NEW ORLEANS -- Do you think natural gas prices will remain strong as heating demand rises this winter? If so, then you might be interested in companies that drill in the Gulf of Mexico, the origin of more than one-third of domestic natural gas.

One small-cap way to play that theme is Energy Partners ( EPL). Sporting a $250 million market cap, this exploration-and-production company is looking to grow largely through opportunistic exploration and exploitation and through development of its prospects in the Gulf of Mexico.

An Interesting Story

"We are a Gulf of Mexico play," said Richard Bachmann, Energy Partners chairman, president and CEO, at a presentation Wednesday at the second annual Louisiana Energy Conference in New Orleans. "That is what we know, and that is our focus."

The company is an intriguing Gulf of Mexico growth story. It has about 45.6 million barrels of oil equivalent in its portfolio, with production of about 17,700 barrels a day in the Gulf of Mexico. Its current production is about 52% oil and 48% gas, but its future is more in natural gas.


Energy Partners
(EPL:NYSE)
Current Price $9.15
52-Week Range $9.45-$5.60
Market Cap $258.7 million
Average Daily Volume 22,545
Inst. Ownership 14%
Dividend Yield None
Beta 0.68
Company Web Site www.eplweb.com
Source: Value Line, company reports, TSC research

Last year, Energy Partners came out swinging with its purchase of Houston-based Hall Houston, an aggressive and successful pure E&P company. From its inception in 1983, Hall Houston drilled 275 wells in the Gulf of Mexico with an 80% success rate. The acquisition merged the lower-risk, shorter-term reward prospects of Hall Houston with the more speculative, yet large potential reward prospects of Energy Partners.

In short, it created a mix of projects that could provide good near-term cash flow with potential longer-term impact, something many Gulf of Mexico E&P companies are looking for amid today's declining production and diminishing prospects.

The combined companies hope to increase production and reserves by about 30% through both low-risk exploitation and production, about 65% of the company's capital budget, and higher-risk exploration. Its 2002 exploratory program shows how serious Energy Partners is about growth through exploration. By the end of the month, the company will have drilled 17 wells in the central Gulf of Mexico, with reserve potential equivalent to 400 billion cubic feet of natural gas.

Energy Partners' drilling program has accelerated dramatically in the past several months. It now has eight rigs working in the Gulf of Mexico, with a ninth on its way to a site today. The company has promising developments in such prolific Gulf of Mexico fields as East Bay, East and West Cameron, Eugene Island and High Island.

Financial Stewardship

Another attractive facet of Energy Partners' story is its financial shape. It's very focused on returns on capital, very cognizant of its production costs and relatively conservative with its use of debt.

Although its debt jumped when it acquired Hall Houston, its current debt-to-capital ratio is only 32%, well below the peer average of 41%. If CFO Suzanne Baer has her way, it will remain that way.

"You won't see that number go above 40%," Baer said. "The industry is volatile enough not to add more risk through debt."

That kind of conservative financial management is a very positive sign from sometimes-aggressive E&P companies. Along with a very disciplined hedging program that provides a level of cash flow predictability, Energy Partners' financial model should continue to steer the company clear of major trouble.


En-Gulfed
Energy Partners bets on Gulf of Mexico natural gas
Year Revenue (millions) Earnings Per Share
2001 $145.90 $0.49
2002* 125.00 (0.38)
2003* NA (0.10)
*Estimated. Source: First Call, company reports, TSC research

Dry Holes

However, Energy Partners isn't without meaningful risk. It is, after all, a small-cap E&P company, where the cost per exploratory well relative to the company's size is significant. A string of bad luck with dry holes -- this year, the company is batting more than 75% -- could hurt its production and cash flow growth.

In addition, a decline in natural gas and oil prices could impact the company's margins. Although its production costs remain relatively low (about $9.78 per barrel of oil equivalent), slipping commodity prices may make risk-reward decisions on where to drill more difficult. The company's hedging program, however, should help manage that impact.

Finally, Energy Partners is expected to report a per-share loss of about 38 cents this year and 10 cents next year, adding a bit of speculation to the play. However, cash flow continues to increase and should largely fund new opportunities in the coming year.

Energy Partners has a good management team with good prospects and good operators finding plenty of opportunities to harvest natural gas in the Gulf of Mexico. Any small-cap exploration play is highly speculative, but Energy Partners is worth a look, especially given its relatively healthy financial profile.

After the stock's recent rally, investors may want to pick their entry point at slightly lower prices, but longer term, this is a small-cap E&P name I like. I give it three barrels. (For an explanation of our barrel rating system, see our description .) Energy Partners rose 22 cents, or 2.4%, to end Wednesday's session at $9.40.
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.