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Oil Industry Winners And Losers

Posted: Aug 08, 2007 10:16 AM by Dean Lundell

Tickers in this Article: PXP, PPP, XEC, COG

There's no denying it; oil and gas exploration is a risky business. Some companies succeed, a few break even and many fail completely. In this article, I will explore three production companies - all of basically the same size, and in about the same location - that have three very different results for shareholders. (For a crude refresher course, read our Oil And Gas Industry Primer.)

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Location, Location, Location!
The "oil" in Cabot Oil & Gas (NYSE:COG) is actually a bit of a misnomer. The company has 90% of its production and 95% of its proven reserves in natural gas. Investors will find this company is as much an asset play as it is an investment in exploration and production.

The company has vast undeveloped acreage, all in the United States, so there is likely no need for costly test exploration drilling, nor is there any foreign government interference. Cabot is so talented with the drill bit that it has replaced 252% of its reserves in 2005 and another 273% in 2006, all within the United States.

Cabot's risk tends to be systemic in the form of a prolonged bear market in natural gas. Although COG does not have the resources of the giant oil and gas concerns, it has responded by securing long-term drilling rig contracts.

Cabot's success has not gone unnoticed by the market - not in terms of its 10.2-times P/E ratio, but more in terms of its market capitalization to revenue ratio of 4.4. That rather lofty number is verified by COG's growth in earnings per share of 117% year-over-year and almost 124% average over the last three years. (To learn more, see our Ratio Analysis Tutorial.)

The company manages a net margin of 43% from a gross margin of 78% and has a return on equity of 30.5%.

Dry Hole Driller
The Cimarex Energy Company (NYSE:XEC) is a bit different from other exploration and production companies. It focuses on returns on invested capital instead of finding additional reserves.

The good news about XEC is that all of its properties are in the Unites States, the bad news is the company tends to drill dry holes. While the firm is attracted to projects with economics that sound good, the reality is the company ends up holding the bag on nothing but dry earth. Furthermore, the company's production fell from 106 million cubic feet per day in the first quarter of '06 to 69 million cubic feet per day during Q4.

Management said the company is determined to produce returns on invested capital in excess of shareholder capital. Cimarex devotes roughly two-thirds of its financial resources to low- and moderate-risk programs and about one-third to riskier but higher-return programs.

Cimarex Energy's conservative posture has produced equally conservative (less impressive) results. Its market capitalization of just over $3 billion is 2.45-times the size of the firm's $1.24 billion in sales. Although its net margin of 23.4 % comes from a gross margin of 72.4%, the company's growth in earnings per share (EPS) has averaged 28.3% for the past three years and -16.1% for the prior year. This has resulted in a return on equity of 9.6%.

Bailing Out
Pogo Producing Company (NYSE:PPP) has perhaps finally seen the writing on the wall - it has been bailed out and accepted a bid from Plains Exploration & Production Company (NYSE:PXP) that is worth about $3.6 billion. Should stockholders approve, the deal will close in late 2007. PXP is offering roughly $60 per share; the stock is currently trading at $51 and change.

A 20% discount with less than six months to go no doubt has risk arbitrageurs excited, but one has to wonder what the market is telling us.

The numbers confirm all we need to know. Pogo Producing thought it better to bail than to keep fighting. Although the firm had an EPS growth rate of over 61% last year, that growth rate has only averaged 18.6% over the past three years.

The company's -2.9% net margin resulted in a -1.8% return on equity. Perhaps management felt that it had no choice but to seek the best way out for shareholders.

Some Things Never Change
Each of these three firms are roughly the same size and operate in approximately the same areas but look at the differences. In this business, its about proven reserves and return on equity. What about their stock price performance? Over the last three years Pogo Producing has appreciated about 22%, as has Cimarex Energy. Cabot Oil & Gas peaked out about 60% and has since traded off to 22% over the last three years.

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By Dean Lundell

Dean Lundell is a former vice president at Merrill Lynch Capital Markets, a principal of a regional investment bank, an independent futures trader and licensed commodity trading advisor. He has written for McGraw-Hill, the Chicago Mercantile Exchange and several financial magazines. Prior to his career on Wall Street, he served with the 82nd Airborne Division in Vietnam.

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