Are These Oil Companies Growing Too Aggressively?

Capital spending across the oil and gas industry varies tremendously depending on how aggressively a company is targeting production growth. Exploration companies can easily outspend cash flow to grow production which requires them to consistently access the capital markets to bridge the gap. The need to spend aggressively isn't surprising when you consider the vast sums of capital required to develop shale plays. As you can see on the chart below, onshore oil and gas companies will need to spend an average of $70 billion per year for the next 30 years just on the top nine plays.

Source: Vanguard Natural Resources Investor Presentation (link opens a PDF)

This has resources E&P companies like SandRidgeEnergy and Oasis Petroleum spending aggressively to grow production in emerging resource plays like the Mississippi Lime and Bakken Shale. Both companies outspent cash flow as measured by adjusted EBITDA on capital projects by nearly two times last year. That's actually fairly in line with a lot of the industry's junior oil and gas resources players, as you can see on the following slide:

Source: Vanguard Natural Resources Investor Presentation

For SandRidge, its robust capital spending has yielded a 105% year-over-year increase in its Mississippian Lime production. Meanwhile, Oasis' production has grown 71% year over year while its reserves in the Williston Basin have enjoyed a compound annual growth rate of 121% since 2009. While that production growth is great, its caused both companies to look externally for funding.

This has been more evident at SandRidge which has raised capital by every means necessary including selling assets and tapping the debt markets. Most recently, the company has used asset sales to improve its credit metrics; however, the company has come to the point where its hitting against the edge of its capacity to spend on growth. That's caused the company to cut $700 million from this year's capital budget. Despite that, SandRidge still expects to organically grow its production by 13% this year with its Mississippian production jumping 60%.

Resource players like SandRidge and Oasis aren't the only energy companies aggressively spending to grow. E&P MLP's like BreitBurn Energy Partners and LINN Energy are also getting into the capital spending act. As you could see in the earlier chart, LINN spends the greatest portion of its cash flow to grow its production. Not only that but LINN is in the process of closing its deal for Berry Petroleum which is a resource player that has been spending heavily to grow production. One of the reasons LINN, as well as BreitBurn, has been investing heavily is to grow oil production in order to offset the effect of lower natural gas prices on margins.

It's been interesting to watch the shift in the capital spending plans of E&P MLPs over the past few years as many have turned toward organic growth to compliment acquisitions. LINN for example has grown its overall capital investments from just $142 million in 2009 to $1.062 billion last year. However, as you can see from the chart it has been money well spent as LINN has achieved an organic reserve replacement ratio of 168% over those four years:

Source: LINN Energy Investor Presentation (link opens a PDF)

BreitBurn seems to be following LINN's lead -- last year it boosted its capital spending plan incrementally as it saw additional opportunities within its portfolio. This year the company is adding another $100 million to its capital plans bringing the total up to about $260 million to drill 135 wells and boost its liquids production by 40%. With no shortage of opportunities, these companies are really only limited by capital.

One company to watch here is Vanguard Natural Resources , which has eschewed increased organic production growth spending until now. However, the company is looking into the possibility of following LINN's blueprint and potentially change its game plan. Last year Vanguard was one of the most conservative E&P MLPs as its adjusted EBITDA was 4.6 times its capital spending. It's one company that certainly has the capacity to pursue organic production growth spending if it can change the philosophical mind-set that would be required to switch models.

The key takeaway for investors is to watch capital spending when investing in an oil and gas company. A company can only outspend its cash flow for so long before it bumps up against danger zones. SandRidge is a great example of this as the company has had to shed assets and cut back on its spending in order to pursue a more prudent growth path. LINN Energy is also starting to draw a lot of criticism for this shift in its business model because the company pays out virtually all of its income to investors. That means the company needs to tap the capital markets to fund its growth capital spending, a fairly aggressive approach. As an investor, you really need to drill down deeply into an investment to make sure its business model is one you both understand and can stand behind.

Investors have had trouble standing behind SandRidge; its aggressive approach hasn't always worked. More recently the company has taken a less aggressive approach and it has vastly improved its financial metrics, which is one reason why its future looks optimistic. If you'd like to learn more about the future of this emerging oil and gas junior and are looking to find out more about its strengths and weaknesses, then check out The Motley Fool's premium research report detailing SandRidge's game plan and what to expect from the company going forward. To get started, simply click here now!

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Fool contributor Matt DiLallo owns shares of LINN Energy and SandRidge Energy. Matt DiLallo has the following options: Short Sep 2013 $5 Puts on SandRidge Energy. The Motley Fool recommends BreitBurn Energy Partners L.P. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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