The Best "Yardstick" for Picking Oil and Gas Stocks to Buy

[Editor's Note: This expert insight into one of the best measures for identifying the best oil and gas stocks to buy was first published Jan. 21 in Dr. Kent Moors' Oil & Energy Investor. Go here to learn how to access Moors' research as soon as it's released.]

As every savvy investor knows, multiples are one of the best yardsticks when it comes to finding undervalued oil and gas stocks to buy.

More often than not, that involves a hard look at the multiple of a company's earnings to determine whether or not a stock is fairly valued.

In the case of energy stocks, however, there is a more important multiple you need to understand.

This yardstick applies most frequently to oil and natural gas stocks, although it has variants that can be applied to power producers and even coal and uranium miners.

This new tool looks at the relationship between a company's booked reserves and its trading price. It takes into consideration the extractable reserves a company has in the ground and opens up a window into how that stock should trade.

I've used this measure time and again to bring home market-beating trades. Once you understand how to use this yardstick, you can too.

Here's how it works...

How to Pick Potential Oil and Gas Stocks to Buy

Of course, using a measure like this is just one factor in determining a target price for a stock.

Aggregate supply and demand considerations, the broader corporate debt and working capital ratios, access to midstream and downstream transport and processing assets and at what cost, along with the market price itself, are certainly other important considerations.

Still, unlike companies in non-energy sectors, there is a rather direct correlation here between what is available as raw materials and how that translates into profit. Reserve multiples address the estimated value of oil and gas a company has accessible, but not yet extracted.

Actually, I prefer to consider this factor as extractable reserves, those assets in the ground that are both technically and financially extractable. That is, what an oil and gas company can extract immediately at a cost that is justified by the current market conditions.

Now, reserve figures are among the most manipulated statistics in the business. But looking at extractable reserves in a way that considers both the effects of technology and economics accomplishes two objectives...

First, it reduces the overall reserve figure beyond even what is required by the SEC before the company can book it. In this case, there are several classifications of reserves essentially separated by how likely (how probable) it is that the reserves can be exploited. My approach reduces the actual reserves considered to those with the highest probability of production.

Second, it places a clear (and statistically verifiable) distinction between reserves and resources.

Companies will often blur the distinction between these two, especially where figures are calculated for foreign holdings. Resources are less reliable and undergo less rigorous analysis than is applied to reserve categories. Among those in wide use, the best approach in applying this distinction may actually be the Russian, rather than the SPE (Society of Petroleum Engineers), categorization.

My far more conservative figures make this distinction between genuine reserves and potential resources easier to make. An extractable reserve multiple merely divides the total market value of oil and gas most easily extractable - though still in the ground - by the total market cap of the producing company.

This should give us a relatively simple way to identify undervalued companies, those with the best opportunity to provide near-term value appreciation in a market where oil and gas prices are trading within a narrow range, are static, or experience appreciation.

In this last case, in which the market price of oil and/or gas is rising, we might anticipate that most producers would benefit.

Yet that is often not the case...

Why Bigger Is Not Always Better

The truth is, some companies are always rising faster than others.

And in the other cases mentioned - when the raw material is trading within a narrow range or hardly changing at all - we also see that some shares fare better than others.

All of this leads me to a couple of interesting observations that I have already applied when selecting shares within the universe of operating companies for both my Energy Advantage and Energy Inner Circle services.

Initially, as I apply my extractable reserve multiples standard (with much lower available reserve figures than generally employed), it allows me to identify the more efficient and cost-effective projects. These projects are the primary profit drivers and tend to benefit the overall valuation of a company's shares.

Next, my (narrowly defined extractable) reserve multiples approach supports an observation I have made several times in Oil & Energy Investor. Super large companies, such as Exxon Mobil Corp. (NYSE: XOM), BP plc (NYSE: BP), Chevron Corp. (NYSE: CVX), and the like, may make a lot of money. But they do not end up with the best figures using those multiples.

Put more directly: Smaller, well-managed, and narrow-focused producers perform better when using the reserve multiples as a yardstick.

As I have noted several times over the past two years, smaller companies emphasizing certain production basins in which they have had prior success, applying leaner field strategies with less overhead, and led by solid management will provide better profits per unit produced and higher stock appreciation than the big boys.

Keep in mind that this yardstick shouldn't be your only consideration when selecting investment plays. But it is becoming a much more important measurement.

And it is likely to give us another way to find undervalued oil and gas stocks to buy that are likely to advance long before everyone else catches on.

Needless to say, that always translates into big investment profits.

The U.S. oil and gas boom has created a seemingly endless list of new investment opportunities... but it also brings an increased need to protect the nation's energy infrastructure. Don't miss two of the best investments in the growing trend of energy security.

About the Author

Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.

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