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For investors interested in speculation seasoned with a dash of geopolitical gaming, it may be time to step on the gas.

The broad-brush reasons for taking positions in small-cap North American energy exploration companies have been in place for some time, as China has emerged as a voracious consumer of energy, Saudi Arabian turmoil

has intensified, U.S. state governments have demanded wider use of clean-burning fuels by power plants, and environmental laws have tightened supplies.

Early-bird speculators have therefore pushed up prices of some of the best little explorers, such as

Ultra Petroleum



Callon Petroleum

(CPE) - Get Callon Petroleum Company Report

, by as much as 100% over the past 10 months. But most of these stocks have cooled recently, providing a new entry point for a second wave of investors and traders seeking a hedge against overseas uncertainty.

Increasing Value

First, the big picture: Back in the 1940s, natural gas was worth virtually nothing. Drillers burned it off in the process of exploring for petroleum. As new uses were discovered, it became increasingly valuable, rising from $2 per 1,000 cubic feet on average during the 1990s to $10 in 2000. The price collapsed back to $2 in 2001, but it has steadily risen since -- spiking above $10 at the start of last year's war in Iraq before settling back to around $5.25, where it is now.

The price of natural gas always jumps during winter cold snaps, and that accounted for its most recent foray above $5.75, but it's unlikely to collapse below its current trading range again, because there's not enough drilling being done to satisfy demand, because of tough environment laws.

Federal Reserve

Chairman Alan Greenspan told Congress in June 2003 that tight supply threatened the U.S. economy.

All gas drillers are not equal, and it pays to understand the industry's superstructure, risks and leverage points. Just as technology investors are accustomed to learning about the varied makers of semiconductors, disk drives and switches that make components for popular consumer electronics devices and determining which ones offer the most oomph at various points in the economic cycle, energy investors must learn about the complex, high-risk way gas is discovered and distributed.

Lesson No. 1, though, is how truly speculative some of these names are. The companies are usually run by cagey industry veterans -- some with checkered pasts -- who suspect they can use new high-tech 3-D seismic imaging tools to find gas formations in properties abandoned by much larger drillers such as

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At the start of new projects, observers are skeptical that the driller will even find financing to start the project. Then they're skeptical they'll persuade an oil-services company to lease them a drilling rig. Then they're skeptical that drilling will ever actually start. Then they're skeptical that the project will ever be completed. Finally, they wait anxiously to learn whether gas is discovered or not.

So drilling is a crapshoot of probability distributions, and as each critical hurdle is cleared, energy speculators become more interested, adding to their positions and pushing up stock prices. The big moment comes when the company announces whether it has hit pay dirt or come up dry. The final press release announcing the success or failure of a new well is like the one that's published when a biotech company tells the world whether the Food and Drug Administration has approved its cure for cancer. It's all or nothing, hero or goat.

Superior Risk, Superior Reward?

Canadian Superior Energy

( SNG) is typical of this high-risk, high-reward world. The company, which had already owned leases to drill in Trinidad and western Canada, obtained four offshore exploration licenses totaling 933,000 acres in relatively shallow water off Nova Scotia a few years ago. In April 2003, it announced it had teamed with gas pipeline giant

El Paso

( EP) to drill an extremely deep well -- about 18,000 feet -- in a property off Halifax known as Mariner Prospect.

In June, Canadian Superior cleared a big hurdle by announcing that El Paso would provide half the project's $30 million cost for half the profit, and in November it cleared further hurdles by completing a $14 million private placement, securing a drilling rig from



, and started to drill. Over this period, the stock went from 80 cents to $3.03; it's now around $2.65.

The largest institutional shareholder of the stock, at 6.5% of the outstanding shares, is Palo Alto Investors (PAI), a private, value-oriented hedge fund in Northern California. David Anderson, the analyst on the hook for the investment at PAI, says he believes the value of the company's other properties in Western Canada provide the bedrock for the share price today, and the Nova Scotia project could add $5 to $8 to the stock price if the company meets its goal of drilling into the middle of a formation with 1 trillion cubic feet of gas. "As a value player, we see a lot of optionality," he said, meaning that the stock is like a call option on the Mariner project.

Two weeks ago, Anderson flew out to the rig. He said he learned that Canadian had 4,000 more feet to drill, that the drilling personnel were "fantastic" and that there have been "gas shows" along the way.

But he said that neither he, the crew bosses nor company executives had any idea yet whether the project would be successful. "It's sort of like the swordsman who lives to fight another day," he said. "Every day they drill without doing anything wrong removes a little uncertainty, but until they get to 18,000 feet and do some expensive tests there, it's still just a speculation."

Cheap, Strong Explorers

The day of truth will come in about three weeks. In the meantime, Anderson, whose hedge fund was up 90% last year and has compounded returns of 25% over the past 14 years, has been quietly investing in several other exploration ventures he declined to reveal.

He primarily buys drillers with high "recycle ratios." It's a simple concept: Find companies with proven ability to replace the oil or gas they're extracting from the ground for much less than the production costs and the expected future commodity price. If you can sell gas for $5.50 that costs $1.50 to find and make, you can use some of the profit to explore for more.

"The key thing is to replace your depleted asset at low costs, and if you can provably do that repeatedly -- fantastic," Anderson said. And, he added, all of the information necessary to make such judgments can be found in the footnotes of explorers' annual 10-K filings with the

Securities and Exchange Commission


Not including the ones he's currently buying, Anderson said he believes the strongest, least expensive explorers at this time are small-caps

PetroQuest Energy



Patina Oil & Gas

( POG),

Wiser Oil

( WZR),

Harvest Natural Resources



Callon Petroleum


Meridian Resource

( TMR); and mid-caps

Ultra Petroleum


XTO Energy

( XTO),

Evergreen Resources

(EVG) - Get Eaton Vance Short Duration Diversified Income Fund Report


Newfield Exploration



Pogo Producing



Ultra Petroleum is a good example. Although it has properties in Pennsylvania and China, Ultra's main asset is in the Pinedale Anticline of Wyoming, located southeast of Jackson Hole. A company typically does great if it hits oil in half the wells it sinks, but Ultra is virtually 100 for 100 in Wyoming and has more than 700 drilling prospects left. That makes it a "reserves growth" story that Anderson believes is worth $30 to $40 -- about 50% more than the current price. (His firm owns 1 million shares.)

Likewise, Harvest Natural Resources is a low-cost producer off the coast of Venezuela that might be undervalued because of political risk stemming from the unstable regime of President Hugo Chavez. Anderson considers CEO Peter Hill one of the industry's best.

Side bets abound. Consider drilling technology provider

Carbo Ceramics

(CRR) - Get CARBO Ceramics Inc. Report

, a small-cap maker of little clay balls that are used to prop open fractured rock underground, increasing oilfield yield.


Golar LNG

(GLNG) - Get Golar LNG Limited Report

, a fast-growing, profitable but inexpensive Norwegian shipping company that specializes in transporting liquefied natural gas. For returns less subject to the whims of commodity prices, check out large-caps


(HAL) - Get Halliburton Company Report



(SLB) - Get Schlumberger NV Report

, without whose oilfield management and services expertise, worldwide drilling would come to a standstill.

Over the rest of the year, I'll explore the industry further and visit some rigs for a more personal account. Initial ideas are listed in the table below.

Jon D. Markman is publisher of

StockTactics Advisor, an independent weekly investment newsletter, as well as senior strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at At the time of publication, Markman did not have positions in any securities mentioned in this column. His newsletter described Canadian Superior in its Dec. 3, 2003 issue.