Capital is still flowing into the oil and gas industry, but volatile commodity prices and the need for additional infrastructure pose big challenges in North America—especially for small-cap names that can also have a tougher time attracting investors.

In spite of these obstacles, seasoned investors often appreciate the growth potential for smaller E&P names with quality assets, strong balance sheets and proven management teams.

Oil and Gas Investor recently asked four analysts to spotlight some upstream small-cap stocks that offer significant upside.

Phil McPherson, partner, managing director and senior analyst, energy group, Global Hunter Securities Inc., points to Evolution Petroleum Corp. and PDC Energy Inc. as names to follow this year. Denver-based PDC operates within the liquid-rich Wattenberg Field, Piceance Basin and northeastern Colorado, and the Appalachian Basin including the Utica shale play in Ohio and the Marcellus shale in West Virginia.

During the first quarter of 2012, net production from continuing operations increased 25% to 13.1 billion cubic feet equivalent (Bcfe), compared with 10.5 Bcfe in the first quarter of 2011. During the same period, its oil production increased 73%.

“They were one of the first companies in the small-cap word to recognize the glut of natural gas that was coming,” McPherson says. “They were 100% gas about three years ago, but then they started diversifying. They moved into the Wattenberg targeting the Niobrara and into the Permian. Both of those moves were before the plays became buzz words in the industry.”

In recent quarters the industry has seen increased horizontal drilling and downspacing in the Wattenberg, and the recoverable resources there have grown. The play is a mix of 60% oil, 20% liquids and 20% gas.

“It’s a good mix. Traditionally the horizontal wells have only targeted the B bench of the Niobrara; now we are seeing PDC and other companies target both the C bench and the Codell. A company that paid for acreage once now gets a three-for-one as far as the amount of hydrocarbons they can recover. It gives PDC decades of drilling inventory.”

graph- Analysts see potential in the stories of these EPs.

Analysts see potential in the stories of these E&Ps.

In the Utica, PDC is drilling its first wells and is looking for a joint venture partner. “It’s a nice second leg on the stool. The third is its gas exposure in the Marcellus and the Piceance.”

The company’s management team has gone through some transitions in recent years. While the previous team was more financially focused, the current team is very technically focused, he says.

“We are seeing better well results because of it, especially with the horizontal well results in the Niobrara. With those improvements they made a big step during the second quarter when they bought more acreage in the Wattenberg, bringing their position to more than 100,000 acres.”

McPherson expects to see additional results from either the C bench or the Codell bench from PDC and other operators. Just on the B bench PDC has more than 500 horizontal wells. If these other areas work it could triple that inventory to 1,500 wells, he says.

“Right now it’s only running two rigs, so there’s low-hanging fruit there to develop, and infrastructure is starting to catch up. PDC is also planning to add another rig in the Wattenberg, which could help it exit the year with up to 40% liquids—a remarkable transition considering three years ago it was 100% gas.”

Look for the JV partner in the Utica sometime during the third or early fourth quarter, McPherson says. At press time, he had a Buy rating on PDC Energy and a price target of $43.

His other pick is Houston-based Evolution Petroleum Corp. The company has zero debt. It’s generating excess cash flow above its capex budget, so management is currently looking for oily areas to deploy that cash.

Its principal asset includes the Delhi Holt Bryant Unit in the Delhi Field in northeast Louisiana. It also holds 5,362 net developed acres and approximately 4,179 undeveloped net acres associated with its proved drilling locations in the Giddings Field in Central Texas, as well as leases on 764 net acres in the Lopez Field in South Texas; it also holds Woodford shale projects in southeast Oklahoma.

In the third quarter, net production volumes were 56,327 barrels of oil equivalent (619 BOE per day), a 95% increase over the year-ago period. Total volumes in the third quarter of 2012 were 72% oil and 77% total liquids.

“It’s a conservative story that doesn’t focus on one area or well in particular, but the company pulled off one of the sharpest deals I’ve seen in my career,” the analyst says.

In 2005 Evolution purchased Delhi Field for $7.5 million and identified it as a candidate for enhanced oil recovery. Management realized the field was the perfect candidate for CO2 flooding, so it marketed the field to find an experienced EOR company to do that work. Den-bury Resources bought the field from Evolution for $50 million—an instant 7-to-1 return on invested capital.

“Evolution retained a 7.5% royalty interest in the field, and they are still getting that production today—I hadn’t seen that before. They also designed the transaction so that once Denbury recouped a certain amount of invested capital—capped at $200 million—Evolution would then earn a back-in working interest in the field equivalent to 24% of the field production. It’s rare for a company to be able to grow production without spending any capital, and to do so while having a long-life annuity on oil.

A few years later, Denbury took the field from a few hundred barrels a day to more than 5,000 barrels a day, and Evolution has benefitted. McPherson says Denbury will likely reach the $200-million threshold in early 2013.

“So Evolution could go from 500 barrels a day to over 1,500 a day of production overnight without spending a penny.”

McPherson is expecting a huge boost in the absolute reserves and the PV-10 when new figures are released in September, because the current reserve report has the back-in working interest starting in 2014, and his group expects it to start a year earlier.

“Once the back-in interest kicks in, the company becomes very marketable from an M&A standpoint. There’s a lot of MLPs out there that would love to purchase a producing asset of this nature.”

He has a Buy rating on the stock with a $14 price target.

Under the radar

Another stock to watch this year is Bonanza Creek Energy Inc. The Denver-based company was founded in 2010. It operates in the Mid-continent region in southern Arkansas; and in Wattenberg Field in the D-J Basin and the North Park Basin in Colorado. The company also owns and operates oil-producing assets in the San Joaquin Basin in California.

Irene Haas, analyst, Wunderlich Securities Inc., says the stock caught her eye when her group began researching some of the “older resource plays” that are being ignored now.

“We went back and took another look at the Niobrara play which was hot two years ago. At the conclusion of the study, we thought that the Niobrara was very viable, as it offers great returns, even in this environment. We believe that there is at least a 2-billion-barrel-recoverableresource to be extracted, just from the Niobrara. While the Niobrara isn’t in the limelight right now, we believe it is evolving into an oil play of huge significance.”

In looking at Bonanza Creek, Haas says her coverage really began with the assets, and the company has a good production ramp in two oily plays. In addition to the Niobrara, it is also in the Cotton Valley play in Arkansas, a bread-and-butter asset for the company.

“What also caught my eye was the low debt load, which means they have plenty of dry powder. The company also has a well-seasoned management team. In an environment where crude oil is acting more volatile than normal, it’s very important to have a strong balance sheet, good assets and a good team.”

Bonanza Creek is a fairly new company—it went public in December 2011. She has a Buy rating and $28 price target on the stock.

The float (the total number of shares publicly owned and available for trading) is a little thin right now, so investors might prefer a more liquid stock. However, for those who are patient in accumulating a position, Haas likes “how Bonanza Creek is wired, structurally.”

The company is in development mode, and during the second half of this year it is expected to continue drilling vertical and horizontal Niobrara wells. Haas expects Bonanza to eventually drill more horizontal wells and fewer vertical wells.

“The company will probably take a crack at the Codell and evaluate the proper spacing for the horizontals. Another way to improve recovery is to drill extended laterals. If you have acreage that can accommodate the longer laterals, then it’s something companies want to consider because the economics are superior.”

Joel Musante, analyst, C. K. Cooper & Co., adds that most of Bonanza’s Wattenberg Field development should be completed during the third quarter.

“The company will probably be looking to continue or even increase its drilling, which would drive production higher. The main challenge for the company is one that affects all E&P companies: with the state of the economy, how do you effectively manage production and your development plan?”

Musante has a Buy rating and a $28 price target on the stock.

“They strike me as a company that really emphasizes execution and transparency. They definitely look like they’re going places, but by my calculations the stock is trading around its proved reserve value. It’s not getting any credit for the upside potential of its drilling prospects. Wattenberg really has attractive well economics, and the company isn’t getting much credit for that.”

Musante’s other pick is Platteville, Colorado-based Synergy Resources Corp. In second-quarter 2012, net production increased 190% to 124,763 BOE, averaging 1,356 BOE per day versus 467, as compared with the same year-ago quarter. During the period, the company increased estimated proved reserves to 3.6 million barrels of oil and 24.8 billion cubic feet of gas.

It has $27 million in cash, a strong balance sheet and a lot of liquidity. Its working capital is $20 million. It also has a $20-million credit facility where only $3 million is drawn, and this should get them through most of 2013, Musante says.

He has a Buy rating and $5 price target on Synergy stock.

“It’s a pretty small company. It has been acquiring acreage, and has about 12,500 net acres in the core of Wattenberg. I think it makes them a takeover target, especially as more results come in from operators on the different formations in the play.”

Synergy has assets in Wattenberg Field, with 12,506 net acres in what the locals called “the doughnut hole;” this is because everything around it has been densely drilled. The existing productive wells makes Synergy’s Niobrara development drilling very low-risk.

“The management team is also interesting because they were either born and raised in Colorado or they’ve spent a good part of their career working in the region. So the team is entrenched in the community, which is a huge plus when you are trying to do urban drilling.”

Haas has a Buy rating and $6 price target on Synergy stock.

Until recently, the management team has been largely focused on vertical drilling in the Wattenberg. It’s participated in some horizontal to date, and it is planning to drill more Niobrara horizontals this year as an operator. Outside of the doughnut hole, the company holds 15,503 acres in northern Colorado, also prospective for the Niobrara. In western Nebraska, the company accumulated a 109,000-acreage position. The company could begin working on this trend in late 2013.

Haas adds, “Right now they have a good amount of liquidity to power them through fiscal 2012. They are getting noticed, mainly because of the assets. In addition, this is the management team’s third or fourth incarnation in forming companies, which is reassuring.

“Synergy should be able to generate a lot of organic growth from their wells this year. They are in a very good place. Typically, it is hard to get small companies up and running and producing, but this one is making great progress.”

Upside focused

If investors are interested in some international exposure, FX Energy Inc. is a smart small-cap pick, according to Kim Pacanovsky, managing director, research, MLV & Co. Headquartered in Salt Lake City, Utah, FX’s operations are largely focused in Poland.

She has a Buy rating and $11 price target on the stock.

At year-end 2011, worldwide proved oil and gas reserves for FX were approximately 49.6 Bcf of gas and 0.6 million barrels of oil, or a combined total of 53.5 billion cubic feet of natural gas equivalent. Of this, 53.5 Bcfe was in Poland and 7% was in the United States.

FX is busy drilling a large, high-risk 9.5-trillion-cubic-foot prospect in Poland called Kutno. Though it has had some challenges with the well, several industry watchers believe the worst is behind it. Testing and completion should be done by September. If the well is successful the company may launch a joint venture, sell it outright, or raise money to develop it, Pacanovsky says.

The company has $50 million in cash; it is expected to spend between $65- and $70 million this year, and cash flow is at $21 million.

Because of its former capital situation the company has typically drilled one or two wells per year, but this year it should have seven new well results. Its current budget is its largest to date. Also, FX now operates more of the wells it is drilling, which will allow the company to better control its pace of development, Pacanovsky says.

“What initially attracted me to the stock is how it’s operating in Poland—a whole different animal for gas markets. It’s a country that imports the vast majority of its gas from Russia. From the street to the highest echelon of government there is a desire in Poland to be free of Russian gas.”

The Rotliegend sandstone in the southern North Sea comes onto northwestern Poland, and it’s where FX Energy has operated for years. Currently, FX is the second largest gas producer in Poland.

“In Poland, gas pricing is fixed to the price of oil and it’s negotiated by the Russians. FX’s gas, which is low methane, is getting about $6.25 per Mcf.”

Pacanovsky also likes FX’s exploration success in its current program. So far, the company has drilled eight out of 11 wells successfully.

“Because their partner, state-owned oil company PGNiG (Polish Petroleum and Gas Mining), has operated its wells, the wells produce on very restrictive chokes. This is because the Poles want to be able to open up the chokes if there is a situation where Russia turns the taps off. By producing the wells at a low rate, they are insuring some level of gas storage.

“If you’re a small company, you want to get your money back as soon as possible, so FX attempts to negotiate as high a rate as possible. But the wells still produce far below what they are capable of producing, and this has resulted in predictable production growth for FX for the next few years. This also leads to a predictable cash flow stream.”

The company has hit some snags in recent quarters. It had three wells taken offline (though they’re back online now) and there are risks inherent in operating internationally.

“If there is any kind of negative viewpoint toward them being a small-cap company in an international play, I think it’s because people are thinking of the ‘old’ FX. Today they have great prospects and have made great inroads with the government entities.

“There have been several factors that have caused the stock price to be very weak, from technical issues to global events, but there are several potential catalysts on deck. It’s a great time to invest.”

Magnum Hunter Resources Corp. is her other stock pick. During the second quarter of 2012 the company achieved a record average production rate of 12,893 barrels of oil equivalent per day, a 161% increase from the second quarter of 2011. During the same period, its liquids production increased 32% to 5,862 barrels of oil equivalent per day from 4,454 per day in first-quarter 2012.

Despite this growth, Pacanovsky says the market isn’t giving the company any credit for a huge acreage position, a number of locations and improvements in well results.

“Also, everybody pays attention to the Bakken in North Dakota. I don’t think the market realizes that the company’s rates of return in Saskatchewan are just as good. Because they are in three areas—North Dakota/Sas katchewan, Eagle Ford and Appalachia—they’ve been able to take technology that’s working in one place and try it in another area, and it’s been very positive for them.”

As many companies have switched their focus from gas to oil and liquids during the past two years, many have ended up outspending cash flow. This is common, but the trick for investors is to look for the companies that can get back to spending within their cash flow the fastest, Pacanovsky says.

“This year, Magnum Hunter has cash flow of $140 million and the capex budget for the year is $325 million, so obviously there is a big outspend. However, next year we are looking at $300 million of cash flow and I like the way the numbers have evolved.” She has a Buy rating and $9 price target on Magnum Hunter’s stock. “This is a steady-as-she-goes kind of story. It’s an evolution of consistency. Management has made a plan, told the market what they were going to do, and they’re doing it.”

Looking for winners

As investors search the market for winning small-cap names, a strong production profile is essential, says McPherson.

“We went through such a big boom in natural gas, and the high growth rates spoiled investors. Some names were growing gas production each year by 20% or 30%. However, the oil names have always had a harder time growing production. While 10% to 15% year-over-year growth should be rewarded, it isn’t, because it falls so short of the gas growth rates. Once those expectations have been reset, oil companies that are trading at 4 to 5 times EBITDA will get a lot more respect and the multiples will expand.”

Protecting the balance sheet is also a must, he adds. “Doing this via hedging or terming out your debt prepares you for the worst while you’re hoping for the best. Companies that hit their production targets will be rewarded first; those that protect the balance sheet will be rewarded second; and, companies that continue to spend money on unprofitable projects are going to run out of capital and put their shareholders in jeopardy.”

Smaller, riskier names tend to get discounted more in uncertain times and this becomes more pronounced for names that have a lot of debt, Musante adds.

“For me, it starts with high-quality assets,” says Haas. “It’s also good to be in projects that will have a quick payout. What will typically trip up small companies is not being able to capture their operating cash flow as planned.”

“In general, the basic tenants for quality companies haven’t changed: where are your properties; what are you doing with them; and how are you growing your cash flow? There’s a great deal of value in the E&P small-cap space right now, and longer-term investors can make a killing on some of these names,” Pacanovsky says.

DISCLOSURES: C.K. Cooper & Co., Global Hunter Securities, Wunderlich Securities and MLV & Co. or any affiliates in the past 12 months have managed or co-managed a public offering of securities for the subject company; received compensation for investment-banking services for the subject company; or expect to receive or intend to seek compensation for investment-banking services from the subject company in the next three months.
Phil McPherson, partner, managing director and senior analyst, energy group, Global Hunter Securities, points to Evolution Petroleum Corp. and PDC Energy Inc. as names to follow this year.

Irene Haas, analyst, Wunderlich Securities Inc., says Bonanza Creek Energy caught her eye when her group began researching some of the “older resource plays” that are being ignored now.

FX Energy Inc. is a smart small-cap pick for investors interested in some international exposure, according to Kim Pacanovsky, managing director, research, MLV & Co.

Analysts see potential in the stories of these E&Ps.