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Fuel your portfolio with this potentially undervalued oil and gas player

Beach Energy (ASX: BPT), Australia’s sixth largest oil producer, holds interests in more than 300 exploration and production tenements in Australia, USA, Egypt, Tanzania, Romania and New Zealand, although its main assets are located in the Cooper Basin where it is the largest net oil producer.

The company’s share price has increased 25% over the past six months, helped along by its most recent half yearly result, which seemed to surprise brokers and investors alike. Revenue was up 62% on the prior corresponding period, whilst underlying net profit after tax (excluding mark to market derivative movements, asset sales and tax adjustments) increased by a chest-beating 160% (or 267% on a non-adjusted basis).

The increased revenues also translated through to its operating cash flows, leading to a $57 million increase in Beach’s cash position (currently a sizeable $404 million). The company also has an undrawn $300 million debt facility and a fairly conservative ~6% debt-to-capitalisation ratio, indicating that there is potential for some corporate action. Indeed, other writers here have noted Beach Energy’s increased equity interest in Cooper Energy (ASX: COE), taking its total ownership to 18.4%.

However, Beach has stated that “there is no current intention” to make a takeover bid for Cooper Energy and that the equity position is to assist with joint ventures moving forward, although it will “continue to evaluate opportunities that would add value to shareholders”.

Another positive for the company is its positioning as a gas supplier to the Eastern Australian market which may prove to be a lucrative opportunity especially in light of potentially higher gas prices from anticipated supply shortages. A recent Australian Government Bureau of Resources and Energy Economics Report puts historical Australian East Coast gas prices at $3 to $4 a gigajoule, a far cry from the current levels reportedly being hit, at $6 to $9 a gigajoule.

The looming shortage has been characterised by a number of factors, including the expiry of long term wholesale gas contracts and an increase in demand competition from LNG exports. Although an equilibrium price has not been established, it is seems unlikely that the historically low pricing evident in the East Coast market will prevail. In anticipation of this, a number of parties such as Origin (ASX: ORG), Santos (ASX: STO) and  Chevron (NYSE: CVX) have signed gas supply agreements or are working with Beach to explore and appraise its tenements.

From a pricing perspective, Beach’s price to earnings ratio of just under 9x makes it look (suspiciously) cheap, especially when compared to Woodside Petroleum (ASX: WPL) at 16x and Santos at 26x. As Warren Buffet says, “price is what you pay, value is what you get”. So is this value? In addition to its potential share price growth, Beach’s 4 cents in dividends per share this year equates to a dividend yield of just under 2.5%, roughly the same as Santos but well under Woodside’s 5.64%, although one could argue that any dividend from an oil and gas company is a bonus.

On an enterprise value to proven and probable reserves (EV/2P) ratio, Beach Energy at 20 times is in between Woodside at 23 times and Santos at 13 times. Whilst Santos appears cheap, recent concerns around cost blowouts at its Gladstone LNG operations and reserves quality seem to have negatively affected its share price.

Beach is forecasting a production range of 9.2 to 9.6 million barrels of oil equivalent (mmboe) for the full 2014 financial year, with the 5.0mmboe half year result a good sign that this result is on track. The company’s proven and probable reserves (2P) currently stand at 93mmboe, with contingent (2C) resources at 449mmboe indicating that its production growth profile could have some way to go. In particular, the Bauer oilfield in the Cooper Basin’s Western Flank has shown great potential, with recently drilled Bauer 12 and 13 wells both yielding positive results (adding 2.5mmboe to Beach’s 2P reserves).

In terms of production mix, I like that Beach has a 53/47 split between oil and gas, whilst Santos and Woodside both derive the majority of their production from gas and gas liquids. Beach’s percentage of production from oil has increased from 31% in 2011 to the current 53%, although this may not be sustainable in the long run given its reserves split (24/76 oil/gas at 2P level).

Foolish takeaway

Beach Energy has shot the lights out in the first half of 2014 with both revenues and earnings increasing significantly, and production levels on track to hit a record high of (at least) 9.2mmboe. It has a dominant position in the Cooper Basin and strong partnerships with companies such as Chevron. It also has a strong balance sheet (significant cash and minimal debt) and ready access to capital, in addition to a fully funded capital expenditure program for the 2014-15 financial year, which indicates a certain level of flexibility in terms of “adding value” for shareholders.

Given these positive aspects and what seems to be a reasonable price, one could put forward the notion that this rocket has quite a bit of fuel left in it. Ignition sequence initiated.

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Motley Fool contributor Sid Narsey does not own shares in any of the companies mentioned in this article at this time.

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