As we’ve highlighted before, the integrated major energy producers like Exxon Mobil (XOM) and France’s Total (TOT) are truly in a league of their own.
Their production spans millions of barrels per day across all the world’s oceans and continents. All in all, these major players are the prime way the world fuels up and will continue to rule the energy sector.
But that doesn’t mean the small-fries should be ignored.
Truth is, small-cap E&P firms can mean just as much for your portfolio as their larger cousins. In fact, adding swath of them could very well lead to bigger returns over the long haul.
Betting on the Wildcatters
Countless historical studies have shown that, over long stretches of time, smaller firms have beaten large-cap stocks by a wide margin. The most famous such study was prepared by economists Eugene Fama and Kenneth French, who concluded that during a 50-year period — from 1956 to 2005 — small-caps topped their large-cap brethren by nearly 4% per year.
In the energy sector, things are little different.
The S&P SmallCap 600 Energy Index has managed to produce a 19.97% annual return during the past three years. That not only beats the larger S&P 500 benchmark by 6% annually, but also the broad S&P SmallCap 600 Index by 3% annually.
The reason for that success could be twofold.
First, these junior and smaller exploration energy companies serve as one of main providers of new hydrocarbon supplies. These companies find new deposits and bring them into production. Major producers see these junior discoverer corporations as a way to add to their overall reserves, and often partner with or simply buy these mid-tier producers (sometimes at a high premium).
Secondly, it only takes one gusher to turn a small company into a superstar and send its stock price rising. For example, back in 2010, when McMoRan Exploration (MMR) and Plains Exploration & Production (PXP) first made their Davy Jones discovery in the Gulf of Mexico, share prices for the two small-caps surged; McMoRan in specific popped 50% that week.
So for investors who are starting to think small, here are some ways you can play:
When it comes to the shale production in the United States, there really is only a handful of plays truly worth nothing. One of them is North Dakota’s Bakken. The latest numbers from the USGS nearly doubled the amount of energy expected to be locked within the shale rock, containing an estimated 7.4 billion barrels of undiscovered, technically recoverable oil.
Oasis Petroleum (OAS) is looking to take advantage of that. The small-cap E&P firm has expanded its acreage, production and reserve numbers over the last few years. According to its last earnings report, shale oil production grew over 82% year-over-year, while reserves have grown at a compound annual rate of 121% since 2009. That makes the company a prime M&A target in the heart of shale country.
Oasis shares also sport low valuations, including a price-to-earnings ratio of 11.8 and a five-year price/earnings-to-growth ratio of 0.47. That’s a lot of growth, dirt-cheap.
Bill Barrett Corp.
The sharp plunge in natural gas prices during the past few years really took a toll on Bill Barrett Corp. (BBG). Those plunging prices caused BBG to realize negative cash flows some quarters and helped shares plunge down from about $50 to the mid-teens in early 2012.
However, with natural gas prices beginning to rise and more LNG export facilities getting the green light from regulators, Bill Barrett has culminated into a turnaround play and has begun to rebound. Shares are up about 26% so far this year, and there could be more room to run.
Recent management changes have focused on much better cost controls. These have resulted in higher positive cash flows. Additionally, the shift toward more oil production — which has resulted in growing and huge reserves — could see the firm being snagged by another major energy player.
While Bill Barrett is a tad expensive at 17 times fiscal 2014 earnings, that could end up being a bargain if natural gas prices continue to rise this summer.
PowerShares S&P SmallCap Energy
Perhaps the best route to small-cap energy outperformance lies in boring index fund investing. As we noted above, the S&P SmallCap 600 Energy Index has been a powerful outperformer for investors. The PowerShares S&P SmallCap Energy ETF (PSCE) duplicates that success.
The fund tracks the 26 energy firms that are part of the larger SmallCap 600. This produces a holdings mix that includes oil and gas E&P firms, refining, oil services, pipeline and other non-oil based energy companies. While that might seem like an issue to some investors, the two reason for their outperformance still apply. As we’ve seen with General Electric’s (GE) buyout of oil service firm Lufkin Industries (LUFK), larger companies across all sectors of the energy pie have been on the hunt for ways to increase their operations. The bulk of PSCE contains a virtual smorgasbord of potential buyout targets.
Expenses for the SmallCap Energy ETF are cheap, too, at 0.29%.
As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.