Leverage Higher Oil Prices With These Small Oil Producers

by: Michael Filloon

With the price of oil heading upward, smaller oil producers are better placed to outperform. When I look at smaller oil companies, I try to isolate names that have either large speculative acreages when compared to market cap, or acreage just outside the cusp of proven acreage. These can go unnoticed as some trade in the United States over the counter or on the pink sheets. This may surprise the average investor as some Canadian oil producers have United States acreage, and still trade only on Canadian stock exchanges.

Other companies receive little attention due to their small size. Oil producers with market caps below $1 billion are not big enough to be purchased by small cap index funds. Managers do not like to purchase these types of stocks due to high betas. These companies carry a significant risk, but if an investor does his or her homework, they can lead to a significant reward.

I have a list of micro cap oil stocks I follow. I use this for the purpose of identifying large moves and possible variables that could be the start of a bull run. On September 22nd of 2011, I wrote an article on micro caps stocks titled, Looking For Risk? Take A Look At These Micro Cap Oil And Gas Producers. Blue Dolphin (OTCQX:BDCO) has done quite well since. It was trading for $2.42/share at the time, and now sells for $10.38. Blue Dolphin's legacy businesses have included its pipeline, gathering, exploration and production. It recently added midstream, crude processing and storage. Blue Dolphin purchased a crude topping plant located in the Eagle Ford, and sold its Freeport onshore tank facility. This is hoped to offset the declining revenue of its pipeline business. This plant has historically produced 12500 bpd to 17000 bpd. After the re-commissioning it will be used to process condensate into four parts. Operating costs are estimated at $3/barrel. Blue Dolphin is counting on the continued $10/barrel premium of Brent versus WTI, as it will provide lower feedstock costs. The Nixon plant will have an initial capacity of 10000 bpd, and could expand to as much as 30000 bpd. The important variable going forward for Blue Dolphin is its 7% working interest in North Sumatra Basin-Langsa Field. This could be a home run type play given total resources in this field, and makes this speculative play look attractive.

Earthstone (NASDAQ:ESTE) is a favorite of mine and is a stock I currently own. It was selling for $13/share and now trades for $21.50. Earthstone's business has made a change for the better, as it has made investments in Bakken wells. Most of these wells were done in Banks Field, where there has been a recent discovery of additional Three Forks benches. The largest working interests were purchased in Brigham (STO) operated wells, and have proved quite good, with IP rates above 3000 Bopd. It has also began working its Ratcliffe Project in Sheridan County, Montana. Although not as good as Banks Field, it will be interesting to see how Earthstone fares in a county that has not been de-risked to a great extent. It also divested its Weld County, Colorado acreage. This helped to free up cash to pursue its non-operated North Dakota program. Most importantly, Earthstone has had two blowout quarters in a row. Its third quarter earnings of 68 cents per share on revenues of $8.9 million. Year over year this produced net earnings growth of 1457% and revenue growth of 95%. As with Blue Dolphin, it has made changes to its business which seem to be paying off.

HKN (HKN) was trading for $2/share on September 22nd and is now priced at $2.42. HKN has had a very difficult year, but it turned a profit of one cent last quarter, and this pushed the stock price up in the short term. Oil revenues were up significantly, which more than offset lower gas revenues. Production volumes were much lower, but a 132% increase in realized oil price more than offset this, Also, the company is looking to divest its Gulf Coast properties to free up some cash for operations. HKN closed its mandatory offer of Global Energy Development. It seems HKN has made one poor decision after another. The stock price has increased, but selling its interest in Spitfire Energy of Canada has decreased production. Its investment in BriteWater has not produced the revenue HKN had hoped for in recovering oilfield emulsions. The last reported BriteWater supply contract was signed in March of last year. I would not buy this stock, unless we see an increase in revenues and EPS, or more importantly BriteWater contracts.

Mexco Energy Corp. (MXC) has had a nice run since September, where its stock price was $6.05/share versus its currently price of $8.32. It has working interests in more than 2700 wells in the United states. This helps to diversify risk, but can make it nearly impossible to track its current well performance. Mexco's operations performed better in 2011 than 2010, but not enough to warrant a large increase in the price of this stock. Mexco did see a nice move in stock price after announcing earnings. Basically, Mexco is an oil and gas non-operated production company, but I believe Earthstone is a better play given that is is levered to McKenzie County, North Dakota. Keep in mind, if the price of oil continues upward, Mexco's stock price could appreciate significantly.

Royale Energy (NASDAQ:ROYL) has pulled up nicely since trading for $2.25/share on September 22nd. I was surprised how well this stock has held up with the price of natural gas falling significantly. It now trades for $5.53/share. Royale had been a pure natural gas player, but has begun increasing its leverage to liquids. Up until recently, Royale had acreage only in California, Utah, and Texas. In December, it purchased 100480 acres in Alaska. This acreage is 22 miles south of Prudhoe Bay Field and is believed to be commercial for both conventional and unconventional oil. Royale does sell up to a 50% working interest in each of its wells to help mitigate risk. By doing so, it is able to use this cash flow to develop its acreage faster to get production on line. I like Royale going forward, as its shift from gas to liquids could prove lucrative. It seems to have made this major Alaskan purchase at the right time, as natural gas prices continue to weaken. I am very interested in this play; Royale's acreage looks to have speculative upside.

I was bullish on Lucas Energy (LEI) in September as its stock price shrank to $1.75/share. It is now trading at $2.74 and has some momentum. Lucas has been very busy since my last update, including the purchase of Nordic's remaining interest in Wilson, Gonzales and Karnes counties for $22 million. On January 4th, it announced the purchase of an additional 5500 acres of leases from Hall Phoenix Energy for $6.4 million. This purchase increased Lucas' holdings in the Eagle Ford to 27000 gross acres. A week later, it announced the hiring of Global Hunter Securities and Knight Capital to advise in the selling of its Eagle Ford and Eaglebine trend properties. Earlier this month, it also reported a very good Austin Chalk result, for which it has a 25% working interest. Lucas seems to be ramping up production rates, and should continue to see improvements going forward. It also has added production from its JV with Marathon (NYSE:MRO). I think Lucas' outlook is quite good. It managed to sell its New Mexico assets, while acquiring more acreage in the Eagle Ford area. It is selling its Eagle Ford/Eaglebine assets with the intent of working the Austin Chalk in these areas. Its acreage is good, and I believe it could see significant growth in 2012 if Lucas executes.

Lynden (OTCPK:LVLEF) is another stock I own. Although this stock has headed lower since September, it has a very large acreage position relative to market cap. It has 15500 acres in the Wolfberry play of the Permian Basin. Lynden also has 100000 gross and net acres in Mitchell Ranch, which has huge potential. It also has 85000 net acres in the Paradox Basin, which is mainly a gas play. The Wolfberry is a low cost area with multiple resource targets. Completion costs range from $1.5 to $2 million. Mitchell Ranch also has several targets, but is not as developed as the Wolfberry. On January 30th, Lynden had a very good completion in its Tubb area leasehold of the Wolfberry. This was very important as Tubb is the least developed area of the Wolfberry. Lynden believes Tubb could produce 170 wells on 40 acre spacing. It plans 28 gross or 12 net wells in the Wolfberry for 2012. With respect to Mitchell Ranch, Lynden has signed an agreement with a large oil and gas production company to help develop the play.

I had also commented on the bleak prospects for Cano Petroleum (CANO.PK) in September, as the company continued to have significant cash problems coupled with lower production. The stock has since been de-listed and now trades for 7 cents per share versus 16 cents at the time of the article.

In summary, micro cap stocks should outperform in the presence of higher oil prices. Blue Dolphin could have upside based on the purchase of its crude topping plant, and also its Langsa Field oil play. Earthstone has recreated itself as a non-operated Bakken oil player, and this move has paid off over the past couple of quarters. HKN and Cano have not fared well, and look to have continued problems going forward. Royale made a very aggressive move purchasing a large acreage in Alaska. Lucas and Lynden both have decent sized acreage in very good areas. Of this group, Lynden may have the most upside, based on its Mitchell Ranch acreage. If this area is anything like the Wolfberry, there will be several targets/location, on 40 to 20 acre spacing.

To be clear, all of these companies are very risky, and could lead to a large or total loss of capital. Information is difficult to come by in these names, and given the expectations for growth, one well could affect stock price significantly.

Disclosure: I am long OTCPK:LVLEF.

Additional disclosure: I currently own shares of ESTE. This is a list of micro cap oil and gas production companies that could be used to leverage a portfolio as oil prices rise. It is not a buy recommendation.

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