Picking The Right E&P Wildcatters Using Intelligent Behavioral Analysis

by: Peter F. Way, CFA

In this evolving new US energy scene, the biggest opportunities and the most rapidly changing developments are out in the field, where E&P geologists are identifying "unconventional" reserves and operations teams are proving them out. So what is the most important information for an investor to have?

The second most important may be the volume of provable BOE (barrels of oil equivalent) reserves a company controls. Third may be a reliable guess at what Crude and NG (natural gas) prices will be.

But the single most important piece of investment information, for every E&P (Exploration and Production) stock, is: What price may some other investor be willing to pay you, in the foreseeable future, for the stock you might buy today? -- and how likely may that be to happen?

That question is the same whether the intended investment is in the stock of a hamburger chain, a mobile communications/entertainment device producer, or a foreign airline. All the details leading to the forecast may be essential minutia. Still, it is the decision-supporting forecast that fills or kills the investment - in competition with the available alternatives.

How the forecast is reached is itself a multiple-choice decision. The "control freak" investor will insist on having a first-hand intimacy with every trivial building block involved. The "delegator" may turn the whole matter over to an investment manager and limit his/her involvement to signing a check paying for that service. In between those extremes is a range of investor involvements defined by personal preferences.

An approach that appeals to many is to reserve the capital commitment decision to themselves, but to seek out supporting help from the best-informed, non-competing participant, who can provide credible, expert, and focused perspective.

We find that support role is well-played for the individual investor by the market-makers that facilitate multi-million dollar trades for big-money funds. His employer's world-wide, instantaneous information gathering system, bolstered by his everyday frequent conversations with clients to satisfy their "order flow" makes him among the best informed players in this very serious game.

The trick here is to stop playing the information-compiling game, and to start playing the players. That is what the market-maker does. His self-protective hedging actions tell just how far he thinks his clients are likely to run stock prices before they bail out, or pile in. This is behavioral analysis, focused on what informed, experienced players are doing intelligently, in their own self-interest.

Each investment candidate forecast consists of a range of prices, likely enough to be encountered that the pro would pay what could be part of a trade spread profit, to be sheltered from the event. From the current market price, that range defines upside rewards and downside risk exposures.

Daily over the past decade we have compiled actuarial tables of the likelihood of prices reaching or surpassing those expected targets, using the market-makers unintended price range forecasts. On over 2,000 widely-held and actively-traded stocks and ETFs, including many Exploration & Production and energy services names.

In our performance archives we group all prior forecasts on each stock or ETF according to that upside vs. downside balance. Those groupings form an array of risk vs. reward tradeoffs. Past subsequent price experiences across that array suggest what may now be likely to occur. Those tradeoffs at current prices can be among the best means of picking your most successful investments.

Deciding factors for most investors include the size of the potential payoff, the odds of it happening, and the worst drawdown exposure likely to be encountered en route. Which of those dominate the others, and by how much, is your call.

Here are several of the now most appealing forecasts and experiences in the E&P segment of energy stocks, as seen through the lens of those professional market-makers, based on yesterday's depressed market closing prices.

Most appealing from a scale of likely performance, is Rosetta Resources (NASDAQ:ROSE), followed closely by Energy XXI (EXXI). Both of these have histories of winning positions about 8 out of 10 times, at present levels of market-maker outlook.

Consistent past performers are also found in Range Resources (NYSE:RRC) and Carrizo Oil & Gas (NASDAQ:CRZO). Their win ratio over several years has run at profits in 3 out of every 4 positions presented.

Examples of marginal opportunity are found in Cabot Oil & Gas (NYSE:COG) and Bill Barnett (NYSE:BBG). These are not recommended but show how quickly performance can fall off. At present these are the next best items in the E&P list after the first 6. Everything else fails to offer an odds-on positive promise.

That does not mean that the others are bad investments, just that at this point in time and price they are not competitive with the alternatives.

The three right-hand columns of this table are the product of subjecting each buy candidate to our standardized investment test. It consists of a hypothetical buy of all prior forecasts at least as attractive as the current one, using the top of the forecast range as a fixed sell target. A specific holding time limit from the time of purchase closes out the position if the target is not previously reached.

The proportion of profitable priors usually exceeds the odds of achieving the sell targets because the holding time limit may force a profit-taking before optimism lets it escape, perhaps diminishing to a loss. It is the frugality with time that provides the frequent chance for repeated investment (in this or others), compounding gains on the same capital at the annual rate of return potentials indicated. Typical holding periods are about a month and a half.

The E&P buy candidates in the table are from a list of about 50 E&P companies we regularly evaluate. The last two are stocks of firms impacted by the new technologies of extraction, but are downstream from that activity. They illustrate the lower-risk drawdown exposure possibilities where uncertainty over the price of owned reserves is not a factor.

The market is constantly varying the attractiveness of specific E&P stocks, and of the group as a whole. This list is ranked by its past annual rate of return experiences following prior forecasts like the present. There is no guarantee that events of the next two or three months will evolve as they did at various times during the past 4-5 years. But all such priors have been included and number over 100 in all cases but one.

Those rates of return are the annualization of cumulative daily averages of all the prior active investment periods for each stock, including the losing experiences. Here are illustrative pictures of the specifics of some of those gain and loss events, to give a sense of their balance and consistency. Please remember that typical holding periods are 6-7 weeks, making capital compounding of returns 7-8 times a year quite usual, from many different sequential vehicles.

These examples are a reminder that any investment forecast comes in a wrapper of odds. There is always some chance the forecast will not come to pass. The better understood are the odds and the error potential for losses, the more likely suitable comparisons between choices can be made.

This illustrates the performance consistency that can be had from careful selection and the modest give-up of some of high return in favor of minimizing drawdown extent and frequency. Enbridge (NYSE:ENB) is primarily a midstream processor of other firms' products, so is less impacted by product price changes. Here the market-makers seem to have a good handle on how the investment community responds to this equity at this level of outlook.

Our citation of past return experiences are not promises of future behavior, but are offered as a guide to what may be possible, for your convenience in choosing between investment alternatives.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.