To all but the industry insiders, oil and gas investing can be fairly intimidating. We are accustomed to buying gasoline from ExxonMobil (NYSE: XOM ) and Chevron (NYSE: CVX ) stations, but to many Fools, the familiarity ends there. If you're thinking about picking individual stocks in this sector, Peter Lynch's adage of "buy what you know" has to be left at the door. Yep, set it down right there. That's it -- now come on inside.
Over the past several months, I've covered the quarterly operating results of various exploration and production (E&P) companies. While I've introduced some fundamental concepts along the way, like per-barrel operating costs and return on average capital employed, I realize that many of these analyses may be more useful if you're already somewhat familiar with the drivers of an E&P company's success.
Today, I want to take a step back and look at the broader strategies employed by some of the most successful small- and mid-cap E&P companies. Fortunately, there's more than one way to win big in this space. Unfortunately, that means there's no single business model to seek out when sifting through the countless publicly traded E&Ps.
To demonstrate the crucial role of a winning strategy in the sector, I'm going to look at two very different upstream operators, both of which have absolutely smoked the Energy Select Sector SPDR (AMEX: XLE ) over the past five years. In fact, each business has generated in excess of 1,000% returns for investors over that period. A favorable energy backdrop has provided some lift to the shares, but there's clearly more to it than that.
Path No. 1: Outsource everything
First up is Contango Oil & Gas (AMEX: MCF ) , a small outfit lead by founder Ken Peak. Mr. Peak doesn't hold quarterly conference calls, but his Fool-esque slideshow presentations provide a lot of insight into the company's philosophy.
Peak argues that the majority of value creation by E&P firms comes from the successful drilling of exploratory wells. That means that Contango is more focused on the "E" than the "P" side of things. The firm has sold proven reserves in the past, and I expect it to follow that model in the future, in order to free up capital for further high-impact investments.
Equally important is Peak's contention that there are no competitive advantages in this highly commoditized business. The only differentiator is cost management. Most everyone in the space necessarily speaks to cost control efforts, but Contango has structured its operations in a uniquely cost-efficient manner.
Contango outsources nearly every aspect of its business -- from prospect generation to legal services. Amazingly, the company has all of six employees. This arrangement obviously makes Contango highly dependent on the quality of its partners, but it has structured the incentives underlying these business relationships in a smart way. For example, on certain projects, exploration partners only get paid after Contango has made its investment back.
Path No. 2: Minimize exploratory risk
This is a much more commonplace strategy, particularly among onshore natural gas players. In the case of folks like Chesapeake Energy (NYSE: CHK ) and XTO Energy (NYSE: XTO ) , they're exploiting extensive unconventional gas plays, and applying a predictable, repeatable approach to drilling out that acreage. If you hear a company talking about a "manufacturing" or "assembly line" model of drilling, this is the path they're taking.
ATP Oil & Gas (Nasdaq: ATPG ) takes a slightly different approach. This company works exclusively offshore, which you might view as a recipe for higher exploratory risk. It certainly would be, if ATP were out there exploring.
There's no better way to minimize exploratory risk than to avoid exploration altogether. ATP strictly acquires proven undeveloped assets, and then develops and brings them into production. It has a very strong track record in this regard -- the company pegs its development success rate at 98% since inception.
You might be wondering how that's an effective strategy. First of all, this exclusive focus on development and production totally flies in the face of Ken Peak's assertion about where value creation occurs in the E&P chain. Second, ATP is a small fish in a big pond. (Actually, two ponds -- the Gulf of Mexico and the North Sea.) Certainly the majors and supermajors have equal or better skill at developing these assets, no?
Oh, but ATP's size is crucial to the strategy. The firm is small enough that it is able to pick up assets that aren't strategic to larger players. Note how ATP's two bids in the recent Gulf of Mexico lease sale were both apparent high bids. It's simply not targeting the same prize as the big boys.
The Foolish bottom line
As for the question of value creation, I hope that this quick look at contrasting strategies demonstrates that there are very different ways to earn outsized returns in the E&P space. For that reason, it's not enough to hunt for firms with a low PEG ratio (Contango has none, because there are no analyst estimates) or a low price-to-book (ATP's is off the charts).
To find an upstream winner, you need to look for a company that articulates a clear strategy that differentiates it from the pack. If there's a founder at the helm who owns a huge slug of shares, as is the case with both firms I've presented today, all the better. That tends to be a pretty good sign that the company is onto something special.
Small, dominant businesses with significant inside ownership are the bread and butter of the market-beating Motley Fool Hidden Gems newsletter service. You can check out the newsletter, and all its past stock picks, free for 30 days.