History has shown that we are now entering the best three month investment period of the year; November, December and January (refer Jeremy Siegel's "Stocks for the Long Run" spanning the past 200 hundred years). This is good news. However, we also face uncertainties that combine to limit market gains and maintain the index valuations below historical averages despite the fact that money placed in interest rate products offers near-zero returns. These uncertainties include an unclear political landscape, ongoing Euro currency growth and sovereign debt problems, a slowing Chinese economy and within the USA, a fast-approaching fiscal cliff.
But look towards the end of the November-January window and a more appealing picture emerges. By then, the major political unknowns will be removed and the fiscal cliff should be at least partially or temporarily solved. As for China, their Q3, 2012 GDP report, issued October 18, came in at 7.4% and some sources are already hinting at a rebound.
Also important in the New Year, investors - individual as well as fund managers - will get a confidence boost when analysts issue new 'next year' estimates. For the right companies, these new estimates will underscore a continuation of growth for 2013 and 2014 and thereby provide a significantly supportive investment backdrop.
As we progress through the next three months, the scene is set for markets to emerge in a more optimistic mood than at present. Of course there will probably be dips in the meantime, especially if Republicans and Democrats have a food-fight over the fiscal cliff. But given that the S&P 500 index is currently trading at about 14 times 2013 estimated earnings of over $100 a share, versus the long-term historic average multiple of 15 times, a dip from here would represent a buying opportunity. Moreover, considering the amount of cash on the sidelines, and the dearth of investment alternatives with interest rates offering investors minimal returns, it is likely that any solution to the fiscal cliff would actually cause buyers to push the markets higher.
Whilst the major market indices remain reasonably valued, the same cannot be said of the small cap sector-- where the constant flow of negative news has kept individual investors away. With individual investors rooted to the sidelines, there are some very attractive stock picks within the small-cap space-- and especially within the oil shale sector which will be the main focus of this article.
The reality for individual investors is that many would buy, provided they could see an opportunity to exit at a higher price within a reasonable time frame, especially in order to avoid a period when market risk and volatility indices spike. I believe that, as we progress through the November to January time frame, individual investors will move from the sidelines and buy into high-growth value plays such as the small cap oil shale companies. Those who buy now at attractive valuations, or during dips that will invariably occur in the weeks ahead, should be able to cash-out early in 2013 with good gains.
The Oil Price
No investment should be made in the oil sector without keeping an eye on the oil price itself. Brent is currently about $110 and WTI is trading at around $90. Periodically, Brent may dip below $100 or even below $90, but because of the budget balancing needs of major Middle East countries, especially Saudi Arabia as swing producer, Brent is unlikely to stay below $90 for meaningful periods. On the upside it is difficult to argue that higher oil prices will occur because higher oil prices would surely crimp economic activity and be self-defeating to the oil industry.
On October 18, Goldman Sachs issued its latest oil price forecast: Brent to average $110 in 2013 and then settle at around $90 in the longer term i.e. the level at which long dated long Brent contracts have stabilized this past couple of years. Adopting a similar rule for WTI would equate to long-dated pricing of $90, in line with Nymex pricing which is flat-lining between now and March 2016. As with Brent, WTI prices are likely to dip by $10 or more periodically.
So we are left with a likely range for 2013; Brent between $90 and $110 and WTI staying mostly $80 to $90. Estimates currently being used by stock market analysts are largely in line with these ranges, allowing for normal company-specific differentials and hedges.
The U.S. oil shale sector can offer investors exceptional opportunities for the next few years. This is particularly true for companies with a cheap stock price, large drilling inventories, unleveraged balance sheets and minimal threat of shareholder dilution. Mid to large cap drillers such as EOG Resources (EOG) or Continental Resources (CLR) are trading on 2013 price earnings ratios of 20. But because individual investors have been reluctant to enter the market, buyers can pick up exciting small-cap growth companies at a valuation discount of more than 50%.
This exercise offers a preliminary view of the outlook for six small-cap oil shale companies for 2013 and 2014 with emphasis on (i) sales and earnings per share, (ii) balance sheet liquidity and (iii) potential drilling inventory. There are some very appealing investments in this group.
In the tables presented below, the analysts' consensus sales and EPS data for 2012 and 2013 are taken directly from sites such as Yahoo Finance. The lease operating expense (LOE), taxes and depletion data for 2012 and 2013, and earnings per share estimates, are obtained from a combination of each company's SEC filings and the existing analysts' estimates. Similarly, capital expenditure numbers for 2012 are taken from SEC filings and company presentations. The 2013 and 2014 capital expenditure numbers are estimates which represent moderate increases needed to achieve additional reasonable growth in the business without being aggressive. The Net Debt and Debt/Equity figures are calculated from opening positions with work-through from the related P&L data and other known items such as share offerings, capital expenditure, asset sales etc.
Bonanza Creek (BCEI)
|LOE, Taxes, Depletion % of Sales||51%||45%||44%|
|Earnings per Share||$1.47||$2.59||$3.40|
|Capital Expenditure, millions||$300||$400||$500|
|Net Debt, millions||$150||$310||$490|
|Boed, exit rate||12,500||18,500||23,500|
Bonanza Creek is a driller active mostly in the Niobrara where it has 63,000 net acres predominantly in the Wattenberg field.
Currently the company is only drilling the Niobrara 'C' bench where it has identified 360 locations using 80-acre spacing. Bonanza's immediate neighbors have already drilled using 40-acre spacing and Bonanza is expected to confirm positive results from its own 40-acre tests before the end of 2012. At a stroke this would almost double the company's inventory to over 700 locations. Very possibly some down-spacing confirmation will be included as part of its Q3 earnings report in November.
Bonanza is also testing the Niobrara 'B' bench and the Codell bench. Based on recent test results from neighbors, BCEI anticipates that these will further substantially boost drilling inventory. In the case of the 'B' bench this traverses all of the company's acreage whilst the Codell is expected to be economic for about half of Bonanza's acreage.
There is a useful conversation about the company's potential to substantially increase its existing drilling inventory on its August 14 conference call transcript recorded by Seeking Alpha.
Bonanza is scheduled to drill 36 Niobrara horizontal wells in 2012. This represents 10 years inventory using the 360 drilling locations number (I believe this low 10-year number helps explain why the company's analysts' target stock price is only slightly above the current cheap stock price). When the existing series of test programs is concluded, Bonanza should have a minimum of 800 drilling locations, equating to 22 years inventory at the 2012 run rate of 36 wells.
Confirmation of positive results from its various tests would be transformational because, then, substantially all its capital can be directed into more drilling for a period with less need to divert capital towards acquiring new leases. Favorable results should also be a major catalyst for brokers / analysts to raise their target stock price.
Currently trading at $23.70 the stock is on a 2014 p/e of 7.0 based on $3.40 EPS. For a company with a clean balance sheet, and on the cusp of substantially improving its drilling inventory numbers, this is cheap.
Carrizo Oil & Gas (CRZO)
|LOE, Taxes, Depletion % of Sales||55%||46%||46%|
|Earnings per Share||$1.80||$3.99||$4.75|
|Capital Expenditure, millions||$600-(250)||$600||$600|
|Net Debt, millions||$785||$945||$1,030|
|Bopd, average (liquids only)||7,500||15,000||18,500|
|Bopd, exit rate (liquids only)||9,000*||17,000||20,000|
* excludes North Sea oilfield production of 5,000 Bopd, due to commence end 2012.
Carrizo had planned to sell its 15% stake in a 33,333 Bopd North Sea oilfield by summer 2012 but having failed to solicit an acceptable price, the company appears to be content to keep that asset. In September, in order to fill the funding hole left by the non-sale, Carrizo issued $300 million notes due 2020, expanding its already large balance sheet borrowings.
Analysts' consensus quarterly earnings per share estimates for Carrizo are: Q3'12 $0.40, Q4'12 $0.63, Q1'13 $0.83, Q2'13 $0.99, Q3'13 $1.04 and Q4'13 $1.13. The big jump in here - from $0.40 in Q3'12 to $0.83 in Q1'13 - occurs when CRZO's 15% owned North Sea oilfield finally starts production. The implication here is that the North Sea asset is worth over $1.00 in EPS annually.
Going from analysts' consensus EPS of $1.13 in Q4'13 to something like $4.75 EPS for full year 2014 appears to be a reasonable, if cautious, progression. Increasing sales by $100 million from 2013 to 2014 on the back of $600 million capex in 2013 and again in 2014 shouldn't be difficult to achieve. A further assumption embedded in the 2014 estimates is that total LOE, taxes and depletion expenses at 46% of sales do not incorporate any natural efficiency improvement over the 46% used by analysts for 2013. In essence, the 2014 EPS figures may be on the low-side and EPS of over $5.00 is possible.
Unless Carrizo receives a substantial offer for its North Sea asset, I believe the company is correct not to sell. Carrizo becomes self-funding in 2014, or by H2 2013 using less cautious numbers. Once it reaches that point, the debt/equity ratio should then start to reduce at a reasonable clip.
Carrizo's main asset is 41,000 net acres in Eagle Ford, followed by 58,000 net acres in the Niobrara of which the company has just sold 30% on favorable financing terms, plus the 15% North Sea oilfield, plus a smallholding in the Utica and finally plus some natural gas plays.
The Eagle Ford and Niobrara acreage gives the company about 1,000 horizontal drilling locations which, at the 2012 drilling rate of 45 wells, equates to over 22 years inventory. This 1,000 number assumes that the down-spacing improvements, which the company is now testing and assessing, will be successful. Refer to the latest IR presentation on Carrizo's web site for more about drilling locations.
Considering Carrizo's high debt/equity ratio, this 22-year drilling inventory gives the company adequate time to reduce borrowing levels before having to acquire further acreage. I suspect the company may use the current surge in natural gas prices to sell some of its remaining natural gas assets to raise cash and boost its balance sheet.
The stock is trading at $26.50 which, come early 2013, equates to a next year p/e of 5.6. That offers plenty of upside scope for investors even allowing for high debt levels.
Click here for Part 2