Bottom of the Barrel: Exploring Energy Partners - TheStreet

As North American natural gas production slides 3% to 5% per year, investors should take note of companies that buck the trend by actually increasing production.

That's primarily why

Energy Partners

(EPL)

deserves your attention if you're seeking exposure to the exploration-and-production group. I

first profiled this stock in Bottom of the Barrel last December, when it was trading at about $9, and I also mentioned this small-cap on "Kudlow & Cramer" earlier this week. It was lately trading at $11.57.

Winning Characteristics

I look for three hallmarks in an E&P company:

  • A focus on one regional play in exploration. That allows a company to become an "expert" in the area and understand the best technologies to exploit hydrocarbons from the ground in the region.
  • Solid prospects. These provide the opportunity to replace depletion and grow production consistently.
  • Strong leadership. A company needs a good management team as well as a technical team that has proved itself through drilling success.

These three qualities position Energy Partners to post solid production growth in the coming year.

Still on the Shelf

Energy Partners is a pure play on the Gulf of Mexico shelf, typically operating in shallow water just miles offshore. The company has done well there, growing reserves from an equivalent of just 5 million barrels of oil (mmBoe) in 1998 to more than 47 million at the end of 2002. Its reserves are split nearly evenly between oil and natural gas.

More important, the company has replaced more than 118% of its reserves over the past three years through drilling, a record that would make any E&P company proud. If you include acquisitions, that number jumps to 360%.

Production also continues to increase, from just 750 Boe per day to an estimated 21,000 Boe/d by year-end, and that growth is likely to continue. Energy Partners' drilling program will be especially active in the fourth quarter, and with a skilled drilling team and a little luck, the results could spark the stock. For example, in the Gulf of Mexico region known as South Timbalier 26, the company's Mossy Creek well is just about complete and could provide good news for investors in the next several days. While the pre-drill estimates were around 1 million barrels of oil, the project may prove to be larger.

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Wells that are drilling in other locations, such as South Marsh Island 109, High Island 55 and Mesa Verde East, could all add meaningfully to reserves by year-end and to production as early as next year. In fact, even without any of the fourth-quarter finds, Energy Partners seems likely to increase production by 5% to 10% next year. If so, the contrast to the overall industry should also spur investors' interest.

An Acquisitive Tone

Although the company is still growing through drilling, it also has a penchant for acquisitions. It has been very successful in acquiring properties that provide new exploration and exploitation opportunities. Its smartest acquisition to date was the merger with Hall Houston, a private E&P company. Energy Partners not only received a portfolio of properties with significant production potential but also got a boost to its management stable with Gary Hall, who is now vice chairman.

Today the company is sitting on a bucket of cash and has promised an acquisition that would boost the returns on that currency. Some may criticize its deliberate pace in announcing a deal, but shareholders should consider that a positive, because it suggests that the company isn't willing to overpay for just any group of Gulf of Mexico properties.

Many point to the possibility of Energy Partners bidding on shelf properties for sale by

ChevronTexaco

(CVX) - Get Report

, but I doubt that will happen. Instead, I'd watch for Energy Partners to acquire a group of assets not commonly known to be for sale. The company may even offer to purchase a smaller, capital-challenged player.

Energy Partners' balance sheet continues to improve, and cash flow -- estimated to be about $140 million this year -- will more than cover the capital budget of $110 million, leaving additional free cash flow to add to its drilling and acquisition arsenal. I'd expect Energy Partners to spend about $110 million next year on exploration and development as well.

Overhang

Although the story seems compelling on the basis of potential growth, some people remain skeptical. Certainly, there's risk in the drilling program, but to date, Energy Partners has done a terrific job of identifying solid prospects and limiting drilling risks. The company has noted that it attempts to keep its potential "dry hole" costs to about $3 million per well.

In addition, one of the larger concerns has been the overhang of stock held by an opportunity investor, Evercore Capital Partners. Earlier this week, Evercore filed to sell its remaining 4.5 million shares of Energy Partners, likely in the coming weeks. That sale will probably pressure the stock as it is executed, but it will result in eliminating the overhang from the Evercore block as well as additional liquidity. That said, the stock's probable weakness could offer an opportunity for patient investors. The Evercore sale likely won't begin until after Energy Partners reports earnings in the first week of November.

There's also risk from commodity prices. If oil and gas prices decline precipitously, then all E&P companies, including Energy Partners, could suffer. Exploration-heavy companies such as Energy Partners carry more risk.

However, if you think natural gas prices will remain in the mid-$4 range, little besides ordinary exploration risk stands in the way of Energy Partners' 2004 growth prospects. If the company's track record is any indication of future success, small-cap investors could benefit from Energy Partners' exploration profile.

Christopher S. Edmonds is vice president and director of research at Pritchard Capital Partners, a New Orleans energy investment firm. He is based in Atlanta. At time of publication, neither Edmonds nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to

Chris Edmonds.