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Most investors in the E&P sector are aware that oil output from shale falls sharply during the early life of a well. Data from a typical 750Mbo well highlights this point. Initial production during the first 30 days may be 1,000 Bpd, dropping to about 300 Bpd by the end of year 1, then 160 Bpd in year 2, to 110 Bpd in year 3 and so on. Usual fall off rates are about 40% in year 1, 30% in year 2, 20% in year 3, 15 % in year 4 etc.

What all this means is that shale E&P companies must drill an increasing number of wells year after year in order to continue to grow strongly. This presents shale companies with challenges.

To drill more and more wells a shale company must have a large inventory of potential wells, either by having large undeveloped acreage or by having acreage with additional unexploited pay-zones. Alternatively, the company must have a strong/liquid balance sheet that will enable it to acquire additional acreage without too much financial difficulty. Failure on these fronts leaves a shale company prone to issuing share offerings to fund acreage acquisitions, which in turn dilutes earnings per share.

The top investments in the oil shale sector are those companies that have the best combination of (1) cheap valuation, (2) good acreage and drilling inventory, and (3) strong balance sheet liquidity and flexibility.

Listed below are some of the best value small cap oil shale stocks. What is evident is that the recent market pullback has thrown up some very attractive buying opportunities. Each of these stocks has their merits, although, in my view, the best potential investment of all from this list is BCEI. Microcaps have been excluded due to the risk that small drillers may be more exposed to escalation in costs or delays from service providers caused by high demand and logistical issues in areas such as the Bakken.

KOGCRZONOGMPOBCEI
Stock price$8.98$27.62$19.46$16.42$21.39
Shares, mm26339.662.16639.5
Market Cap, mm$2,362$1,094$1,208$1,084$845
EPS 2012$0.78$2.35$1.32$1.11$1.65
EPS 2013$1.25$4.25$1.92$1.90$2.91
P/e 201211.511.814.714.813.0
P/e 20137.26.510.28.67.3
Debt/Tot Assets 201240%41%30%15%12%

Kodiak (NYSE:KOG)

By Kodiak's own estimates it has 817 drilling locations in its 157,000 acres located in the Bakken core. At the expected 2012 drilling rate of 51 net wells, equates to 16 years inventory. Tighter spacing can be expected in future and the possibility of additional pay zones also exist.

The 2012 drilling program is expected to boost production from 15,000 Bpd in February to 27,000 by year-end. This translates to 2012 sales of $608 million and EPS of 79 cents. Forecasts for 2013 are sales of $950 million and EPS of $1.25. KOG stock currently trades at $8.98 and on a forward basis this represents a next year p/e of just over 7.

Obviously this valuation is appealingly cheap. The follow-on question becomes - is KOG likely to make these sales and EPS estimates? For me the answer is 'probably not' based on the fact that the 2012 ramp-up is very aggressive, that some delays are being reported in the Bakken and based on the fact that the company fell short of most of its earnings estimates during 2011.

Nonetheless, it seems pretty clear that KOG will achieve tremendous growth in 2012 and into 2013 and, even if estimates are lowered a notch, that 2013 earnings of $1.00 should be attainable, with much higher EPS to follow in subsequent years. Thus the shares represent good value, provided that no further share dilution occurs and to this question the balance sheet provides comfort.

At the start of 2012 KOG had borrowings of $750 million and cash of $80 million. The 2012 capex budget is $585 million and cash from operations this year should be $410 million. This gives year-end 2012 net borrowings of $845 million, being manageable ratios 40% of total assets.

In 2013, based on $1.25 EPS, KOG is forecast to generate cash from operations of $680 million. Allowing for a capex budget of $600 million this would leave the company with reduced year-end 2013 debt of $765 million, equating to a comfortable 28% of total assets.

Overall KOG is cheap on a forward valuation basis, it has a large inventory of drilling locations and has a balance sheet that facilitates growing capex budgets without the company needing to tap shareholders for additional funds. I own KOG shares as a core long term holding.

Addendum: Yesterday KOG announced results for Q1 that disappointed the market and the shares dipped. I do not see this as a surprise and intend to use the weakness as an opportunity to buy at an appealing price. Big picture, KOG is cheap and attractive.

Carrizo (NASDAQ:CRZO)

Carrizo stock is currently trading at $27.62, it is on a next year p/e of 6.50 which is clearly very cheap. Mostly this is because of the overhang caused by the company's high borrowings.

Carrizo's primary assets are 41,000 net acres in the liquids rich window of Eagle Ford and 58,000 net acres in Niobrara. It also owns some nat gas properties, a minority stake in a North Sea oilfield and a small holding in the Utica.

The Eagle Ford acreage has potential for 321 wells using 115 acre spacing equating to 8 years inventory. In February this year EOG, CRZO's immediate neighbor, confirmed the benefits of tighter spacing and this would grow CRZO's inventory by about 33%. In Niobrara CRZO has 114 potential wells using 320 acre spacing. But here again this spacing is understood to be overly generous and CRZO should announce favourable results of its 160 acre downsizing tests in the next couple of months - this would double the Niobrara inventory to about 18 years. CRZO's Niobrara acreage may also have additional pay zones although this is speculative on my part largely based on comments from Bonanza Creek (see below) whose Niobrara property runs alongside that of CRZO. In essence CRZO has good acreage with a healthy inventory of drilling locations.

CRZO has a 2012 capex budget of $440 million which is being funded by a mixture of cash from operations of $290 million plus disposal of two non-core assets - sale of Barnett property for $190 million announced in February plus sale of its 5% North Sea oilfield stake for about $200-250 million expected before mid-2012. This would leave CRZO's with year-end 2012 net borrowings of about $410 million - much lower than year-end 2011 borrowings. However, the company intends acquire more Utica land rights and in this exercise I assume that CRZO will spend up to $300 million (probably too high, but visible and serves a purpose here) on acreage and/or other acquisitions during 2012. Whilst this would maintain CRZO's borrowings at the current high level it would also boost the company's drilling inventory very significantly.

Carrizo management have stated that they expect the company's growth after 2012 to be fully funded internally. The projections bear this out. Cash from operations in 2013 is forecast to come in at $450 million which can all be used towards capex. This would leave the overall amount of borrowings unchanged but the debt/total assets ratio would contract.

Overall CRZO is a very cheap stock and the indications are that over the next two years the company will grow EPS aggressively whilst increasing its drilling inventory and reducing it debt ratios to more comfortable levels, all without any apparent need to dilute existing shareholders. As with KOG I own CRZO shares as a core long-term holding.

Northern (NYSEMKT:NOG)

Northern has 170,000 net Bakken acres with 800 well drilling inventory using generous 1,280 acre spacing. In 2012 NOG plans to spud 40 wells, implying a very large inventory of 20 years at the current run rate.

Recently NOG's stock has dipped below $20, putting it on a next year p/e of 10. This, combined with its very large asset base/inventory, makes NOG an unusually good value play.

From a balance sheet perspective the liquidity has been well managed with low borrowings. This is changing somewhat during 2012, largely because NOG plans a big capex budget for the year of $405 million*. Net of about $210 million cash from operations in 2012 this should leave NOG with net debt at year-end of about $268 million. In 2013 NOG should generate cash from operations of $300 million, enabling the company to fund another large capex program (say $350 million for drilling) without ballooning borrowings. At this level the debt/total assets ratio would remain a comfortable at 30% and 28% for year-ends 2012 and 2013.

*Of this $405 million, $325 million is going towards drilling. Against such a large drilling capex figure analysts' estimates for sales this year and in 2013 of $315 million and $425 million seem conservative.

Overall, NOG is currently a very good value play. I own some.

Midstates Petroleum (NYSE:MPO)

First and foremost the MPO numbers here are guesstimates. MPO came to the market just one week ago (April 19) and it will be approximately one month before analyst projections appear in print.

MPO IPO'd during a period of low risk appetite because it needed funds to help fund its growth strategy. It priced at $13, below the expected $17 tag. Currently at $16.42 the stock looks interesting.

Midstates own 77,100 acres of the Upper Coast Territory Trend in central Louisiana and an option to acquire a further 31,700 acres. For the most part this is a stacked play with multiple pay zones that will be drilled vertically with a smaller number of horizontal wells also being drilled. The play has 974 identified locations which represents almost 15 years inventory at the 2012 drill rate.

The company has laid out a large $380 million capex budget for 2012 including $306 million towards drilling and completion. For a company that had total sales in 2011 of $210 million this represents a large step-up. Using very broad brush strokes one might expect sales for 2012 of $300 million or more and, assuming a similar sized $380 million capex plan for next year, this may produce 2013 sales of over $400 million. Extrapolating MPO's existing costs and applying a non-cash 30% tax rate EPS would come in at about $1.1 for 2012 and somewhat under $2 for next year. I would stress that these numbers will surely change as more information becomes available.

Coming into 2012 MPO had $235 million of debt. Net of the IPO proceeds, and adjusting for $360 million capex plus $245 million cash from operations, the company would exit 2012 with net debt of about $150 million. Looking to 2013, and penciling in capex of $380 million plus cash from operations of $345 million, this would lead to year-end net debt of about $185 million. Thus very preliminary debt/total assets ratios for year-end 2012 and 2013 are both about 15%, certainly a positive.

Overall, it is too early to say if MPO is an attractive investment. It may be. Certainly it is worth watching and, at the current $16.42 level, there does seem to be room for the underwriters to give the stock some nice support when they issue their initial cover notes on or about May 18. Currently I do not own shares in the company.

Bonanza Creek (NYSE:BCEI)

Bonanza is a very cheap stock on a forward earnings basis (2013 p/e of 7.3) at the current $21.39 price, it has (among other) 63,000 net acres in the Niobrara with multiple potential pay zones, and it has an unleveraged balance sheet. Finally, the stock had recent insider buying at approximately the current share price. All told an enticing combination.

The Niobrara acreage comes in two parts; 30,000 acres in Wattenberg (65% oil) sandwiched by EOG to the north and south, and also having Noble and Anadarko as direct neighbors, and; 33,000 acres in North Park Basin (90% oil) beside EOG.

Overall the Niobrara asset base is expected to produce tremendous growth. The company published indications along the following lines, achieved by a combination of horizontal and vertical drilling; y/end 2011 exit rate 1,500 Boe/d, y/end 2013 approx 7,000 Boe/d and y/end 2014 indicative exit rate of about 12,000 Boe/d.

As well as drilling verticals through multiple zones, BCEI currently drills horizontal wells into the Niobrara B formation. Anadarko has recently achieved good results from two horizontals into Codell with 30-day rates of 461 Boe/d and 508 Boe/d. Bonanza has also earmarked a number of locations in Codell for horizontals, leaving two additional pay zones that for later exploration; Niobrara C and Greenhorn.

Of BCEI's $250 million 2012 capex budget $170 million is earmarked for the Niobrara.

Separately Bonanza owns 13,000 acres in the Mid Continent, SW Arkansas. This is a conventional play which the company regards as its cash cow and represented about half the company's oil output at year-end 2011. During 2012 BCEI has allocated $59 million of its capex budget to drill 38 vertical wells here.

Investors should pay attention to Bonanza's balance sheet - it provides the company with a lot of financial flexibility going forward. Year-end 2012 projected net borrowings are about $94 million, this being just over 10% of total assets. In 2013, assuming Bonanza has another capex plan of $250 and adding in cash from operations of $260 million, this would leave the company with net debt of about $84 million, equating to less that 10% of total assets.

This unleveraged balance sheet gives BCEI scope to comfortably issue a large tranche of notes, perhaps in the region of $300 million, which would be the cornerstone of another major step-up transaction for the company. It would be a surprise to me if BCEI did not complete such an issuance in 2012. Certainly the issuing houses will be crawling all over BCEI management with their best ideas in order to earn some fees. Comment: $300 million new borrowings would still leave the debt/total assets ratio at December 2012 at under 40% i.e. in line with KOG.

In summary BCEI is a highly attractive stock on multiple levels; cheap valuation, good acreage, unleveraged balance sheet and insider buying at the current stock level. Considering these metrics and the fact that its major land asset - the 30,000 net Wattenberg acres - is surrounded by EOG, Noble and Anadarko, then one could easily argue that the stock should carry an acquisition premium. All told this is one highly attractive package. I own BCEI shares as a core long term holding.

Source: 5 Oil Shale Stocks: Aware Of Challenges, Open To Opportunities