How to Invest in Oil & Gas Stocks – Part I

by Keith Schaefer. October 6, 2009

Investing in oil and gas stocks is actually quite simple, even if you don’t know anything about the energy industry. (My friends in Calgary would say I am living proof of that.)

From my experience in speaking with management teams and reading research reports, I’ve put together a basic information list for retail investors doing initial research into oil & gas companies. It’s not exhaustive, but the answers should provide the basic information to decide if you want to do more due diligence.

Either call management, or go to the company’s website and look at its corporate presentation. The Top 10 bits of information I want to find out initially is:

How many barrels of oil per day (bopd, or “boe” for natural gas – barrels of oil equivalent) is the company producing, and how quickly have they grown production in each of the last 3 quarters.
How much of their production is oil and how much is natural gas (gas prices are very low right now and doesn’t produce much if any cash flow for companies)
How much net cash or net debt do they have? This industry uses a lot of debt, so if a company actually has net cash, they could grow more quickly because they have an entire untapped line of credit waiting to go drilling, and grow the business. And of course no debt means no debt payments and flexibility in doing business.
Where are the properties? Investors give North American assets a slight premium, unless the company is either growing very fast or has a management team that has built and sold an oil & gas company. Political risk shows up in the stock price.
How many wells will the company be drilling in the coming nine months? This will give you an idea of how fast they may grow. Companies usually say in their presentation how many wells they will drill property by property, but don’t often give an overall number in one slide. Odd, but true.
How much will all this drilling cost, and do they have the money or cash flow to do it? Most companies have a slide in their corporate presentation that shows their estimated cash flow for this year or next along with their estimated capex, or capital expenditure, which is their drilling budget. Or do they have to raise money in the market to do the drilling they want? (This is not good—when the market smells a financing coming, it drives the stock lower.)
1. Are these wells higher risk exploration wells or lower risk development stage wells? Development wells are just filling in an already discovered oil field. It means these wells will almost certainly repeat the success of the discovery well; the oil or gas formation is large and drilling success is “repeatable”. The market loves certainty, and most companies go out of their way to crow about their “undeveloped land acreage” and “X year drilling inventory” the number of wells they could drill on this development stage land.
As an example, the new, big shale formations in North America are very “repeatable”. The Bakken oil field in Saskatchewan is “repeatable” in large scale, i.e. it could support many wells.
If the company is doing exploration drilling, what has been the company’s success rate in each of the last two years? HINT: if it’s not on the powerpoint, guess what… There is new technology called 3D seismic that allows companies to see the producing oil/gas formations much better – and now means a much higher success rate for exploration. Anything under 70% success in raw exploration I get nervous. (I don’t buy the longshots.)
What has management done in the past – have they ever built and sold a producing energy company?
How many research analysts follow the story? If the answer is 3 or less, why hasn’t management been able to secure more coverage–there is a reason. It might be because your target investment is small. It might be it is just not a compelling growth story as you think. Or it might be just because management doesn’t raise money much, i.e. rarely if ever issues equity. Analysts get partly compensated on the business they can bring into the firm. If they cover a producer who will never raise money, they’ll never get paid, so who cares?

Without analyst coverage there is no institutional money flow in the stock. And without institutional support, your stock will need A LOT of drilling success to move up, and will likely always trade at a big discount to its peer group.

There are LOTS of other questions to ask. This is just Round 1. In my next column, I will outline my Round 2 of questions I pose to management.

A couple of those questions are a little more delicate; you can tell that when management tells you – oh, all that information is in the quarterly financial statements, go look it up – that they really don’t want you talking about it.

Asking the above questions has led Oil and Gas Investments’ $200,000 portfolio to a gain of +79% over the past six months. These criteria work and as a subscriber, you can see this first hand.

Copyright © 2009 Keith Schaefer
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Keith Schaefer, Editor and Publisher of Oil & Gas Investments Bulletin, writes on oil and natural gas markets - and stocks - in a simple, easy to read manner. He uses research reports and trade magazines, interviews industry experts and executives to identify trends in the oil and gas industry - and writes about them in a public blog. He then finds investments that make money based on that information. Company information is shared only with Oil & Gas Investments subscribers in the Bulletin - they see what he’s buying, when he buys it, and why.

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