Surging market ignores oil stocks. E&P companies face new investment challenges as standards change
Houston Business Journal, April 3
Monica Perin
Gasoline and crude oil prices are soaring as the bulls stampede on Wall Street. While such conditions have pumped up energy stocks in the past, the share prices of independent exploration and production companies continue to languish.
It's an unprecedented disconnect, and energy executives are baffled by the reversal of fortune and at a loss to explain why they are being ignored by the same markets that used to lavish them with capital.
The flow of money into high-tech and dot-com stocks offers one possible explanation. Many investors are withdrawing capital from traditional industries such as oil and gas to bet on the potential riches of the microchip.
But that's only part of the problem, according to analysts at Simmons & Co. International, a Houston investment banking firm that specializes in the oil and gas industry. Simmons, which has followed the oilfield services sector for years, recently expanded coverage to E&P with an inaugural report entitled "It's A Whole New Ball Game."
The report challenges the traditional yardsticks that have been used to value E&P companies, especially cash flow and volume growth.
Financial markets have lately begun demanding that E&P companies improve their earnings and return on capital -- the same standards that have always been used to measure other public companies. The Simmons report says the markets should "address these important criteria" in their valuations of E&P companies' stock instead of "fixating" on cash flow.
Judged by the new standards, the stock prices of independent E&P companies aren't really so low. The sector's stock prices are about five times cash flow, a dismal multiple based on the old standard. But price-to-earnings multiples are 21 to 22, which isn't cheap and may even be too expensive.
"The industry is in transition right now, and there is a lot of confusion among companies and among investors," says Dan Pickering, managing director for research at Simmons.
"Officers of these companies are wondering why their stock is so cheap and why the market doesn't recognize what they are doing.
We say the market is generally efficient and it is telling you something. You can't keep going back every two years getting $50 million and put it in the ground and not create any value."
"This group is getting hit from both ends," says Mark Meyer, lead E&P analyst for Simmons. "They are still expected to produce volume growth of at least 5 percent with unbridled spending, but also produce better returns. You can't have it both ways."
In adjusting to the new market paradigm, E&P companies will have to learn new ways of managing their admittedly tough cyclical business to smooth out the boom-and-bust patterns, says Meyer. That will mean choosing niches and not spreading themselves thin by getting involved in far-flung projects all over the world.
The major oil and gas companies have led the way in focusing on managing capital to produce earnings. They are doing this by narrowing their business focus and shedding non-core assets. Independent E&P companies will have to do likewise. Currently, about one-third of the assets of independent E&P companies are non-core.
"The independents can't keep staffing up and then taking down costs by taking out people," says Meyer. "They have to be able to still make money when crude is $17 a barrel."
Some will get it, and some won't, Meyer predicts. Those who don't will fade away while those who make the adjustment will be rewarded by the markets with strong stock prices and accessibility to capital.
DISCOUNTING CASH FLOW
Investors really got burned by E&P companies during the 1990s, says Wes Ralston, an analyst with Howard Weil investment banking firm in New Orleans.
"Shareholder equity was destroyed. As a result, in spite of $30 oil, these companies are seeing no real resurgence in their stock prices," Ralston explains. "The capital markets have remained closed because of investors' past experience with what these companies have done with the proceeds they raised in the capital markets. They will have to prove that they have financial discipline and won't just blow their money buying a bunch of acreage that won't get drilled for five or 10 years."
"Cash flow is not the prime methodology it was two or three years ago," says Larry Benedetto, who heads E&P research at Howard Weil.
In fact, he says cash flow ranks behind such criteria as value of reserves, amount of debt, management history, growth potential and full-cycle economics -- meaning reinvesting cash flow to grow the business.
As to whether E&P companies are currently undervalued or overvalued based on the new criteria, Benedetto says it depends on the individual firm. Now, as historically, companies that perform the best financially are focused in certain regions and activities.
Simmons analyst Pickering uses Houston-based Ocean Energy is an example of an independent exploration company that is learning how to operate the new way.
"Five years ago Ocean Energy was hot, and they were focused in the Gulf, completing wells the majors left behind. Then they got bigger and got into West Africa and all over the place. Now, they are doing some focusing again and selling off some assets."
Indeed, Ocean Energy CEO James Hackett's blueprint for the company is strikingly similar to the Simmons and Howard Weil scenarios.
"The marketplace today requires sophistication to do well," says Hackett." It requires familiarity in the use of financial instruments and the ability to manage capital flexibly. Our goal is to grow internally during high price times and take advantage of low acquisition and exploration costs during bad price times."
The bottom line, says Meyer of Simmons, is that the E&P industry is "going to look different" a year or so from now.
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