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We continue to see an exciting transformation within the US oil and gas business. Buoyed by high global oil prices, solid growth is being reported across the entire sector. Drilling down further into the data, into the shale patch specifically, the advent of horizontal drilling and hydraulic fracking has led to some exceptional growth. Consequently new investment stars have emerged in the names of Brigham (BEXP), Northern (NOG) and Kodiak (KOG). From 2010 to 2011 these logged sales growth of 150%, 230% and 450% and from 2011 to 2012 they are projected to bump sales by a further 90%, 100%, and 330%. These are enviable growth figures, especially considering the weak economic backdrop.

Will the growth last?

Shale drillers must deal with a particular phenomenon - low rock porosity that causes a steep fall-off in flow-rates during the early life of an oil well. Output may be about 180,000 barrels in year 1, followed by 80,000 in year 2, then 60,000 in year 3 and so on. In order to continuously grow production and profits, shale producers must roll out ever larger capital expenditure budgets over time. Hence, some question the potential of the shale sector to produce good profits. In actual fact shale producers are reporting some of the absolute highest profit margins in the entire E&P sector. Their big profits are producing strong cash flows which facilitate large capital expenditures and which, in turn, lead to even higher profits. A self perpetuating profits-cashflow-capex cycle is already under way. Thus, to the question “Will the growth last?” an examination of the profitability and cash flows of individual shale drillers say a clear “Yes,” certainly with oil at about $90 per barrel.

Because of the relative newness of the shale sector, coupled with a highly uncertain economy, not to forget the need for the industry to develop a well understood safety record for fracking, some investors remain cautious about investing in shale producers. Consequently, related stock valuations are invariably attractive with some excellent buying opportunities on offer.

In order to identify the best stocks to buy it is necessary to look at forecast earnings per share not just for 2012 but, more especially, for 2013, which will be published in early 2012. The key is that in early 2012 – now weeks away – stocks with strong 2013 EPS growth over 2012 are likely to show compellingly low “next year” p/e ratios. Normally, it is these stocks that will perform best between now and spring 2012 when analysts disseminate new research reports through the investment community. Investors would be well served to get there before the analysts go public in coming weeks.

As shale producers go through the early and most aggressive ramping-up stage, the majority of their capital expenditure, sales and profits occur in the second half of any given year. In order to get a first look at full year 2013 earnings per share it is important to examine the company’s sequential quarterly EPS during 2012. Generally, for companies with cash flows that enable continuing capital expenditures, their 2013 full year EPS will be considerably more than four times their Q4 2012 EPS. A broad rule of thumb is to construct full year 2013 EPS estimates by up to five times Q4’12 EPS for high growth companies, four times Q4’12 EPS (or occasionally less) for low growth companies and something in-between for others. In all cases the resulting EPS data should be tweaked for company specific metrics such as strength of operational cash flow, balance sheet flexibility, reservoir potential, past operational efficiency record etc.

The remainder of this note concentrates on independent E&P companies with a market capitalization of greater than $1 billion. Operationally, they include all types of producers; conventional, shale oil/liquids/gas, oil sands, offshore etc and many companies will have operations in more than one of these sectors. Using the criteria described above, and incorporating known company-specific factors, I’ve penciled in reasonably cautious 2013 EPS figures. Whilst the list offers several interesting points it is apparent that the best growth comes from shale, more specifically shale oil/liquids. Further, because oil and liquids have much strong earnings growth visibility than natural gas, the list only includes E&P companies that generate, or will soon generate, at least half their business from oil/liquids.

Lastly, the Q1’12, Q2’12, Q3’12 and Q4’12 EPS figures used in this exercise (in columns 2 to 5) – upon which much of the forecast 2013 EPS is based - are analysts’ published estimates as obtained on proprietary sites such as TDAmeritrade etc. That same EPS data for 2012 is not available in a quarterly format on popular sites such as Yahoo Finance. Consequently, there are some differences in the full-year 2012 EPS between the two sets of data but such differences do not alter the overall 2013 EPS thesis.






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Here are commentaries on 5 of the best buys from the list.

Carrizo Oil & Gas has its main focus in the Eagle Ford but also has assets in Niobrara, Barnett, Marcellus, The North Sea and Utica. Carrizo is at the inflection point of changing from a natural gas producer to an oil company and to a lesser extent other liquids including propane, l-butane , N-butane and l-pentane, which sell at or above WTI oil prices. In Q3 2011, CRZO reported 33/67% liquids/gas sales mix. This is forecast to be 60/40% liquids/gas by Q4 2012 and 70/30% by 2013.

Full-year 2012 EPS estimates for CRZO were cut in recent months primarily because the commencement date for the North Sea operations was delayed because Sevan, the Norway owner of the floating production storage and offloading units, experienced financial difficulties. In October Teekay Corporation (TK) provided the solution when it announced it was acquiring the related assets from Sevan and full production from the three wells (2 already drilled) is now expected in Q3 2012.

Observe the sharp quarterly ramp-up in CRZO’s 2012 EPS: $0.47, $0.54, $0.85, $1.14 and full year $3.00. With CRZO about to announce a 2012 capex budget of $440 million, the great majority of which will be invested in oil/liquids, full year 2013 EPS should be greater than 4 times Q4 2012 EPS i.e. 2013 EPS of $5.25 should be reasonable. At the current share price of $29 the stock is on a 2013 p/e of 5.5. In early 2012, after analysts disseminate their new estimates, the shares should trade on a next year (2013) p/e of at least 7 or 8, equating to a stock price of $37 to $42. CRZO could easily be given a better p/e target but the company has quite high debt levels and this usually acts as a stock valuation drag. In reality practically all of CRZO’s debt is in the form of long-term notes, which contain no restrictive covenants and, as such, carries virtually zero repayment risk. Bottom line, CRZO is just too cheap.

Kodiak Oil & Gas is a fast-growing driller in the Williston basin. The ‘November transactions’ where KOG raised almost $1 billion cash, acquired additional acreage and oil production, and announced a 2012 capex budget of $685 million, all served to make Kodiak a better company with improved scale, a healthier balance sheet and stronger earnings potential.

In recognition of these game-changing improvements, analysts increased their estimates and there is now an eye-catching up-trend in 2012 quarterly EPS numbers: $0.18, $0.21, $0.26 and $0.30, giving full year EPS of $0.95. Because Kodiak will spend most of the $685 million 2012 capex during the second half of the year with the related production benefits falling into 2013, full year 2013 EPS should certainly be greater than four times Q4 2012 EPS, say 2013 EPS of $1.30 or more. At the current share price of $9.18 this represents a 2013 p/e of just over 7. In early 2012, keeping in mind the company’s continuing growth prospects and strong balance sheet, the stock should trade on a next year (2013) p/e of 10 without stretching itself, equating to a stock price of about $13. KOG has all the potential to be a star stock for 2012.

Hess is a global oil & gas company that is trading cheaply because, at face value, it is not known as a company that will enjoy exciting growth like many of its E&P peers. However, HES is increasing its capital expenditures and targeting large amounts toward higher-growth unconventional oils. For example, during 2011 the company plans to spend nearly 50% of its global $7.3 billion capex budget in Bakken, Utica and Eagle Ford. The superior underlying economics of these predominantly oil plays should help HES achieve accelerated growth.

Analysts’ 2012 EPS estimates are: $1.60, $1.64, $1.83, $1.80, total 2012 $6.87. In 2013 Hess should have EPS of at least $7.50, being just over four times Q4 2012 EPS. At the current share price of $58.47 that represents a 2013 p/e of 7.7. For a large predominantly oil E&P business with a safe balance sheet this is a solid buy. In spring 2012 investors can expect the shares to trade on a next year (2013) p/e of 10 or more, equating to a share price of about $75.

Whiting Petroleum generates over 90% of sales from oil and over 65% of total sales come from the Williston basin. Though not as exciting a prospect as Kodiak, Whiting does have many years of superior growth future ahead – it has an enviably large tract of Williston acreage (678,000 acres), which it acquired cheaply early in the life of the Bakken.

Analysts’ 2012 EPS estimates are: $0.95, $0.98, $1.05, $1.06, total 2012 $4.04. In 2013 Whiting should achieve EPS of $4.60 or more. At the current share price of $48 that represents a 2013 p/e of 10.4. Given its large Bakken acreage and long-term growth prospects this is good long-term value. In spring 2012 investors can expect the shares to trade on a next year (2013) p/e of about 12, equating to a share price of more than $55.

Plains Exploration is another E&P company transitioning from natural gas to oil. Currently generating 55% of sales from oil this is expected to grow to 70% over the next 4 years. Plains owns extensive leases in Eagle Ford, California, Gulf of Mexico, and Haynesville and from these resources the company guides that it should achieve compounded annual growth of 15% or more between 2011 and 2015.

Analysts’ 2012 EPS estimates are: $0.79, $0.79, $0.84, $0.87, total 2012 $3.29. In 2013 Plains should achieve EPS of $3.75. At the current share price of $36 that represents a 2013 p/e of 9.6. Again this is good value given its long-term growth prospects. In spring 2012 investors can expect the shares to trade on a next year (2013) p/e of up to 12, equating to a share price of up to $45.

There are several additional value plays on the list including ROSE, NOG and probably SU. Other stocks appear relatively fully valued, notably APC, CLR and EOG. I would emphasize that in all cases these EPS estimates are preliminary and intended to be conservative. Still, and in conclusion, it is becoming increasingly clear that there are some truly excellent buys available in the E&P space.

Disclosure: I am long CRZO, KOG.