E&P Stocks for 2013

Barring any global surprises, the price of oil and gas will likely be range-bound in 2013, governing the effect commodity price movement will have on stock upside. So what is an investor to evaluate in an E&P stock in the near term?

“Catalysts are important,” says Gabriele Sorbara, vice president of E&P for Imperial Capital LLC. He also considers potential from stacked-pay zones a driving force. “Derisking these newer zones is going to be key to outperformance.”

Companies in the Permian Basin, Eagle Ford, Niobrara Wattenberg and Bakken will garner the premium valuation, he says. Likewise, some companies don’t have the capital to bring forward this value, and will be marked as takeout candidates. “M&A premium” is large, as well.

“The ones I’ve focused on can grow production and proved reserves in double digits on a debt-adjusted basis,” says Gabriele Sorbara, vice president of E&P, Imperial Capital LLC.

Sorbara likes capital discipline when recommending a stock. “The ones I’ve focused on can grow production and proved reserves in double digits on a debt-adjusted basis. That’s key. Those names will be the outperformers.”

Global Hunter Securities senior E&P analyst Mike Kelly voices a similar theme. “2013 is going to be about proving up undeveloped acreage.” His favorite strategy for assessing an E&P today is to identify one that trades at roughly market median valuations, but has a big, undeveloped shale play in its back pocket. “It puts the risk-reward profile in your favor.”

Michael Scialla, managing director at Stifel Nicolaus & Co., agrees, with a twist. “To be an exceptional stock, a company has to have an unappreciated asset or be an unappreciated operator. The stocks I’m recommending for 2013 have under-appreciated big resource play assets that are capable of generating strong returns at much lower commodity prices than we’re seeing now.”

Oil and Gas Investor asked these three analysts to pick their favorite E&P growth stocks for the upcoming months.

Bonanza Creek’s firepower

Denver-based Bonanza Creek Energy Inc. “is one company I think is going to be a home run in 2013,” says Sorbara. “It’s a small company—just over a $1-billion enterprise value—but there is a lot of firepower here with the Wattenberg Niobrara and the stacked-pay potential in the play.”

Formed in 2005 as an outlet for institutional capital from D.E. Shaw & Co., and having IPO’d just a year ago, in December 2011, Bonanza Creek is not getting the love from the Street that Sorbara thinks it deserves. The issues are acreage and float. While it holds some 32,000 acres in Wattenberg Field in the sweet spot of the Niobrara play in Colorado, investors see this as lackluster compared with other operators in the play with larger acreage positions.

In addition, the availability of publicly traded shares is meager, making it difficult for large institutional investors to buy in. “They have 40 million shares outstanding, but just 10.5 million is the float. That’s one reason the stock is cheap.”

These factors have shaded investors’ viewpoint, and suppressed the stock, which traded at about $26 at press time.

But strong leverage to the Niobrara Wattenberg provides literal layers of upside, he believes, specifically five prospective zones. “One knock on Bonanza Creek is that its acreage position is not large enough. However, its position in the core Wattenberg has the potential for significant running room.”

Like other operators surrounding it, Bonanza Creek is developing the “B” bench of the Niobrara with 30- and 60-day rates averaging 470 barrels of oil equivalent (BOE) and 373 BOE per day based on 16 and 11 producing wells, respectively, of which about 76% is oil. Wells are tracking three-stream (oil, gas liquids and gas) estimated ultimate recoveries (EURs) of 356,000 BOE, generating “very compelling economics” of 50%-plus internal rates of return (IRR) at $95 oil. “We believe EURs will ultimately exceed type-curve expectations.”

But that is just one zone of opportunity. The “A” and “C” benches, along with the Codell and Greenhorn formations, all appear prospective. Bonanza Creek and others are currently testing these zones.

“Bonanza Creek may ultimately end up with as many as five horizontal drilling opportunities. On 80-acre spacing, this could ultimately translate into more than 1,800 drilling locations—and that’s conservative,” Sorbara says. He believes that number could easily double if 40-acre spacing proves to be optimal drainage. From the Niobrara B bench, he calculates 96 million barrels of upside potential across its position here. He models Bonanza Creek to drill 73 horizontal Niobrara wells in the Wattenberg next year.

Assuming only 54% of the Wattenberg acreage is economic, Sorbara credits $13.48 per share for the horizontal B bench alone.

Additionally, Bonanza Creek holds interests in the North Park Basin area of the Niobrara, and in the liquids-rich Cotton Valley and Smackover-Brown Dense in southern Arkansas, for which he gives no per-share value as yet.

As to the float problem, a solid acquisition with an equity raise attached would solve that, he says. “A transaction funded with equity would go a long way to improving the float. There is room for them to be opportunistic with acquisitions, given their balance sheet.”

Sorbara particularly likes Bonanza Creek’s debt-adjusted metrics, which should be given a premium, he says. The balance sheet is less than 10% net debt to capitalization. Its multiple on a cash-flow basis—enterprise value to EBITDA (earnings before interest, taxes, depreciation and amortization)—is 3.7x for 2013, compared with 5x for its peers. Its proved net asset value (NAV) year-end 2012 is $24, while most resource play E&Ps trade at a 50% to 100% premium to their proved NAV.

“This one is very attractive at these levels. It’s outright cheap,” Sorbara says. “This is a call on the stacked-pay potential of Wattenberg Field. As those different layers get derisked, the asset value is going to go higher.”

Sorbara initiated coverage of the company in October with an Outperform rating and a price target of $30. “This is an attractively valued Niobrara oil company,” he says.

“Further, there are numerous catalysts in the Niobrara Wattenberg into early next year that provide upside above and beyond our price target. As they get more derisked, investors will start to realize that their inventory could be tremendous.”

TMS upside

Global Hunter Securities senior E&P analyst Mike Kelly says that “2013 is going to be about proving up undeveloped acreage.”

Global Hunter’s Kelly particularly likes two things about Goodrich Petroleum Inc.: its aggressive move to oil, and its Tuscaloosa Marine shale upside—a potentially company-making play, he says.

“The real reason to be in this name is to see what happens in the TMS. The upside simply can’t be ignored.”

Goodrich, headquartered in Houston, now trades around 5x 2013 EV (enterprise value) to EBITDA, roughly in line with the group and reflecting its Eagle Ford and Haynesville shale holdings. But Goodrich has collected 132,000 acres in the Tuscaloosa Marine—with early indications of being in the right position—for a cost basis of $250 per acre.

Only a handful of well results have been released from the play thus far, but Encana Corp. has pegged EURs at 730,000 barrels, he notes. With six rigs now in the play, a flurry of data points is expected by first-quarter 2013.

“If ultimately this acreage is worth $10,000 an acre, which isn’t outlandish if the TMS is similar to the Eagle Ford, then that is $36 NAV to a Goodrich share. For a stock that is trading at $12 today, that shows the upside potential if this acreage is proved up. It could be a three-bagger if this acreage lives up to its hype.”

Goodrich was supposed to announce results from its first TMS well, the Denkmann 33H, in third-quarter results. Would a poor result change Kelly’s mind? “Figuring out a new play is never easy,” he says. “It’s not automatic you’re going to knock out 1,000-barrel-a-day wells on day one. I would use it as a buying opportunity .”

Investors have shied away from the cost of Tuscaloosa Marine wells, which can exceed $15 million, but these costs will come down, he says. “If you’re knocking out wells that are 600,000 EURs at $10 million, that’s an attractive rate of return.” Goodrich plans a second rig in the play by year-end.

The company is grinding gears from a 90% gas weighting in 2011 to becoming 40% oil by end of 2013, largely on Eagle Ford shale development. “We’re talking oil, not liquids,” Kelly says. That move will result in better margins, return on capital and cash flow. “Such a move lights a fire under EBITDA,” growing to 34% in 2012 and 41% in 2013, by his estimates.

Kelly places a Buy rating on Goodrich shares, with a $24 price target.

“The current price gives little if any valuation to the TMS. Even if the TMS doesn’t work, the company is still on sound footing, but the risk-reward is in your favor.”

The growth train

Last year, SM Energy was on a 50% growth rate and the stock was doing well, until infrastructure constraints in the Eagle Ford shale “caused the wheels to fall off on growth,” says Stifel Nicolaus’ Scialla. The result was three straight disappointing quarters.

“It was growing at a terrific rate, then infrastructure caused a roadblock, and the stock cratered. It’s recovered some, but still trading at a 16% discount to our peer group.”

All of SM’s 149,000 net Eagle Ford acres are in Webb County, Texas, with a core 65,000-acre position the Galvin Ranch area next to Rosetta Resource’s Gates Ranch. Rosetta projects an average EUR of 10 billion cubic feet (Bcf) per well, and Scialla gives SM credit for 8 Bcf EUR per well, which it is able to drill cheaper and with comparable returns.

“We don’t have any issues with the performance of the wells. We’ve analyzed the wells and taken apart their Eagle Ford acreage. There haven’t been any well-performance issues—the resource is solid there, and the economics are very stout.”

While natural gas liquids contribute about 16% of production volumes from the play, “dry gas and condensate alone generate a very favorable return at current prices,” he says.

Michael Scialla, managing director at Stifel Nicolaus & Co., says the stocks he’s recommending for 2013 have underappreciated big resource play assets able to generate strong returns at “much lower commodity prices than we’re seeing now.”

And Scialla believes the Eagle Ford infrastructure problems are behind the company. “When SM gets back on the growth train, people will realize they can generate a good return. The stock will recover.”

Beyond the Eagle Ford, SM has opportunity in other areas. It holds 195,000 “very good acres” in the Bakken shale, an underappreciated asset, he says, that generates a solid 20% IRR at $50 to $60 per barrel of oil. Another catalyst to keep an eye on: a developing position in the Mississippi lime play of the northern Midland Basin in Texas. “They are feeling good about results they’re seeing there.”

SM is in an outspend mode for the next 18 months, he projects, going from 1.2x debt-to-EBITDA to 1.8x, still below the group average. “Once they get to that 1.8x by the end of next year, it looks like they can live within cash flow and still grow at a very solid rate going forward.”

Scialla says Buy with a $95 price target.

Sweet home Permian Basin

“Investors are missing this name,” Sorbara says of Energen Corp. The Birmingham, Alabama-based E&P with a heavy dose of Permian assets, like Bonanza Creek, traded just above its proved NAV at $46 per share following its third-quarter announcement, making it heavily discounted compared with its peers.

“Energen trades at an attractive 2.2% above our proved NAV of $45 per share, versus peers that trade at north of a 40% premium. Energen is very low risk—I see minimum downside from these levels.”

Aside from proved NAV, Sorbara likes the stacked-pay upside Energen holds in both the Delaware and Midland basins in the Permian Basin.

In the Delaware Basin, the company controls 82,500 net acres prospective for the Third Bone Spring formation, and 110,000 with Wolfcamp and Avalon shale potential. Both the Bone Spring and Wolfcamp feature multiple target benches.

“Energen has some of the best Third Bone Spring wells in the Delaware Basin,” he says. The company has focused east of the Pecos River, where it has about 80 Third Bone Spring locations remaining, “and they’re putting up some really outstanding wells.” Its Third Bone Spring Black Mamba 1-57H is credited with skewing averages, with an IP of 2,257 BOE per day.

Overall, eight Third Bone Spring wells in third-quarter 2012 averaged 639 BOE per day on a 30-day average.

“Their initial operated Wolfcamp well in Winkler County, Texas, while not a home-run well, is encouraging, with a 30-day average rate of 487 BOE per day.” He expects results to improve as more wells are drilled.

West of the Pecos River in Reeves County, where early results were disappointing, Energen has teamed up with BHP Billiton on a small portion of acreage to test potential horizontal targets, particularly the Wolfcamp shale.

He sees the horizontal Wolfcamp shale play in the Southern Delaware Basin emerging on investors’ radar in 2013. With 110,000 net acres in the southern Delaware Basin, he views Energen as the best way to play the improving results out of the stacked-pay opportunities.

In the Midland Basin, in addition to 800 vertical locations in the Wolfberry play, Energen may have 785 potential locations in the horizontal Wolfcamp play, and another 495 in the Cline, using 160-acre spacing. Energen plans to initiate a horizontal drilling program in the Midland Basin targeting both zones—a low-risk area in which offset neighbor Laredo Petroleum has been active with strong results.

“There is a lot of running room there. All the resource potential of the Wolfcamp and Cline shales are free upside to our proved NAV.”

A production miss due to gathering constraints on third-quarter earnings caused the stock to dip. “We would be buyers on weakness,” Sorbara says. He rates Energen Outperform with a $72 price target. “Energen remains our top pick, given its robust production growth over the next few years, especially from liquids, and its leverage to the stacked-pay opportunities in the Permian Basin.”

Stacked-pay heaven

The Permian Basin is stacked-pay heaven, says Kelly, and no operator knows it like Concho Resources Inc. “The Permian is hot, and Concho is a Permian pure-play,” he says. “It’s got leverage to one of the most exciting, consistent and reliable basins.”

The Midland, Texas-based company with a $10-billion market cap advertises that it has 10,600 horizontal drilling locations in inventory across the Permian, a “very conservative” number, per Kelly. “Each location could have four to five intervals that are prospective to exploit, and they only count 1.3 horizontal targets per location. That inventory count could be multiples of where it is now.”

Concho’s rig fleet, too, is swinging horizontal, from 14% at the beginning of 2012 to more than 50% by year-end. Horizontal drilling, resulting in wells that produce on average four times that of vertical wells, is resetting the stage in this granddaddy of all basins, which Concho is best positioned to maximize.

Analysts look for stacked-pay potential, underappreciated assets, M&A premium and capital discipline when picking stocks for 2013.

“It’s an acceleration of growth and better returns. You’re seeing a whole new slew of opportunities” with horizontal targets, Kelly says.

The most exciting portion of Concho’s portfolio is 125,000 acres in Reeves and Pecos counties in the southern Delaware Basin in Texas, prospective for the Wolfcamp shale. At press time, it had drilled four horizontal wells with one revealed producing 758 barrels of oil (91%) per day after 30 days.

“If the company can show its acreage is capable of producing consistent results of that order, there is going to be tremendous NAV accretion just in that portion of the basin alone,” Kelly says.

On a debt-adjusted, per-share basis, Concho leads the way among E&Ps, the analyst believes. “A lot of operators can claim they’ve grown production by 20% plus, but when you factor in equity dilution in what they took on in debt, it’s not nearly as attractive. Concho has an extremely high return on capital, and is best-inbreed for growth on a per-share basis.”

While certainly not flying under the radar, Concho’s valuation actually trails its Permian peers. The five-year average EV to EBITDA multiple on a current-year basis is 10.5x. Concho now trades at 7.9x, and just 6.5x for 2013 EV/EBITDA.

“Concho production will grow in the high teens to 20%, and do that within cash flow, which is rather unique. You can only do that if you have a high-margin business like Concho.”

So why the share underperformance from such a well-known company? “It’s an underappreciation of the amount of undeveloped locations due to the stacked-pay nature of the Permian. We’re in the early stages of defining some of these horizontal reservoirs,” Kelly says. Concho will target five intervals in the Delaware Basin alone, and by the end of 2013, it will potentially define an additional 1,000 horizontal Wolfcamp locations in the southern Permian, he says. “That will just add to the story.”

Kelly marks a Buy rating on Concho with a $120 price target.

A Niobrara story

Landing on another Niobrara Wattenberg player, Stifel Nicolaus analyst Scialla likes the upside of PDC Energy Inc., which trades at about a 23% discount to peers.

“The company’s Niobrara acreage could be worth several times our current $15 per share estimate,” he says. “We remain encouraged by results in the play, which are rapidly derisking the bulk of PDC’s 103,000 net-acre position.”

Scialla notes the assumptions leading to the $15 NAV per share for the Niobrara assets are conservative—quite conservative. “Ultimately, it’s going to be a whole lot more than that. If you plug in numbers that some companies in the play are talking about in terms of well spacing and reserves per well, we can get to north of $100 per share easily.”

The current model assumes 160-acre spacing and an average EUR of 250,000 BOE per well, giving the company 510 drilling locations. Offset operator Noble Energy has tested 40-acre spacing, and models 350,000 BOE EUR per well. “That gets us above $100.”

The assumption also only modeled half of PDC’s acreage being developed. “Essentially all of the acreage is going to work,” he avers, citing offset results. “It’s been derisked by competitors around it.” And while not all Niobrara acreage is created equal, “within Wattenberg Field, it looks like it is delivering solid, consistent results.”

Scialla gives kudos to the PDC operating team, who have worked the Denver-Julesburg Basin most of their careers. “That gives them a leg up on the competition.”

PDC also holds an untested 45,000 net acres in the Ohio Utica shale, with results of its first two wells still pending, due to the practice of dissipating Utica wells. The position is on the southern edge of the play in Guernsey, Washington and Noble counties, where other operators have had IP success.

That’s all upside to valuation in Stifel Nicolaus’ model. “We’ve put zero on the NAV for the Utica at this point because it’s still exploratory, although a portion is looking de-risked by others.”

PDC earlier scuttled plans to joint venture its Utica acreage, which will likely slow development there. That puts the capex emphasis on the Niobrara. He puts a Buy rating on PDC, with a price target of $45. “In my mind it’s a Niobrara story,” says Scialla. “I’m not counting on the Utica working.”