Multiples are one of the most popular "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. Much more important, in fact, and more reliable, too.
I generally use it to target oil and natural gas stocks, although the "yardstick" can be tweaked to apply to power producers, and even coal and uranium miners.
It's a way to cut through some of the fast and loose "games" management can play with its reserves, too, and to get a more accurate feel for a company's booked reserves and its trading price.
Ultimately, my yardstick 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 double- and triple-digit wins.
Once you understand how to use this yardstick, you can too.
It's easy - here's how it works...
My "Yardstick" Cuts Through the Noise to Get Right at the Profits
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 has not yet extracted.
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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, longtime energy market-watchers, myself included, will tell you that reserve figures are among the most manipulated, "cooked" statistics in the business.
But there's a way to cut through the omnipresent "smoke and mirrors" routine. The most important thing is to be conservative.
You see, looking at extractable reserves in a way that considers both the effects of technology and economics accomplishes two objectives...
Primarily, 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 probable it is that the reserves can be exploited. My approach reduces the actual reserves considered to those with the highest probability of production - the real McCoy.
There's another benefit to looking at reserves this way: It places a clear, 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.
Interestingly, among those in wide use, the best approach in applying this distinction may actually be the Russian, rather than the 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.
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Bigger Firms Are Not Always Better Buys
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 (very conservative) extractable reserve multiples standard, it allows me to identify the more efficient and cost-effective projects.
It's these projects, in particular, that are the primary profit drivers and tend to benefit the overall valuation of a company's shares.
Interestingly, my conservative reserve multiples approach supports something we've seen have made several times in Oil & Energy Investor.
The so-called "supermajors" - the large, globally operating companies, such as Exxon Mobil Corp. (NYSE: XOM), BP Plc. (NYSE ADR: BP), Chevron Corp. (NYSE: CVX), and the like, may make a lot of money... but they most definitely 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 reserve multiples.
We've profited time and again for the past two years with smaller companies that emphasize certain production basins, like the Permian in Texas, or the Marcellus in the eastern United States, where they've had prior success.
Here, these well-managed companies are applying leaner field strategies with less overhead. This almost always provides better profits per unit produced and higher stock price appreciation than the "big boys."
Now, this isn't the only yardstick I use when recommending companies for my readers; it shouldn't be the only consideration in selecting great investments.
But... the inescapable fact is, my yardstick is becoming a much more important measurement.
It's important precisely because it gives us another way to find undervalued oil and gas stocks to buy that are likely to advance long before everyone else catches on.
And that always translates into big investment profits.
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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.