One of the trends that I think will play out over the coming years in the energy sector is that small domestic producers will outperform their larger, more geographically diversified peers such as Exxon (XOM) and Chevron (CVX). Not only do they have the potential to be acquired, but they are also poised to grow their production much faster, and will be awarded much higher multiples than the oil majors. There are two main reasons I believe this will happen:
- Thanks to new technology, the U.S. and Canada are going through an energy production renaissance. There have been so many finds in natural gas shale area over the past five years that natural gas prices are at decade lows and consumer spending was bolstered over the winter in no small part by lower heating costs. In addition, both manufacturers and the chemical industry are starting to expand domestically driven by lower operating costs enabled by lower energy prices. Finally, coal use is being curtailed drastically as many utilities change over to using natural gas because it is cheaper and cleaner than coal. Oil production has dramatically increased over the past five years as well. To cite but one example, North Dakota has quintupled its oil production (mainly from the Bakken reserve) over the last half decade. Its 500,000 barrels-per-day (bpd) of production makes it a bigger producer than Ecuador, which is an OPEC member.
- I also believe that North America's lower geopolitical risk will help drive production as well as multiples higher. This is especially true given the increasing hostile environment in other parts of the energy producing world, particularly South America. To cite three recent examples:
- Argentina looks poised to nationalize its oil giant, YPF, which could have a significant negative impact on the Spanish oil firm Repsol (REP).
- Brazil is trying to extort $11 billion from Exxon and Transocean (RIG) for a relatively small spill that is still in dispute. This has the potential to sharply curtail investment in the region.
- Both Exxon and ConocoPhillips (COP) are still battling Hugo Chavez in Venezuela on that country's prior nationalization of its assets.
Here are two undervalued oil firms whose primary revenue streams are from domestic oil and gas production. Both should benefit from increasing production as well as higher multiples being applied to its earnings.
Whiting Petroleum (WLL) is an independent oil and gas company whose main production of oil and gas comes primarily from the Permian Basin, Rocky Mountains, Mid-Continent, Gulf Coast, and Michigan region.
Four reasons WLL is significant undervalued at $52 a share:
- The market seems to undervaluing Whiting's growth prospects. It has a low five-year projected PEG (0.61) and sells for 10 forward earnings.
- The company is priced at just over 5x operating cash flow. More impressively, it grew its OCF at over 250% from fiscal year 2009 to the just completed fiscal year 2011.
- Whiting recently raised its first-quarter production forecast to 75,700 boe/d to 79,100 boe/d and analysts expect revenue growth in the teens for both fiscal year 2012 and fiscal year 2013.
- The stock is selling significantly below analysts' price targets. The consensus price target by the 28 analysts that cover the stock is $69.50. Credit Suisse has an Outperform rating and a $77 price target on WLL.
Swift Energy (SFY) is an oil and natural gas producer focusing on inland waters and onshore oil and natural gas reserves in Louisiana and Texas.
Four reasons Swift Energy is a bargain at $27 a share:
- It is approximately 50% below consensus analysts' price targets. The mean target for the 17 analysts that cover the stock is $41 a share. Standard & Poor's has a Buy rating and a $42 target on SFY.
- Production was up 26% in 2011. Reserves also went up by 20% and the company is a large player in the developing Eagle Ford shale region.
- Approximately 80% of the company's 2012 capital expenditures budget is geared toward oil and liquid production, which should boost the ratio of liquid production vs. natural gas. (It was 50/50 in 2011.)
- The company has easily beat earnings estimates the last four quarters. The average beat over this time period was north of 20%. The stock has a forward PE of 11, which is around a 40% discount from its historical average.
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