Sweet 16 Update - June 24

[dan_s]

The Sweet 16 drifted 0.96 percent lower during the week ending June 23. The portfolio is now down 28.03% YTD, compared to the S&P 500 Index which is up 8.91% YTD. To say the upstream oil & gas sub-sector is out of favor on Wall Street is a gross understatement. This is the worst first half of a year the I've seen for upstream equities since EPG was founded in 2001.

What is weird is that Q1 and Q2 financial results are going to be good and MUCH BETTER than the first half of 2016.

CPE, FANG, GPOR, PE and RSPP were up for the week. GPOR reported two outstanding new wells in their new SCOOP leasehold. All of these companies are going to report strong production growth this year. GPOR is now running four operated rigs in SCOOP and should have a lot more details when they report Q2 results. If they report more wells like the first two, this company has a lot of upside for us. I have followed GPOR for over six years and I have a HIGH level of confidence in my forecast model.

This morning I updated my forecast models for CRZO, CLR, EOG, and NFX. I particularly wanted to look at CLR and EOG because they don't have any of their oil production hedged. My valuations came down to $73 for CLR and $106 for EOG. Valuations for CRZO and NFX came down slightly.

All four of these companies have low lifting costs and they produce a lot of natural gas and NGLs. Wall street is fixated on oil prices, but the outlook for gas and NGLs is better.

All of the "gassers" (AR, GPOR and RRC) are trading at market caps below book value. If you know how conservative GAAP/SEC accounting rules are for upstream companies, you know that companies with solid balance sheets and double digit production growth locked in, should NEVER trade below book value. If you read the Credit Suisse report on natural gas that I sent out last week and you have been paying attention to my podcasts, you know that the near-term outlook for natural gas and NGLs is looking very good. Natural gas and NGL prices are not tied to oil prices, they trade on regional markets and the U.S. market is very good for these commodities.

Unless there is a big spike in commodity prices this week, most of the Sweet 16 will report earnings that include some very big mark-to-market increases in the value of their hedges. Earnings and cash flow from operations should be good for all 16 companies. "Adjusted Earnings" and cash flow from operations s/b about the same as they were for Q1. Realized commodity prices will be just slightly lower and production will be higher.

John White (Roth Capital) attended our luncheon in Houston yesterday. He mentioned that he thought RSPP was grossly undervalued by the market; I agree. It does trade at a lower multiple of operating cash flow per share than the other Permian Basin peers. CPE also looks super cheap. The recent death of Fred Callon, the company's founder, may have frightened some investors. CPE has a rock solid management team. The dip is a buying opportunity in this pure play Permian Basin company. Go to the forecast model for CPE and take the oil price down to $45 for all future periods and you will see that the valuation just goes down to $19.00. Now notice that about 50% of their oil production in 2H of 2017 is hedged at $47.50.

CRZO is now trading at the lowest multiple of operating cash flow per share (~3X) in the Sweet 16. First Call's price target is $37.52 for CRZO.

The main Sweet 16 Excel spreadsheet shows my valuation for each company, compared to First Call's price target as of the date of the report.

What can change Wall Street's attitude about the upstream sub-sector?
> When Goldman Sachs gets all of their big clients into the sector and they come out with a report that says oil prices have bottomed. This reason is a bit sarcastic, but I've seen it happen many time before. GREED and FEAR drive Wall Street. Don't be surprised if a sudden change of heart by the "heartless" big Wall Street firms causes a rally.
> At the beginning of each quarter, a lot of hedge funds are required to "re-balance" their portfolios. Fund managers like to harvest gains to lock in their big fees.
> Q2 results that come out at the end of July and early August might surprise investors a bit. 2nd Quarter results will be good.
> If Credit Suisse is right, natural gas prices are going a lot higher in Q3. Credit Suisse forecasts that ngas price will average $3.75/MMBtu in Q3. We will need a spike above $4.00 to make that happen. HOT weather in the last half of July should cause weekly draws from natural gas storage. Keep in mind that there are over a 100 more gas fired power plants in the U.S. than there were five years ago. Just four weeks of warmer than normal weather from mid-July to mid-August should push ngas storage below the 5-year average. The last time we saw ngas storage below the 5-year average at the beginning of Q4, natural gas spiked to over $5.00/MMBtu.
> Increasing draws from OECD crude oil inventories. This is the most fundamental reason for oil prices to stabilize and for investors to gain more confidence in the sector.

As I pointed out in Thursday's podcast, the fundamentals are heading in the right direction. We just need Wall Street to believe them.