Digging for Oil Producers

 | May 19, 2014 | 1:00 PM EDT
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Oil prices refuse to come down, even domestically, where first-quarter results from U.S. exploration-and-production companies continue to stun investors with fantastic year-over-year production increases. You'd think that you can almost randomly choose any mid-cap, dedicated producer of liquids and crude oil in any of the rapidly expanding shale plays in the U.S. and make money -- but like the Gershwin song says, "It ain't necessarily so."

I spend almost every day looking over the dozens of small and mid-cap E&P players, trying to find the next great shale producer that will triple over the next year or two, and there is a reason that they're not so easy to find. We've haven't been in such a massive "wildcatting" oil environment in the U.S. since perhaps the 1970s, when the first oil crisis hit and oil companies were scrambling for new sources of crude.

The outline for these wildcatters is always the same: finding, or trying to find, potentially good acreage and then going into massive debt trying to prove the potential of the acreage they've bought. We've seen it repeatedly, and the trick as an investor is not necessarily trying to do a better job of assessing the potential of the acreage, but assessing the level of debt that's being taken on in view of the upside potential for production.

That's what makes EOG Resources (EOG) such a unique company in the space, though it is a long way now from "wildcat" status and cannot capture the profit for investors in a triple anymore, no matter how great their results will be from here on. But its debt position and positive cash flow is almost unheard of in the shale producers, and that makes them not only a strong play, but also a relatively safe one, something you rarely see.

Everyone wants the kind of results Carrizo Oil & Gas (CRZO) delivered in the last two years, tripling in share price in the past 14 months while hitting on all cylinders in the Eagle Ford Shale and the Niobrara. But for every Carrizo, there are three that haven't fared nearly as well. Take Midstates Petroleum (MPO) for example, an E&P company focused in the Mississippi Lime (like SandRidge Energy (SD)). Since its initial public offering in spring 2012, Midstates has ballooned its debt to more than $1.7 billion while delivering exceedingly disappointing results. MPO shares got a small pop last week on word that it's looking for a buyer of its assets, which is to me a surprising catalyst for shares; it shows the company is ready to throw in the towel.

One E&P I've been watching that might be ready to make its move is Rosetta Resources (ROSE), a secondary player in the Eagle Ford and Permian Basin shales. This company hit many speed bumps in 2013 and only started to look good today, as small improvements in production are hopefully showing a turnaround on execution that's so far been lacking. It's in the right places, working the right acreage, has debt relatively under control, but it just cannot get the results Marathon Oil (MRO) or Pioneer Natural Resources (PXD) can get. This is not a company I have much confidence in, so this is not a core recommendation.

I believe there are still values among the crude producers; I just don't think finding them will be easy.

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