Are there any more values bubbling up in the oil patch? I recently wrote about several acquisitions in the oil business, wondering if they might help identify other oil and gas companies that could be buyout candidates. Like a good engineer, I built a spreadsheet and looked at the reserves, production rates, developments, and locations for 13 independent oil and gas companies with market capitalizations between $1 billion and $4 billion. From the list, I offer three stocks worth a further look: Plains Exploration & Production (NYSE:PXP), Pogo Producing (NYSE:PPP), and Houston Exploration (NYSE:THX). But before we get into the details, let's take a look at the method behind my madness.

One way value investors assess the margin of safety in an investment is to determine what a private investor would pay to purchase the entire company. While it sounds simple in theory, in practice it often proves quite subjective, because items like brand names and patents are more difficult to price than buildings and land. In the oil patch, however, this method seems reasonable, because the vast majority of a company's value can be assigned to oil reserves and production facilities. Just like in the housing market, the easiest way to value an oil property is to see what recent purchase prices have been for similar properties. The oil patch has created several comparable prices in recent months with the purchases of Unocal, Spinnaker Exploration (NYSE:SKE), and Vintage Petroleum (NYSE:VPI). Stephen Simpson examined the purchases of Spinnaker here, Vintage here, and Unocal here.

Two valuation metrics
A simplified method of evaluating the price paid is to look at the purchase price per BOE (barrel of oil equivalent) of proven reserves. On this basis, the values were $41.82 per BOE for Spinnaker, $8.70 for Vintage, and $10.23 for Unocal.

In the nearly fivefold difference in price between Vintage and Spinnaker, one can see that this measure doesn't tell the entire story. This is because reserves and production rates are totally different items. Huge reserves with low production rates could indicate old, depleted wells, difficult production environments, or lack of development. If the property is not developed, the buyer would need to invest millions and wait years before receiving a satisfactory return on his investment. Quite simply, the buyer can't sell oil that remains in the ground, and the longer it takes to produce, the less it is worth.

Therefore, I went back to production figures and rearranged the numbers to see the price per BOE of annual production, which gave me $299 per BOE for Spinnaker, $155 for Vintage, and $183 for Unocal.

Bear in mind that this is not a standard metric, but rather something I am using to understand the difference between Spinnaker and the other purchases. Looking at the purchase in this light allowed me to see that the value of Spinnaker lies in having several large fields just beginning production. Furthermore, production is set to increase substantially because Spinnaker has been developing additional significant discoveries in the Gulf of Mexico. Spinnaker also holds a huge base of seismic data for deepwater Gulf of Mexico, where the Minerals Management Service estimates oil and gas reserves to be 71 billion BOE. Therefore, NorskHydro (NYSE:NHY) valued Spinnaker as a growth stock with a great deal of existing production power, whereas Occidental Petroleum (NYSE:OXY) pegged Vintage as a value stock that needed to be whipped into shape with further investments before it could boost production and improve returns.

Valuing the three candidates
While it may be interesting to analyze why Norsk Hydro paid such a premium for Spinnaker, it probably isn't a very good benchmark for valuing other oil companies. Instead, I averaged the prices of the other two deals to arrive at a "market value" for reserves at $9.46/BOE, and a "market value" for annual production of $169/BOE. Let's take a look at how my three candidates stack up:

Company

$/BOE (Proven Reserves)

$/BOE (Annual Production)

Plains Exploration

$8.45

$155

Pogo Producing

$12.40

$95

Houston Exploration

$14.00

$90

Market Value

$9.46

$169



Right now, based on both valuation metrics, Plains Exploration is valued at very close to the price at which Vintage was purchased; however, I would argue that it's a better value. Plains has been increasing reserves and production rates, whereas Vintage's reserves have decreased in recent years. Trading at a 13% discount to its recent high price, Plains is worth further study.

Pogo Producing trades at a discount based on production rates, but at a 30% premium based on reserves. Yet reserves have been growing at Pogo for 14 years in a row, with a new development in New Zealand starting in 2006. This company has one of the highest drilling success rates of the companies evaluated and several geographically distributed properties. I wouldn't be surprised to see Pogo fetch a premium.

Houston Exploration has the largest discount based on production rates, but nearly a 50% premium based on reserves. It's heavily focused on natural gas production in the Gulf of Mexico, so it could offer diversification to a company looking to enter that area. With a price-to-earnings multiple of just 10, Houston Exploration also offers the best value by this more standard measure.

Strategy plays a role, too
Of course, the motivation for a big fish to swallow a guppy is not as simple as the guppy being cheap. Strategic interests also play a role. Norsk Hydro bought Spinnaker and its growing production in the deepwater Gulf of Mexico to diversify its portfolio away from the North Sea, where production rates are declining. Occidental Petroleum bought Vintage to gain access to South American natural gas properties and because many other Vintage sites were neighbors to many Occidental sites. Unocal was a highly sought-after jewel because of its huge reserves in Southeast Asia -- with easy access to fast-growing markets like China.

I'm sure when the next merger occurs, the buying company will provide an equally compelling strategic story. In the meantime, the recent drop in oil prices looks to be creating a buying opportunity for long-term believers in the oil market. With that in mind, I will be looking closer at Plains, Pogo, and Houston Exploration.

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Fool contributor Robert Aronen does not own shares of any company mentioned in this article. Feel free to share your comments with him at robertaronen@yahoo.com. The Motley Fool is investors writing for investors.