Vaalco Energy: A Value Pick In Oil Exploration

Jun. 4.12 | About: VAALCO Energy, (EGY)

Back in August I covered Vaalco Energy (NYSE:EGY), a small-cap E&P company with properties in Africa and recently purchased, but undeveloped, acreage here in the U.S. Despite a nearly 25% drop since the first of April, Vaalco still stands some 15% above where I recommended it last summer.

And despite falling oil prices, the company remains an excellent choice for a value portfolio. Vaalco has $140 million in net cash on its balance sheet, over 30% of its $450 million market capitalization. 2011 free cash flow was $57.6 million, about 19% of its enterprise value.

More impressively, nearly all of Vaalco's 2011 revenue came from its operations in the West African nation of Gabon. Yet Vaalco retains a long-stalled interest in Angola, and is developing properties in Montana and Texas. (The American purchases were an attempt by the company to diversify away from its reliance on still-unstable African governments.)

With oil prices falling, Vaalco's earnings potential for 2012 looks less promising than it did earlier this year. However, the lower selling price for oil does not look set to completely wipe out the company's profits and cash flow. In 2010, Vaalco earned 50 cents per share, with an average selling price for the year of just $78 per barrel, still below where oil (even WTI) is currently trading. With the stock trading at just 14 times trailing earnings -- and less than 10 times on an enterprise basis -- the company, and the stock, should be able to withstand lower oil prices.

The price of oil is not the only risk involved with Vaalco; political risk for its African operations remains a worry. The Gabon operations have been relatively peaceful (and profitable), but African politics remain unstable. In fact, the company faced a four-day strike in the country just last year. Its exploration contract in Angola was signed in late 2006, but after a default by the government-assigned partner and continued failures in negotiating an acceptable placement, the company is attempting to go it alone. According to the most recent 10-Q, Vaalco is "waiting on a response from the Angolan government" to its offer to begin exploration activities alone. If the company does not negotiate some sort of agreement or additional extension to its contract, a potential $10 million fee is due the host nation.

Closer to home, while the political risk in the U.S. properties is obviously lessened, all of Vaalco's American acreage remains unproven. Initial wells have been drilled, but information concerning the potential success of those properties will not be known until later this year, at the earliest.

But given Vaalco's recent success -- it has been profitable since 2007, excepting only recession-marred 2009 -- the risks can also be potential rewards. A restart of the Angolan government or successful drilling in the U.S. could be a key catalyst for the stock.

In the meantime, the over $2 per share in net cash and solid earnings history gives the "margin of safety" traditionally sought by value investors. The company appears to have dodged a bullet by reducing a controversial long-term incentive plan for its executives, and can now focus on the myriad opportunities at hand. As I argued back in August, the bull case for Vaalco rests on the fact that it need not execute on every one of its ventures. It simply needs to maintain its execution in Gabon, while gaining traction in the U.S. or Angola. If either one of those operations takes off, Vaalco is sure to follow.

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