Article Objective: The objective of this article is to analyze upstream oil and gas companies based on operations, financials and risk. I will examine several factors in each category and then organize the companies from strongest to weakest. The reader, with their own opinion of the future price of oil and gas, can use this as a guideline to find a company to take a position in.
The portfolio: The portfolio is composed of 54 exploration and production companies that trade on a US exchange with a market capitalization of at least $25 million. It includes OTC stocks provided they have a reasonable trading volume. They must be producing. I lost a handful because they hadn't released 2017 information at the time I started the analysis (I gathered them into another portfolio and may repeat this analysis on them).
The portfolio constituents are:
- Advantage Oil & Gas (AAV-OLD)
- ARC Resources Ltd. (OTCPK:AETUF)
- Apache Corporation (APA)
- Antero Resources Corporation (AR)
- Approach Resources Inc. (AREX)
- Continental Resources Inc. (CLR)
- Canadian Natural Resources (CNQ)
- Cabot Oil & Gas Corporation (COG)
- Crescent Point Energy Corp. (CPG)
- Concho Resources Inc. (CXO)
- Devon Energy Corporation (DVN)
- Encana Corporation (ECA)
- Erin Energy Corporation (ERN)
- Earthstone Energy Inc. (ESTE)
- Gear Energy Ltd. (OTCPK:GENGF)
- Gulfport Energy Corporation (GPOR)
- GeoPark Ltd (NYSE:GPRK)
- Gastar Exploration Inc. (GST)
- Gran Tierra Energy Inc. (GTE)
- Halcon Resources Corporation (HK)
- Jagged Peak Energy (NYSE:JAG)
- Jones Energy Inc. (JONE)
- Kosmos Energy Ltd. (KOS)
- Legacy Reserves LP (NASDAQ:LGCY)
- Lilis Energy Inc. (LLEX)
- Laredo Petroleum, Inc. (LPI)
- Mid-Con Energy Partners LP (MCEP)
- Contango Oil & Gas Company (MCF)
- MEG Energy Corp (OTCPK:MEGEF)
- Murphy Oil Corporation (MUR)
- Noble Energy (NYSE:NBL)
- Newfield Exploration Company (NFX)
- Northern Oil and Gas Inc. (NYSEMKT:NOG)
- Parsley Energy Inc. (NYSE:PE)
- Peyto Exploration & Development Corp (OTCPK:PEYUF)
- Pengrowth Energy Corporation (PGH)
- Panhandle Oil and Gas Inc. (NYSE:PHX)
- PetroQuest Energy Inc. (NYSE:PQ)
- Penn West Petroleum Ltd (PWE)
- Pioneer Natural Resources (NYSE:PXD)
- QEP Resources Inc. (NYSE:QEP)
- Range Resources Corporation (RRC)
- RSP Permian Inc. (RSPP)
- Stone Energy Corp (SGY)
- SM Energy Company (NYSE:SM)
- Sanchez Energy Corporation (SN)
- Seven Generations Energy Ltd (OTC:SVRGF)
- Transglobe Energy Corporation (NASDAQ:TGA)
- Tourmaline Oil Corp. (OTCPK:TRMLF)
- Whiting Petroleum Corporation (WLL)
- WPX Energy Inc. (NYSE:WPX)
- W&T Offshore (WTI)
- Cimarex Energy Co (XEC)
- Extraction Oil & Gas Inc. (XOG)
I analyzed the companies in the following areas: operational, financial and risk-reward. I also included a bonus analysis of price sensitivity to the underlying commodity.
In the main portion of the analysis I use at least one ratio in each of the operational, financial and risk-reward segments. In order to make sense of all the numbers, I ranked each outcome from 54 to one, with 54 indicating the best score and one indicating the worst. I summed the scores across the categories and then re-ranked the companies from 54 to one, with 54 indicating the highest score and hence the strongest company.
I looked at the following operational metrics:
- Production to reserves ratio ~ Reserve Life Index
- Reserves replacement ratio
Netback is an oil & gas specific operational metric that measures the gross profit per barrel (revenue less royalties less production costs less transportation/annual production in barrels of oil equivalents). It's a measure of operational efficiency.
There were challenges in using this metric. It doesn't have a prescribed meaning under IFRS or U.S. GAAP so there's no official pronouncement on how it should be calculated and there's no obligation on the company's part to report it. As such, only a few companies made it available. Calculating it by scratch from the financial statements was still problematic because not all of the elements were reported.
However all companies did report gross profit. In order to have a consistent calculation across all the companies, I took the reported gross profit figure and added depreciation back in and then divided it by annual production.
I decided to look at netback in three ways to allow different kinds of strengths to shine through (like a year over year improvement).
- Absolute value for the current year,
- Change in netback from the previous year (y-1) to the current year (y),
- The change calculated in 2 divided by the standard deviation between y and y-1. I decided to make this calculation available because I noticed some companies had a small year or year difference in netback and some had a huge difference. Although it's good to see an improvement, it's a bit unnerving to see such wild swings in the value. Dividing the change in netback by the standard deviation rewards more stable companies and punishes more risky ones.
I didn't want to over-weight this factor. Each of these three metrics is scored from 54 to one, summed, and then re-ranked.
Production to reserves ratio (PRR) and Reserve Life Index (RLI)
The PRR shows the percentage of production relative to reserves and the RLI shows how long the reserves will last at current production levels. I felt it was redundant to include both as one is the inverse of the other. I used RLI.
Reserves replacement ratio (RRR)
This ratio measures the amount of reserves added to a company's reserve base relative to the amount of production. It's calculated as the change in reserves from y to y-1 divided by production. The higher the better.
I looked at three financial/valuation metrics for the group:
- Market cap to free cash flow,
- Enterprise value to debt-adjusted cash flow (EV/DACF), and
- Enterprise value to daily production.
Market cap to free cash flow
Cash is vital for oil and gas companies. They're capital intense, highly leveraged, and subject to severe price fluctuations. They must been disciplined about controlling their cash. Market cap to free cash flow is effectively a valuation metric and we're looking for a low valuation. After I ran the calculation, I scored the results from lowest to highest starting at 54 for the lowest positive score. Firms with a negative result were scored with a zero.
There were a lot of firms with a negative result, enough that I was concerned about the metric. I wanted to see how much of an aberration it was that almost 80% of the stocks were showing a negative free cash flow. I looked at the instances of positive free cash flow for each stock over the past five years: 34 had no instances of positive FCF in 5 years, 14 had one year and 6 had two years.
The companies with two years of positive free cash flow are:
Enterprise Value to Debt Adjusted Cash Flow (EV/DACF)
This metric is similar to the first, market cap to free cash flow, but takes into account the capital structure of the firms. DACF is the sum of operating cash flow and after-tax financing cost. QEP had a negative EV/DACF, so I scored it zero.
EV to daily production
This measure looks at how efficiently the firm is organized relative to its operational objective - producing oil or gas. I used 2018 production guidance for the 47 companies that provided guidance. For the seven that didn't I used actual 2017 production (ERN, GENGF, HK, PHX, PQ, SGY, WLL). For the seven that didn't provide guidance, with the exception of ERN, GENGF & PQ, their production declined from 2016 to 2017.
The lower the ratio the higher the score.
I looked at the Sharpe ratio to measure the reward-risk trade off by taking the average return (or expected return) and dividing it by the standard deviation (or expected deviation). I used 12 months of monthly data.
I thought the best way to display the results was in order from best to worst (as opposed to alphabetical).
Bonus analysis - Stock Price Sensitivity
The future price of oil and gas was beyond the purview of this analysis. However I did want to provide some guidance on stock price sensitivity. Some of these firms produced gas and some produced oil and some produced a mix. I calculated two correlation coefficients to measure stock price sensitivity, one using natural gas prices and the other crude oil. I also looked at their betas.
On the whole, upstream oil and gas companies seem to be very sensitive to the market. I wouldn't recommend this group as a hedge against a bear market.
AREX, WLL, SM, SGY, WPX, SN all had a beta greater than two.
Only AAV, PEYUF, GENGF, TRMLF, SVRGF and GPRK had a beta under one and the first four listed was between .92 and .87. The last two had betas of .61 and .51 respectively.
The balance of the companies were greater than one and less than two.
Oil correlation coefficient
The correlation coefficient measures the direction and strength of the relationship between two sets of numbers, in this case the price of the stock and the price of oil.
I was surprised to find that almost half of the companies showed a negative correlation to the price of oil. The symmetry extends further, the range goes from .96 to -.97.
Obviously I needed to look at this deeper. What I found was that the negatively correlated companies actually seemed to be demonstrating a lag between their stock price and the price of oil. As you'll notice from my notes, I used 12 months of monthly data for my calculation (which also may have been a factor, if I used more points, the negative correlation might have disappeared).
The bottom five, the most negatively correlated stocks are AAV, PEYUF, TRMLF, SVRGF and AETUF. With the exception of the first, those are all OTC stocks. Notice the crossover between this list and the list of low beta stocks.
My untested hypothesis is this represents a potential arbitrage opportunity (some stocks, particularly OTC will reflect the price of oil on a lagged basis). This is worthy of further analysis at a later date.
The top 10 most correlated stocks are WPX, CLR, WTI, WLL, CXO, ERN, SGY, RSPP, GPRK and GTE.
Gas correlation coefficient
The gas correlation coefficient numbers ranged from .53 to -.39 but unlike the oil coefficient, there were only 11 stocks with a negative number.
The top 10 most correlated stocks are DVN, NFX, HK, MUR, GENGF, APA, GST, SM, MEGEF, PXD.
Although I abstained from commenting on the future price of the commodities, I suspect this will be an interesting year. Over the time I've been working on this article I've been reading about the industry both on Seeking Alpha and in other publications. The most recent one was about the possibility of an oil shock in the near future.
This analysis opened my eyes to the complexity and vastness of the oil & gas sector. The 54 companies I examined represent only a segment of it. There are still midstream, downstream and integrated companies. Not to mention companies that support it in various ways such as pipeline construction, shipping and well drilling.
I think there are some interesting analysis possibilities in the area of stock price sensitivity. It was important to me to provide overview information for this article but I didn't answer all of the questions that arose from drilling into the price sensitivity oil patch. At a later date perhaps.
My objective in this article was to provide some organization to this large industry and to provide analytical information to investors interested in taking a position, short or long, in an upstream oil and gas company.
I like the following companies for a long position:
I would not go short, but if I was considering it, HK would be the first one I would look at.
Thank you for reading.
Many companies produced a mix of oil and gas. All operational calculations converted gas into a barrel of oil equivalent.
The conversion factor to change gas reserve and production information to a barrel of oil equivalent was 1/5658.53.
I used 1P (proven) reserves information.
Used the average of 2018 production guidance
Correlation coefficients were calculated using monthly data for 12 months.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CNQ over 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.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.