what would cause a suitor to make an attractive offer. The company’s extensive seismic testing and drilling expertise makes BEXP an attractive purchase and should propel the stock higher in this M&A environment.

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W&T Offshore Inc. (WTI)

• Established history of increasing production and reserve growth.

• New reserves in separate drilling areas creates diversification and stability for investors.

• Drilling projects funded by internal cashflow.

• Market cap small enough to make WTI an attractive takeover candidate.

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W&T Offshore has been busy building its reserve base. At the end of 2009, the company boasted proven reserves of 371 bcfe. By the end of 2010, the number reached 485 bcfe. And according to a July investor presentation, the latest figures show 688 bcfe in reserves.

That’s an increase of 85% in just 18 months!

Not only is the company increasing its underground assets, but development programs have been increasing earnings along the way. WTI earned $1.57 per share in 2010, and is expected to generate $1.81 this year. At this point, 65% of the company’s fields are in production, so investors can be comfortable with positive cash flow rolling in each quarter.

Over the last several quarters, management has been working hard to diversify their operations. The company added new properties to their lucrative Gulf of Mexico shelf operations. New drilling rights in deepwater Gulf locations along with assets in the Permian Basin (Texas) give the company more acreage to drill, and more asset diversification.

Even with these new assets, WTI doesn’t have to borrow additional capital to fund drilling projects. At this point, all capital expenditures are financed through internal cash flow. Similar to BEXP, this gives the company a stronger presence at the negotiating table (in the event of a takeover offer). It also allows WTI to continue to develop its assets regardless of the economic environment.

With a $2.1 billion dollar market cap, W&T Offshore would represent a material investment, but is well within the range of what a large-cap producer could acquire on a cash basis.

The stock is currently trading in a well-established bullish trend. But based on the 688 bcfe of proven reserves, the company’s ability to grow (and develop) their reserve base, and the potential for an acquisition bid, the stock could have much farther to run.

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Disclaimer: This content is general information only, not to be taken as investment advice or invitation to buy or sell securities. As active traders, we may or may not have positions in securities mentioned. For full disclaimer click here.

Source: Strategic Intelligence Report: Oil and Gas Stocks With Explosive Potential