A few years ago, small-cap exploration and production stocks represented a way for investors to have energy exposure on the cheap. Without risking a fortune, individual—and even some institutional— investors got to stick a toe in the sector, sometimes reaping financial benefits when smaller, “diamond-in-the-rough” stocks eventually rewarded stockholders with returns several times over initial investments.

Before the financial markets crashed, small caps could sometimes attract investor interest by simply playing in the right basin at the right time. But today, though there are successful companies in play with market caps below $500 million, they’re often swimming upstream against the shale frenzy, dismal natural gas prices and renewed caution on Wall Street.

Some small-cap investors have opted to focus on names with market caps closer to $1 billion; other investors haven’t given up on the power of the smaller underdog stock. To help in navigating the new playing field, Oil and Gas Investor asked three analysts to spotlight small-cap stocks worth watching into 2011.

One of the biggest challenges facing smaller E&P companies involves their ability to grow in a balance-sheet-friendly manner, says Chris Pikul, senior E&P analyst, Morgan Keegan Equity Research.

“Small caps used to be where investors turned for above-normal growth in production and reserves. But that landscape has changed since the independents have become so heavily involved in the shale plays. Larger independents with good shale-acreage positions can now offer investors 30% to 40% growth, backed in many cases by a stronger balance sheet with ample financing capabilities.”

Access to capital has also become more difficult for small caps because of pricing issues and tighter credit markets. Also, there was a historical tendency for small caps to be gas levered; this business model has been compromised in the near term by the influx of shale gas, forcing many companies with marginal assets to rely on debt to bootstrap more expensive shale-drilling programs.

“The M&A cycle has also forced a change in the way the small caps operate,” says Pikul. “There used to be a number of small companies out there taking the lead in exploration, taking risks and outspending cash flow, knowing that there was always a market to sell out to the larger independents seeking drillbit-growth opportunities. But now many independents have a major position in the new shale plays and their portfolios may not need replenishing with M&A activity.”

When evaluating small-cap stocks, investors have become even more critical about balance-sheet strength, asset quality and the ability to fund development plans, according to Pikul. Although the height of the financial crisis has passed, many smaller, gas-levered E&P companies are still in limbo.

“They need capital to develop their assets, but I don’t think a lot of these marginal gas plays will attract a high level of investor interest, no matter how economic they might be. The preferred habitat for investors has definitely changed to more stable, oilier company names.”

He says Kodiak Oil & Gas Corp. and Energy XXI Ltd. should definitely be on investors’ lists of smaller E&P companies to watch.

Denver-based Kodiak is focused on the oily Williston Basin. There, it has roughly 70,000 acres, with 40,000 to 50,000 of those potentially productive in the Bakken. The company is in the early stage of its growth profile and posting relatively high growth rates. Its market cap is about $400 million, with zero debt.

“This is a company that narrowly escaped bankruptcy. A few successful Bakken wells helped resurrect the stock last year. Today the company has some pretty strong drillbit catalysts ahead of it. It still hasn’t transitioned to the longer lateral wellbores that its competitors are drilling. It also has yet to test the Three Forks potential on its acreage.”

Pikul says the industry may see Kodiak become more aggressive in expanding its footprint in the greater Bakken play. This strategy may pose some financing or dilution risks, but it may also be the step-change approach that grows the company quickly rather than by a few thousand acres per quarter, he says.

“Right now the company is focused on ramping up production and the drilling program is pretty active. They were producing 600 barrels of oil equivalent per day in 2009, and management has suggested doubling to tripling that on an exit basis. However, there’s a lot of activity going on in the Bakken and companies are having a hard time getting wells completed in a timely manner, so some of the growth investors are looking for may not be visible until later this year.”

Kodiak recently reported results from its Red River wells, one of which came in at 287 barrels of oil per day. “That wouldn’t necessarily excite you as a Bakken well, but these are vertical wells that cost much less to drill and complete. They have a different production profile and some investors probably didn’t know what to make of the rate,” notes Pikul.

During the next 12 to 18 months, some of the big growth drivers for Kodiak will be completion results from its longer laterals and from the Three Forks formation, as well as newer completion techniques being applied in the legacy Elm Coulee area.

“When it comes to the smaller E&P companies, investors are right to have an even sharper focus on management. To Kodiak’s credit, management has been very transparent about well results and has worked to distinguish its well quality among competitors. It gives investors a high degree of confidence in what they’re doing with the drillbit.”

He has an Outperform rating on the stock.

Pikul’s other small-cap opportunity is Gulf of Mexico-focused Energy XXI. Its market cap is just about $1 billion, and its asset profile is roughly 70% oil.

“The sizzle in this story is in the way it’s pioneering the ultradeep shelf in the Gulf of Mexico. Unfortunately, the shares have been caught up in the aftermath of the BP oil spill and a lot of investors have exited the sector.

“There’s still a lot of regulatory risk out there, but it appears shallow-water drilling can continue unfettered for Energy XXI even with new safety and testing regulations in place.”

Months ago, investors were excited about initial results from a discovery on Energy XXI’s Davy Jones ultradeep prospect on South Marsh Island Block 230 (operated by McMoRan Exploration Co.), but much of the buzz has faded, says Pikul.

“The ‘oil spill effect’ has overshadowed it, and, the fact is, this is a well with a long development time frame, so investors probably won’t definitively know the productive capacity of this discovery until this time next year.

“Justified or not, there appears to be a permanent risk factor that’s worked its way into these Gulf of Mexico stocks, so investors may not see stock prices return to pre-oil-leak highs anytime soon. But there is still significant exploratory upside to Energy XXI that may be captured in the stock price over the next 12 to 18 months.”

Pikul says the industry has migrated toward a lower-geologic-risk, higher-financial-risk drilling profile as shale plays have taken center stage. This, in turn, has made producers of all sizes even more sensitive to commodity prices and well costs.

“There’s been a lack of investor enthusiasm in assuming real geologic risk, but one of the benefits with Davy Jones is the prospect already appears to be significantly de-risked. It offers a nice carrot for investors looking for outsized returns that aren’t necessarily reflected in the stock price.”

He has an Outperform rating on the stock.

Reward Potential

Jeff Hayden, managing director, E&P research, Rodman & Renshaw LLC, agrees that the financial crisis has created a particularly tough environment for small caps.

“When everybody panics, you see a shift to ‘safer stocks,’ which tend to be larger-cap names. Once the panic subsides and people get more comfortable with the idea of investing, more investors are willing to consider smaller-cap names again.

“With the shale revolution, investors’ approach was sometimes to look harder at small-cap, under-the-radar names that had the most shale exposure. Thus, if you’re a small cap with exposure to a hot shale play, investors would typically give you a look. However, liquidity issues have kept some smaller players from successfully developing a position in the shales.”

In the world of small caps, higher risks have to be balanced against the potential for greater rewards, Hayden says. Investors need to see why they should take on the additional risk that can come with investing in smaller-cap names.

Two names he likes are Carrizo Oil & Gas Inc. and American Oil & Gas Inc.

Houston-based Carrizo is focused on unconventional oil and gas trends in the Barnett, Marcellus, Niobrara and Eagle Ford plays, in addition to others in the U.S. and in the North Sea. As of year-end 2009, it had about 445 gross wells. Its market cap is $650 million.

“The company’s primary producing area is the Barnett shale,” Hayden says. “It still has running room there, but it has expanded and added other growth areas. It recently expanded into some oilier plays, picking up a nice position of about 58,000 net acres in the DJ Basin Niobrara and 9,000 net acres in the Eagle Ford.”

In the Barnett shale, the company has a little over 50,000 net acres, of which 21,000 acres are in the core. Its next growth area would be the Marcellus shale, where it has more than 100,000 net acres. Both areas are gas.

“We’re still more bullish on oil, especially in the near term, so we like what it did in the Eagle Ford and Niobrara. It is going to start drilling up the Niobrara during the second half of this year, and if things go well, it could have a full program running there next year.”

Hayden is expecting impressive growth numbers from the company. This year he’s forecasting production growth of 15% to 20% and next year, 30% to 35%, driven by results from the shale plays. While this growth has stemmed largely from the Barnett, next year investors should start to see contributions from other plays, and possibly, the company’s Huntington discovery in the North Sea.

He has a Market Outperform rating and $29 target price on the stock.

“The big pushback you get from investors on the stock right now is because of the company’s debt load. If you look at the industry as a whole, net debt to capital runs about 30% to 35% on average. Carrizo’s is closer to 65%. The headline number creates a bit of sticker shock, but we think the debt load is manageable and its existing liquidity is enough to allow it to conduct its capex program.”

Denver-based American Oil & Gas is another smaller stock on Hayden’s radar. The company controls approximately 85,000 net acres in its Goliath Project in the Williston Basin; its market cap is about $380 million.

At press time, Hess Corp. announced plans to acquire the small cap in an all-stock transaction, significantly increasing Hess’ strategic acreage position in the Bakken. The deal represents a 9.4% premium to American Oil & Gas stockholders based on the closing prices of Hess’ and American’s shares on July 27.

“American has held a significant acreage position in the Bakken, and as the play moved west across the Nesson Anticline with companies reporting impressive well results, it really opened up the company’s acreage. American sold a lot of its other assets in the first quarter for about $46 million, using the proceeds to help fund its Bakken program.”

Before the acquisition announcement, it had only drilled a few Bakken wells.

Hayden had a Market Outperform and $8 target price on the stock, but has taken his rating to Market Perform since the acquisition.

Back to Basics

Many oil-weighted names have fared better than gassy companies coming out of the financial crisis. Going forward, investors should revisit the basics of stock picking, says Phil McPherson, senior E&P analyst with Global Hunter Securities.

“If investors stay away from names that are natural-gas levered, and focus on ones that can spend capex dollars in liquids-rich areas, they’ll have a better recipe for success.”

His list of smaller stocks to watch moving into 2011 includes Magnum Hunter Resources Corp. and Houston American Energy Corp.

Houston-based Magnum Hunter is a reincarnation of the early version of the company, which was successful in the late 1990s. The proven management team built the company from scratch and later sold it to Cimarex Energy Co. in 2005 for $2.2 billion. In 2009, Gary Evans, founder of the original Magnum Hunter, bought into a company called PetroResources (later renamed Magnum Hunter). He brought in his management team and geologists and started bolting on acquisitions in the Marcellus and the Eagle Ford plays.

In just over a year the company’s stock price has jumped from $0.25 per share to $4. Its production is almost 2,000 barrels of oil equivalent per day.

“They’ve got the recipe to repeat what they did previously,” McPherson says. “Wall Street loves management teams that have already made money, since this takes much of the execution risk out of the mix. The company is about two-thirds oil, and with the Eagle Ford wells that may come on in the next few months, things could get even oilier, and this is a huge advantage for the company.”

Why? From a market-cap or capital-structure perspective, one good well can make a huge difference for the company, while some gas-weighted independents could drill 100 wells and still not move the needle, McPherson says.

“When you can grow 100% on the production side you can bring more eyeballs to your stock than an independent can that is only growing 10% per year.”

He has a Buy rating and $6 price target.

“In this case, management’s reputation is key. Geological risk is important for investors to consider, but many fund managers aren’t in a position to have an educated opinion on it.”

His second pick is Houston-based, Colombia-focused, Houston American Energy. The small-cap identified Colombia as an attractive place to look for oil back in 2002.

The company runs a pretty lean ship; it only has three employees. It’s debt free, and its market cap is approximately $290 million.

Houston American has two major projects under way. One is a heavy-oil project in the southern portion of Colombia, where it plans to drill several wells as a direct offset to a 1.3-billion-barrel field discovered in 2008 by Emerald Energy.

“Net to Houston American, after royalties, we’re talking about 20- to 30 million barrels to this $300-million company, and $10 per barrel for this one project—it’s pretty attractive when you think of small-cap companies and being able to find that much oil.”

Its second project is the CPO #4 Block in Colombia. There, Houston American is partnering with Korean conglomerate SK Energy Co. Ltd. This block is analogous to where Petrominerales Ltd. drilled three wells in late 2009/2010. Those wells came on at 10,000, 12,000 and 15,000 barrels per day, respectively.

“You can’t drill a well in the Lower 48 that has that type of profile unless you’re offshore. These results made people notice Houston American’s stock, and the share price went to $20 off of this news. After a little market pullback and some of the bogus stories that have been written about the company, the stock has cratered a bit from $20 to $8 to $9. It’s actually a good range to look at accumulating the stock, as the company will spend the second half of the year doing exploration and capex work.”

He has a Buy rating and $14 price target.

“When you talk to the buyside about Colombia, 50% of the folks turn their brains off. They still associate the area with the kidnappings, cocaine trade and terrorism of the late 1990s. The other 50% of investors are starting to understand Colombia. They realize that the opportunities to invest there are limited, which should bring more investors to the table.

“If the company hits one or two of the wells it plans to drill in the CPO #4 Block in December, at 25% working interest, it could more than triple its current production to 3,000 to 4,000 barrels per day.The company could easily move into 2011 with a lot of momentum.”