Data by GHS Research

Slicing and dicing data might seem somewhat specious to those in an industry charged with getting drillbits to turn and oil to flow.

After all, there’s always the risk that results simply support a preconceived point of view. Exemplifying this suspicion is the phrase popularized by Mark Twain: “There are three kinds of lies: lies, damned lies and statistics.”

Nevertheless, the exercise of measuring oil and gas industry performance has merit. In assessing exploration and production (E&P) companies, analysts have their own sets of biases, incorporating attributes that they weigh more or less heavily. Some factors, like exploration risk, are subject to a wide range of interpretation. Is the chance of success more likely to be one in three, or one in 10?

If successful, are reserves likely to be closer to P75 estimates or P25?

Other factors come into play as well. To what extent does an analysis rely on historical data? If that is the case, it might be easy to assume the data are to a large extent accurate, but they might prove less useful in predicting trends. Past performance is no guarantee of future performance, we are frequently reminded. Even so, recent historical data can lay the foundation for analysis, and E&Ps are rarely successful in undergoing overnight transformations.

Given these factors, a methodology that provides for a systematic analysis of results and is easy to comprehend has appeal. In this regard, Investor turned to Global Hunter Securities and a methodology refined by senior analyst Mike Kelly, CFA, over a number of years.

When he travels to major money centers to provide updates of his data, a discussion of his findings-- and sometimes, even a specific page--frequently are the basis for investor meetings.

Referring to meetings with portfolio managers in Boston, “sometimes we spend the whole meeting on this one page,” Kelly said.

The page in question focuses on one of Kelly’s core metrics, which he terms the recycle ratio. Global Hunter uses this measure as a proxy for return on investment.

In plain English, the recycle ratio represents the cash earned per barrel of oil equivalent (boe) produced, relative to the investment required to bring that oil out of the ground. Put another way, it is the operating margin per barrel divided by the finding and development cost per barrel (F&D/bbl).

Another key metric preferred by Kelly is “production growth per debt-adjusted share,” which will be discussed later in this article. For now, suffice it to say that if the two concepts are found together in an E&P, working in harmony and pulling in the same direction, they can provide an indicator of superior share price performance, according to Kelly.

These companies are laying the groundwork for superior growth by advancing the two components--rising cash flow and falling F&D cost per barrel--that make up a favorable recycle ratio.

When he assesses an E&P’s overall capital efficiency and ability to create value from a growing production stream or reserve base, “Our rule of thumb is that assets with high cash operating margins and low F&D costs produce a superior recycle ratio, which leads to higher organic or per debt-adjusted-share growth rates, which in turn translates into share price outperformance,” Kelly said.

This means an E&P with high operating margins and low F&D costs sets itself up, as a first step, to grow production and reserves organically at a faster rate than its peers, other things being equal, according to Kelly.

But before assessing the next step, the spotlight can be turned to which companies are laying the groundwork for superior growth by advancing the two components--rising cash flow and falling F&D cost per barrel--that make up a favorable recycle ratio (see Recycle Ratio Ranking By Three-Year Average). Here data are also shown on a three-year basis in an attempt to iron out unusual year-to-year fluctuations. Company data are presented for both cash flow and F&D costs/bbl categories and are arranged by market capitalization.

An example of impressive progress in both categories is Continental Resources Inc. (NYSE: CLR). Continental has maintained its cash flow/bbl metric around $50/bbl (for 2013, $51.89/bbl, up from the prior year’s $46.06/bbl), a level higher than many of its peers.

An E&P with high operating margins and low F&D costs sets itself up, as a first step, to grow production and reserves organically at a faster rate than its peers, other things being equal.

Meanwhile, its F&D costs of $22 to $24/bbl in 2011 and 2012 came down to just over $14/bbl in 2013. The product of both these categories is a three-year average recycle ratio of 2.6x, ranking it #3 in the large-cap category.

Continental's three-year average recycle ratio of 2.6x ranks #3 in the large-cap category.

Looking at production growth per debt-adjusted share results in an "apples-to-apples" comparison of organic growth between firms that exhibit different levels of aggressiveness toward issuing new shares or taking on more debt.

The correlation between a recycle ratio and production growth per debt-adjusted share is shown here, with the best performers in the upper righthand quadrant.

"Too often, companies highlight absolute production growth accomplished by diluting shareholders by issuing equity or debt," said Mike Kelly, Global Hunter Securities senior analyst.

If an E&P has a more attractive record in terms of growth per debt-adjusted share, it is also highly likely to outperform in terms of stock price performance, with best performers in the upper righthand quadrant.

On the F&D side of the equation, Global Hunter uses an all-sources number (this includes leasing, seismic, drilling and infrastructure expenses, plus acquisitions). This is “adjusted” in instances where an E&P has booked a high number of proved undeveloped reserves (PUDs) without an offsetting estimate of the costs to develop them. Here the methodology adds a cost estimate based on the difference between the current year’s future development costs and the prior year’s (see All-Sources F&D Costs). (Note: GHS Research acknowledges Abraxas Petroleum Corp.’s Geoff King for his contribution in analyzing future PUD development costs.) It should be noted that Global Hunter’s adjusted all-sources F&D estimates do not include revisions related to changes in year-end commodity price assumptions.

Back to Continental. Recall that a higher-than-average recycle ratio is expected to lead to a higher level of growth—with an important distinction. Use of a “production growth per debt-adjusted share” metric is intended to take into account all changes to the capital structure (principally the addition of incremental debt or shares) of a company and thereby translate “absolute,” or top-line, growth into a production growth per debt-adjusted share metric (see graphic). In doing so, the purpose is to make an “apples-to-apples” comparison of organic growth between firms that exhibit different levels of aggressiveness toward issuing new shares or taking on more debt.

Debt-adjusted growth

In Kelly’s adjusted growth formula, the production (numerator) is divided by an adjusted share count (denominator) that is calculated by adding the company’s equity share count to a debt-equivalent share count, which Kelly renders by dividing the company’s debt balance by its average share price throughout the year. Kelly believes the adjustments quickly filter out companies that grew their top lines solely through tapping the debt or equity markets.

“Anyone can grow if they inject capital,” he said. “Too often, companies highlight absolute production growth accomplished by diluting shareholders by issuing equity or debt. Debt-adjusted growth per share shows whether companies are growing production for the benefit of shareholders, as opposed to growing production to show tall bars in presentation slides.”

Shown is three-year stock price performance alongside E&Ps' three-year CAGR in production.

With a #3 recycle ratio position, Continental also placed #2 in its market capitalization for production growth per debt-adjusted share.

Although its debt was up almost fourfold, its shares outstanding were up only about 4% between year-end 2011 and year-end 2013, with the net effect being a 23% compound annual growth rate (CAGR) for production growth on a per debt-adjusted-share basis. This represented a fairly modest reduction from its absolute growth metric of 30% CAGR, and exceeded by far the average CAGR of just 4% production growth for its peers on a per debt-adjusted-share basis.

Yearly stock performance is subject to many variables, while a three-year look smoothes out market changes.

How widely does an absolute measure of production growth prove less robust when re-evaluated using the latter methodology?

In 2013’s fourth quarter, when Global Hunter undertook a quarterly evaluation of its E&P universe, the sector looked like it was on a tear, with production growth over the third quarter running as high as 8.6%, or at an annual run-rate of over 34% on an absolute basis.

However, when measured on a debt-adjusted-per-share basis, the sector had eked out quarterly production growth of a mere 1.3%.

But just as some E&Ps are serial issuers of equity and debt, others shine because they not only place highly in recycle ratio rankings, they also succeed in guarding their equity jealously.

Cabot Oil & Gas Corp. (NYSE: COG) exemplifies the latter. With a recycle ratio of 2.7x, Cabot holds the #2 recycle ratio ranking, and this helped position the company to achieve growth during the three-year period under review. The company’s absolute CAGR was a lofty 30% over 2011-2013. And, with no change in its capital structure—-essentially no new shares issued over the period, and debt almost unchanged—-Cabot’s growth rate on a debt-adjusted per-share basis holds at that level.

SM Energy Co. has been similarly careful with its stock. It issued no new equity, although it has modestly added to its debt. Its absolute CAGR of an average 39% over 2011-2013 is trimmed only slightly to 35% on a debt-adjusted per-share basis, putting it in the #2 position as far as growth in the mid-cap sector. Its recycle ratio is 1.9x, above the mid-cap average of 1.56.

Global Hunter illustrates this correlation between a recycle ratio and production growth per debt-adjusted share in the accompanying chart (Three-Year Average Recycle Ratio vs. Three- Year CAGR Production Growth Per Debt-Adjusted Share). E&Ps that rank highly on both metrics appear in the northeast quadrant. To name a few: Cabot, Continental, EQT Corp. and Range Resources Corp., as well as small-cap Synergy Resources Corp. (Antero Resources, which led the pack with the #1 recycle-ratio ranking at 3.1x, is not shown due to a public production history shy of the three-year period.)

In turn, if an E&P has a more attractive record in terms of growth per debt-adjusted share, it is also highly likely to outperform in terms of stock price performance, according to Kelly. In the chart illustrating this metric (Three-Year CAGR Stock Return vs. Three-Year CAGR Production Growth Per Debt-Adjusted Share), several names are repeated from the previous chart—and exhibit the same pattern of being in the northeast quadrant—including Cabot, Continental, EQT Resources and Range Resources, among the large caps, and Synergy again in the small-cap category.

For reference, a table shows three-year stock price performance alongside E&Ps’ three-year CAGR in production. Looking at the large-cap category and using a cutoff of 20% or better for CAGR, for example, the prior names mentioned are joined by Pioneer Natural Resources Co. and EOG Resources Inc. All six companies’ stocks showed gains of at least 80% and up to 310% in 2011-2013.

Among mid-cap names, using a similar cutoff of around 20%, Gulfport Energy Corp., Oasis Petroleum Inc. and Kodiak Oil & Gas Corp. recorded gains of between 70% and 190% over the three-year period. In the small-cap sector, the standout performers were American Eagle Energy and Synergy Resources, with gains of over 300% and 200%, respectively, while EPL Oil & Gas and Evolution Petroleum had gains of about 90%.

Synergy’s President, Ed Holloway, suggests Global Hunter’s methodology is largely aligned with the philosophy followed by Synergy.

“We tend to keep debt low, issue stock sparingly, achieve a high velocity of capital, and target a return of capital in two years or less,” he said. “By keeping completed well costs low, we have rapid payout on wells and-—with recent netbacks around $50/boe—-a high recycle ratio. That sets us up to target 100% annual growth financed with internally generated cash flow, while keeping net debt at less than one times EBITDA.”

Kelly is quick to note that the methodology he uses is not ideal in every instance. Relying on historical data, it is generally “backward looking,” which might obscure the advances being achieved by an E&P if it is in the early innings of a play, when operators devote much science to initial wells and have yet to fine tune drilling practices. Another shortcoming might be in assessing the sustainability of a play, especially if progressing toward “manufacturing mode” depends on a substantial inventory of locations to drill.

These factors—coupled with the risks inherent in exploration-—stand out as major obstacles when applying such a methodology to, for example, Goodrich Petroleum (NYSE: GDP). Nonetheless, Kelly has been a long-time proponent of the name, which under his recent coverage carried a $39 target price. Goodrich is known for its leverage to the Tuscaloosa Marine Shale (TMS) play, “and we banked on this new play giving them a whole new life,” recalled Kelly. “They now have an asset base that will be able to completely change the company’s fortunes. A few years from now, they’ll make a climb out of the doldrums to that northeast quadrant where you find an above-average recycle ratio combined with an above-average growth per debt-adjusted share.

Historical data is generally backward looking, which might obscure the advances being achieved by an E&P if it is in the early innings of a play, when operators devote science to initial wells and have yet to fine tune drilling practices.

Another name that attracts Kelly is Cimarex Energy Co. (NYSE: XEC), a name that historically has ranked in the upper echelons in terms of recycle ratio, at 2.0x, but has been in the middle of the pack in terms of its CAGR, at 3%. Not only is Cimarex now projecting 25% growth in 2014, but it also has two focus areas that are generating dramatically higher pre-tax internal rates of return, said Kelly.

A year ago, those areas had 30% IRRs. Now, new completions on its Cana wells are helping generate 86% IRRs. And, in Culberson County in the Delaware Basin, the company’s long lateral Wolfcamp D wells are generating 160% IRRs with a present value of $31.6 million per well. As Cimarex knocks out those wells, its recycle ratio will go through the roof.”

Of course, at this point in the analysis we have migrated from historical trends to more recent performance data. In the first half of this year, for example, Cimarex has joined the top five E&Ps in terms of large-cap stock performance, reflecting its successes in developing its Delaware and Cana plays. Others in the top five include Continental, EOG Resources, Anadarko Petroleum Corp. and Concho Resources Inc. Meanwhile, Cabot, Range Resources and Antero Resources have moved lower under the weight of the logjam of gas trying to exit the Northeast, which hurts the basis differentials.

Whether your interest lies in checking out a metric like cash flow/bbl or F&D/bbl, which together produce a recycle ratio, or a measure of growth, be it on an absolute or on a growth per debt-adjusted share basis, the data are at your disposal. And, perhaps, curiosity will compel you to investigate to what extent such metrics prove useful as indicators of stock performance. Good hunting!

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