Spotting value in US E&Ps is the focus of Mike Kelly, vice president and senior E&P analyst for Global Hunter Securities LLC, Houston. Kelly joined GHS in August 2011 as the investment bank expanded energy coverage.

A native of Chicago, Kelly played baseball at Trinity University in San Antonio and majored in business administration with a minor in political science. It seemed“exotic” to play ball outside in February, in contrast to the harsh winter climate of the Windy City. He injured his arm as a junior, but still holds the conference record for ERA (1.12), set in his sophomore year.

After college Kelly returned to Chicago and joined FactSet Research Systems. That led him to buysider Kennedy Capital in St. Louis, where he joined a team of 15 analysts and was introduced to the energy sector. For five and a half years he covered E&Ps as well as oilfield services, utilities, coal—“everything that fell under the Russell 2000's Energy Sector.” At night he worked toward his MBA at Washington University, also earning his CFA degree during those busy years.

When the opportunity arose to join Global Hunter as a full-time E&P analyst, he jumped at it. Today he covers midcap independents, ranging from Permian Basin-focused Clayton Williams Energy Inc. and Concho Resources Inc. to Bakken shale expert Whiting Petroleum Corp.

Kelly runs several marathons a year, and is looking forward to the birth of his first child in the fall.

Investor What attracted you to the E&P space?

Kelly It's such an interesting business. There's the opportunity to, as buysiders say, add alpha, if you dig in and do your homework. I wanted to completely understand what makes a good E&P company, and to be in Houston where about 90% of them are located.

Investor You focused on small-cap stocks at Kennedy. What did you learn then that you still apply today?

Kelly Kennedy is a value-oriented shop, and return on capital is the main pillar of the investment philosophy. I was fortunate to have great mentors there and the lessons learned will forever be a huge part of how I approach valuing E&P businesses.

For example, at GHS we publish a report every quarter that looks at, among other factors, return on capital for 60-plus E&Ps. We also look at production growth on a debt-adjusted per share basis. The ideal companies show a strong return on capital and the ability to grow organically on that basis. They don't just grow because they diluted shareholders and took on debt—that growth didn't count at Kennedy and it doesn't count for me at GHS.

Investor Which names look good?

Kelly There's a consistent group that always looks good on these metrics: Concho, Continental Resources, Rosetta Resources, Whiting Petroleum. It's also important to have a line of sight that growth will continue for the next five years and beyond. That requires a thorough analysis of a company's undrilled inventory, or 3P reserves.

Investor Will we see more Linn/Berry-type mergers?

Kelly I think the deal woke some corporations up. We're about to see a transaction from Whiting where they'll sell assets either to a royalty trust or an MLP. It's an $800-million-plus deal involving a low-growth, but low-decline, enhanced-oil-recovery asset, Postle Field.

Investor Many people say the shale land rush is over. Is it?

Kelly That's actually a fairly controversial topic. That might be Chesapeake Energy's view, but it's not universally held by all industry participants. Southwestern Energy and Devon, for example, claim that the US is in the early innings of resource capture and delineation. If you look back at the gas plays, first it was the Barnett, then the Woodford, then the Haynesville, then the Marcellus, which seemed to trump previous plays 10 times over.There are still plenty of plays being worked on that may have similar economics to the big three.

The other interesting aspect is stacked pays. In the Permian, Concho and Pioneer Natural Resources are targeting seven-plus intervals with testing. It's an acreage multiplier—you don't need a huge footprint to participate. It can be a smaller footprint, but the number of locations will be exponential. This could be explosive in terms of US potential.

Investor Your thoughts on commodity prices?

Kelly We believe US oil production will be the driver of worldwide growth for the next five years, with the ability to really tip the scales. The supply-demand balance may be taken out of equilibrium, putting downward pressure on prices. In terms of natural gas, we think $4 is about the right price, until you see incremental demand drivers, which would be LNG exports.

Gassy companies that have survived and thrived have been low-cost players in the Marcellus. Chesapeake said recently on an earnings call it was drilling wells for $5.5 million for 10 Bcf (billion cubic feet) wells in the Marcellus. F&D costs are approaching 50 cents per Mcf. If you're a Cabot Oil & Gas or a Range Resources and have a prime position there, you're just fine. Others haven't been as lucky.