Stocks to Watch

“If I were a $20-billion-plus company trying to get into the shales and get people that understand how to acquire leases, drill and develop as well as run a midstream business, Petrohawk is a takeout candidate,” says David Heikkinen, analyst with Tudor, Pickering Holt & Co.

The energy industry is regaining its footing following the financial meltdown of 2009. Investment capital has started flowing again and upstream stock prices have improved. But, without higher commodity prices as a general-interest magnet, how should wary investors spot winning E&P stocks? We asked four analysts to pick upstream small- and midcap stocks worth watching this year.

Noble Energy Inc., Petrohawk Energy Corp. and Brigham Exploration Co. should definitely be on investors’ radar, according to David Heikkinen, analyst with Tudor, Pickering Holt & Co. He describes Houston-based Noble as a diversified domestic and international company with a good balance between oil and gas. During the past few years, the company has had significant exploration success in the deepwater Gulf of Mexico, West Africa and now Israel.

He’s also looking forward to Noble’s emerging horizontal Niobrara resource play in the Rockies, where the company has accumulated 800,000 to 900,000 acres. Noble’s year-end 2009 estimated reserves were 820 million barrels of oil equivalent, down 5% over 2008.

“Noble is on a path of more than doubling the size of the company on a production and reserves basis over the next three to four years, and doing it with best-in-class management, a strong balance sheet and within cash flow is a rare combination,” Heikkinen says.

In valuing the stock, TPH has placed higher value than the market has on the company’s Tamar gas discovery in Israel. The largest discovery in the company’s history, the well in the Mediterranean Sea encountered more than 460 feet of net pay in three reservoirs in early 2009. An appraisal well increased the gross mean resources of the structure to approximately 7 trillion cubic feet of gas. He says Noble’s Israel volumes could ramp up to as much as 1 billion cubic feet a day by 2013—“something that’s going to completely change the profile of the company.” (For more, see “Israel,” Oil and Gas Investor, November 2009.)

Meanwhile, Noble is continuing to explore in deepwater Gulf of Mexico prospects like Deep Blue, which is expected to add $6 per share, and could add three times that, Heikkinen says. Overall, he expects Noble to focus on developing key projects in the Gulf of Mexico, defining the scope and size of assets in West Africa—which will be closer to production in 2011—ramping up Tamar by 2012 and defining the Niobrara.

He had a Buy rating on the stock in late February and a $105 price target.

His second stock pick is Houston-based Petrohawk Energy Corp., one of the leading onshore gas players focused on the Haynesville, Fayetteville and Eagle Ford shales. For the full year 2009, company production totaled 174 billion cubic feet equivalent (pro forma for the sale of certain Permian Basin properties), a 76% year-over-year increase.

In 2008, the company went out on a limb with a significant cash investment to acquire shale acreage, raising capital through the equity markets along the way.

“There is, without a doubt, a question from investors today about what management will do about the long-term funding capital structure that weighs on the stock now,” says Heikkinen. “But we think a few of the things that they’re doing around asset sales on the E&P and the midstream sides are clearly going to provide additional capital beyond cash flows. Investors aren’t being naïve in thinking about them accessing the capital markets, but dilution is overly priced in the stock today.”

One of the growth drivers for Petrohawk in 2010 and 2011 is the Haynesville, he adds. Out of Tudor Pickering’s total valuation for HK the Haynesville makes up $24, or almost half the total price target. The next step will be Eagle Ford shale development.

“If I were a $20-billion-plus company trying to get into the shales and get people that understand how to acquire leases, drill and develop as well as run a midstream business, Petrohawk is a takeout candidate.”

He has a Buy rating on the stock with a $49 price target. His target without the Eagle Ford factor would be closer to a mid-$30s valuation, he says. “They’re expecting overall production to grow close to 50% in 2010 and north of 40% the year after, so by 2011 they become free-cash positive at a $1.5-billion capital budget, something that the market isn’t paying for yet. A company growing 50% in production and reserves that trades at 6x multiples is the cheapest stock we follow relative to growth rate.”

Heikkinen’s final stock pick is Austin, Texas-based small-cap Brigham Exploration Co. Historically, its E&P activities have been focused in the onshore Gulf Coast region, the Anadarko Basin and West Texas. Beginning in late 2005, it began to acquire acreage within the Williston Basin in North Dakota and Montana. In late 2007, the majority of its drilling capital shifted to the Williston, where it’s targeting Bakken, Three Forks and Red River objectives. To date, it has approximately 483,506 gross leasehold acres in the Williston and has identified more than 800 horizontal drilling locations. Average daily production volumes for 2009 were 5,034 barrels of oil equivalent per day, with oil up 41% from 2008.

“The company’s well quality in the Bakken has really caught our attention,” Heikkinen says. “We’ve seen a strong correlation between longer laterals, and more frac stages per lateral foot—all that is driving higher production growth. Brigham expects to grow production north of 30% this year, and more than 70% in 2011, and they’re doing it out of the oil side of the ledger.

“Their reserves are primarily gas, but they’re definitely shifting back toward a 50-50 position and eventually 80-20 oil as you look at production. As oil prices stabilize, the rates of return for their core development are going to be some of the best in the oil business.”

Brigham is boosting 2010 capex to $300 million to grow production. Though several hedge funds own the stock right now, as the company grows its market cap the investor base should broaden, Heikkinen says. This should attract more investors and bring the company into midcap status. At press time, he had a Buy rating on the stock with a $22 target.

Recently Cimarex Energy Co. has broadened its portfolio focus and is seeing success in the Midcontinent, especially on the unconventional side with the burgeoning Woodford Cana shale, says Nick Pope, Dahlman Rose & Co. analyst.

Growth driven

Dahlman Rose & Co. analyst Nick Pope points to Cimarex Energy Co. and McMoRan Exploration Co. as two E&P names to track in 2010. Denver-based Cimarex, which had a market cap of about $4.9 billion at press time, has traditionally focused on conventional assets in the Permian Basin and Gulf Coast. Full-year 2009 production volumes averaged 462.9 million cubic feet equivalent per day.
Recently the company has broadened its portfolio focus and is seeing success in the Midcontinent, especially on the unconventional side with the burgeoning Woodford Cana shale in western Oklahoma. It’s the piece of the Cimarex story that’s changed, Pope says.

“From 2000 to 2003, Cimarex expressed a lot of skepticism toward unconventional assets, and investors haven’t forgotten this. The company missed part of the early moves into unconventional plays, so they’ve been painted with that brush of being a more conventional producer. It also didn’t have a big inventory of repeatable assets. Their position in the Cana shale adds a big unconventional piece to their portfolio that they didn’t have before.”

On the conventional side, specifically the Gulf Coast, Cimarex was successful in drilling higher-risk wells during the second half of 2009, which yielded flush production and cash flows. This cash flow will help feed the development phase of its Cana efforts.

“They’re still trying to figure out where the core is, and there is a lot of work being done on the lengths of horizontals, the number of frac stages, etc. We’re still early enough in this play where the companies in it are seeing improvements every quarter,” says Pope.

Cimarex is also active in some of the horizontal oil plays in the Permian Basin, including the Abo and Bone Spring. Analysts anticipate hearing more about its progress there this year.

Meanwhile, the company’s strong balance sheet works in its favor, Pope says. Cimarex has fairly low debt, around 15% debt-to-total capital. It wouldn’t be difficult to add more for the right opportunity.
Investors following the stock have always been fans of the company’s management but haven’t been huge fans of its assets, Pope says, and that’s the other piece that’s changing. Now investors like both, and it’s “a top-five performer in the E&P space.”

Cimarex’s midpoint for production guidance is 20% growth in 2010 over 2009. At press time, Pope had a Buy rating on the stock and a price target of $65.

Pope’s other E&P darling is New Orleans-based, Gulf of Mexico-focused McMoRan Exploration. Glenn A. Kleinert is chief executive and James R. Moffett and Richard C. Adkerson are co-chairmen. In early 2010, its market cap was about $1.5 billion. It has producing assets offshore and onshore in the Gulf Coast area and much of the capex budget is weighted toward exploration. Year-end 2009 proved reserves totaled 271.9 billion cubic feet equivalent.

“If people aren’t watching this company this year, they’re crazy,” Pope says. “Moffett is one of the best exploration geologists of all time. He views the deepwater differently than many geologists, and really sees the ‘big picture’ potential of the Gulf of Mexico.”

The company made headlines in recent quarters with its discoveries in the deep shelf and ultradeep Gulf. Flatrock Field in the deep shelf is the source of much of McMoRan’s production, and the recent success of the Davy Jones ultradeep discovery well has excited the market. The company’s 2010 ultradeep plans include drilling Blackbeard East, Lafitte and an offset appraisal well at Davy Jones.

“The Davy Jones structure itself could be 20,000 acres, and they’ve only drilled one well. In the Gulf of Mexico, it was never about a single well for McMoRan. They’re trying to open up a trend. The company has more than 10 individual prospects that they’re going to be looking at over the next few years in the ultradeep. If they start to work it’s hard to see how the company wouldn’t become a very attractive target for the big offshore players.”

McMoRan is also drilling Blueberry Hill, a lower-risk, deep-shelf prospect that isn’t part of the ultradeep trend. It could provide a lot of production and cash flow in the near term.

In February Pope had a Buy rating on the stock and a $20 price target.

As the company expands its Marcellus shale position, there are a lot of reasons to track Ultra Petroleum Corp., says Michael Bodino, managing director and head of energy research with Global Hunter Securities.

Shifting focus

Another stock to watch this year is Houston-based Ultra Petroleum. As the company expands its Marcellus shale position, there are a lot of reasons to track Ultra, says Michael Bodino, managing director and head of energy research with Global Hunter Securities LLC, New Orleans, and formerly with Madison Williams and Co. “Ultra was one of the companies on the back burner in a lot of people’s minds. No one could seem to find a reason to invest in the company. Now they’re back on track with manageable, measurable, steady growth, and they’re in a position to wield a better market valuation.”

With a market cap of about $7 billion, Ultra’s focus has historically been tight-gas sands in the Green River Basin of southwestern Wyoming, in Pinedale and Jonah fields. But in late 2009, the company surprised the market when it acquired 80,000 net acres in the Marcellus shale in northeast Pennsylvania from a private company for $400 million, expanding its net position to 170,000 acres.

“The Pinedale Anticline is profitable and gives the company a foundation property that can manage production and reserve growth for the foreseeable future,” Bodino says. “The inclusion of the new Marcellus properties gives them something that’s going to continue their historic growth profile, growing production and reserves at a 20% to 25% compound annual growth rate, which gets a lot of attention.

“Also, here’s a company that was getting 70% of Nymex-type gas pricing. With the inclusion of the Rockies Express pipeline volumes and Marcellus gas, we’re looking at a company that should yield closer to Nymex pricing. Ultra is consistent, and consistency gets rewarded over time.”

Fifteen years ago, when Ultra first started developing Pinedale, it was considered a high-decline asset at 42%, but today the industry is successfully working shale-gas assets that are declining 70%-80% annually.

This year, Bodino expects to see 25% production growth from Ultra. Beyond 2010, investors should see a combined high rate of return and economic growth for the next five years. There’s a tremendous amount of resource to be converted into the proven category even beyond 2015, he says.

Bodino upgraded the stock from Accumulate to Buy in February with a $71 price target.

The analyst’s other stock pick is an under-the-radar, internationally focused small-cap company: TransAtlantic Petroleum Corp. Based in Dallas, the company has a $650-million market cap and focuses on development and exploration primarily in Turkey, Morocco and Romania. Malone Mitchell III is chairman and Matthew McCann is chief executive officer. Prior to TransAtlantic, Mitchell built Riata Energy into one of the largest privately-held E&P companies in the U.S. He sold his controlling stake in Riata in 2006, and later the company was renamed SandRidge Energy.

Bodino says, “First, it’s worth noting that Malone has participated in all of TransAtlantic’s equity offerings and he’s still the largest shareholder in the company by a large margin. He’s putting his money where his mouth is and that says a lot to us. Second, he’s built a service company within the E&P company. Having an integrated service company really shortens the cycle time on projects.”

TransAtlantic bought Incremental Petroleum in a deal that closed less than 12 months ago. Incremental’s assets in Turkey consisted of the producing Selmo oil field, the Thrace gas field, additional exploration acreage, and various prospects in California. Management spent the summer of 2009 capitalizing the company and doing a small bolt-on acquisition (Energy Operations Turkey LLC), jump-starting drilling in third-quarter 2009. Year-end proved reserves totaled 11.7 million barrels of oil equivalent.

TransAtlantic’s stock price doubled in 2009, and Bodino thinks it will happen again during the next 12 months. He expects the company to also expand its service offerings, increase its acreage positions and execute farm-ins to work into some assets. It plans to spend between $120- and $130 million this year—$50 million is earmarked for known fields, $20 million for the service industry and the rest, for exploration.

“Even though it’s a smaller company with a largely international focus, there are several things working in its favor. It is run by an executive that Wall Street knows; the company is based in Dallas; and, it has a wide institutional support base in the U.S.,” says Bodino.

“This year, we hope to see TransAtlantic develop a couple of their key fields in Turkey; get some reserves and production out of Romania; and finish some exploration in Turkey and Morocco. Any one of the prospects they’re working could be company makers.”

He has a Buy rating on the stock with a $5 price target.

Concho Resources Inc. combines low operating costs and relatively fast production-growth rates—in the low-to-high-20% range—that can be repeated for the next three years, says Sven Del Pozzo, analyst with Irvine, California-based C. K. Cooper & Co.

Oil weighted

Whiting Petroleum Co. and Concho Resources Inc. are also winners, according to Sven Del Pozzo, analyst with Irvine, California-based C. K. Cooper & Co. Denver-based Whiting is an oil-weighted E&P that just finished executing a large capex program during the past few years. The company has assets in the Permian, Rocky Mountain, Midcontinent, Gulf Coast and Michigan basins. As of year-end 2009, Whiting had estimated proved reserves of 275 million barrels of oil equivalent.

In particular, Del Pozzo has his eye on the company’s Bakken shale development. “They have a reasonable amount of acreage in the best part of the play that’s just about right for the company’s size, and they should be done drilling their core acreage in about four years,” he says. “It provides growth and creates near-term value relative to most other Bakken E&Ps, which the market should like.”

The company recently emerged from a tough 15-month period for its balance sheet. When commodity prices plummeted in 2008 it faced a heavy debt load and eventually had to sell assets and issue stock. Today, Del Pozzo says, Whiting’s asset base will be firing on all cylinders at $70 oil.

“Many investors want more oil exposure instead of gas. In Whiting’s case, it’s a company that doesn’t have to invest a lot of money in order to see production growth in coming years, because they already went through the big capex phase of investment.”

This year he expects Whiting to broaden its Bakken footprint and drill wells in locations outside of its core area to validate additional North Dakota acreage. The market is also watching for a response to its CO2 injection efforts in the Permian Basin’s North Ward Estes Field in West Texas. A positive production response would be a very good signal and boost the share price by de-risking reserves, Del Pozzo says. In late February, he had a Buy rating on the stock and a price target of $80.

Concho is another oily, midcap niche player in the Permian. Company production for 2009 totaled 10.9 million barrels of oil equivalent.

What makes the company a stock to watch? “The company has very low operating costs, almost as low as some heavily gas-weighted producers, which is unusual for an oil-weighted asset base. This is partly because their assets are concentrated in a small area, so they benefit from economies of scale…(Also), unlike many other U.S. E&Ps, Concho actually gets excellent gas-price realizations—so they actually get good value for the one-third of their reserves that are gas and NGLs (natural gas liquids).”

In late 2009 the company initiated a $260-million acquisition from undisclosed sellers in the Permian, not far from the acreage it acquired in 2008 when it bought Henry Petroleum.

“The latest acreage package is mostly undeveloped and we already have a pretty good idea of how good the acreage is,” Del Pozzo says. “Buying more acreage in a region that continues to post excellent results means there’s not as much risk associated with this latest acquisition, so investors should like it. Also, they control this new acreage, so they can plan their development schedule.”

This year, the company will be in development mode, focused on Permian drilling and projects in its Lower Abo horizontal oil play, along the northwestern rim of the Delaware Basin in Lea, Eddy and Chaves counties, New Mexico. The investment community should learn how successful the Lower Abo play is in 2010, Del Pozzo says.

“Concho’s stock should be trading higher. They combine low operating costs and relatively fast production-growth rates—in the low-to-high-20% range—that can be repeated for the next three years.”
At press time, he had a Buy rating and a $54 price target on the stock.

What to look for

No matter what the markets are doing, there are always stocks that should stand out.

“We’re in the Big Shale Era,” Heikkinen says. “If you’re heavily gas-levered, then you need to have the lowest-cost assets and you need to have an inventory of projects that create superior returns on a lower gas price.”

Bodino notes that gas-weighted names posting strong performances have been companies completing strategic, transformational transactions, which can be hard to predict.

On the oil side, Heikkinen says his firm is more confident in a higher oil price—$90 a barrel long term—because the industry is not going to oversupply the market. In that environment investors are paying more for oil stocks.

“There are generally three levers that drive companies,” Bodino says. “Commodity prices are No. 1, then growth rates and what winds up being an appropriate discount factor that companies can be evaluated on.”

Capital discipline, as always, is critical. “The broader E&P group has never been the most disciplined group in terms of spending,” Pope says. “But everyone was taught a lesson in 2008 about spending too aggressively.”