4 Reasons This Gulf Oil and Gas Producer Might Be a Good Buy

While shares of Energy XXI (NASDAQ: EXXI  )  plummeted after its purchase of EPL Oil & Gas  (NYSE: EPL  ) was announced, the selling might have been overdone. Factors related to the merger and a compelling valuation when compared to Freeport-McMoRan Copper & Gold's (NYSE: FCX  ) recently acquired oil-exploration unit suggest the stock price retreat might be an excellent buying opportunity. Here are four reasons why.

Making a good acquisition
Energy XXI's buyout of EPL Oil & Gas looks like an acquisition that could provide many benefits. For around $2.3 billion, including the assumption of debt, Energy XXI acquires an additional 7.3 million barrels of oil equivalent (BOE) of annualized production. That production is located mainly in the Gulf of Mexico, where the company already has most of its properties.

The centralized location of these oil and gas fields should deliver meaningful cost savings. Overall operating costs can be pruned as duplicate expenses are eliminated. Developmental expenditures will also be more effective, producing more oil per dollar spent via a focus on developing only the best of the combined fields.

The transaction also brings more than cost savings. EPL's seismic data and field study abilities should fit nicely with Energy XXI's production expertise. EPL recently committed to $45 million worth of new 3D seismic mapping projects, a critical tool for finding oil and gas under the sea floor. The resulting data should assist in determining the amount of reserves available and which are the most advantageous to develop.

While paying a reasonable price
The fact that Energy XXI didn't overpay for these benefits enhances the deal significantly. At an estimated enterprise value, or stock market worth plus total debt, cost of around $2.3 billion, the purchase came to roughly $315 per BOE of EPL production based on the latest quarterly figures annualized. On an annualized sales basis, the transaction was worth about 4 times revenue.

These valuations aren't a bargain but seem fair. They are very close to what Freeport-McMoRan Copper & Gold paid for Plains Exploration & Production and McMoRan Exploration in 2013. Freeport, trying to diversify away from its core mining business, obtained an entire oil and gas division with the buys, receiving substantial oil and gas assets in regions such as the Eagle Ford shale in Texas, onshore and offshore California, and the Gulf of Mexico.

Paying about $6.6 billion for Plains and $3.1 billion for McMoRan, with the assumption of around $11.2 billion in total debt, Freeport's total cost came to near $316 per BOE of annualized production; that's approximately 4.3 times yearly revenue on an enterprise value basis.

Good prospects in the Gulf of Mexico
Besides undertaking a good merger at a decent price, Energy XXI's exploration prospects are encouraging. One area of focus is Gulf of Mexico salt domes. Salt domes are large, thick mineral beds that can hold oil and gas reservoirs. Though discovering these reserves can be difficult, they have been known to contain world-class resource amounts. In partnership with Freeport-McMoRan's oil and gas operations, Energy XXI is involved in two promising salt-related plays.

The first is called the Davy Jones field, where two wells have already been drilled. The Davy Jones No. 1, drilled to a depth of more than 28,000 feet, logged 200 net feet of pay. That's a hopeful sign since pay is the thickness of a potentially viable reserve base. The Davy Jones No. 2, located 2.5 miles away from the first well, seemed to confirm the field's potential when it found 120 net feet of potential pay in one area and 192 net feet of pay in another section.

The Blackbeard East ultra-deep field is another discovery. An exploration well drilled to a depth of more than 33,000 feet indicated the presence of hydrocarbons below the find's salt weld. Still in early days, further testing in the field's upper area is planned for 2014, and actual development of the shallowest zones could happen later this year.

The EPL purchase might add another potentially lucrative find. Investigation into EPL's Ship Shoal 208 field began in late 2013 with an exploratory well making a possible oil sand discovery. A currently running test well is expected to provide additional information by mid-2014, and further developmental steps are anticipated once new seismic data has been received.

Trading at an attractive valuation
Energy XXI's attractive valuation may be the company's most appealing feature, however. On a combined pro forma, or post-merger, basis, the company currently trades at an enterprise value of around 3.3 times its $1.7 billion in expected revenue. On an oil-deliveries comparison, Energy XXI is valued at around $243 per BOE from an anticipated 23.7 million BOE in annualized production.

Pricing is noticeably lower than Freeport-McMoRan's 4.3 times revenue and $316 per BOE acquisitions price tag from last year. While some discount may be justified, the current cut appears excessive. Given potential merger benefits, plus meaningful oil and gas discovery possibilities, Energy XXI looks like it could deliver considerable share price appreciation on any sort of unexpected good news.

Bottom line
The recent sell-off in Energy XXI shares may have been overdone. The company's acquisition of EPL Oil & Gas looks a good one, and its market valuation seems significantly discounted when compared to Freeport-McMoRan's recently acquired energy business. Of course, an energy company's worth will ultimately depend on how much oil and gas it can find. If Energy XXI can deliver -- even slightly -- on its exploration potential, the stock price may react with a substantial rise.

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