Microcaps' Winning Hand

Caza Oil and Gas Inc. is an “up-and-coming story with a new partner,” says Adam Connors, director of C.K. Coopers’ corporate finance group.

In recent months, investors discouraged by volatile stock prices and risky high-yield debt are finding they still have a few cards left to play. When looking for favorable equity returns based on real but undervalued assets, they need look no further than at microcap oil and gas exploration and development companies (defined as having a market capitalization less than $250 million).

U.S.-based microcaps have seen climbing shareholder values since the market low in March. They have shown quick reaction to market pressures and are adapting to today’s challenges of low commodity prices, high service costs and scarce capital by ably applying the same technology used by their larger competitors to smaller, albeit similar assets bases—for proportionally greater benefits. New strategies, new plays, new names and new partners often can give these entities a winning hand.

Yet, not everyone agrees. Despite their best efforts, “Microcaps are not a good bet right now, due to liquidity issues and oil prices that might once again fall as China cools down,” says Harry Chernoff, managing director of Pathfinder Capital Advisors LLC, based in Charlotte, North Carolina.

“I’m not giving an all-clear to microcaps yet, except those that have a very good liquidity position. Some oil-weighted microcaps may be a good buy now, but gas-weighted stocks probably are not. Oil stocks have a durable advantage in the market, especially those with low-cost and low-royalty structures,” he says.

Other analysts, such as Rehan Rashid, head of energy research for FBR Capital Markets, Arlington, Virginia, say microcaps “are doing okay.” In the past, FBR indexed a group of small and microcap E&Ps, and noted in 2007 that the group “outperformed the small-, mid-, and large-capitalization E&P indices as well as the Russell 2000 Index, by 34%, 14%, 20% and 20%, respectively.

“While FBR no longer tracks microcaps,” Rashid says, “there is a tremendous amount of shale gas to be found in the country, and while the larger companies are making money there, many of the smaller microcap names will be well-positioned for it as well.”

Adam B. Connors, director of Irvine, California-based C.K. Coopers’ corporate finance group, agrees, saying “After recent commodity volatility events, microcaps now have a chance to continue to outpace and offer validity based on their business models. There is inherent value from those which have low lifting and finding-and-development costs. The microcaps’ business models will determine which will benefit most from current commodity prices.”

Brigham Exploration

One such oil-oriented player is perennial favorite Brigham Exploration Co. (Nasdaq GS: BEXP) based in Austin, Texas, boasting a six-month stock-price increase of almost 106%.

Over the past year, microcaps’ stock prices have varied greatly, but seem to be on the road to stabilized recovery in the second half of 2009.

Although Brigham has oil and gas assets along the Gulf Coast, the Anadarko Basin in the Texas Panhandle and western Oklahoma, and in the Permian Basin in West Texas, it may be the $250-million market-cap company’s Williston Basin assets which have piqued investors’ interest in recent months.

Within North Dakota and Montana, Brigham has interests in about 290,000 acres, which produced about 7.8 million cubic feet per day equivalent in first-quarter 2009. It holds some 23.4 billion cubic feet equivalent of reserves as of year-end 2008.

In July, the E&P reported its Strobeck 27-34 #1H well produced 2,021 barrels of oil equivalent per day from the Three Forks formation during its early 24-hour flow-back period. The well, in the Ross area in Mountrail County, North Dakota, was successfully fraced to produce about 1,788 barrels of oil and 1.4 million cubic feet of gas. The long-lateral well was completed with 20 fracture stimulation stages (the first operator there to do so many), 18 of which were effectively stimulated.

Brigham’s well claims the second-highest initial production rate for a Three Forks completion in the Williston, second to XTO Energy Inc.’s Boucher 41X-21, which produced 2,571 barrels of oil equivalent during its initial 24-hour flow-back period. Brigham has a 77% working interest (63% net revenue interest) in the Strobeck well.

In the Williston, the company is targeting Bakken, Three Forks and Red River potentials, and has acquired significant acreage during the past 18 months, structured in less-than-five-year leases. Companywide, Brigham holds some 407,800 acres, with 2008 year-end reserves of 137.1 billion cubic feet equivalent and 31.8 million cubic feet of equivalent production per day.

Magnum Hunter Resources

Another microcap anteing up is a reincarnation of an old favorite—Magnum Hunter Resources Corp. (AMEX: MHR). In July, Houston-based Petro Resources Corp. changed its name to Magnum Hunter Resources, a decision driven by Gary C. Evans, who joined the company as chairman of the board in May. Since March, the company’s stock price had lifted by nearly 200% (at press time).

An acreage position in a shale play, where we can repeat our success, is where we get out value as a public company," says Gary Evans chairman of Magnum Hunter Resources Corp.

This is the second incarnation for Evans who, during the mid-1980s with $1,000 of seed capital, founded the first Magnum Hunter, which subsequently became a NYSE-listed company. In 2005, Evans sold it to Cimarex Energy Co. for $2.2 billion.

Along with the name change, the new $24-million market-cap E&P has undergone a management transformation. Wayne Hall, founder and former chief executive, stepped down from day-to-day operations and will take on the role of vice chairman of the board. Donald Kirkendall remains president, but has resigned from the board.

As incentive for the new management to build strategic shareholder value, their employment contracts require activities such as acquisitions and financings within defined periods to trigger equity and cash compensation. The new management plans to acquire and develop predominately oil-based properties and transition the company into an operator, although in the past it had not operated its assets.

“As a public company, it makes sense to operate so we can control our capital costs,” says Evans. “This is especially important in periods of declining commodity prices, an environment we’ve been in over the past year. It’s all about controlling the timing and where the money is spent.”

To achieve its objectives, Magnum Hunter is now operating its wells in Louisiana and, going forward, all of its targeted acquisitions will be operated properties. “We won’t look at anything that is not operated,” says Evans. “By our acquisition efforts, we will transform the way this company functions.”

Magnum Hunter has properties in North Dakota (in the Williston Basin), West Texas (Permian Basin), East Texas (Haynesville shale), Louisiana and South Texas (Eagle Ford shale).

“Our shareholders are looking for repeatable success,” he says. “An acreage position in a shale play, where we can repeat our success, is where we get our value as a public company.”

But Magnum is betting on oil as well, with its Williston water-flood project. Says Evans, “Over the past 18 months, capital was spent there by Petro Resources. We are now beginning to realize the oil response from that effort without much further infusion of cash.”

Presently, Magnum Hunter produces about 730 barrels of oil equivalent per day and owns interests in some 50,600 net leasehold acres, of which 43,300 net acres are undeveloped. Results from the company’s mid-year evaluation show it had an estimated net total proved reserve of about 3.5 million barrels of oil equivalent, 79% of which is oil and natural gas liquids.

As part of his strategy to grow the company, Evans will be closely watching for distressed-asset sales. “Many of us are former bankers. We know what they have to deal with, from hedges rolling off to the upcoming borrowing-base redeterminations based on low commodity prices. We will be evaluating opportunities as they come to market during the rest of the year.”

Caza Oil and Gas Inc.

On the other hand, The Woodlands, Texas-based Caza Oil and Gas Inc. (London AIM: CAZA.L, Toronto: CAZ.TO and Pink Sheets: CAZFF.PK) is an “up-and-coming story with a new partner,” says Connors.

Caza, a $20-million-market-cap E&P that focuses on the Texas Gulf Coast, South Louisiana, Southeast New Mexico and the Permian Basin, (totaling some 17,300 net acres) is now looking into a new play.

“They have recently entered into a joint exploration agreement with Endeavour International (NYSE-AMEX: END) to help develop their asset base,” says Connors. Endeavour will fund the acquisition, exploration and appraisal activity costs attributable to Caza’s interest to earn 75% of Caza’s participating interest. Caza will remain program operator.

In the near term, Endeavour’s infusion of cash will fund the drilling of three wells located in the emerging Abo-Wolfcamp trend in New Mexico. On June 1, Caza executed an exploration agreement with Wise Oil & Gas No. 8 Ltd., naming Caza as operator to jointly lease acreage in Lea, Eddy and Chaves counties on a 50/50 basis. So far, the parties have leased some 7,362 gross acres in three separate properties in the Wolfcamp, including Moore Cap (3,642 gross acres), Sombrero (1,280 gross acres) and Bada-Bing (2,440 gross acres).

Michael Ford, president and chief executive for Caza, is pleased with the progress, especially the work program projects being jointly pursued by Caza and Endeavour. “The work program with Endeavour has been implemented quickly and has become the focus of Caza’s exploration activities,” he says.

The venture’s three initial wells are Lucky Penny 10 State #1, Bada Bing 23 State #1 and Moore Bailout 11 State #1. The Lucky Penny will test the Abo-Wolfcamp formation at a measured depth of 12,250 feet including a 3,500-foot horizontal lateral. The Bada Bing will test it at a measured depth of 13,225 feet including a 4,100-foot horizontal lateral. The Moore Bailout will test it at a measured depth of 12,500 feet including a 3,800-foot horizontal lateral. Caza, as operator, has scheduled the three wells to be drilled back-to-back. At press time, Caza was producing about 175 barrels of oil equivalent per day.

“Caza has a good amount of working capital to execute their plans, with about $12 million in the bank,” says Connors. “Caza will be looking to migrate over to a U.S. listing and will be one to watch.”

Vanguard Natural Resources LLC

Already trading on the big board, Houston-based Vanguard Natural Resources LLC (NYSE: VNR) is all-in for growth.

In July, the $188-million, Houston-based limited liability company announced plans to acquire producing oil and gas properties in South Texas from an affiliate of privately held, San Antonio-based Lewis Energy Group LP. For its $52.25-million spend, Vanguard will gain proved reserves estimated to be 27 billion cubic feet equivalent (94% gas; 70% proved developed). Current net daily production from the assets is about 5 million cubic feet equivalent, with a reserve-to-production ratio of 15 years.

Vanguard chief executive Scott W. Smith says, “We announced the acquisition in July and we expect to close sometime in the third quarter. The acquisition will increase our reserves and production by about 30%. We are excited about getting this acquisition done and are glad the capital markets appear to be opening.”

Vanguard Natural Resource’s new asset acquisition will increase its production by 30%, says chief executive Scott Smith.

At closing, Vanguard will assume gas puts and swaps based on Nymex pricing for some 61% of the estimated production from existing wells from August 2009 through 2010. The E&P entered into a collar for certain volumes in 2010 and a series of collars for a substantial portion of the expected production for 2011. In total, nearly 90% of the estimated gas production from existing producing wells will be hedged through 2011 using structures which ensure a weighted average floor price of about $7.50 per million Btu.

Since March, Vanguard’s stock price has risen some 61% (at press time), due in no small part to its reliable distributions to unit holders.

“We are an upstream LLC comparable to other MLPs, so we are a yield product. The market judges us by the security of our distribution and we’ve made our first-quarter and our second-quarter distributions. Our attractive yield is not going away, due in large part to our effective hedging strategy, which insulates us from commodity price volatility, so we are pricing in line with our better peers,” Smith says.

The LLC, which does not have incentive distribution rights for its management, has properties in the Permian Basin, South Texas and in the Appalachian Basin in southeastern Kentucky and northeastern Tennessee. Vanguard targets conventional oil and gas plays; no coalbed methane, no shale gas.

Prior to the acquisition, the company’s total production is about 17.5 million cubic feet per day, mostly gas, with proved reserves of 97 billion cubic feet.

“We are looking forward to further opportunities as the year progresses,” says Smith.

Quest Energy Partners LP

Another Appalachian player, Quest Energy Partners LP, does target unconventional gas, but is struggling to keep its seat at the table. It is attempting to emerge from its troubled past. That includes a shareholder lawsuit, a Nasdaq noncompliance notice, a merger termination and the firing of its former CFO (based on certain questionable transfers of funds to an entity controlled by the former chairman and chief executive). Its $11-million market-cap parent, Quest Resource Corp., recently announced its intention to recombine in a series of mergers and entity conversions.

According to the plan, Quest Resource Corp., Quest Energy Partners LP and Quest Midstream Partners LP would combine to form a new entity, tentatively called NewGasCo. The new company will focus on unconventional plays, including coalbed methane in the Cherokee Basin of southeast Kansas and northeast Oklahoma and the Marcellus shale in the Appalachian Basin

The reformed, Oklahoma City-based company faces several hurdles, including the arrangement of credit facilities and stockholder, unitholder and debtholder approval, before it can complete its transformation.

In July, the Nasdaq Listing Qualifications Hearings Panel approved Quest Resource’s request to continue to be listed on the stock market, a step in the right direction.

At year-end 2008, the company had 174.8 billion cubic feet equivalent of estimated net proved reserves, and operated 2,438 gross gas wells and 27 gross oil wells in the Cherokee Basin, along with 55 gross productive oil wells and the development rights on nearly 1,500 net acres with estimated net proved reserves of some 588,800 barrels in Seminole County, Oklahoma. It also has a 2,173-mile gas-gathering pipeline network in the Cherokee Basin and a 1,120-mile interstate natural gas pipeline, which transports gas from northern Oklahoma and western Kansas to the metropolitan Wichita and Kansas City markets.

In the Appalachian Basin, it had 500 gross gas wells and the development rights to approximately 68,161 net acres and 183 miles of gas-gathering pipeline.