John S. Herold chairman comments on oil stock valuations

Published March 27th, 2001 - 02:00 GMT

Despite a heightened level of deal activity among oil and gas companies in the past six months and more than 150 currently pending deals placing assets on the market worth more than $40 billion, industry executives will learn the hard way that they'll get no respect on Wall Street for trying to acquire their way to a higher valuation, Art Smith, chairman & CEO of energy research and consulting firm John S. Herold, Inc. told a meeting of the Society of Petroleum Evaluation Engineers recently.  


Acquisitions made at high prices in a sellers' market will just add to the Street's concern about the E&P sector's ability to generate good returns over time.  


"Wellhead values are strong as horseradish with $28 oil and $5 gas, but the companies' stock prices have not moved up. 


Wall Street and investors are discounting this industry group very heavily because they're worried about reinvestment risk," Smith said.  


The biggest challenge facing E&P companies today is what they are going to do with the cash flow produced by higher prices, according to Smith. 


"In the past, companies have always overextended themselves and made bad acquisitions at the top. The last time the industry put the pedal to the floor on acquisitions and exploration in 1997 and 1998, finding costs went out of sight and destroyed the economics of the business.  


Nevertheless, there is no question capital spending is going to be up sharply in 2001," he added.  


"We've never seen an industry that has generated this kind of money and is not spending it as aggressively as in the past because they're concerned about making mistakes. 


Investors are skeptical and cynical, very concerned about the ability of the E&P sector to generate good returns over time, because they believe that whenever oil companies have money they will spend it, and they won't always spend it wisely," Smith said.  


A lack of credibility has largely choked off the E&P sector from the capital markets since 1998, despite the fact that for the previous 20 years E&P companies grew through use of external funds, including debt offerings, IPOs and secondary issues. "E&P stocks are cheap today because Wall Street expects another whipsaw," he added.  


At the same time, low valuations have driven managers to try to "grow for growth's sake and it doesn't work."  


Because small cap and mid-cap companies are not valued as richly as the large caps, all the managers who want to grow their companies to get a higher valuation and better liquidity "are being driven into an intense competition for a universe of opportunities that is shrinking," he said.  


"However, it's clear that we are not early in the cycle and, now with Shell turning around and coming back into the market with their $2.3 billion offer for Barrett Resources, things could get wild."  


As an example of the amount of resources that could become available for various transactions, he cited Herold's calculation that, beyond $13 billion in planned 2001 capital expenditures, ExxonMobil currently has cash and equivalent resources totaling approximately $20 billion.  


"That's enough to buy EOG Resources, Ocean Energy and about half of Anadarko." In this environment, Smith predicted a lot of people will take their money off the table by selling their companies under the philosophy that you can always start over again.  


"I'm encouraging the companies not to overspend, not to do aggressive acquisitions, and instead buy their own shares in to take advantage of the big disconnect between the forward market and the valuation of the companies," Smith told the group.  


A buyback strategy can be attractive at least until the equities market begins to appreciate that E&P companies can create value.  


"If you sold forward the proved producing reserves -- gas reserves in particular -- of most of the oil companies in North America, you'd receive a present value of about $1.50 per million BTUs. At the same time, most of the companies are valued at about $1.00 per million BTUs.  


So managements who really believe in their companies can sell forward their proved producing reserves and buy-in their stock, because that's accretive to their value per share."  


Just such a contrarian investment style has been one of the few consistent ways to prosper in the E&P business for the past 20 years, according to Smith, who cited examples of well-executed contrarian investment styles in Apache Corporation, CrossTimbers Oil and Andersen Exploration (Canada).  


"They buy when it's low, they sell when it's high, and they always work to keep a strong balance sheet."  


© 2001 Mena Report (

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