Investors are prospecting for new energy plays -- and hitting paydirt -- outside the normal discovery zones. Granted, many people continue to pile into gushers like Apache ( APA), ConocoPhillips ( COP) and Valero ( VLO). But some have moved on to more obscure opportunities that, thanks to bullish energy prices, suddenly look like attractive places to drill. Even veteran producer Penn Virginia ( PVA) spotted value in the likes of GMX Resources ( GMXR). At one time, it seemed, GMX had dug itself into a hole so deep that it didn't seem to matter whether it was a dry one or not. As recently as last year, in fact, the cash-strapped company found itself unable to drill any new wells at all. But high-priced natural gas caused Penn Virginia to lend a hand, and a new joint venture has brought success to both parties. The energy boom has breathed fresh life into several overlooked players, in fact. Now a company like Encore Acquisitions ( EAC), which squeezes excess oil from the castoff properties of others, enjoys a little more sex appeal. Vaalco ( EGY), a tiny company making big discoveries, leaps from the OTC Bulletin Board to the American Stock Exchange. And TransGlobe Energy ( TGA) -- which simply boasts well-placed properties that might produce "elephants" -- starts to look like a future heavyweight. Harry Chernoff, an analyst at Pathfinder Capital Advisors, often relies on his deep industry knowledge to research more popular companies. But record energy prices have pushed him to study these less visible names -- and personally invest in most of them.
At long last, GMX has plenty to celebrate as well. Less than a week before Penn Virginia's late-September production warning, GMX announced its "best completion results and operations update" ever. Through its joint venture with Penn Energy, GMX saw its gas production increase and its downtime and operating costs decline. Looking ahead, the company -- idle for two long years -- now expects to drill as many as 20 gas wells in 2004 alone. It then plans to double, and possibly triple, its capital expenditures in 2005. Given the company's past, however, even Hibernia felt compelled to hunt for red flags.
Second ChanceChernoff calls GMX his favorite pick of the lot. And at least one research house now shares his bullish view. Late last month, Hibernia Southcoast Capital became the first firm to cover the stock -- starting it at "buy" -- since the company joined forces with Penn Virginia. Before, analysts had avoided the stock for a reason. Less than a year after going public during the market drought of 2001, GMX announced a major lawsuit against Nabors Drilling ( NBR) that soon disabled its exploration and production program. Only after settling that case last year did GMX finally snag a partner with the capital necessary to end the company's long dry spell. To be sure, Penn Virginia inked a lucrative deal for itself. By providing financial backing for GMX, Penn Virginia secured a major interest in some valuable GMX properties. Now, that investment is visibly paying off. When warning of lower production results last month, Penn Virginia pointed to its production program with GMX -- now accelerated and exceeding expectations -- as a bright spot for the quarter.
"We conducted our most extensive due diligence on GMX Resources, its management and its partners when compared to all other E&P companies under coverage," Hibernia analyst David Heikkinen wrote. "The justification for our intensive due diligence was to determine if the company had any risks beyond the lawsuit against Nabors Drilling that was settled in May 2003." While scouring court records and other public documents, Heikkinen uncovered no material legal problems. He still describes GMX as "an emerging company with limited capital resources." But GMX's joint venture with Penn Virginia has left him optimistic about the company's future. "GMXR has an impressive inventory of drilling locations that we believe will add reserves, production and net asset value as the company accelerates their drilling heading forward," Heikkinen wrote. "We believe the company is well positioned with its joint-venture partner to significantly grow reserves and production between now and 2006." Shares of GMX, while down 1.4% to $7.02 on Friday, have more than quadrupled over the past year.
Future GainsChernoff sees plenty of upside left. "The market is still treating GMX as a dubious company that's had litigation problems and mediocre reserves," said Chernoff, who owns GMX himself. But "everything is setting up for a big, big gain in the value of the company." Because GMX is now actually drilling, Chernoff says, the company can simultaneously expand both its energy production and its proved reserves. He expects the company's production and cash flow to increase "rapidly" -- starting this quarter. In the meantime, the company itself has already cast a strong vote of confidence in its future. In a brief announcement earlier this month, GMX laid out plans to repurchase warrants that, until early 2006, can be exercised at $12 a share. "Why would a company with a stock price of $7 do this -- especially when they need money for drilling?" Chernoff asked. "This indicates they expect their own stock price to be over $12" before issuing new equity next year. Chernoff is convinced that the market will eventually recognize GMX's true value as well. The company's "exchange of working interest to Penn Virginia for equity and accelerated drilling is an excellent trade," he said. "It perfectly positions GMX to drill and prove up reserves on the remainder of its acreage, where it has retained as much as a 100% working interest." So "GMX gets a smaller piece of a much larger pie -- and a much larger valuation once the market realizes the size of the pie."
Repeat WinnerChernoff's second pick, Encore, has already proven itself. While young like GMX, Encore enjoys a much larger market value -- exceeding $1 billion -- and a profitable history. The company makes money by snatching up depleted fields on the cheap and then using technology to extract leftover oil from the properties.
Chernoff, who owns the stock, concedes that the company's operating costs can be high. But he says that operating margins "skyrocket" when oil prices surge. Indeed, Encore this July reported "record" second-quarter results as it ramped up production and collected higher prices for its fuel. Two days later, Credit Suisse First Boston analyst Phillip Pace began recommending the stock. "The theme we are trying to position for is the increasing value of probable resources in a higher price environment," Pace explained. "The net result of this is visible growth with good returns into the next decade." Encore's stock climbed 30 cents to $33.60 on Friday and is up nearly 50% in a year. Still, Chernoff insists that many investors tend to overlook Encore because the company will never announce a big find like those that score sexy headlines. Instead, he says, Encore quietly pumps more and more oil at increasingly high margins. "They do it over and over again. ... But what they're doing," he adds, "I don't think too many people are noticing."