Here is a Bit of Help Finding Undervalued Energy Stocks

Generally, small-cap independent oil producers trade at significant discounts to the value of their assets or reserves. That's because many investors do not wish to take the risk of investing in what could be called a speculative, small-cap oil play.

Because of this, however, many small oil exploration and production, or E&P, companies can be lucrative investments over the long term as they develop.

But where to look?
When trying to identify potential E&P plays, I like to use two main valuation methods. First, the enterprise value to reserves figure, or EV/reserves, which gives an indication of what value the market is placing on each barrel of the company's reserves. Generally, this figure can be compared to the rest of the industry or the company's close peers to get an indication of whether or not the company is undervalued.

Second, I like to use the PV-10 ratio. This figure helps us understand how much the company's oil reserves will be worth over the life of the project, minus 10% as a discount rate to account for items such as inflation and taxation. PV-10 attempts to show us the future value of all of the reserves held by the company, net of extraction expenses.

So, let's take a look at some seemingly undervalued oil minnows and try to establish their worth.

North America
I have come to the conclusion within a previous article that domestic E&P companies now look relatively overvalued in comparison to their international peers, as the domestic oil boom has sent valuations skyrocketing. However, Resolute Energy seems to have bucked the trend.

As of December 2012, Resolute's reserves totaled 78.8 million barrels of oil equivalent. Using the present value method, the company's engineers estimate that the pre-tax value of these reserves was $1,127 million at year-end 2012. After tax, the company estimates these reserves are worth $872 million.

Whatever the case, the value of Resolute's reserves is more than the company's current market capitalization, which currently stands at $686 million.

If we divide Resolute's enterprise value of $1.4 billion by its reserve figure, we get an EV/reserve figure of $17.30. In comparison, U.S. oil market leaders, EOG Resources and Pioneer Natural, are trading at an EV/Reserve figure of $30 and $196 respectively; so using these methods we can see how undervalued Resolute actually is.

The Middle East
TransGlobe Energy  is another small fish that appears cheap on the face of it. However, the majority of the company's operations are in Egypt, which is a highly unstable region at present. That said, Egypt's instability started back during 2011 and as of yet, TransGlobe's operations have not been affected.

Still, it seems as if TransGlobe is trading at a significant discount to the value of its reserves. This leads me to believe that this discount could mitigate some of the risks that investors would be taking on due to TransGlobe's geographical location.

Indeed, at the end of fiscal 2012, TransGlobe had 28 billion barrels of oil reserves, after the deduction of royalty interests to other parties. The company's engineers reckon that these reserves have a PV-10 value of $860 million, 34% more than the company's current market capitalization of $640 million.

However, if we compute the EV/Reserves figure, we see that TransGlobe is trading at a value of $23 per barrel of reserves, which is slightly more expensive than the figure we got for Resolute but still less than the figures for EOG and Pioneer.

Having said all of that, TransGlobe is sitting on a net cash position, so the company does look financially stable from that point of view and extra financial stability does deserve a premium.

Warped by one-off gains
Unfortunately, although some oil and gas minnows are undervalued based on the value of their reserves, others do look expensive. Contango Oil & Gas  currently has a market capitalization of $736 million, but its pre-tax net present value of reserves, discounted at 10%, is approximately $550 million. What's more, the company currently looks expensive on other metrics.

Specifically, Contango recorded a one-off profit from its investment in a peer during the third quarter, which boosted earnings by $15.6 million. However, excluding this one-off gain, the company's net income only amounted to $4.1 million, or approximately $0.27 per share. This means that over the past four quarters, Contango earned $1.44 per share, implying that the company is currently trading at a trailing earnings multiple of 33.

It's up to you whether or not you feel that Contango is expensive on this multiple, but personally I would rather invest my cash in one of the cheaper companies above.

Foolish summary
All in all, small-cap oil companies can be risky and highly speculative. However, if you know where to look and do your research, you can minimize the risk. Both TransGlobe and Resolute are trading at a value that is below the estimated value of their reserves, which makes both companies look undervalued with potential for capital gains as the companies monetize their assets. This low valuation also opens up the possibility of takeovers as oil majors buy up smaller peers in an attempt to drive production higher.

EOG is just one of 3 stocks we highlight that's booming in the U.S.
Record oil and natural gas production is revolutionizing the United States' energy position. Unfortunately, identifying the winners can be difficult. Thankfully, the Motley Fool is offering a free, comprehensive look at three energy companies set to soar during this transformation in the energy industry. We invite you to read our special free report, "3 Stocks for the American Energy Bonanza." Don't miss out on this timely opportunity; click here to access your report -- it's absolutely free. 

The article Here is a Bit of Help Finding Undervalued Energy Stocks originally appeared on

Fool contributor Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.

Copyright © 1995 - 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

Read Full Story