Oil wells, and to a lesser degree natural gas wells, are still being drilled and completed, despite the economic turmoil that has cast global markets into a malaise. Most wells in the U.S. are drilled by smaller independents that are decidedly not household names. With that in mind, we queried E&P analysts about which small caps might be creating value at the end of 2011.

Raymond James & Associates Inc. managing director John Freeman, who covers the E&P space, notes that some recent small-cap market raises have been well received.

The impact of the shale-oil run on service costs has been significant for small-cap E&P companies. Demand for pressure pumping, rigs and related paraphernalia required to drill and produce in the hot plays has been a keen focus for analysts like John Freeman, managing director covering the E&P space for Raymond James & Associates Inc. Logically, smaller companies were seeing the brunt of service pricing increases, but that trend is settling.

"Small companies should be seeing the biggest inflation. That is still the case, but the increases are starting to flatten out," says Freeman, who sees investors more willing to buy small caps currently. He points to data points on small-cap market raises, which have been well received.

"Take Kodiak, for instance. They did three equity deals in a matter of months, and their stock went from $4 to $7." Kodiak Oil & Gas Inc. is focused in the Bakken.

"The market is giving Kodiak a free pass on its balance sheet and cost inflation. A $7-million Bakken well from a year ago is now closer to $10 million, but with oil around $100, that doesn't seem to matter to most investors."

The market has become more tolerant of companies outspending cash flow, at least compared with a year ago. But to do so and remain in the market's good graces, a company must be in hot plays like the Bakken or Eagle Ford. Natural gas drilling is not viewed as positively.

Neal Dingmann, managing director of equity research at SunTrust Robinson Humphrey Inc., notes that small-caps are increasingly hedging to manage risk and cash flows.

Neal Dingmann, managing director of equity research at SunTrust Robinson Humphrey Inc., splits the E&Ps into two groups—those above and those below a market capitalization of $1.5 billion. He found an interesting trend when comparing the two groups on forward-cash-flow multiples. The larger-cap group is trading at an average of around 6.6 times price to cash flow this year, and the smaller caps average 6.5 times cash flow—meaning size is a small factor in valuation currently. But when he projected multiples for next year, he got a different result.

"If you look at next year, the larger caps are at 4.6 price times cash flow. That's slightly lower than I've seen. And the average of the small-cap group is only 3.7 times cash flow for next year," he notes. This indicates that the overall small-cap group is trading at a larger discount versus large caps than it usually does, and both groups appear likely to trade lower next year than today.

"It's not a surprise, given the down market. You generally see the 'flight to quality.' But my view is there is upside for the right small-cap E&Ps, if they have access to capital." Additional forces

There are other forces at work in the small-cap E&P landscape. Dingmann says investors would rather small caps not outspend cash flow, but if there is access to capital, it is not a value killer. The high-yield market has become more difficult, however, especially for smaller-cap companies. But many companies are in a different situation than during the last downcycle.

"This cycle is different from 2008. Northern Oil & Gas, for example, perhaps did not have a lot of cash in 2008. But Northern somewhat recently did an equity deal, and many others have done other transactions that supplied either cash or a credit facility they can tap now," he says.

"We're going to see companies continue to drill as much, because of the financing deals that have happened since the last upcycle," Dingmann believes. Debt-to-capitalization ratios are not much different today for large caps than they were, at around 19%. But the small-cap group is much less levered than it had been, averaging 24% debt to cap. Dingmann says most E&Ps are comfortable with debt to cap in the 40% range, which leaves ample room from current ratios. But deleveraging is not the only thing that the small-cap E&Ps have done to manage risk and cash flows.

"What you have seen because of the volatility is small caps hedging more than they used to." Hedges are up for companies of all sizes.

Dingmann says Clayton Williams Energy Inc. is a good example of this trend. A stock he likes, with a target of $90, Clayton Williams locked into an oil price in the high $90s per barrel a year from now.

"What I hear is if they can lock in oil somewhere around $100, they will lock a good bit in, and anytime they can lock gas in at $5 per Mcf (thousand cubic feet), they will do it as far out as 2013," says Dingmann. The company has a higher debt-to-cap ratio than typical, and as a result it recently gave guidance that it would reduce its drilling budget this year instead of increase debt.

Raymond James managing director Andrew Coleman sees potential in the stock of PetroQuest Energy Inc., which has been transitioning from offshore to onshore production.

Natural gas prices are still relatively soft, but natural-gas-weighted companies are not completely overlooked by investors. There are certain characteristics the market favors in this pricing environment, Dingmann says.

"The gas names trading at high valuations are those that have large, contiguous blocks of acreage. A major or foreign IOC (international oil company) can come in and buy that kind of asset, because they have more cash and a longer time horizon. Range Resources Corp. is trading as rich as most oil stocks, and there is likely some takeover premium in that name."

In contrast, companies sitting on small, disparate gas fields, with leases that expire soon, are far from ideal. Favorable gas positions lend themselves to economies of scale to keep drilling costs down, and so acreage can be more easily held by production. Dingmann says market forces may drive E&P companies to sell assets that fall outside of this profile.

"There is pressure to get out of gas assets. Tom Ward (chief executive officer) of Sand-Ridge Energy recently hinted at potentially selling its remaining gas assets to fund oil drilling. And players that have started to make the liquid transition might just keep selling.

"I would say the theme for most small caps is they are trying to grow production, but they are being more creative in how they finance."

Intriguing names

"My favorite in the small-cap range is Resolute Energy Corp.," says Raymond James' Freeman. He notes the management team built one of the strongest energy stocks in the 1980s, HS Resources, taking it public at $200 million and selling it for about $1 billion.

Resolute is 90% oil weighted, and built around a cash-flow cow, Aneth Field in Utah, which was discovered in the 1950s by Texaco and other majors. It was subsequently an ExxonMobil and Chevron project, which Resolute acquired from each in 2004 and 2006 in two separate transactions.

A big legacy oil field, it subsequently was placed on a CO2 flood program, as it is conveniently located near the largest organic CO2 source in North America, the McElmo Dome near the Colorado-Utah border. The company invested in infrastructure, and has had floods working for two years.

"Resolute spits out predictable cash flow and production, and we think they can grow the field 15% to 16% over the next five years, and it would only cost them $60 million per year to do that," says Freeman. The field is already generating $90 million per year in cash flow, an uncharacteristically large cash flow for a small cap.

Freeman also likes the company's other growth opportunities. It announced in June it would enter the Permian Wolfbone, and it has a free call option on the Mowry oil shale in Wyoming, should that play pan out. The company can also chase the Turner formation, also in Wyoming. Devon Energy Corp., EOG Resources Inc. and Plains Exploration & Production Co. are working there as well, the latter of which is on its third well in the formation. Plains has yet to announce results of those wells, but has doubled its acreage position.

The small-cap group is much less levered than it had been, and has better access to capital than in the last economic downcycle.

"Resolute trades at PV-10 value, and most small companies trade at double their PV-10 value. It's relatively attractively valued," says Freeman, who has an $18 target on the stock.

Freeman also likes BPZ Energy Inc., and has a $6.50 target on its stock. The company has been through a leadership overhaul in the past 12 months as it focuses on assets in Peru.

"The prior management team had operational problems, but found oil," says Freeman. The company retained the services of a new chairman, James Taylor. A former executive vice president of Occidental Petroleum Corp., Tay- lor got rid of entire operations and finance teams at BPZ and brought in big names from BP, Oxy and Schlumberger.

This beefed-up management team has 40 million barrels of oil equivalent (BOE) of proved-only reserves. That would equate to somewhere around $6.50 per share at the high end of recent oil pricing, but the stock currently trades anywhere between $3 and $4 per share.

"The new team wants to monetize the assets, so they opened a data room and will start taking bids in the fourth quarter," says Freeman. BPZ should announce a joint-venture partner by the end of the year. Freeman believes BPZ will get more in the market for the asset than the market is pricing in right now at its low stock price.

Freeman's fellow managing director at Raymond James, Andrew Coleman, also covers some small caps of interest. One company Coleman likes is PetroQuest Energy Inc., a familiar name that has remade itself since 2003, when it was a dedicated offshore company.

"I'm a huge believer in what they are doing," Coleman says. Roughly 75% plus of the company's reserves are onshore in shale basins, and over 60% of its production is onshore. Over the past two years the company has de-levered from 55% to a 30% debt-to-cap ratio.

PetroQuest brought in a JV partner in the Oklahoma Woodford shale, Florida-based NextEra Energy Resources LLC. The agreement with NextEra could also provide JV funding for future plays. At the same time, PetroQuest has lowered finding and development costs by 60%. The company is sitting on legacy acreage in East Texas, plus has been building positions in the Mississippian, Eagle Ford, and Niobrara.

The company has also had offshore success recently at its La Cantera prospect, but is still trading at sub-4x forward EBITDA. Coleman sees the company as more opportunistic in recent years, largely because it paid down a good bit of debt. Resulting ratios suggest an onshore profile, which the market has yet to recognize.

"Their trading multiple puts them squarely in the middle of the Gulf of Mexico peer group, but over half of their production is onshore. At some point investors will see them as an onshore player," says Coleman, who has a $9 target per share.