How to Research an Oil Stock: Part 4

Howdy, Fools. Last week, I made an attempt to share with you exactly how I approach an unfamiliar oil stock for the first time. I chose Gulfport Energy (NASDAQ:GPOR) for the exercise, figuring that its small size and fairly concentrated operations would yield to a simple analysis relative to larger E&Ps like Anadarko Petroleum (NYSE:APC) or Devon Energy (NYSE:DVN). Nevertheless, we've faced a few curve balls.

Over the course of three installments, we've reviewed everything from Gulfport's share structure to its board composition and production profile. I was ready to move on when a few reserve classification numbers didn't add up, but a few of you asked me to continue, so let's proceed.

The race to replace
In a business where you're dealing with a depleting asset like oil, the pressure's always on to add new reserves to replace the ones you've just produced. That's the only way to keep the cash-flow engine humming.

Companies with high reserve replacement ratios (reserve additions divided by production) and low finding costs (the per-barrel cost of those reserve additions) can be counted on to trumpet these figures loudly each year. These tend to be folks like Quicksilver Resources (NYSE:KWK) and EQT (NYSE:EQT) -- onshore companies with highly repeatable resource plays.

In contrast to these rapid growers, Gulfport's proved reserves have barely budged over the years. Reserve totals in 2008 were a bit lower than those in 1997, with modest fluctuations throughout the intervening years. Now, that's not necessarily a bad situation, so long as reserve levels are sustained cost-effectively. Let's look at the past few years in greater detail.

When reserve adds go bad
For 2006, Gulfport broke out price and performance-based revisions in its annual results press release. The company hasn't made these helpful disclosures in subsequent years.

Performance, rather than commodity price declines, accounted for 94% of the negative 0.57 million BOE revision. That's a large revision, knocking off more than a third of the 1.54 million BOE in organic reserve additions. Recurring negative performance revisions would indicate that prior reserve bookings were too optimistic.

It's too bad we don't know the breakdown for 2005, which also saw negative revisions. We do know, however, that year-end prices in 2005 were $57.75 per barrel and $10.08 per million BTU, compared to $40.25 and $6.18, respectively, at the end of 2004. It doesn't look like price declines were much of a factor in the 2005 revision, either.

Turning to the 2006 annual report, we notice a funny thing. Oil reserve revisions are marked as a positive 1.02 million barrels. Gas revisions, after conversion to BOE, are slightly negative at 0.05 million BOE. That nets out to a positive 0.97 million BOE revision, versus the negative 0.57 million BOE figure we saw a moment ago.

Ah, I see what Gulfport has done. They've added drill bit reserve additions to the negative revisions, and reported the net change on a single line item called "Revisions of prior reserve estimates." This is strange, since the word "revision" has a very specific meaning in reserve reporting, and FAS 69 requires that reserves added through extension and discovery (i.e., through the drill bit) be reported separately. Gulfport used this same shorthand in 2007.

At least the firm properly separated these entries in its 2008 10-K, bringing Gulfport up to a very basic reporting standard met by peers like Petroquest Energy (NYSE:PQ) and Clayton Williams Energy (NASDAQ:CWEI) in their own annual filings.

Where were we?
Sorry for the diversion. In light of the difficulties we had with reserve percentages in the last installment, I deemed it important to check the addition on these reserves additions. These financial statements have really given me some headaches.

Now, bracketing off the issue of negative performance revisions for a moment, let's look at gross organic reserve replacement ratios …

Data from company press releases.

… and finding costs over the past few years:

Data from company press releases.

Neither the reserve replacement rates nor the finding costs look so good here. They would look worse still if we included Gulfport's negative performance revisions. We were only provided that figure for 2006, though, so we can't go down that road.

At least annual production has been growing at a rapid rate in recent years, nearly tripling in the period under consideration. This actually brings something important into focus. Gulfport's significant investment in its U.S. operations in recent years has indeed generated growth -- just not in proved reserves.

Stay tuned for a look at Gulfport's potentially most valuable asset -- its stake in prime oil sands country.