There it is:
IDEAS & TRENDS
Monday, May 24, 1999
Alan Gaines,Contributing Editor
Drilling for Oil Stocks
Has Devon Energy Corporation's May 20 announcement to acquire beleaguered PennzEnergy Co. (formerly known as Pennzoil Co.) marked the beginning of a feeding frenzy of sorts, whereby well positioned large independents take advantage of still weak stock prices (despite the recent advance in hydrocarbon pricing) of their leveraged brethren? I believe it is quite possible.
In the aforementioned case, Devon's highly regarded management boasts an excellent track record, stressing growth via acquisition coupled with solid operating results, while PennzEnergy's senior management has not been held in the highest esteem by Wall Street due primarily to poor operating results. In addition, Pennzoil turned down an $84 per share offer from Union Pacific Resources a few years ago, and its shares (adjusted for the merger of its Pennzoil lube oil and auto products division into Quaker State to form Pennzoil-Quaker State Co.) have never even come close to the lucrative Union Pacific offer (which management rejected as being inadaquate). I certainly expect to see the continuance of M&A activity during the remainder of 1999.
One obvious area of future consolidation is sure to be the deepwater Gulf of Mexico, where activity has soared over the past few years. It should be pointed out that deepwater Gulf of Mexico prospects are insulated (to a certain degree) from short term disruptions in pricing, and the fact that a meaningful discovery could have enormous impact on the fortunes of a singular company. However, risks (and costs) are high, therefore companies drilling deepwater prospects must have the girth and capitalization necessary to withstand inevitable dry holes.
During 1998, troubled deepwater player Oryx Energy was acquired by Kerr-McGee to create the fourth largest domestic independant. The two companies brought different strategic strenghs to the table. Kerr-McGee contributed a relatively unlevered balance sheet, good exploration and expoitation projects, while Oryx kicked in a very impressive inventory of deepwater prospects (and unfortunately, a miserable balance sheet and horrible management). Luckily for shareholders, Kerr-McGee is in effect the surviving entity. The bottom line was that the transaction made sense. Others will surely follow.
Turnaround Candidate
One independent E&P company I am particularly fond of is EEX Corporation. Down sharply from its 52 week high of $29.63 (it reached as high as $36 in February 1997), the shares have recently "recovered" to $6.63. Lower commodity prices coupled with a few deepwater dry holes were the culprits. EEX's strategy has been to shed mature onshore properties, and reinvest the proceeds through leasehold acquisitions in the shallow and deepwater Gulf of Mexico. Currently, EEX boasts perhaps the most sizeable and prospective holdings of any independant in the entire Gulf. A full one third of its 300 blocks are located in deep water, comprised of 23 prospects and 25 leads. In order to accomplish its agressive drilling program, EEX has secured two rigs, capable of drilling the deeper Pliocene and Miocene sands at 20,000 to 28,000 feet, where many gigantic discoveries (Shell's Auger Field) have been announced.
EEX is uniquely positioned via an alliance with Enterprise Oil plc, which allows it to leverage its deepwater assets, and accelerate its drilling program. EEX, in effect, monitized its impressive leasehold position by bringing in a partner. Under the 1997 agreement, in exchange for half of its interests in 78 blocks, Enterprise funds the initial $65 million of EEX's share of exploration expenses, and pays the first $10 million in development costs on the first commercial success, and $15 million on the second commercial development. This partnership has afforded EEX the opportunity to sharply accelerate its deepwater program, and minimize potentially sizable upfront expenditures.
In 1997, the EEX/Enterprise alliance reported a large discovery on Garden Banks 386. The Llano Field, located in 2,600 feet of water, is located only 11 miles northeast of Shell's 300+ million barrel Auger discovery. EEX owns nine contiguous blocks in the greater Llana area. An initial appraisal well confirmed the discovery, and a second appraisal well will be spudded by yearend. It is my estimation that Llano contains at least 200 million barrels, while greater Llano could contain a multiple of that. EEX is presently drilling its George prospect (Mississippi Canyon 441/2), with an expected TD of 20,000 feet to be reached very shortly. There are a number of producing fields around this prospect, so management is quite excited. In addition downside risk is low in that significant dry hole cost is mitigated over the coming year, as Enterprise carries the next $100 million of drilling costs.
EEX presently has proved reserves of approximately 60 million barrels of equivalent. Llano alone (30% owned) could literally double its reserve base. Keeping in mind the company's extensive acreage portfolio, it is quite possible that EEX could grow its reserve base to a multiple of its current size.
Utilizing more mundane valuation standards, I expect EEX to report cash flow per share of $2.50 and $2.90 in 1999 and 2000, respectively. EEX trades at just 2.3 times expected 2000 cash flow. A more appropriate multiple of 5.0 would produce a share price approaching $15. Should the company report another meaningful discovery, the stock could trade well in the $20s. It is also possible that a larger independent or major with a bulging checkbook coupled with a shortage of prime deepwater acreage in the Gulf could step up to the plate and provide long suffering shareholders with a bit of instant gratification.
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