After a horrific few months driven by the demise of oil prices, there are some potential bargains for contrarian investors willing to take a chance on the long-term prospect of rising energy prices.
Shares in Beach Energy Ltd (ASX: BPT) are now down 36%, while Santos Ltd (ASX: STO) is down 47% in 2014. However not all energy companies are created equal, so here are three tips to help you identify a winner:
1. Know how much energy they have
Knowing how much oil or gas a prospective company has allows it to be compared to others of the same calibre. 'Reserves' represent the amount of commercially recoverable oil and gas a company has, which is broken down into three grades:
- 1P (proved reserves)
- 2P (Proved + probable reserves)
- 3P (Proved + probable + possible reserves)
1P is the most accurate forecast of reserves, which have a 90% chance of being recovered. 2P is the sum of proven 1P reserves, plus less certain 'probable' reserves, which combined have a minimum 50% chance of being recovered, while 3P is the sum of proven, probable and 'possible'.
According to the American Society of Petroleum Engineers (SPE), the best estimate of energy recovery from a project is generally considered to be the 2P figure. This is also the figure to use when comparing companies, for example using the EV/2P (enterprise value (EV) divided 2P reserves) ratio, which identifies companies that are cheap relative to their 2P reserves.
For example Santos (ASX: STO) has an EV/2P ratio of around 9.9 (based on 2013 year-end 2P reserves), whereas Beach Energy Ltd (ASX: BPT) has a ratio of around 10, suggesting an investor could buy Santos's reserves for marginally less than Beach Energy.
2. Acreage isn't everything
Don't believe the hype. Many energy companies boast about holding extensive acreage in a particular area. While this can be a valuable asset if it holds ample recoverable oil and gas, it is of little use if the company does not have the expertise, or funds, to explore and develop any opportunities.
3. Low debt and low costs are essential
It may be boring, but it is essential to understand how the company plans to fund its projects to get the oil and gas out of the ground and on to customers. Debt can quickly wipe out a company with high development or operating costs, while on the flip side relying on shareholder equity may mean continued capital raisings and requiring you to stump up cash.
An ideal capital structure is a self-funding one, where a company establishes early production that then funds future growth. This is the model being adopted by Senex Energy Ltd (ASX: SXY) as it takes on its aggressive growth drive.
Understanding how much energy a company has, avoiding the acreage marketing trap and mapping out the capital structure are three key steps to picking a winning oil and gas company. If the prospects for oil improve in 2015, this could help send your portfolio soaring higher.
