Sometimes a company comes along that shakes up an industry that thought it already had all the answers. That’s the way I look at the remarkable energy small-cap Evolution Petroleum (AMEX:EPM).
Evolution is a small, Houston-based oil and gas firm that operates production facilities in Texas, Oklahoma and Louisiana. What makes this little gem special is that it operates a model that varies greatly from the traditional drillers of the world such as Apache (NYSE:APA) and Anadarko Petroleum (NYSE:APC).
A typical upstream company is engaged in the exploration and production of underground or underwater oil and gas fields. It will drill exploratory wells and, upon a successful discovery, will operate the well to bring that oil or gas to the surface.
Simple enough, right? Well, these firms spend significant capital long before any discovery is made in the hope that the risks will be paid off with a successful strike. Even the smallest of these firms will utilize advanced technology and employ dozens of engineers and specialized geologists with complex computer models to increase the likelihood of drilling a successful well.
Click to EnlargeEvolution takes a different tack. It focuses on cheaply acquiring existing domestic onshore projects that other companies have started and abandoned, then uses its technology to extract enough oil to make the effort worthwhile. The company reduces its risk by bringing in financing partners. It then simply takes a royalty interest — essentially just taking a percentage of the gross production.
This model allows Evolution to spend very little in its quest to make sizable discoveries. Nice business plan. CEO Robert S. Herlin has said the firm is particularly interested in acquiring wells that have been orphaned because of the expectation of low margins and limited upside.
In other words, one man’s trash is Evolution’s treasure.
This process only works if Evolution can efficiently extract oil and gas where other firms cannot. This is where its proprietary technology comes into play. An example: artificial lift technology developed by operations vice president and inventor Daryl Mazzanti.
Mazzanti’s technology is aimed at extending the life of oil production in horizontal wells, and Evolution estimates that it can recover an additional 10% to 15% at a cost of less than $10 per barrel of oil equivalent. That’s phenomenal, and something no one else is doing.
Evolution began operations in 2003 originally under the name Natural Gas Systems. Herlin has been at the helm since founding the firm. He built it with only $8.3 million of capital and has 28 years of leadership experience in management roles with several oil and gas exploration firms.
The company is in extremely strong financial shape, with no debt and a cash position of $4.5 million. Evolution is seriously undervalued by the Street, with an enterprise value of only $190 million despite reserves estimated to be worth as much as $375 million.
Evolution has grown revenues by 21.3% annually during the past five years while increasing positive free cash flow each year. The Street is just catching on, as shares are up 44% this year. Analysts are expecting the company to earn 65 cents per share in 2013 for a valuation of 12.5 times earnings.
There’s still a lot of room for EPM to advance even if oil prices weaken, so it’s still buyable.
Jon Markman operates the investment firm Markman Capital Insights. He also writes a daily trading newsletter, Trader’s Advantage, and a long-term investment service, Strategic Advantage.
