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VAALCO Energy (NYSE:EGY) is a Houston-based oil and gas exploration company that holds drilling rights to oil fields in west Africa (Gabon and Angola), along with Texas and newly purchased rights in Montana.

EGY is currently trading at $6.67, some 20% off its 52-week high reached in early March, despite the fact that oil prices have strengthened over the summer. The company has earned 74 cents per share over the past 12 months for a trailing P/E of just 9. More impressively, when one considers the $1.62 in net cash per share -- nearly 25% of VAALCO's $380MM market cap -- EGY is trading at a current enterprise value-to-earnings ratio below 7.

EGY annual earnings and average price per barrel sold
2007 2008 2009 2010 2011 2012
EPS $0.32 $0.50 ($0.14) $0.65 $0.84* $0.89*
$/bbl $71.16 $92.87 $59.54 $78.38 $103.76** ???

* Projected, based on average of two analyst estimates
** First quarter only, from the company's first quarter
results.

If the company can meet analyst projections, it will have grown earnings 278% in five years, or nearly 23% annualized. This is an impressive performance for any company, let alone one trading at such low P/E ratios.

The company is expanding its operations; currently, essentially all production and reserves are in the Etami field in Gabon, according to the company's most recent 10-K. Development in offshore Angola has been stalled due to partnership issues, while the company's purchases of rights in Texas and Montana's Bakken play won't yield exploratory wells until late 2011 or 2012. Capital expenditures should increase in turn; the company has committed at least $18.5 million to wells in the US plays, according to press releases announcing the initial and secondary purchases. The company expects to cover all capital expenditures, including the new drilling in the US, from existing cash flow.

That said, the Etami field, the current source of EGY's revenue, should not be written off just yet. Proved developed reserves -- oil in the ground that is accessible by existing equipment -- actually increased 4.8% from 2009 to 2010, to just over 5 million barrels. VAALCO's share of daily production has increased as well, to 5,400 barrels a day, according to the company's presentation at the June 1 annual meeting: $200 million annualized in production versus $151 million a year ago. Current oil prices and current production bode well for VAALCO's ability to grow earnings yet again in 2011.

In short, investors in VAALCO are getting a company that looks undervalued based on current production and current reserves, while also getting a company that offers new opportunities for growth in proven areas of success here in the U.S. Given the company's clean balance sheet, cash on hand, and proven oil reserves, one might think that the company could be a takeover target; even at a premium, a price tag of a half-billion dollars would be pocket change for any of the oil multinationals.

But of course there are risks. Any O&G exploration company is almost by definition a speculative stock. While the company has not announced the price it paid for the Bakken acreage bought in the second quarter (we should have a better idea come earnings on August 9), it would appear the company plans to devote in the range of $50MM in resources to those plays between the cost of acreage and the cost of exploratory wells. A negative return on those plays would not only hurt the stock but also impair the company's ability to self-finance capital expenditures as the Etami field matures.

Political risks abound as well. While Gabon is, according to the CIA Factbook, "one of the more prosperous and stable African countries," it is still a work in progress after four decades of rule by the autocratic Omar Bongo. Violent riots followed the 2009 election, and a four-day strike shuttered VAALCO's operations earlier this year.

In Angola, meanwhile, VAALCO must negotiate with a country ranked 44th of 48 in the Ibrahim Index, a measuring stick for the effectiveness of African governments. Production there has been delayed due to a delinquent partner in the exploration product, leaving the company at the mercy of the Angola government. From the 10-K:

If necessary, the government of Angola has expressed willingness to consider a further time extension once the new partner has been selected and a timeline of the drilling plans is completed. While we believe that the government of Angola will grant us another extension if necessary, we can provide no assurances that such an extension will be granted. If the government of Angola were to deny a time extension, and the wells are not drilling by the end of November 2011, the Company risks forfeiture of its $10 million funds in escrow, and the Company may be required to impair its leasehold costs and other investments with a carrying value of $13.7 million as of December 31, 2010.

VAALCO still has not found a replacement partner, and may need yet another time extension to maintain its rights to the field. Such an extension, even if granted, may require concessions that will reduce VAALCO's potential returns from the play.

Finally, President Obama has announced his opposition to the oil depletion allowance, which could raise the company's tax bill and hurt returns on the new US-based plays. The depletion allowance allows a 15% write-off on revenues, significantly enhancing net income for US-based wildcatters.

Despite the risks, VAALCO seems to be a solid play. Management has so far performed well in guiding the company to profitability. The company's focus on its balance sheet has given it the flexibility to expand its operations through existing cash flow rather than the issuance of debt or dilutive stock offerings. The Gabon field continues to perform well, and given that the Gabonese government now has a 7.5% working interest in the field, the likelihood of politically motivated disruption seems muted. Explorations in Angola and the US are essential to the company's long-term future, but it does not appear that the company need hit a home run. Given that the company expects to generate positive free cash flow while expanding capital expenditures for the new plays, any significant finds should have a significant effect on margins and earnings. Investing in any oil and gas exploration requires a bit of a gamble; the track record of VAALCO's management and the potential of its new assets seems to make this gamble worthwhile.

Investors can choose to mitigate the risks through covered calls: The January 7.5 call is bid at 0.30, and asked at 0.60, with a last sale at the midpoint of 45 cents. With a limit order filled at the last sale, a covered call would require a net outlay of $6.22, offering 6.7% downside protection and a maximum return of 19.2%.

More speculative types may look to purchase the January 5 in-the-money call, currently asked at $2.10 with a last sale at $2.00. Break-even at the ask is $7.10, which requires a 6.5% gain between now and January 21 (nearly six months). Given that EGY has traded above $7 for most of the year, traders betting on a rebound can look to the ITM calls for a leveraged play. Of course, a straight purchase at Monday's close of $6.67, in the midpoint of the stock's 52-week range ($5.07-8.40), looks like an acceptable gamble based on VAALCO's earnings history, management, and stewardship of shareholder capital.

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

Source: Vaalco Energy: A Speculative Value Play in Oil Exploration