Raymond James & Associates: E&P stocks could offer potential returns of 25-40%

Exploration and production companies' stock could yield potential returns of 25-40% during the next 12 months because investors are beginning to recognize the sustainability of higher, long-term natural gas prices.

May 27, 2003

3 min read

By OGJ editors
HOUSTON, May 27 -- Exploration and production companies' stock could yield potential returns of 25-40% during the next 12 months because investors are beginning to recognize the sustainability of higher, long-term natural gas prices.

The St. Petersburg, Fla.-based Raymond James & Associates Inc. (RJA) issued a research note Tuesday saying E&P stocks surged 4% last week on the S&P 500 Index.

The S&P 500 E&P Index has climbed 9.2% year to date but has "tremendously lagged" the escalation in natural gas prices, up 33.2% year to date on the New York Mercantile Exchange 12-month natural gas futures strip.

RJA analyst Wayne Andrews offered three strategies to help investors identify E&P stocks having high return potential:
--target the companies that have the strongest production growth per debt-adjusted share.
--invest in companies having the most leverage to robust North American natural gas prices.
--buy stocks trading at discounted valuations relative to their growth, risk, and return.

Production growth/debt-adjusted share
Andrews sees relative stock price outperformance by companies in RJA's coverage universe that have the highest compound annual growth rate in debt-adjusted production per share.

"In 2002, companies that generated positive production growth per debt-adjusted share saw their share prices increase an average of 29% more than the S&P 1500 E&P Index. It is also important to point out that companies with negative production growth per debt-adjusted share saw their share prices decrease an average of 2.2% vs. the index," he said.

RJA evaluated future production growth per debt-adjusted share as an indicator of future stock outperformance by using RJA's production, cash flow, and capital requirement estimates. Andrews used estimates covering 2002-04 for companies in RJA's coverage universe.

"Most companies under coverage are expected to grow production on an absolute basis (despite flat to down industry expectations)," and debt-adjusted growth typically is higher than the absolute growth, he said.

In the current $6/Mcf gas price environment, E&P companies are generating more cash than they can reinvest efficently in the industry, resulting in significant free cash flow during the next 2 years, Andrews said.

"Companies may choose to reduce debt or increase spending for further production growth. Either scenario bodes well for our debt-adjusted growth calculation. In this group of 25 companies, the median expected annualized production growth per debt-adjusted share is an outstanding 17.5% vs. the average absolute growth of 11.5%/year," he noted.

Price leverage and stock valuations
RJA also included each company's reserve life index to provide a guide to the timing of its ultimate production.

"While the level of hedging varies, and many companies will have exposure to volatile basis differentials, the companies with 60%-plus gas reserves should benefit from strong natural gas prices over the next few years," Andrews said.

As a group, E&P stocks should be trading for $1.50-1.75/Mcfe of proved reserves and in the mid-to-lower end of the historical forward earnings before interest, taxes, depreciation, and amortization (EBITDA) multiple range of 4.5-6.5. Currently, large-capitalization stocks are trading well below the low end of historic trading ranges at $1.30/Mcfe and four times 2004 EBITDA, Andrews said.