Judging by how frequently small-cap oil and gas firms have showed up on the Foolish 8 idea list in recent months, a little digging into what's going on in the energy business right now is probably in order. All told, 11 different oil and gas exploration and production (E&P) companies landed on the list at some point in 2000. A half-dozen remained on the list as the year drew to a close with natural gas prices soaring toward the heavens.

Natural gas is the main business of the majority of the small independent E&P companies still hunting for hydrocarbons in the U.S. and the Gulf of Mexico. Late last year, a spike in prices caused the U.S. to rapidly realize exactly how natural gas-dependent it has become. The benchmark gas futures contract hit a high of $10.50 per million Btu in late December, but has recently settled back to trading around $5 per million Btu. That's still well above last decade's trading band of $1.50 to $2.50 per million Btu, however.

With natural gas prices coming back down, many of last year's small-cap E&P firms are seeing their share prices back off from last year's highs as well. In line with our recent thoughts on investing with an eye toward relative share price weakness, now may not be a bad time for investors to poke around in the industry for some potential opportunities. Also, it may be worth exploring whether there is a case to be made for small-cap E&P companies as multi-year growth opportunities rather than just cycle plays.

Small-cap oil and gas companies are a fairly specialized investment field. Still, there are undoubtedly opportunities for those investors who already know something about the area or are willing to spend some time building up a base of knowledge about some of the more interesting players. Here are some ideas to keep in mind during your own investment exploration efforts.

Growth Strategies

There are two main ways for small E&P companies to grow their cash flows. First, the companies can increase their current production levels and future reserves through successful exploration on their own. This is known as "growing through the drill bit." The other principal way to increase cash flow is to acquire it directly either by buying drilling properties or by buying whole companies outright. For lack of a better phrase, this growth route can be thought of as "growing through the checkbook."

Neither growth method is very easy. Moreover, neither is very attractive in terms of investment rates of return. A constant stream of cash is a prerequisite for either growth method, which is the main reason why running an E&P businesses is said to be like running on a treadmill. Just in order to stay in the same place, you need more and more cash. It's a lot like being a politician.

Getting high product prices in the market is still the simplest way for companies to grow their cash flow. For a drill bit growth company, margins can be enhanced by running a focused operation. The company's focus can be the geographical markets where it concentrates its exploration activities, the regional trading markets where it sells its production (since they all offer different prices), or the quality of product it aims to produce from a certain location.

Drill Bit Growth Value Chain

Production and Reserve Growth ==> Focus on Markets, Product Quality ==> Higher Margins ==> Increased Cash Flows ==> Production and Reserve Growth

For companies growing through the checkbook, the main way to add value is to identify value in the undrilled prospects owned by others and to acquire those prospects at the lowest possible prices. Horse trading is about as common in this business as drilling rigs, which gives the small-cap E&P area its flavor as an industry that is seemingly in a constant state of consolidation. Acquisitions are frequent, as many players seem incapable of sitting on their hands for very long. Again, it's just like politics.

Checkbook Growth Value Chain

New Undrilled Prospects ==> Production Growth ==> Economic Rates of Return ==> Increased Cash Flows ==> New Undrilled Prospects

Some Valuation Methods

With these differences in mind, some standard valuation guidelines for small-cap investors can be laid out. For companies growing through the drill bit, operating margins are a crucial touch point. For checkbook growth companies, balance sheet debt is important to consider. It's worth pointing out that leverage cuts both ways, adding the flexibility to hunt for growth prospects during the good times but hampering the financials of an acquisition-happy company during the bad times.

Since most small-cap E&P firms use a combination of the drill bit and checkbook growth strategies, investors should look at both margin levels and debt loads. As a catchall market valuation yardstick, the enterprise value to cash flow ratio can be used to compare companies to each other.

Here's how a crop of small-cap E&P firms stack up based on these measures. These six firms all appeared on the Foolish 8 idea list or on the Quicken.com one-click scorecard "strong interest list" at some point over the past year. Additionally, they all at least doubled in stock price during 2000, but have dropped by 20% or more so far in 2001.

Name and           EBIT     Debt/Capital    EV/CF 
Ticker            Margin         (%)             
Production (KP)     47%         20%          4.1x     

Energy (PENG)       60%          0%          9.1x   

Resource (TMR)      47%         47%          4.2x 

Clayton Williams 
Energy (CWEI)       29%         15%          2.7x    
Resources (DNR)     50%         48%          4.9x  

Resources (CRK)     52%         54%          5.2x

At the time of publishing, Brian Graney did not own shares of any oil and gas companies. In fact, he doesn't even own a car. The Motley Fool is investors writing for investors.