At NAPE, in August, KeyBanc Capital Markets offered up a chart illustrating year-over-year stock price returns for pure-play exploration and production (E&P) companies vs. diversified E&Ps. Pure plays outperformed 43% to 17%. That one-year snapshot illustrates a new reality: Single-basin operators command a higher premium.

“On the investor side, there is an overall bias toward pure plays,” said KeyBanc analyst David Deckelbaum. “The more plays you’re in, the higher the investment risk. If you’re a jack of all trades, you’re the master of none.”

Once upon a time investors preferred asset diversity. It spread risk across the portfolio in case one play didn’t pan out economically. With the advent of resource plays—and more confidence in well results—investors now view diversity as a drag on growth. Companies are expected to high grade their attention and capital to their best-performing assets.

“Investors have an appetite for more growth,” said Deckelbaum. “If you’re in multiple plays, your capital is never fully optimized because you’re not going as fast as you can in every single asset. There has to be at least one asset that is not being developed optimally. You’re leaving value on the table that would be worth more to someone else.”

That sentiment is mirrored in new issues as well, where Wall Street has favored pure-play IPOs over the past few years almost to the exclusion of diversified names coming to market. With a pure play, “your operating results are more predictable, and you can scale your program up or down faster in response to commodity prices.”

Simply, investors desire simplicity. Single-basin E&Ps have, in theory, better capital discipline, greater transparency, are easier to understand and make more sense as take-out candidates.

“Investors want cash flows that are visible to them. They want to see a contiguous acreage position and think about what that might look like in 20 years, and triangulate what that might be worth to them,” said Deckelbaum.

Beginning in early 2013, pure plays have outperformed diversified names by 29.6%. Since the beginning of 2014, pure plays have outperformed by 7.3%.

"The more plays you're in, the higher the investment risk. If you're a jack of all trades, you're the master of none," said KeyBanc analyst David Deckelbaum.

Streamlined equals growth

“The average small-cap pure player is going to grow faster than your average small-cap diversified company,” said MFS Investment Management equity research analyst Katharine Jackson, based in Boston. While not limiting investments solely to pure-play companies, she likes that she can pick and choose the best assets in the highest return basins via basin-focused E&Ps.

“We like to own the best area in each play, and the easiest way to do that is to look at the best operator in that play. I’m not coming at it from the perspective that I can only invest in a pure player; we’re all looking for stocks that are fundamentally undervalued. But sometimes you can get that with a bit more clarity on a pure play, as there are more moving parts to a diversified player.”

Jackson focuses on small- and mid-cap stocks in both energy and health care. She believes the E&P pure-play phenomenon is better suited to smaller companies, which the costs and scale of resource play development have naturally molded into single-basin endeavors.

“In small-cap land, you need enough scale in the basin to get services and secure takeaway capacity. It can be hard to get critical mass if you’re spreading your capex budget and people across multiple plays. Smaller companies have to focus on their highest value proposition, which is probably just one play instead of multiple.”

The opposite is true for larger companies, she said, which can find it hard to get enough good core acreage in a single basin to maintain production and cash flow.

It comes down to capital allocation, said Jackson. “If you’ve got a lot of inventory in a high-returning play, it makes sense to monetize a lower returning play and put the capital to the higher return one.” It does increase the risk profile by being in a single basin, she said, but “it’s also a potentially higher reward of a higher returning play.”

It’s a risk she is willing to bet on. “If I believe in the assets, I’m willing to take on that risk.”

Jackson mitigates that risk by buying one or two stocks in each of her favorite basins. She views the Permian’s Delaware Basin as underappreciated by the Street, and singles out Energen Corp. as a Delaware-focused company with upside. While not exactly a pure player, 95% of Energen’s capital goes into the Delaware Wolfcamp play.

“Energen’s gone through a transformation in the past few years, selling off their utility and getting bigger in the Delaware Basin. They’ve got a fairly large acreage position, and though it’s still early in the technology development curve there, we’re seeing solid results from multiple zones.”

Rice Energy, a newly public Appalachia player, is another company she points to for share growth. “Rice Energy has done a great job of focusing and developing their resource base, continuing to add acreage in both the Marcellus and Utica.”

She dubs Rice a pure play as its positions in the Marcellus and Utica plays are complementary, and the infrastructure is synergistic. “They have solid production history in the Marcellus, and some exciting new wells are being developed in the Utica.”

MFS Investment Management equity research analyst Katherine Jackson believes the E&P pure-play phenomenon is better suited to smaller companies, which the costs and scale of resource play development have naturally molded into single-basin endeavors.

Risk vs. reward

Doesn’t putting all your assets in one basket, so to speak, create investment risk as well? Maybe, Deckelbaum said, but not to the extent of multibasin risk.

“If a company is in six areas, it can suffer from weather, basis differentials, service capacity or infrastructure constraints” in each area. “If you’re in one basin, you just have to understand the variables within that basin. It’s a lot easier.”

Deckelbaum’s favorite regions for pure plays are the Wattenberg and Utica, as well as the Permian. The Eagle Ford and Bakken names are facing economic headwinds from a soft oil price. He characterizes names in the Tuscaloosa Marine Shale and Marcellus as challenged.

Specifically, he likes Bonanza Creek Energy Inc., a Wattenberg/Niobrara pure player with “an attractively underlevered balance sheet and a robust production growth profile.” Deckelbaum believes Wattenberg economics work below $70 oil. “Bonanza Creek has ample liquidity, even in a depressed commodity environment, to take them through 2016,” he said.

Another pure-play pick, Gulfport Energy Corp., is camped in the Utica Shale. “We think they have some of the best acreage in the Utica, and we’re still seeing compelling returns there,” north of 50% even at commodity prices at the end of October, he said.

Even though the company has not been favored recently due to operational issues, he believes those issues are in the rearview mirror and the company can be cash-flow neutral in 2015. As well, he sees Gulfport holding a marketing advantage, with the ability to move some 75% of its gas outside of Appalachia in the coming year to better priced markets.

“Gulfport is a name we see growing almost 100% in 2015,” Deckelbaum said. “Given the spending plan to be announced in the first of the year, investors will see them as an improving operational and returns story.”

Has the music stopped pure-playing?

KeyBanc’s aforementioned August evaluation of pure players occurred before the downdraft in oil prices and a volatile market ride in October. Does the premise hold up in a shaky tape?

“In a volatile market, people are trying to high grade their portfolios as quickly as possible. They invest in companies that have the best plays, are the best-run, and are the best stewards of capital,” said Deckelbaum. “Those are not necessarily always a pure play. In a market like this, it doesn’t matter where your plays are. What matters overall is do you have a healthy balance sheet?”

Deckelbaum revised the pure-play vs. diversified comps to reflect the current marketplace. Beginning in early 2013, pure plays have outperformed diversified names by 29.6%. Since the beginning of 2014, pure plays have outperformed by 7.3%.

Even in a volatile market, pure players hold a slight advantage over multiplay operators, he believes, everything else being equal. Where multibasin players might experience a drag on valuation from lack of clarity, in contrast, “It’s easier for investors to grasp what a pure player is worth at $90 oil and at $80 oil.”

Jackson views volatility as opportunity. “As painful as those periods can be, they’re the best time to revisit risk/reward. Periods of commodity price volatility are where, as a long-term, long-only investor, you can potentially make some of the best long-term trades.”

She maintains that she has held to the same oil price deck for the past four years. “If I’m concerned about a play being uneconomic, I’m no more interested in it at $100 oil than I am at $80 oil. A lot of good companies have sold off, and these companies have cash and liquidity options that will serve them well in periods of prolonged commodity price volatility.”

Pick wisely

But being a pure player does not necessarily a good investment make. “There are plenty of pure plays I’m not interested in,” Jackson said. Reasons might include a high cost structure, limited ability to get scale, fringe acreage or lease issues. “It comes down to risk and economics,” she said.

Deckelbaum concurred: “If you’re a pure player in a bad asset, you’re irrelevant.”

One other advantage of investing in pure players: “As an investor, I have an advantage of liquidity,” said Jackson.

“I can sell the stock more quickly than the producer can sell the assets. Having that liquidity allows me to create diversification through a portfolio versus at the company level. I can hold a basket of single-asset E&Ps that I think have the best shot, and if one runs into trouble, I’ve probably got another going in a different direction in a different basin to balance my portfolio.”

EnCap Investments partner Murphy Markham said, "Most of our companies will end up in a single basin, simply because they go to the most economically attractive opportunities. That's where they spend their capital."

Single-Minded Private Players

When asked if private-equity provider EnCap Investments is targeting diversity or a single-basin focus in its current E&P investment decisions, partner Murphy Markham laughed and said nothing is crystal clear, and selections might even appear contradictory on the surface. On the front end, EnCap funds companies with a large enough commitment to potentially develop two to three different plays. That being said, “one play takes over as being the most economically viable, and as a result, a lot of our companies focus on that one play,” Markham said.

“Most of our companies will end up in a single basin, simply because they go to the most economically attractive opportunities. That’s where they spend their capital.” And that’s a good thing, because buyers in today’s marketplace tend to shop for assets à la carte, rather than buying a cornucopia.

“We do focus on who’s going to buy these assets. Clearly, the single-basin players have achieved a higher multiple, particularly in the Permian and the Utica.” Even if a portfolio company develops multiple basins, the parts are more likely to be sold than the whole. “To maximize value, we’re probably going to sell to a player that wants that focus, be it in the Marcellus, Eagle Ford or Permian.”

EnCap currently backs some 45 portfolio companies, most of which have a one-basin focus. Recent EnCap-backed company sales netted Athlon Energy and Parsley Energy as buyers, both public Permian pure players. Other Permian and Utica assets have gone to American Energy Partners, an asset-hungry private company with basin-specific sub-entities.

“Definitely, the buyer universe we’re selling into has a single-basin approach.”

Especially public E&Ps. “They’re getting a higher multiple, and when their multiples imply a very high acreage price, they can afford to pay you a premium and it’s accretive to them. We’re selling to these companies.”

It’s that premium offered by the Street that motivates EnCap to often run a dual sales process when time to exit a company—one for a cash sale, the other to IPO.

“A lot of times we do a two-pronged approach where we pursue an IPO and let the public market say what the company is worth. And we pursue an M&A and let the buyer universe determine what it’s worth. If someone knows we can go to an IPO and get a set amount, then they have to compete with that.”

But an IPO is a rare exit, and not the preferred option.

“We would settle for 100% cash below any IPO price, no question,” Markham said. “There is still a risk to IPO.” The good news: Sales metrics have trended closer to IPO valuations over the past year.

“In today’s market, you’re going to end up selling a multibasin approach to multiple buyers, because the buyers don’t want that diversified portfolio as much any more. If you look back at where we’ve made our most value, it’s predominately one asset selling to a very focused company.”