Investors, take heed. This still may be an excellent time to buy the stocks of U.S. exploration and production companies, and the shares of small-cap independents in particular. Several E&P analysts note that, going into this fall, the stocks of many small-cap U.S. producers-those with market caps less than $2 billion-had skyrocketed in market value since the start of 2004, in some cases nearly doubling. In light of this, one might reasonably argue that the time for plunging into the shallower end of the upstream investment pool has already passed. These same analysts, however, take just the opposite view. "The consensus is that as U.S. crude inventories continue to build ahead of the winter heating season-as the result of OPEC continuing to produce at flat-out levels-there should be a pullback in oil prices," says Larry Busnardo, small-cap E&P analyst for Petrie Parkman & Co. in Denver. "That, in turn, should lead to a pullback in the market price of upstream stocks, presenting attractive buying opportunities within the group." Recently, his firm has been using commodity-price forecasts of $30 oil and $5 gas for 2005. Greg L. McMichael, recently retired worldwide energy research group leader and senior E&P analyst for A.G. Edwards & Sons Inc. in Denver, also sees commodity prices remaining strong for the foreseeable future. "This is an 80-million-barrel-per-day market, in terms of worldwide oil consumption, and we estimate that excess productive capacity right now is only about 1 million per day compared with 5- to 6 million in the past." Emphasizing further market tightness ahead, the analyst predicts worldwide gross domestic product (GDP) growth during the next couple of years will generate 2% to 3% annual increases in oil demand. In the case of natural gas-largely a North American market-McMichael sees production continuing to decline 2% to 3% annually despite robust drilling activity. "This reflects steeper natural depletion rates in the Lower 48; during the past 12 years, those rates have accelerated from an annual level of 18% to 28%. At the same time, North American gas demand has been rising almost 2% per year." His 2005 commodity-price forecast: $35 per barrel for West Texas Intermediate crude and $5.75 per million Btu for Henry Hub spot gas. Ray Deacon, managing director, equity research, energy and power group, for Harris Nesbitt Corp. in Denver, contends that although oil and gas inventories should build in the near term and global GDP growth may likely be slow going forward, the oil and gas markets will nonetheless remain tight in 2005. Commodity prices would continue at a robust $33.50 for oil and $5.75 for gas. Beyond 2005, he's using a price deck of $28.50 for oil and $4.75 for gas. "This year, our coverage group of 19 E&P companies should be able to replace production with about 60% of their cash flow, leaving the remainder for growth projects, acquisitions or ramping up exploration." These analysts see modest to strong upside in small-cap E&P share prices in 2005. But they all offer one caveat: investors need to be selective in their stock choices. So how exactly how does one go about being selective? Multiple metrics In screening for the best buys within his upstream coverage universe-stocks with market caps less than $2 billion-Busnardo emphasizes several metrics: a company's price/cash flow, its EV (enterprise value or market cap plus long-term debt minus working capital)/EBITDA (earnings before interest, taxes, depreciation and amortization) and the implied value of a producer's reserves in the ground relative to the market price of that company's stock. The latter value is calculated by dividing a company's EV by its annual reserves. "We also look at price/NAV (net asset value or net present value of reserves minus debt) and a producer's prospects for production growth-particularly organic production growth through the drillbit versus acquisitions." Viewing these metrics in their totality, the analyst believes Cimarex Energy (NYSE: XEC) and Plains Exploration & Production Co. (NYSE: PXP) are currently among the most attractively valued producers in his coverage group. Busnardo points out that Denver-based Cimarex, which is focused primarily in the Midcontinent, the Gulf Coast and Texas, is trading at five times estimated 2005 cash flow versus a peer-group multiple of 5.5. Similarly, on an EV/EBITDA basis, the stock is trading at a 2005 multiple of 4.5 compared with a peer-group average of 6.1. The reason for the significant EV/EBITDA discount, he explains, is that Cimarex has no debt. Focusing on the implied value of its in-ground reserves, the analyst notes the stock is trading close to $3 per thousand cubic feet equivalent (Mcfe)-a substantial premium to a group average of $1.85 per Mcfe. "We would point out that unlike many other producers, XEC doesn't book proved undeveloped (PUD) reserves, thus investors may view its reserves as understated," explains Busnardo. "Also, [booking only PDPs] gives Cimarex a short five- to six-year reserve life-and producers with short-lived reserves typically tend to be valued higher than those with long-lived reserves because they're getting reserves out of the ground over a shorter period of time." On a price/NAV basis, the company is also trading at a premium to the group, he says. "Again, one could argue this is because the company books only PDP reserves." The analyst sees the company's production growing 20% this year-all of it organic growth-and another 8% in 2005, without factoring in acquisitions. Houston-based Plains Exploration & Production, focused on southern California oil, trades at a price/2005 cash flow multiple of 3.8-well below the group average of 5.5. Its EV/EBITDA multiple, meanwhile, is 5.4 compared with 6.1 for the group. "Given that the company has acquired Nuevo Energy, which gives it meaningful size, we expect Plains in 2005 to generate meaningful free cash flow (cash flow from operations minus capex) of about $200 million, which it could use to pay down debt," says Busnardo. Also due to the Nuevo acquisition, Plains' production should grow 91% this year, then 36% in 2005, of which 5% to 10% would be organic growth. Screening the implied value of Plains' in-ground reserves relative to its stock price, the analyst notes the company is being valued at only 87 cents per Mcfe versus a group average of $1.85. This isn't surprising, he says, given that it has a longer reserve life than many other producers and hence, is not being valued as highly by the market on that metric. Although it trades at a premium to NAV, Plains nonetheless remains an undervalued story on most other metrics, says Busnardo. Yardsticks In studying the appreciation potential of small-cap E&P stocks, McMichael applies three principle valuation metrics: price/debt-adjusted or unlevered cash flow, price/net asset value (NAV) and the implied in-ground value of a company's proved reserves based on where its stock is trading. The analyst also looks at three main performance metrics: how well a company has grown NAV, production and proved reserves on a per-share basis. "We look at stocks that have very good performance metrics, then turn to valuation metrics to determine whether those stocks are expensive and already reflect strong growth-or whether they're being valued in line with or below peers that are not performing as well." Those stocks that score high on performance metrics but are being valued by the market in line with or below lower-growth peers are the ones in which an investor should be very interested, he says. In his coverage universe, McMichael likes Quicksilver Resources (NYSE: KWK), whose stock has risen 84% on a year-to-date basis. In terms of performance metrics, the Fort Worth-based producer is generating annual NAV growth of 20% versus a peer-group average of 5% to 10%, the analyst says. Meanwhile, its 2003-05 estimated growth in production and reserves per share is 12% and 11%, respectively, compared with corresponding peer-group averages of 9% and 13%. But on an overall valuation basis-taking into account price/debt-adjusted cash flow, price/NAV and value of in-ground reserves relative to share price-the stock is expensive, trading at an average 50% premium to its peers, he concedes. "However, Quicksilver, with vast coalbed-methane holdings in Alberta, and tight-sands gas holdings in the Barnett Shale play in East Texas, has a very large inventory of drilling prospects in front of it which will continue to generate a great deal more organic growth for the company." Another favorite is Denbury Resources (NYSE: DNR), whose stock has risen 103% during the past 12 months versus a peer-group average of 59%. While this Dallas-based producer's annual growth in NAV is running about 15%, the company's estimated 2003-05 per-share production and reserve growth is down relative to the group, the analyst says. The reason for this divergence: the company has sold noncore assets and is now booking a lot of reserves that will be providing production and cash flow growth further out as it develops its CO2 oil-recovery project in Mississippi. He notes that on an overall valuation basis, DNR shares are trading at an average 15% premium to peers. Stresses McMichael, "The company's inventory of drilling prospects is sufficient to generate double-digit growth in NAV, production- and reserves per share during the next 10 years. That's why it trades at a premium." The analyst also likes Denver-based Whiting Petroleum (NYSE: WLL), which commenced trading during the fall of 2003. The stock has climbed 51% since then. On performance metrics, the company-focused in the Rockies, the Gulf Coast and Michigan-has grown NAV almost 20% since going public; similarly, production per share has risen about 25% compared with a group average of 9%, while reserves per share have jumped 80% versus a group average of 13%, says McMichael. On an overall valuation basis, the stock is trading at an average 20% discount to its peers. "So despite very high growth rates, the stock is cheap." The analyst believes Whiting can continue to achieve double-digit NAV growth annually based on its "growth through low-cost acquisitions" business model. Undervalued but growing Deacon focuses on stocks trading at a discount to their NAV that have some catalyst for per-share growth in production and reserves-from exploration or high-return development projects. Within the small-cap sector of his coverage universe, he likes Penn Virginia Corp. (NYSE: PVA) and Comstock Resources Inc. (NYSE: CRK) and also micro-cap Gasco Energy Inc. (Nasdaq: GASE). Radnor, Pennsylvania-based Penn Virginia, focused mainly in the Appalachian Basin, has seen its share price increase more than 65% in the past year, the analyst says. "Notably, it has been able to take advantage of its approximately 42% ownership of Penn Virginia Resources (NYSE: PVR), a coal royalty trust, from which it has redeployed some $25 million of cash flow to help grow its E&P business." Deacon points out that during the past five years PVA has managed to grow reserves and production at a 25% annual rate. At year-end 2003, proved reserves were 54 million barrels of oil equivalent or 323 billion cubic feet equivalent (Bcfe) of gas. "With a focus on horizontal drilling, the company has managed to collapse the reserve life in one Appalachian field from 20 years to four," he says. "So it's getting more gas out of the ground at a faster rate than before-and the annual return on an average well in that field has moved up from around 20% to 100%." Despite this performance, Penn Virginia this fall was still trading at a discount to appraised NAV. Comstock Resources, focused on southeast Texas and the Gulf of Mexico, is yet another small-cap growth story. During the past four years, that Frisco, Texas-based producer has ballooned production and reserves 30% annually, he says. One of the big drivers of this growth has been Comstock's focus on the Woodbine sands in the AA Wells Field in southeast Texas, says Deacon. "In the past four years, it has increased reserves there-with some contribution from its Ross Field to the south-more than fivefold, from roughly 76 gross Bcfe to greater than 500 Bcfe." The company also has some exploration legs in the Gulf of Mexico shelf, where it was 12-for-12 in exploratory drilling in 2003 in the South Timbalier and South Pelto blocks. Again, despite this success and per-share production and reserve growth, the stock has recently traded at a discount to appraised NAV. While Gasco Energy doesn't have a lot of performance history yet, Deacon calculates that within four years, this Englewood, Colorado-based producer will see its Uinta Basin reserves in Utah grow from a current 21 Bcfe to more than 300 Bcfe as daily production ramps up from a net 2 million cubic feet equivalent to 26 million. The analyst assumes that of the 60,000 net acres the company has in the Uinta Basin, half will be productive and that reserves per well will average 2 Bcfe. "When we discount back to the present the future value of 300 Bcfe of reserves, we get an NAV of about $5 per share-based on $4.75 gas," says Deacon. "The stock has recently been trading at less than half that appraised NAV."

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