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Andrew Coleman: E&Ps with Margins for Error

Source: Brian Sylvester of The Energy Report 02/01/2011
February 3rd, 2011

Andrew Coleman, E&P analyst with Madison Williams & Co., is all about the numbers. His research reports are laden with calculations proving or disproving his 2011 investment thesis, which is that reserves and production growth, especially in liquids-rich oil plays, will continue to drive the share prices of E&Ps even higher. In this exclusive interview with The Energy Report, Andrew provides you with his favorite oil and gas names for 2011, as well as some others with margins stout enough to withstand just about anything the market throws at them.

The Energy Report: Andrew, you cover 14 exploration and production (E&P) names for Madison Williams & Co. It's a relatively new company; please tell us about it and your role there.

Andrew Coleman: Madison Williams is effectively the private spinout of the institutional equities business of Sanders Morris Harris Group Inc. Madison Williams was spun out in December 2009, and I joined the firm in May 2010. I was brought in from UBS to spearhead E&P research. At this point I work with one other individual, and we will try to get more than 20 companies in our initial build-out of E&P research. We will then probably bring in some additional help to take us north of 30 companies. We're trying to build a pretty detailed E&P research franchise from the bottom up. Additionally, within the energy vertical, we cover oilfield services and master limited partnerships. Other verticals for Madison Williams include healthcare and coverage of OTCQX-listed companies.

TER: Your investment thesis among the E&P names for 2011 is that reserves and production growth will drive E&Ps higher. With that in mind, you have raised your price targets on 11 of those 14 E&P companies. Could you give us your outlook for 2011 and tell us more about that thesis?

AC: In modeling an E&P company, I focus a lot on its operational integrity and cash margins. First off, I use the forward curve for input commodity prices—as that's the best proxy for where the market thinks commodity prices will go. The key idea that we're seeing out there—and it's been around for at least the last six months— is that the move toward liquids and oil plays is driving E&P returns. To the extent that commodity prices may be higher or lower than the forward curve, I can build those sensitivities into my models. But my bullishness on the space is based on the fact that gas prices are better heading into this year's reserve-reporting cycle than they were last year, and this will be the second straight year that oil prices have been stronger.

Overall, on the reserve side, I expect companies to be able to book more barrels in their undeveloped as well as proved developed reserve profiles. That should drive value, even though short-term margins might be a little bit more pressured on the gas names.

TER: What oil price is that forward curve modeling for 2011?

AC: For 2011, the curve is effectively a little over $90/barrel for oil and about $4.50/MMBTU for gas. On the sell side, and (according to investors I have spoken to) on the buy side, there's a lot more negative bias on gas in the short term, somewhere closer to $4/MMBTU. As we roll through the year, it is entirely possible that gas may not hold at the $4.50 level but given the forward curve, companies continue to hedge at that level. That's giving me a little bit of comfort. Additionally, winter weather and the unfolding situation in Egypt are adding near-term support to commodity prices.

TER: China is making some significant attempts to put the brakes on its overheated economy. Are you concerned that these moves will impact the oil price?

AC: Certainly, oil is a commodity as well as an inflation hedge for people looking at the space. We have high oil inventories, and we have high gas storage inventories. Should global macroeconomic expansion slow or come under pressure that would certainly have at least a short-term impact on commodity prices, especially oil.

However, when I look at the cash margins for the oil companies that I cover, many of them have margins of $35–$40 per barrel. Even if commodity prices were to pull back on the oil side, say to $60, the margins would still be better than what many of the gas companies are seeing now, even with gas at the $4.50 level. I am not worried about oil in the short term, unless we get a pullback significantly below $60.

TER: Your two top picks on the oil side for 2011 are Whiting Petroleum (NYSE:WLL), with a Buy rating and a price target of $142, and GeoResources Inc. (NASDAQ:GEOI), which also has a Buy rating and a price target of $30. Could you tell us about those two names?

AC: When I rank my companies, I'm looking at the cash margins, the EBITDA (earnings before interest, taxes, depreciation and amortization) margins and debt-adjusted production growth to get a sense of things. Effectively, do these companies have the balance sheets and the margins to justify drilling for more than the current year?

The main reason why Whiting and Geo are my favorite picks is that the Bakken oil shale is white-hot in terms of sex appeal and intensity because of the quality of the wells being drilled there. Companies with exposure to that play have really outperformed recently. Secondly, the oil shale business model is relatively new. I think you can make the argument that the Bakken has some of the flavor that the Barnett Shale had a couple of years ago. While investors are starting to look for new oil shales like the Niobrara, Utica, Eagle Ford or Tuscaloosa Marine, we don't know if all of those will be as prospective for oil as is the Bakken. It's far easier to step out on the Bakken and develop more acreage than it is to find a whole new play. Recent M&A in the Niobrara has signaled that play may be ready for "prime-time" too.

Whiting and Geo also have strong cash margins, very low debt, low proved undeveloped (PUD) reserves in their reserve make-up and good acreage positions. Whiting has over 900,000 gross acres and about 580,000 net acres, of which 470,000 are undeveloped. That puts the company in a top-five Bakken acreage position. Geo has 46,000 acres; and given its small-cap size, is also relatively well positioned.

On a comparison basis, Geo trades at about 70% of the multiple of an Oasis Petroleum Inc. (NYSE:OAS) or a Brigham Exploration Co. (NASDAQ:BEXP) and yet, six months ago, Geo and Oasis were about the same size in terms of production. As investors look for the next set of names with the capital and the management wherewithal to develop and accelerate activity in the play, Whiting and Geo are two names that can benefit by putting more capital to work there.

TER: At least on the gas side, the long-term production rates in these hydraulic fracturing plays don't match the early production rates. In fact, the depletion rates tend to go up quite dramatically as production continues. Are you worried about that?

AC: I think it's a good data point to consider. Initial technological improvements always have their fits and starts. What ultimately gives me comfort with names like Whiting and Geo is that as the play matures, the key is who has the ability to generate the economies of scale to grind down their costs across their acreage positions. As we get well data from the entire play and as more wells are drilled, I would expect players like Whiting and Geo, which have those good cost margins, to be better insulated should the price environment deteriorate.

In addition, they have big enough acreage positions that as they start locking up drilling rigs to develop their core positions, they have the size and scale to command the best rates from the service companies. GEOI is partnered with Slawson (a private E&P company in the Bakken) one which has earned high marks from industry for its operational acumen in the play as well.

TER: Tell us more about those margins.

Source: Brian Sylvester of The Energy Report 02/01/2011
February 3rd, 2011

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1) Brian Sylvester of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: Energy XXI and Transatlantic.
3) Andrew Coleman: View Andrew Coleman's disclosure.

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