Exploration and production (E&P) equities are down nearly 15% since early December, but if the current seasonal weather reverts to warmer-than-normal conditions in the next three weeks, share prices likely will be slapped down again in mid to late February, which could create "compelling acquisition opportunities," energy analysts said Tuesday.
John Gerdes and Michael Dane of SunTrust Robinson Humphrey/the Gerdes Group wrote in a research note that with the current high service cost levels and with gas prices hovering around $7/Mcf, "U.S. gas drilling activity should decline at least 10% and oilfield service costs should fall 10% over the first half of the year." Instead, they noted that the gas rig count rebounded last week by 33 rigs to 1,444 rigs, well in line with the 1,395-1,450 rigs working since last August.
"Our main concern...is that many E&P companies suggest that their current drilling program makes economic sense in a $7 gas price environment, when in fact they are needlessly spending capital well beyond cash generation," they wrote. Gerdes and Dane suggested that the E&P industry is "almost 30% free cash flow negative" with $7 gas. "The lack of an appropriate E&P industry response to natural gas price weakness may only prolong the current weather-induced down cycle in gas prices."
Gerdes and Dane ran an "acquisition screen" on 62 E&Ps in SunTrust's coverage using three enterprise valuation metrics: 2007 estimates of EBITDA (earnings before interest, taxes, depreciation and amortization), proven reserves and their last 12 months (LTM) of production. They then established a "valuation expensiveness" limit of 4.5 times (4.5x) 2007 estimated EBITDA, $3/Mcfe proven reserves and 10x LTM production. Target prices are based on a return on capital of 11-15% per year, with long-term gas prices at $8.50/Mcf and long-term oil at $65/bbl.
Based on the combined criteria, the analysts said nine E&Ps offered the "most compelling valuations" for possible takeover targets: Apache Corp. (4.3x), Callon Petroleum (3.4x), Forest Oil (3.3x), Noble Energy (4.3x), Plains Exploration (4.3x), Swift Energy (4.3x), Stone Energy (3.8x), Meridian Resources (2.5x) and Cimarex Energy (3.5x).
"The median of our acquisition candidates trade at about a 30% discount to the E&P industry," wrote Gerdes and Dane. The median candidate trades at 3.8x 2007 estimated EBITDA, offers $2.18/Mcfe proven reserves, with 8.8x LTM production. "In contrast, the median E&P company trades at 5.2x '07 estimated EBITDA, $2.99/Mcfe proven reserves and 12.2x LTM production." The criteria found Apache, Plains Exploration and Cimarex offering "the best combination of attractive valuation, lower relative asset intensity and an underutilized capital structure." Forest Oil also "offers a compelling valuation," but its equity is "relatively highly leveraged."
The analysts said their acquisition candidates offered 40% or more upside over last year's actual acquisition targets. The 2006 "precedent E&P acquisitions imply proven reserve purchase multiples over $3/Mcfe and production rate multiples well above 10x," they said. The acquisitions last year "generally have a higher percentage of natural gas and proven undeveloped reserves than our acquisition candidates," but they still offer a "reasonable proxy."
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