Under the Radar: Energy's high five

PORTFOLIO POINT: Even if you can identify a good sector, identifying a good stock still requires work. Luckily, by drilling down deep enough in the Australian energy sector, there’s a couple of real gems.

On Monday I wrote about US stocks, noting that as signs of a market peak accumulate, investors need to be more selective on how they get exposed to the world's biggest market. The same goes, of course, for Australian equities, with the currency-addled sideways bear market of 2009 until now making it more than ever a stock-picker's market.

The solution for many investors is to go beyond the index and carefully select stocks and sectors. Taking a top-down approach, I wrote that one of my favourite sectors at the moment – both in the short and long-term – is energy. I also wrote that by taking a sectoral approach, you needn't look for needles in haystacks, as a rising tide can lift all boats. Yet this was somewhat facetious; if you have any real interest in investing sensibly, you should always be particular about where and how you invest your money. Today’s exercise then is to look at the small cap end of the energy market as a whole and pick a needle from the haystack.

There are 111 listed energy stocks on the ASX with market capitalisations between $20 and $200 million, according to Standard & Poor's global industry classification standards (GICS). If we rank these 111 stocks by market capitalisation, ranging from Guildford Coal (GUF) at $193 million as of Wednesday's close, to Gas2Grid Limited (GGX), at $21.05 million on the same date, the larger the cap, the smaller the number, as can be seen in the chart below.

The energy eleventy-one: GICS energy stocks under $200 million, above $20 million
Source: ASX

For investors looking for under-the-radar small cap energy stocks, it's already clear that when just accounting for market cap, the choices can be limited if investors desire reasonable depth and liquidity. The choice shrinks further if we add another variable like, say, profitability within the last year, with the list shrinking just to 17. And then if we strip out the services companies, demand a debt-to-equity ratio of less than one and a more-than-reasonable price to earnings ratio of 25 (let’s be fair, many of the companies on our original list that did make a profit had PEs over 50, some over 100), then suddenly we're down to just five.

The high five: energy stocks that make the cut (so far)

-Code	Name	Price	Cap (m)	Profit Margin	Debt to Equity	Price to Earnings
CCC	Continental Coal Limited	$0.23	$95	<0.01%	0.60	1.72
CUE	Cue Energy Resources Limited	$0.27	$188	40.39%	0.38	8.63
EME	Energy Metals Limited	$0.33	$51	11.62%	0.02	23.4
HOG	Hawkley Oil and Gas Limited	$0.23	$44	33.26%	0.08	5.65
PSA	Petsec Energy Limited	$0.22	$51	62.41%	0.16	1.47

Source: Stock Doctor; Datastream

From the array of fundamentals above, we can safely say that Continental Coal (CCC) barely makes the grade, with a $2,000 pre-tax profit for the December interim barely giving it a return on investment for the period. Besides, a PE ratio of barely two is a big warning sign. Similarly, we can cull Energy Metals (EME) from the list, as its PE ratio stands head and shoulders above the rest. Indeed, I doubt the underlying story of EME's PE; while post-tax earnings per share were two cents on a 33c stock for the last reported interim – full-year numbers are still to come – underlying pre-tax profits were $22,000 on equity of $50 million, a return of less than 0.1%.

That leaves Cue Energy Resources (CUE), Hawkley Oil and Gas (HOG) and Petsec Energy (PSA). By overlaying some more criteria on these three, namely the price-to-net tangible assets (NTA) ratio, the interest coverage ratio, the returns on assets and equity and the average daily trading volume, we can make a better comparison. Each stacks up pretty well, though returns are lower for Cue Energy and volumes are lower for Petsec. As for price to NTA, Petsec seems especially undervalued (though ratios of 1.5 and 1.52 are pretty good as well – BHP's ratio is a price 2.99 times NTA), while interest coverage is fine for all. Indeed, Cue and Hawkley had no interest-bearing liabilities as at the last reporting period.

Source: Stock Doctor; Datastream

As for forecasts and price targets, only Hawkley enjoys mainstream broker coverage as compiled by Thomson Reuters, with a 'consensus' forecast (admittedly a consensus of one) of earning 3.8 cents in the year to June 2012 and 16.3 cents in FY2013. That same broker has a price target of 61 cents, over twice current levels.

At this stage, it is obvious that a deeper analysis is required. In terms of the charts, each of these stocks has been a pretty poor performer on a risk-adjusted basis when charted against the ASX All Ordinaries. While fortunes have turned around for each of the three in the last few months, only Petsec is in the black when compared to a year ago. And as for Hawkley, the clear price under-performer, its share price is still half the 52 cent highs it reached in January 2011, though it's well ahead of its reinstatement price in June 2010, when biotech Incitive Ltd was reborn as an oil and gas explorer with a $5.5 million raising at 20 cents per share.

Price performance: 1-year
Source: Stock Doctor

Price performance: 21-months
Source: Stock Doctor

In terms of the macro picture, each of these stocks is an emerging oil and gas producer, yet each operate in very different markets. Hawkley has assets in the Ukraine, Petsec in Louisiana and the Gulf of Mexico and Cue in Australasia – notably the Carnarvon Basin, Papua New Guinea, offshore New Zealand and Indonesia. While geographically dispersed, however, none of these operating locations are complete greenfields. Although the Ukraine is more known these days as a victim of energy diplomacy with an unhealthy reliance on Russian gas pipelines and Soviet-era nuclear plants, its western region was once one of the world's leading oil provinces as part of Austro-Hungarian Galicia. Louisiana and the Gulf of Mexico, meanwhile, may have been supplanted by the Middle East and Western Siberia in terms of reserves and volume of production, but are still vital sources of supply for the United States.

Closest to home, Cue also operates in oil provinces well-known to larger companies, including $370 million market cap Horizon Oil (HZN), which was featured in an Under the Radar column in August 2010 (click here). But most importantly for my piece of mind, Cue operates in oil provinces that are more understandable to Australian investors.

While the prospects for both Hawkley and Petsec are intriguing intriguing (although Petsec’s low PE ratio, like that for Continental Coal, is troubling), for different reasons both the United States and the Ukraine have their share of sovereign risk. The US, especially Louisiana, has a highly politicised oil and gas industry – notwithstanding the wishes of both Congressional Republicans and Democrats to have more oil and gas sourced domestically – and in many respects the Ukraine is a failed state (its former PM Yulia Tymoshenko, jailed on charges relating to energy corruption, is facing a second trial on charges of tax evasion).

Indeed, according to the 2011 Failed State Index compiled by magazine Foreign Policy and US think tank Fund for Peace, its overall ranking was one rung above that of Libya. On the list's measure of a country's factional elites – all important for companies operating in the energy business – Ukraine ranks at 8/10 alongside Egypt, Bolivia and the Solomon Islands.

Perhaps surprisingly, Indonesia has a better ranking on this measure (7.0), notwithstanding Jakarta's infamous nexus of money and power. Papua New Guinea also has a better ranking (7.1) than the Ukraine and as for New Zealand, their sovereign risk rating is much better than our own.

And happily, the geology is as prospective as the operating finances are sound and the sovereign risk is manageable (attempted mutinies in PNG notwithstanding). Spread across the four countries, Cue’s assets are also spread across various stages of production, development and exploration meaning that risk is manageable. Still, there are several keynote projects that add spice to the stock, notably Jeruk and Barikewa, both appraisal-stage projects in Indonesia's East Java Basin (the Sampang production sharing contract) and PNG, respectively.

Right on cue'¦

Source: Company website

In total, Cue has 2.7 million barrels of oil reserves and 118 billion cubic feet of gas reserves and resources. While existing producing assets are expected to decline in the coming years, the company's future production is forecast to increase considerably. Most of this is gas, which I am not crash-hot on, but with zero debt and tight control of costs – it is typically a non-operator of farmed-out projects (JVs are conducted with Woodside, Santos, Oil Search and others) – the downsides are limited.

'¦ and setting the stage
Source: Company presentation, March 20

The company has large ambitions to become a billion-dollar business, which would translate to a share price of over $1. Of course, the best laid schemes of mice and men often go awry, but major shareholders Singapore Petroleum and Todd Corporation, the New Zealand conglomerate, appear to be in for the long-haul.

There are many ways to value a company like Cue, but invariably they wouldn’t do it justice as this is primarily a growth company, not a value stock. Nevertheless, value there is, with oil prices still trading strongly and the share price well beneath its 12-month high of 35.5 cents. On short-term considerations of a test result, Cue closed on Thursday at 27 cents. Justifiably, for where it is in the present, it should be closer to 35 cents. And for the future, the upside, as they say, is significant.