Analyzing oil and gas exploration and production (E&P) stocks can be overwhelming for those without an oil and gas industry background. But, with just a basic understanding of exploration, production and reserves, investors can get a better grasp of E&P stock evaluation and make profits from this lucrative, albeit cyclical, industry group. (For related reading, see Oil And Gas Industry Primer.)

Oil and gas wells can generally be classified into two different types - exploratory wells and development wells. Sometimes known as a wildcat well, exploratory wells are those drilled to find new reservoirs (places where hydrocarbons haven't been found in the past). Wells drilled into the known extent of a producing reservoir are known as development wells. (For related reading, see Drilling For Big Tax Breaks.)

Exploratory wells are much riskier endeavors than development wells. However, similar to the world of equity investing, the extra risk often correlates to extra potential reward. Drilling an exploratory well can sometimes result in the discovery of a large new reservoir or oil and gas field. Most E&P companies will drill a combination of exploratory wells and development wells in the course of any given exploration program. The approach is similar to building a diversified portfolio of stocks.

Because all hydrocarbon production declines over time, E&P companies must drill new wells in order to grow revenue and earnings. Therefore, a key analytical consideration is the company's drilling program. Investors should read about what the E&P has been doing and what it plans to do in its drilling program to understand where revenue and earnings growth could come from.

There are a lot of factors to consider - the oil vs. gas mix, the drilling cost of each well, the company's working interest (essentially the ownership percentage of the well) and the mix of development and exploratory wells to name a few. The better the E&P is at increasing production in a cost effective way, the greater the potential return on equity for shareholders. (To learn more about ROE, check out Keep Your Eyes On The ROE.)

Analysts usually consider the company's overall drilling success rate, or the percentage of all wells drilled that resulted in economic production. If the company plans to drill the same type of wells (and in similar geographic locations) in the future as it has in the past, the past drilling success rate can be somewhat of an indicator of future success. If the analyst is confident that the drilling program will be successful, he or she will have confidence in the company's ability to increase production and cash flows in the future.

Investors are wise to carefully consider an E&P's production trend before investing in its stock. E&Ps usually report several production figures, such as average daily production rate, total production for the period, and the exit production rate in every earnings press release and every financial filing. Like the analysis of any company, investors want to see production (and therefore profit potential) increasing over time without corresponding material increases in new debt and equity securities. The combination of those factors, with all other things being equal, is what drives earnings per share growth for an E&P.

Analysts use an E&P's financial statements in conjunction with production figures to examine revenue and costs on a per-unit-of-production basis. Revenue per barrel of oil equivalent (BOE) of production is tied closely to the prevailing market price for oil and gas. Revenue per unit can differ substantially from market prices if the E&P hedges production using futures contracts. (To learn more, read Fueling Futures In the Energy Market.)

E&Ps generally incur period costs in three categories: cash operating costs, general and administrative expenses, and depletion and depreciation expenses (which are non-cash costs). It is useful to look at each cost category on a unit of production basis to assess trends and to compare the E&P to other companies in the sector. E&Ps are always price takers because of the nature of the commodity they produce and sell, so managing for profitability always relates closely to effective cost management.

E&P companies may use the successful efforts method or the full cost method to account for exploration activity. Under the full cost method, all exploration costs are capitalized on the balance sheet and charged against revenue over time in the form of depletion expense. Under the successfully efforts method, certain exploration costs are expensed as incurred and costs associated with unsuccessful wells ("dry holes") are expensed in the period in which they are incurred.

The two methods can generate significant differences in the E&P company's income statement. Other things being equal, the depletion, depreciation and amortization cost using the full cost method will be higher compared to the successful efforts method. Regardless of the accounting method used, to get a sense of drilling costs the analyst must look closely at both the income statement and the cash flow statement. Exploration costs are classified as capital expenditures on the cash flow statement. (Learn how to read financials properly in Introduction To Fundamental Analysis.)

It is partially because of the differences in accounting treatment for exploration costs that analysts often look at operating cash flow per share when assessing E&Ps. Another reason is that exploration costs are generally tax deductible in the period in which they are incurred and, as a result, much of the tax expense of an E&P is of the deferred variety. Many oil and gas investors consider E&Ps to trade on price-cash flow basis and not on a price-earnings basis. Therefore, analysts often project cash flow per share to arrive at target prices for E&P stocks.

Analyzing petroleum reserves - the estimated quantity of hydrocarbons owned by the E&P that are still in the ground - is important because these are the source for all future revenue and cash flow streams. There are several common classifications for reserves. Proved reserves are those that engineers have the most confidence calculating because the field has been proved by appraisal wells or producing wells. In other words, we know the hydrocarbons are there because production has been generated from the reservoir. Proved producing reserves are reserves that are proved and expected to be recovered from existing wells, existing equipment and current operating methods. Proved undeveloped reserves (commonly called "PUDs") are reserves that are expected to be recovered from new wells on undrilled acreage or from geologic zones untapped by existing wells.

The Importance of NAV
Investors generally want to see reserve growth over time, although in an economic way that will benefit the shareholders. Therefore, if the company has been acquiring reserves, analysts will want to ensure the price paid for them was reasonable. Reserves are also important in the calculation of net asset value (NAV) and net asset value per share (NAVPS) for the company.

Similar to book value, NAV considers the present value of after-tax cash flows from reserves (usually at a 10% discount rate) as well as the present value of cash flows from future exploration activity. NAVPS is frequently used to value E&P companies in the same way that one would use a discounted cash flow valuation for an industrial or consumer products company. The formula for NAVPS could be given as follows:

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Note that the NAV calculation is usually best performed by those with an oil and gas engineering background because a highly important factor is the present value added from future exploration. That number is difficult to calculate and is dependent on the company's undeveloped acreage and drilling prospects in that acreage.

All oil and gas reservoirs shrink over time. In order to maintain and grow profits, E&Ps must drill new wells and find new reservoirs or fields. Profiting from E&P equity investments means finding companies that can do this well - or at least better - than the masses of investors think they can.

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