3 Small-Cap Oil and Gas Stocks You Should Be Watching

Generally, small-cap independent oil producers trade at significant discounts to the value of their assets or reserves. That's because many investors don't wish to take the risk of investing in what could be called a speculative oil play.

Because of this, however, many small oil exploration and production, or E&P, companies can be lucrative investments over the long term as they develop. I feel that I have found three such lucrative plays in the form of Resolute Energy (NYSE: REN  ) , TransGlobe Energy (NASDAQ: TGA  ) , and Contango Oil & Gas (NYSEMKT: MCF  ) .

But where to look?
When trying to identify potential E&P plays, I like to use two main valuation methods. First, the enterprise value to reserves figure, or EV/reserves, which gives an indication of what value the market is placing on each barrel of the company's reserves. Generally, this figure can be compared to the rest of the industry or the company's close peers to get an indication of whether or not the company is undervalued.

Second, I like to use the PV-10 ratio. This figure helps us understand how much the company's oil reserves will be worth over the life of the project, minus 10% as a discount rate to account for items such as inflation and taxation. PV-10 attempts to show us the future value of all of the reserves held by the company, net of extraction expenses.

So, let's take a look at some seemingly undervalued oil minnows and try to establish their worth.

North America
I came to the conclusion in a previous article that domestic E&P companies now look relatively overvalued in comparison to their international peers, as the domestic oil boom has sent valuations skyrocketing. However, Resolute Energy seems to have bucked the trend.

As of December 2012, Resolute's reserves totaled 78.8 million barrels of oil equivalent. Using the present value method, the company's engineers estimate that the pre-tax value of these reserves was $1.1 billion at year-end 2012. In comparison, Resolute's enterprise value currently stands at $1.3 billion. As you can see here, major oil and gas companies tend to trade at a significant premium to the value of their reserves.

If we divide Resolute's enterprise value of $1.3 billion by its reserve figure, we get an EV/reserve figure of $16.50. In comparison, U.S. oil market leader EOG Resources is trading at an EV/reserve figure of $28, and Pioneer Natural resources has an enterprise value of $26 billion while the PV-10 value of its reserves is only $8.3 billion, based on the most recent data .

The Middle East
TransGlobe Energy is another small fish that appears cheap at face value. However, the majority of the company's operations are in Egypt, which is a highly unstable region at present. That said, Egypt's instability started back during 2011 and as of yet, TransGlobe's operations have not been affected.

Still, it seems as if TransGlobe is trading at a significant discount to the value of its reserves. This leads me to believe that this discount could mitigate some of the risks that investors would be taking on due to TransGlobe's geographical location.

Indeed, at the end of fiscal 2013, TransGlobe had 45 million barrels of gross proved plus probable oil reserves. The company's engineers reckon that these reserves have a PV-10 value of $615 million, 42% more than the company's current enterprise value of $608 million .

Although, if we compute the EV/Reserves figure, we see that TransGlobe is trading at a value of $13.5 per barrel of reserves, which is lower than the figure we got for Resolute but still less than the figures for EOG and Pioneer.

Having said all of that, TransGlobe is sitting on a net cash position, so the company does look financially stable from that point of view, and extra financial stability does deserve a premium.

Cheapest of all
Contango Oil & Gas currently has a enterprise value of $550 million, and it its pre-tax net present value of reserves, discounted at 10%, is approximately $550 million.

It does get a bit complicated here as Contango is not strictly an oil company and produces more gas than anything else. Of course, this means that the company's reserves are worth less than those of its peers (gas is cheaper than oil). Contango has proved reserves of 236 billion cubic feet of natural gas, 8.7 million barrels of oil, and 8.3 million barrels of natural gas liquid. All in all, this works out to 338 billion cubic feet of gas equivalent. Translated, and put into simple terms, this implies that Contango's reserves are currently being valued at $1.63 per million British thermal units -- with natural gas currently priced around $5 per million British thermal units, you can see the valuation discrepancy here.

Foolish summary
All in all, small-cap oil companies can be risky and highly speculative. Nevertheless, if you know where to look and do your research, you can minimize the risk. All three companies above, TransGlobe, Resolute, and Contango, are trading at a value that is below the estimated value of their reserves, making the companies look undervalued with potential for capital gains as the companies monetize their assets. This low valuation also opens up the possibility for takeovers as oil majors buy up smaller peers in an attempt to drive production higher.

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