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Show Me The Money

posted Dec 28, 2011, 9:26 AM by Jeff Davies   [ updated Dec 29, 2011, 11:22 AM ]
Money to me in the context of e&p analysis isn't EBITDA, net income, or eps, its straight up cash  - and like Jimmy Fallon says in his recent Capitol One commercials, who doesn't want more cash?  Every business should be run for cash and it seems logical to me that all else being relatively equal, companies in the same industry should convert revenue into cash at a similar rate.  For e&p's, differences in the ability to convert revenue into cash flow can highlight financial leverage, cost structure, hydrocarbon mix, hedging policies, accounting treatments, and tax shielding, among other factors.  

Theoretically, the market should price companies with superior cash flow margins and stability at a premium to the peer group.  Intuitively, companies that convert more revenue into cash should outperform over medium and longer time periods.  In the short-term, the market may disagree positively or negatively for a number of reasons and clearly the analysis is backward rather than forward looking, but ultimately cash is king.  Further, cash flow margin divided by f&d costs or dd&a can show how efficient companies can replace their reserves.  Below is a ranking of cash flow margin, volatility of cash flow margin and recylce ratio for a number of e&p's.  

The sheet should be self explanatory, but:

- Cash flow is defined as cash from operations before working capital
- Cash flow margin is simply cash flow/revenue, with revenue adjusted for unrealized hedge gain/loss, marketing, and other items when appropriate.
- I'd like to think I've made most of the adjustments to allow the numbers to be viewed on apples-to-apples basis, but I can't guarantee that to be the case.  A company like CHK, who capitalizes most of its interest, thus moving it from operating to investing cash flow will appear better than it would otherwise.
- Recycle ratio is calculated by dividing the revenue per unit at assumed prices by 2yr avg dd&a.  I'm not adjusting liquids for NGLs so the ratio is likely overstated for companies not producing mostly oil in their liquids stream. 

A few comments on the rankings and rankings relative to market returns...

- NOG, with the highest cash flow margin and second best cash flow stability stands out.  No leverage and the non-operated model help keep the margin high.  As a Bakken and crude pure play, the name has substantial leverage to oil prices.  The non-operated, odd-lot leasehold likely hinders m&a value, but the assets could fit nicely into a MLP structure down the road, which would help achieve premium valuation.  Being ranked so high on these metrics doesn't jive with some of the short arguments that have been out there the last year.  Their f&d costs can't be higher than Bakken peers as their acreage costs are generally lower and they simply get AFE'd, so with the highest cash margins the numbers appear to be hard to argue with.  Oil leverage, stable cash flows and high short interest.  Something has to give.

- A number of gassy names in the top ten and a number of oil-ly names in the bottom ten.  Higher commodity prices help, but they aren't the only factor in a solid cash flow margin.  Naturally, high leverage names such as ATPG, KWK, SD are near the bottom of the list.

- The rankings and market agree most to the downside/lower ranking with ATPG, KWK, GDP, GMXR AND CRZO, while disagreeing on SD, REXX, EXXI, GEOI and KOG.

- The rankings and market agree most to the upside/higher ranking with CLR, AREX, GPOR, SGY, and PXP, while disagreeing on NOG, CHK, UPL, WLL and CRK.

- COG has really outperformed the group this year, which I view as two part, superior Marcellus acreage and a head-start on infrastructure.

- COG & KOG, number 1 & 2.  Interesting.

- The market seems to believe in SD's liquids transition, but they have significant wood to chop before they will be anywhere close to the upper quartile in cash flow margin.  Likewise, the market is looking through REXX's weak cash flow metrics to its Marcellus wet gas growth. 
- The simple average ytd return for the group is -2%.  Marcellus, oil and liquids growth stories are what worked in 2011.  
- With a consistent name like CLR, a rough cut on cash flow is a relatively simple calculation of period production x price x cash flow margin.