Energy Takeover Targets

(source: Barron's Dec. 5, 2013)
Some small U.S. exploration and production companies look ripe for consolidation. Two stocks that could rise at least 50%.

While merger activity this year has been relatively subdued, there is ample reason to expect increased consolidation among small U.S. exploration and production companies.

"I think we will see more energy deals. Doors may be closing for major oil companies, whose growth is constrained," says Bernard Picchi, a portfolio manager at Palisade Capital Management in New Jersey. "Oil-and-gas producers know they can operate with political stability in the U.S., where new drilling-and-completion techniques offer upside."

Horizontal drilling, and fracturing, the technique of shattering underground rock to harvest hydrocarbons, have resulted in the highest level of U.S. oil production in decades as the country edges toward energy independence.

Growth-oriented exploration companies that have taken on excessive debt are more likely to be takeover candidates, because "outspending cash flow is unsustainable. The party will end with a pullback in commodity prices," says Sven Del Pozzo, an energy analyst at IHS Herold. U.S. oil prices, near $97 per barrel, have fallen almost $10 in recent months.

At a Glance

Northern Oil & Gas (NOG)

Stock Price:	$15.40
52-Week High:	$17.90
52-Week Low:	$11.79
Market Value:	$940 million
Est. 2014 EPS:	$1.31
Price/Earnings	11.7
Est. Long-Term EPS Growth:*	N/A
Est. ('14/'13) EPS Growth:	12%
Revenue (trailing 12 months):	$350 million
Dividend Yield:	None
CEO:	Michael L. Reger
Headquarters:	Wayzata, Minn.

N/A=Not available
* Based on analyst estimates looking ahead three to five years.
Source: Thomson Reuters, Yahoo!

The biggest energy companies, whose shares have lagged the broader market this year, can afford premium buyout prices. A larger acquirer can find cost efficiencies and better manage commodity price swings thanks to a more robust balance sheet. Midsize explorers and private-equity players could also bid. Targets would most likely be companies worth $500 million to $3 billion.

We asked energy-focused investment advisors to identify takeover candidates, based on undervalued assets in hot oilfields. Two names bubbled up:Northern Oil & Gas (ticker: NOG) and Approach Resources (AREX). (For a longer list, see the table below, "In Play? Cheap Oil Exploration Plays.")

Northern Oil & Gas
Northern Oil & Gas, focused on the oil-rich Bakken Shale, has a passive business model: It has minority interests in wells, and gets a cut from partners drilling on its acreage in North Dakota and Montana. This year, the U.S. Geological Survey doubled its estimate for undiscovered oil volume in the Bakken and Three Forks formations, where Northern also operates.

A buyer could pay up for Northern's cash flow, broad acreage holdings, and its knowledge of multiple operators in the basin, says Art Smith, senior portfolio manager at energy-focused Triple Double Advisors in Houston. He thinks shares could double in a takeover. Assuming no deal, they could offer 35% upside in the next year, he says. Short interest totals about 25% of outstanding shares as of Oct. 31. The stock closed Thursday at $15.40.

Using Northern's enterprise value (market value plus debt) of about $1.5 billion, it trades at about just 5.4 times trailing earnings before interest, taxes depreciation and amortization. Larger peers in the Bakken are trading at about nine times trailing Ebitda.

Moreover, Northern may be positive cash flow in 2014, says Smith. Northern was the target of short sellers in 2011, the result of an accounting controversy. Today's discount, despite disappointing third-quarter production, looks unwarranted.

At a Glance

Approach Resources (AREX)

Stock Price:	$19.93
52-Week High:	$31.67
52-Week Low:	$19.77
Market Value:	$778 million
Est. 2014 EPS:	$0.68
Price/Earnings	29
Est. Long-Term EPS Growth:*	N/A
Est. ('14/'13) EPS Growth:	70%
Revenue (trailing 12 months):	$158 million
Dividend Yield:	None
CEO:	J. Ross Craft
Headquarters:	Fort Worth, Texas

N/A=Not available
* Based on analyst estimates looking ahead three to five years.
Source: Thomson Reuters, Yahoo!

If bad weather crimps fourth-quarter production, any selloff among Bakken players would be a buying opportunity, says Tyler Kocon, a portfolio manager at Split Rock Private Trading, an investment advisor in Duluth, Minn. with energy portfolios. He likes Kodiak Oil & Gas (KOG) for its acreage, and says shares, which ended Thursday at $11.64, could rise 20% in a takeover.

Approach Resources
Another attractive buyout candidate: Approach Resources, which owns some of the cheapest reserves in the Permian Basin in Texas. Approach's assets are likely worth a good deal more given the rich price paid by Chinese energy company Sinochem for a 40% stake in Permian player Pioneer Natural Resources (PXD). (See Barron's, Sizing Up Small Caps, "Approach Resources: At Least 50% Upside," Sept. 21.)

Approach has dropped 17% since our story, when we argued that shares offered 50% upside, due to disappointing well results. However, the selloff appears overdone. As we wrote in September, "Approach is unlikely to remain independent long-term."

The stock trades at 10.6 times EV/trailing Ebitda, a significant discount to Pioneer's multiple of about 14.5 times.

Of course, small exploration companies are hypersensitive to commodity prices. If oil prices spike, takeovers become more expensive and less likely. If oil prices fall, shares can drop even more sharply. But oil prices look like they may remain in the $90s in the next year based on the futures market.

And as the patchwork quilt of exploration companies consolidates, investors could find themselves blanketed with nice returns.

In Play? Cheap Oil Exploration Plays

Company/Ticker	Recent Price	12-Mo Change	EV/ Reserves (BOE*)	EV/ Trailing Ebitda	2014 Est Production Growth	Asset Locale
Approach Resources/AREX	$19.93	-13.3%	$10.50	10.4x	41%	Permian Basin
EPL Oil & Gas/EPL	$28.74	34.4%	$22.50	4.2x	6%	Gulf of Mexico
Kodiak Oil & Gas/KOG	$11.64	35.8%	$55.61	9.3x	52%	Bakken Shale
Northern Oil & Gas/NOG	$15.40	-4.7%	$22.11	5.3x	24%	Bakken Shale
Rosetta Resources/ROSE	$51.74	14.1%	$21.31	7.5x	31%	Eagle Ford Shale

*Per barrel of oil equivalent
Source: Triple Double Advisors