Best E&P Catches

In a heady commodity-price environment where E&P stock valuations are reflecting bullish investor sentiment about the energy sector in general, it's hard to do any bottom fishing in the small- to midcap upstream pond. Very simply, there are hardly any overlooked minnows left to reel in.

Indeed, a review of Oil and Gas Investor's top 15 small- to midcap E&P stock picks for 2003 reveals that nearly all of them exceeded their 12-month target prices. For instance, the shares of Westport Resources, picked a year ago to climb from $19.71 to $25, have been recently trading around $31 while the shares of Quicksilver Resources, expected 12 months ago to rise from $22.88 to $28, have been recently hovering around $37.

In today's ebullient market, it's particularly hard to find value plays. Instead, investors seem to be more focused on stories of growth-in production volumes, reserves, cash flow and earnings. If there is any focus on value, it's generally from the perspective of where E&P stocks are now trading versus the even loftier market levels they can reach as the result of accelerated volume and cash flow growth.

So which are the best upstream catches for 2004 in a sea of high-flying small- to midcap stocks? To find out, Oil and Gas Investor polled seven E&P analysts at five investment-banking firms. Their top 13 choices follow, in order of how frequently a stock was mentioned and highest projected percent gains in share price.

Notably, there are a few value plays touted by these analysts, including Denbury Resources, Magnum Hunter Resources and new market entrant Whiting Petroleum Corp. Also, despite its recently announced substantial downward reserve revisions, Forest Oil is still seen as having significant double-digit volume growth in front of it.

Comstock Resources

With core areas in the Gulf of Mexico, South Texas and East Texas, this 80% gas-weighted producer is on track to achieve 10% to 15% production growth in 2004, says Ronald E. Mills, senior E&P analyst, Johnson Rice & Co. in New Orleans. "This should lead to increased earnings and cash flow and hence, higher market valuation."

Comstock, whose average daily output in third-quarter 2003 was 123 million cubic feet equivalent (MMcfe), recently made two significant gas-weighted Gulf of Mexico discoveries at South Pelto 22 and 25, due to come online this March and April. The operator, whose estimated year-end 2003 reserves were 640 billion cubic feet equivalent (Bcfe), also has other Gulf of Mexico exploration prospects it will drill this year plus a high-potential onshore gas prospect in southeast Texas.

Wayne W. Andrews, vice president, equity research, for Raymond James & Associates in Houston, eyes 15% growth in production volumes this year for Comstock, driven by the producer's drilling activities in the Gulf of Mexico and southward extensions of gas discoveries the company has made in the Woodbine formation in East Texas.

Comstock has plenty of capital to grow and pay down debt, says Andrews. "We're forecasting discretionary cash flow this year of some $200 million while the company's unofficial 2004 capex budget is $120 million."

Pioneer Natural Resources

"With four of its recent deepwater Gulf of Mexico discoveries coming online in 2004-namely the Harrier, Devils Tower, Raptor and Tomahawk projects-we're forecasting 23% growth this year in Pioneer's daily production, to 1.1 Bcfe," says Larry Benedetto, E&P analyst for Howard Weil in New Orleans.

The company's overall exploration inventory worldwide-including Gabon, Tunisia and Argentina-totals about 100 prospects that have net unrisked reserve potential of 1.2 billion barrels of oil equivalent (BOE), the analyst says.

"With an announced capex budget of $575 million this year and expected 2004 cash flow approaching $1 billion, Pioneer will have plenty of room to pursue these opportunities, make acquisitions and buy back stock." The company will also begin paying a 20-cent-per-share dividend this year.

Andrews says Pioneer's 2004 production profile will also benefit from a full year's output from three projects that came online in 2003: Canyon Express and Falcon in the Gulf of Mexico and its Sable project in South Africa. He sees the company's daily production rising 17% in 2004-after a 30% bounce in output in 2003-and increasing by more than 10% annually for the next several years.

"Although Pioneer's 2004 capex budget is roughly the same as last year, the company will not be spending as much on infrastructure," says Andrews. "That will allow it to drill more exploration, development and delineation wells in its core areas in order to fuel further reserve increases."

Denbury Resources

The largest producer and owner of oil reserves in Mississippi, the company also controls within the state 5-plus trillion cubic feet (Tcf) of CO2 reserves around Jackson Dome and a major CO2 pipeline.

"Denbury has successfully used this CO2 for tertiary floods in several older oil fields in western Mississippi," says Kenneth H. Beer, senior E&P analyst for Johnson Rice & Co. in New Orleans. "Ultimately, with CO2 pipeline extensions, the company can use these same floods in other older oil fields in eastern Mississippi and South Louisiana, exposing itself to an added 100-plus million barrels of recoverable oil reserves."

The producer, with average daily 2003 production of 35,000 BOE and estimated year-end 2003 reserves of about 145 million, can grow output and reserves by 5% to 10% annually for the next five to 10 years, claims Beer.

"Additionally, it has gas exploration exposure in South Louisiana and the Gulf of Mexico and a gas-exploitation project on 20,000 net acres in the Barnett Shale play in Texas."

With almost a limitless supply of CO2, Denbury is in a position to add hundreds of millions of barrels of oil reserves during the next five to 10 years, agrees Greg L. McMichael, vice president and small-cap E&P analyst for A.G. Edwards & Sons in Denver. He notes that in the three Mississippi fields where the company has already used CO2 flooding, daily oil output has jumped from 1,400 to 6,000 barrels-and is expected to peak at around 18,000 to 19,000 barrels in 2007 and 2008.

Despite this outlook, McMichael says the stock is priced about 15% below its peer group, in terms of price/net asset value (NAV), enterprise value (EV)/EBITDA (earnings before taxes, interest, depreciation and amortization) and price/implied in-ground value of reserves.

Energy Partners Ltd.

This 65% gas-focused company, with estimated year-end 2003 reserves of 51 million BOE and core offshore properties in Bay Marchand, East Bay and the central Gulf of Mexico, drilled 16 of 19 successful exploration wells in 2003, says Mills.

"Based on this drilling success, we expect 10% growth in daily 2004 production, up from a third-quarter 2003 level of 22,000 BOE per day." The analyst points out that the company's 2002 acquisition of Hall-Houston added not only to EPL's exploratory asset base in the Gulf, but also strengthened the company's technical expertise there.

Mills expects the New Orleans company, which will drill 23 to 25 exploratory wells in 2004, to use 60% to 65% of its 2004 capex budget of $115 million for lower-risk exploration and exploitation projects in the Gulf; 20% to 25%, for moderate-risk projects; 10% to 20%, for higher-risk projects.

"Energy Partners is also sitting on about $90 million of cash and is looking for an attractive acquisition candidate," he adds.

Benedetto says the company has a three-year drilling inventory ahead of it, with 80 prospects currently identified. "While we're forecasting 8% growth in production this year, that estimate could be revised upward if EPL has early success with its 2004 exploration program."

Tom Brown

The company's large acreage position and drilling programs in the Rockies, and its leverage to average $4 to $5 gas prices there, make this stock very attractive, says Larry Busnardo, small-cap E&P analyst for Petrie Parkman & Co. in Denver.

He notes the 90% gas-weighted producer, with reserves of better than 1 Tcfe, has about 1 million acres under lease in the U.S. portion of the Rockies and another 300,000 acres in the Alberta, Canada, portion. Complementing its exploration program in Wyoming's Wind River and Green River basins and Colorado's Piceance Basin are its development programs in these regions, he notes. Also, the company recently began drilling its high-potential, 600-Bcfe Cotton Deep prospect in East Texas, in which it holds a 90% working interest.

With a 2004 capex budget of about $275 million versus $250 million last year, plus a full year's contribution from its 2003 Matador Petroleum acquisition, the company's daily 2004 production should be 20% above a third-quarter 2003 daily average of 296 MMcfe.

"We, too, see the company's 2004 daily production rising 20%, inclusive of the Matador acquisition," says Benedetto. "We also see Tom Brown generating 2004 discretionary cash flow of $366 million-about $90 million above its capex budget for the year."

Quicksilver Resources

"We like this stock because of its exposure to a major coalbed-methane (CBM) play in the Palliser Block some 40 miles east of Calgary," says Busnardo. "The company has grown daily CBM production there from 3 MMcf in third-quarter 2003 to 18 MMcf recently, and as it continues to ramp up, it could exit 2004 at 30-plus MMcf per day."

Busnardo says the company plans to expand its Canadian CBM drilling program from 173 wells in 2003 to more than 300 wells this year. "This will be the main driver of Quicksilver's overall 27% production growth in 2004 and its estimated 15% to 20% annual growth in output beyond that."

The 85% gas-focused company, whose average daily production was 107 MMcfe in third-quarter 2003, also has assets in the Antrim Shale play in northern Michigan, the New Albany Shale play in Indiana and the Barnett Shale play in Texas. In the New Albany play, its daily production should rise from a pipeline-constrained 3 MMcf last September to 10 MMcf in first-half 2004, Busnardo says. In the Barnett Shale, the company has a 100,000-acre lease position, on which it has only drilled five wells so far, he adds.

Michael Scialla, small-cap E&P analyst for A.G. Edwards & Sons in Denver, says Quicksilver has at least 20% annual growth rates ahead of it in production and reserves-with very low finding costs because of its large 450,000-net-acre CBM position in Canada. "We estimate its average finding costs during 2001-2004 at 50 cents per Mcfe-one-third the industry average."

He adds, "This is not only a story of growth, but efficient growth."

Magnum Hunter Resources

This gas-focused operator, with core areas in South Texas, the West Texas Permian Basin, southeast New Mexico and the Gulf of Mexico, should be able to achieve 8% to 10% growth in daily production through the drillbit in 2004, up from a current 203 to 225 MMcfe, says McMichael.

Reserves, meanwhile, should edge up from roughly 865 to 885 Bcfe.

"Additionally, management has indicated a strong conviction to reduce its current 60% debt/total capitalization to 40% to 50% by the end of 2005," he says. "This, coupled with organic production growth, would support a higher stock valuation." Currently, the stock is undervalued, trading at about a 20% discount to the analyst's peer coverage group of 20 companies, based on price/NAV.

Whiting Petroleum

With core areas in the Williston Basin in North Dakota and Montana, the Wilcox play in South Texas and the Antrim Shale play in northern Michigan, this balanced oil and gas producer-whose IPO debuted in late 2003-average third-quarter 2003 daily production of 101 MMcfe and reserves of 430 Bcfe.

"A good valuation story, the stock trades at about a 20% discount to its peer group, in terms of price/NAV, EV/EBITDA and price/implied in-ground value of reserves," says McMichael.

"While all of Whiting's core areas should contribute to an organic 10% growth rate in production and reserves in 2004, the producer-historically an acquire-and-exploit company-is unlikely to go through the year without making an acquisition," he adds. "It has about $55 million in cash on the balance sheet and is constantly looking at deals. So its 2004 growth in output and reserves could be greater than 10%."

McMichael notes that between 1999 and October 2003, the company grew reserves at a 22% compounded annual rate, largely through acquisitions.

Forest Oil

This company is in a state of transition under new management headed up by Craig Clark, former head of Apache's North American operations, says Andrews.

"Clark is playing by the Apache play book of successfully combining acquisitions, development and delineation drilling," he says. "Since Clark's arrival, he has done an excellent job of focusing Forest on converting its unproven U.S. property base in the Gulf of Mexico and the Texas and Louisiana Gulf Coast into producing, cash-flowing assets."

The company, whose average third-quarter 2003 daily production was 400 MMcfe, could grow daily 2004 output by nearly 20% through drilling and additional acquisitions, Andrews believes. He notes that Forest will get a full year's benefit from its late 2003 acquisition of Gulf of Mexico properties from Unocal. He also notes that, with the exception of its South Africa drilling program, the company will be curtailing its international activities this year in favor of a more North American focus.

Ultra Petroleum

"This is the fastest-growing E&P company in North America in terms of both production and reserves, and it's my top E&P pick for 2004," says Andrews.

With average third-quarter 2003 daily production of 75 MMcfe per day-100% from Wyoming's Pinedale Anticline-Ultra recently indicated a year-end 2003 proven gas reserve target of 875 Bcfe, up from 700 Bcfe at year-end 2002. "We believe the company will exceed that target and report proven reserves in excess of 900 Bcfe."

In the Pinedale area, Ultra has a 10-plus-year inventory of exploitation- and development-drilling opportunities requiring several billion dollars of expenditures, the analyst says. He notes that with $2.50-per-Mcf net wellhead gas prices, Ultra can earn a 45% rate of return, and at current gas prices, more than a 100% ROR.

The company-expected to achieve a 40% to 50% annual growth rate in production through 2006-should also start oil production from China's Bohai Bay in second-half 2004. "Ultra has discovered nine fields there and will start producing from two of them, with collective output of about 5,000 net barrels per day."

Not surprisingly, Ultra's stock trades at huge price/cash flow and EV/EBITDA multiples versus its peer group, mainly on the basis of its reserve potential at Pinedale. Says Andrews, "We see this company as a potential takeover target for larger independents seeking opportunities to deploy capital and earn an excellent return."

Westport Resources

With its 2002 Uintah Basin acquisition from El Paso, which added 603 Bcfe of Utah gas reserves; its recently announced joint venture with Chevron in the Gulf of Mexico; and its 2003 acquisition of United Resources in South Texas, Westport is positioned to grow 2004 daily production 26% over an estimated 2003 daily average of 452 MMcfe, says Busnardo.

The analyst says this 70% gas-focused producer, with reserves of 1.8 Tcfe pro forma the United acquisition, not only has a good core base of gas development-drilling opportunities in the Uintah Basin and South Texas, but also oil exploitation projects in the Williston Basin, gas exploitation projects in Wyoming's Powder River Basin and exploration exposure in Wyoming's Wind River and Green River basins.

"Also, through its Chevron joint venture, it has further exploration exposure to an initial eight Gulf of Mexico prospects-each 50- to 200 Bcfe targets."

Busnardo says Westport's 2004 capex budget will jump to $350 million from $275 million last year and will be geared toward its three principal growth areas: the Gulf of Mexico, the Uintah Basin and South Texas. "With this three-legged stool, the company has visible, organic production growth for the next several years, plus an attractive valuation." Recently, the stock has been trading at 4.0 times estimated 2004 cash flow versus a peer-group multiple of 5.7.

Stone Energy

Mainly a Gulf of Mexico and onshore South Louisiana exploration and exploitation company, Stone's daily production dropped to 265 MMcfe in 2003 from about 285 MMcfe the prior year due to a lack of exploration success in 2002, says Beer.

"However, the company had good exploration results in 2003 which should translate into 10% to 15% gains in production volumes in 2004, particularly as its Gulf of Mexico discovery at South Pelto 22 comes online." The analyst also looks for Stone's reserves to increase, from 800 to 850 Bcfe by year-end 2004.

Beer adds that upwards of 15% of the company's reserves and production are in the Rockies, where it has a good position in Wyoming's Pinedale Anticline. "Long-lived gas properties will help complement the short-lived nature of Stone's Gulf of Mexico gas properties."

Noble Affiliates

This globally focused producer, with balanced oil and gas assets in the onshore and offshore U.S., the North Sea and the offshore areas of Equatorial Guinea and Israel, should be able to grow daily 2004 production by 22%, to 733 MMcfe, and 2005 output by another 7% to 10%, says Benedetto.

The primary drivers for this growth will be new gas production offshore Israel, which came online last December, adding 40 MMcf per day to output, plus additional oil production from Noble's Alba Field offshore Equatorial Guinea, which last December began adding 9,500 net barrels per day to output, he says.

"In 2004, the company will have a full year of production from both these areas-at the same daily rates."

He adds that the company, whose year-end 2002 reserves were 2.8 Tcfe, will have at least $180 million of free cash flow this year above some $450 million of budgeted capex. "This should allow Noble to make additional acquisitions, buy back stock or make further debt repayment."

Top E&P Stock Picks - 2004