Here’s what I know about the sector so far:
- The independent oil & gas sector as a whole has a poor track record of profitability.
- Reserve estimation is an educated guess. Small changes in assumptions can have a massive effect on the economics of a reservoir.
- One common pattern in the oil & gas sector is for a company to overstate its reserves and to continually raise capital. See #1.
- PUD (proven undeveloped) reserves are especially prone to abuse (overstatement of reserves).
- Most of the value creation in the industry comes from exploration. Exploration is the most open-ended and uncertain aspect of E&P (exploration and production).
- Technology is another area of value creation.
- Historically, debt has often been dangerous to the companies which use it.
- Opportunities are the greatest when overly leveraged companies are forced to sell.
ATPG / ATP Oil & Gas
This is a stock that I profitably shorted in the past. (I covered the short quite early as I did not feel comfortable paying 40-90%+ interest for the borrow.) It has been written up multiple times on VIC as a long. To me, it was an obvious short due to:
- Negative cash flow from operations. It makes sense to short companies that are losing a lot of money.
- Overly promotional management team that has repeatedly broken its promises in the past.
- High short interest. The worst companies tend to have extreme short interest.
- Insider selling. (Though this is not always a great indicator of over/undervaluation.)
- High levels of debt accelerates the decline in the stock. (However, debt always cuts in both directions.)
- Constant equity raises.
- It was obvious to me that the company was getting desperate. It was selling royalty interests to its suppliers who normally expect to get paid in cash.
To me, ATPG exemplifies the ugliest aspects of the independent E&P industry. Many E&P stocks are investment traps.
Hedging (it usually does not matter)
Generally speaking, most forms of hedging trade one set of risks for a different set of risks. Hedging can get rid of some price risk. However, hedging generally introduces other risks depending on the contract:
- Counterparty risk.
- Risk of a margin call if shorting futures.
- Hurricane risk. If you hedge offshore production, a hurricane can cause all offshore producers to stop production. The production halt can cause prices to skyrocket due to the reduced supply. An offshore producer that sold natural gas futures would suddenly be in big trouble as it would have to deliver very expensive gas that it does not have.
- Basis risk. Oil and gas are local commodities with different prices at different locations.
- There are some other risks.
Hedging generally does not reduce risk significantly. Many E&P companies will incur debt and use hedging strategies to reduce risk from fluctuations in commodity prices. Historically, these strategies have failed many times.
Buying options is a reasonable hedging strategy as it has few risks. When volatility is cheap, buying options is a very reasonable hedging strategy.
Really understanding these stocks
I do not really understand E&P stocks. I think that if I read engineering textbooks on reserve estimation I would realize that it is very difficult to value oil & gas assets and that publicly-traded companies rarely give out enough information for investors to do so. When oil & gas assets are sold, a company will typically open up a data room for buyers to do due diligence. I do not believe that retail and institutional investors are doing the same level of due diligence as private buyers.
Contango Oil & Gas (MCF)
Contango has excellent presentations on the oil & gas industry.
The ones at the bottom of this page are the most useful.
EDIT (8/8/2015): As new management took down the presentations, I put them up here: Ken Peak MCF presentations (36MB Zip file on Dropbox)
I believe that Contango will create a lot of shareholder return in the long run. Now is probably a great investment environment for Contango as low natural gas prices are forcing many companies into financial difficulty and forced selling.
*Disclosure: Long MCF.