Global oil production has been outpacing demand for over two years. This oversupply has pushed oil prices to lows not seen in more than 10 years, so it’s a good time to start contemplating investments in oil and gas stocks. For consumers, this is a welcomed reduction in fuel prices. For independent producers, the price decline is causing extreme pain.

According to Haynes and Boone, 42 energy companies filed for bankruptcy in 2015 and Deloitte believes 35% of the remaining energy companies are at risk of declaring bankruptcy in 2016. Our in-house analysis found 38 of the 91 independent producers to be at risk of bankruptcy if financing dries up and oil prices do not rise.

2016.04.09 - Oil Supply vs. Demand Graph

When typical investors see this much distress, they run away as fast as possible. We at HIT Investments act differently because that’s what it takes to generate greater than typical returns. Instead of running, we ask whether there are independent producers that may benefit from this downturn.

What oil and gas producers are still financially strong and what differentiates them from those that are failing. We ask whether the price decline will lessen or widen their competitive advantages.

The following analysis helped HIT find producers that are most likely to weather the storm and come out stronger, generating solid returns for their investors.

WTI Oil Price

Oil and Gas Stocks You Should Consider

We first identify businesses with a good “current ratio” (current assets / current debt). When a business loses competition due to competitors’ bankruptcy, its position in the sector typically strengthens. Forty-two energy companies filed for bankruptcy in 2015 and it looks as if more are on their way in 2016.

If a strong company is going to take advantage of its now insolvent counterparts, the company must have a cash position strong enough to acquire the assets of the now insolvent business when the assets are liquidated in the bankruptcy.

The current ratio metric provides insight into whether a company has such liquidity to purchase assets. The current ratio incorporates a company’s liquid assets and debts due within the year. The larger the number, the stronger the business’s liquidity.

We next evaluate the differentiators or competitive advantages between the strongest producers. There is a lot of hype around operating practices, technology, and relationships, but we believe acreage and management potential are the key differentiators. The reasoning is that all the other “differentiators” can be learned and spread across producers through service providers, employee conferences, or industry expert papers.

The best indicator to use to identify businesses with great producing acreage and a competent management team is EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). This metric tells us whether the business is making money. We expect great producers to make money in this low price environment. A high EBITDA signifies that management is being smart about capital allocation and the business holds profitable producing acreage.

The final step is to determine the EV or Enterprise value of the business. The EV is essentially a measurement of how much the business is worth and is often used to determine what a purchaser would have to pay to buy the entire business’s assets and liabilities. EV enters the price into the equation; No matter how strong the business, we are always unwilling to pay an infinite price.

Using these 3 metrics (current ratio, EBITDA, and EV), we ran our analysis on the independent oil and gas producer sector. The current ratio narrowed the list of producers from 91 to 23 when required to have a ratio greater than 2. Having sufficiently liquid businesses remaining, we ranked the rest by EV/EBITDA.

The top investments for oil and gas stocks were:

1. Jones Energy (JONE)
2. Resolute Energy (REN)
3. Sanchez Energy Corporation (SN)
4. Memorial Production Partners LP (MEMP)
5. Gran Tierra Energy (GTE)

In future newsletters, we will further explain the terms EV and EBITDA as they play an important role in value investing. Sign up here and have the next newsletter come straight to your inbox.

Newsletter Sources:
Financial metrics were taken from the Yahoo Finance and narrowed to the Independent Oil and Gas sector on 4/8/2016
EIA – WTI historical crude oil price
EIA – World Liquid Fuels Production and Consumption Balance
Fuel Fix – Deloitte 35 percent of eps at risk of bankruptcy in 2016

Stephen Read is long Jones Energy, (JONE).

The information written within the HIT Investments newsletter is not specific to anyone’s personal circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable. HIT Investments cannot assure the accuracy or completeness of these materials.

This article is not advice to invest in any given business or sector, including the business and sectors described herein. The examples used herein are used for illustrative purposes only and nothing in this article should be construed as HIT’s advice that you purchase any portion of any businesses or sectors mentioned. All investment is subject to risks, including the risk of negative returns and losses, and there are no guarantees of future returns.