bottom of the barrel: is it time to go bargain hunting in the oil patch?

[note: this post originally appeared on my Yahoo! Finance contributor page.]

Last week, I spent three days in New York City at the annual IPAA (Independent Petroleum Association of America) Conference. Like most people, I’ve been leery of energy stocks in recent months. But I left the conference with a different mentality.

As unlikely as it seems, it might be time to go bargain hunting in the oil patch.

Don’t get me wrong. The energy sector is a long way from a sustained recovery, so investing in smaller, independent oil and oil-related companies is still a very dicey proposition. But if you pick your spots wisely, you can find some winners at prices we may never see again.

The first thing to do is figure out who not to buy. Oil services stocks have been pummeled. Many are down over 60 percent in the last 12 months. At first blush, some might seem oversold. But new drilling activity has been cut in half (the latest Hughes rig count has dropped to almost 700 versus more than 1500 last year) and company reps at the conference conceded that the prices services firms can charge are down up to 35 percent along with it. A third less revenue for half as much business isn’t exactly the recipe for a strong rebound. Buyer beware.

The exploration and production space is far more promising. Once a well is successfully drilled and is producing hydrocarbons, the incremental cost to produce each barrel is relatively small. Better still, many of these companies have hedged their production for most of 2015 and some of 2016 at higher prices than today’s mid-$50 levels. Moreover, on a macro level, I am not nearly as bearish on oil prices as most people these days.

Finding oil is expensive, and unless Saudi Arabia opens the spigots and swamps the markets, I believe prices will inch higher as worldwide economic growth spurs increased consumption. All told, the world consumes about 92 million barrels of oil a day. Three nations– Russia, Saudi Arabia, and the good old U.S. of A.–produce about 10 million of those daily barrels each. All of them have the capacity to produce more, but little incentive to do so until prices get a whole lot higher. As existing wells go dry over the next few years, worldwide supplies will tighten–and wells in shale formations, which made up the bulk of the recent energy boom in America, deplete faster than traditional wells, so that supply contraction should accelerate.

Add it all up and E&P is definitely worth a look, with one crucial caveat: debt. Too many energy companies have leveraged balance sheets, as the industry has a bad habit of borrowing lots of money and plowing that cash into exploration during boom times. I don’t know the exact numbers offhand, but I would bet over 80 percent of all US exploration firms spent more on capital expenditures than their operating cash flows in recent years. That means a lot of them are seriously underwater now. Again, buyer beware. With that said, some names stand out as possible buys. Vaalco (EGY), Pioneer Natural Resources (PXD), Northern Oil and Gas (NOG), and Cimarex (XEC) have all come through the bust with relatively healthy balance sheets and yet their stocks are all closer to 52-week lows than 52-week highs.

Finally, stock pickers like me aren’t the only ones scouring the bottom of the oil sector for discounts. With market caps lower than they’ve been in years, I expect acquisitions to pick up steam as larger energy players look to snap up their smaller competitors. They’ll be looking for cheap, profitable businesses with low debt loads, too–and they should be willing to pay a nice premium to acquire them.


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