3 tips for buying a winning oil and gas company

Energy producers could be set for a strong year in 2014 if oil prices continue to rise on a strengthening U.S. economy. For investors wanting a piece of the action the S&P/ASX 200 Index (Index: ^AXJO) (ASX: XJO) has a number of strong potential candidates. To help sort the wheat from the chaff, here are three tips for identifying a winner.

1. Know how much energy they have

It’s important to understand how much oil or gas a prospective company has so it can 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 ‘proven’ reserves, which stand at least a 90% chance of being recovered. 2P is the sum of proven 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 back in August Santos (ASX: STO) had an EV/2P ratio of around 10.7, whereas Beach Energy (ASX: BPT) has a ratio of around 16, suggesting an investor could by Santos’s reserves for less than Beach Energy.

2. Acreage isn’t everything

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. Capital structure is 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 to customers. Debt can wipe out a company with no existing oil/gas production to sell, but on the flip side relying on shareholder equity may mean continued capital raisings and requiring you to stump up cash. An ideal structure is a self-funding one, where the company establishes early well production that then funds future growth. This is the model being adopted by Senex Energy (ASX: SXY) as it takes on an aggressive 30-well drilling program in the Cooper Basin.

Foolish takeaway

Understanding how much energy a company has, working out its capital structure and avoiding the acreage marketing trap are three key steps to picking a winning oil and gas company. As the U.S. economy improves in 2014, this could help send your portfolio soaring higher.

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Motley Fool contributor Regan Pearson owns shares in Senex Energy.

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