How to Invest in Oil & Gas Stocks—Part II


What are the questions that educated investors ask in oil and gas?

What are the questions that educated investors ask in oil and gas?

Last month I gave investors 10 questions they should be asking management teams, or searching for on the company website, in a recent article. They were basic questions, and you can read them here. After those first 10 are answered, you know how much production a company has, how fast they're growing, how much cash or debt they have, etc.

But if you're still not sure if you want to invest in the company after all that, or just want to know more. . .what are the right questions to ask? What pitfalls or opportunities might an investor uncover?
  1. Decline rates are something management teams don't really hide, but don't really talk about either. Every well has declining production until it's uneconomic. The new shale gas plays often have 85% decline in production in the first year. Tight oil plays (Bakken, Lower Shaunavon, etc.) have 75% initial decline rates. Decline rates are increasing over time now as the industry drills deeper and tighter plays. Ask management what the initial decline rate is, both company wide, and specifically on their main, big play that they believe will be the growth engine of the company. Then ask what the decline rate flattens out to—it's usually 20%–30%.

    Why is this important? Because many investors, when forecasting growth, use the only public numbers given for a well—the ones in the press release. Most companies have a production decline graph in their PowerPoint, but few actually say what the production levels in the wells in the area flatten out at (and many research reports from analysts don't either—don't let The Machine fool you).

  2. If the company is operating in a foreign country, what kind of political connections do they have—who from that country is in management or on the board of directors?

  3. What is the break even cost, companywide, and in their main play, in terms of price per barrel? Management should be able to tell you a very good ballpark number.

  4. How much does it cost them to bring up a barrel of producing oil? Costs can range from $8,000 per flowing barrel to over $30,000. Obviously, the lower the better, as this will be more profitable. Then you compare it to what companies are being bought out for. If a company can produce a barrel of oil for $10,000, and the stocks are being bought or merged at valuations of $70,000 per barrel, that's a very accretive oil or gas play! Again, management should be able to answer that question on the phone.

  5. What is the recycle ratio, both overall corporately and specifically on their main play that will be the growth engine for the company. The recycle ratio is a key measure of profitability for an energy company. It's a fairly simple calculation, and many companies put it in their quarterly and a few even put it in their PowerPoint. Management will know this number off the top of their head like they know their wife's name, so don't be afraid to ask.

    The recycle ratio is the profit per barrel (called the "netback") divided over the cost of finding that barrel–"F&D"—Finding and Development Costs. Both the netback and the F&D costs are in all the quarterlies—usually broken out in simple charts and language in the notes. The higher the recycle ratio the better. Anything over 3 is great, 2 is really good and under 2 can still be OK if it's a big field and lots of wells can be drilled. Different companies report differently so not all recycle ratios are equal, but it will give you a general idea.

    The higher the recycle ratio, the higher the valuation should be.

  6. How much of their own infrastructure do they own? And are they the operator of their plays? Infrastructure includes things like local or regional pipelines, storage facilities, processing facilities. If they don't own them, they have to pay charges to use them, and are subject to somebody else's maintenance and upkeep. And the market often pays a lot less for a non-operating interest in a play, as the operator gets to call the shots most of the time.

  7. Ask management what kind of discount or premium they get for their production, from quoted prices like WTI crude or Brent Crude—and why that is. For example, heavy oil gets a discount—up to 50%—from the WTI price or Brent crude price that is always quoted in the media. Maybe their oil or gas has a high sulphur content (which would also give them a tougher time with environmental permits). A company may say they are producing 10,000 bopd, but if their price is much lower than world price, their future cash flow could be much lower than you think.

  8. How much stock does management own, which people on management are the largest shareholders in the group and how much hard cash—not stock options—does management have in the company.

  9. If the company is operating in a foreign country, what kind of political connections do they have—who from that country is in management or on the board of directors?

  10. And lastly, ask open ended questions, like—what else is there about your company that you want to tell me? Where do you want to improve the most over the next 2–3 quarters?
The list of questions goes on and on. I suggest that investors should remember that the answers to these questions are already priced into the stock; it's highly unlikely you will find any bargains on the stock market from these questions. But the answers will give you a better understanding of how stocks are valued and why, and give you more confidence in acting on your own intuition about a stock.

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Keith Schaefer, Editor and Publisher of Oil & Gas Investments Bulletin, writes on oil and natural gas markets - and stocks - in a simple, easy to read manner. He uses research reports and trade magazines, interviews industry experts and executives to identify trends in the oil and gas industry - and writes about them in a public blog. He then finds investments that make money based on that information. Company information is shared only with Oil & Gas Investments subscribers in the Bulletin - they see what he's buying, when he buys it, and why.

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