A few weeks ago, I sought out some nuggets in the oil patch. Specifically, I was looking for smaller exploration and production (E&P) companies that were trading below the values paid in recent oil acquisitions, and I came up with three: Plains Exploration & Production (NYSE:PXP), Pogo Producing (NYSE:PPP), and Houston Exploration (NYSE:THX). In retrospect, I should have included Forest Oil (NYSE:FST) in this group as well. While not one of the original nuggets, it is certainly one of the more attractive values in the sector.

First, however, the bad news. Last Wednesday, Forest released its third-quarter earnings report, and it did not fare well. The company earned $0.05 per diluted share, compared with $0.53 last year. It took a whack from lost production caused by this year's devastating hurricanes. And it incurred a $72 million pre-tax, non-cash charge for discontinued hedges, as well as a pre-tax $3.6 million charge to set up an insurance reserve. Without these hurricane impacts, Forest would have earned $0.79 per diluted share.

You may wonder what "discontinued hedges" are. I wondered the same thing. I mean, it sounds like a product no longer being carried at your local gardening center. However, with a bit of help from (and many thanks to) Fool colleague Stephen Simpson, I can offer the following: Forest entered into options contracts to deliver oil for a set price at a future date. When it could not deliver the oil, it had to pay the counterparty a fee to get out of the agreement. This is not unusual, and similar language can be found in the earnings reports of many E&P companies. It also goes to show that, while drilling offshore might offer great rewards, the risks of dry wells are also amplified.

With those risks in mind, Forest will be spinning off (link opens a PDF file) its offshore Gulf of Mexico operations as a separate company, and this is where Forest becomes a compelling investment idea. The spun-off company will merge with Mariner Energy, and the combined entity, called Mariner, will go public. Forest Oil shareholders will receive 0.8 shares of Mariner for each Forest share they owned at the time of the spinoff, a deal that will constitute 58% of Mariner's common shares outstanding. Forest will focus on the onshore businesses; Mariner will focus offshore.

Why might this spinoff offer hidden value? Forest before the spinoff is a cheaper company than either Forest or Mariner will be after the spinoff. Including the 0.8 shares of Mariner that will be given to Forest shareholders, and the Mariner reserves associated with those shares, Forest is currently trading for $13.16 per barrel of reserves (bbl). After the spinoff of Forest's offshore operations and the IPO of Mariner, Forest will be trading at $16.03/bbl if the stock price remains at its current level. Meanwhile, if Mariner has a successful IPO at the proposed offering price of $20 per share, its reserves will be valued at $20.29/bbl.

This is really quite interesting, since Forest's peer group of companies trades at an average value of $15.50/bbl. Therefore, buying Forest now offers a 15% discount to its peer group. A good comparison for Mariner is Bois d'Arc Energy (NYSE:BDE), which currently trades for nearly $18/bbl. Therefore, after its IPO, Mariner would be trading at a premium of almost 13% to one of its peers. The next logical question is: Do both companies deserve to trade at a peer-group premium after the spinoff and IPO?

Here, only Mr. Market and time will have the answer. However, I think a premium is justified. Both companies have high production rates and growing reserves. Splitting the businesses will allow both companies to focus on what they do best -- Forest will find oil on land; Mariner will find oil offshore. In this case, though, it is important to note that the flip side of high production rates is low reserve life. Both companies will need to spend a lot of money and demonstrate drilling success if they want to maintain their premium prices.

As a final thought, I began looking at smaller oil companies because I think they are very likely takeover candidates. The government is greedily looking at Big Oil's huge cash stockpiles, and several major oil companies are having a tough time growing production. Buying smaller companies can be a good use of cash, as well as a good way to increase production. I think Forest and Mariner are both potential takeover candidates in the coming years.

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Robert Aronen owns shares of none of the companies mentioned, although he thinks Forest looks like not too bad a deal. Please feel free to share your comments with him at [email protected].