[Editor's note: A version of this story appears in the February 2019 edition of Oil and Gas Investor. Subscribe to the magazine here.]

With oil retreating more than 30% as 2018 approached an end, E&Ps—and especially the less liquid, small/midcap (smid) subset—were under heavy pressure. In addition, E&P stocks, in general, were tumbling along with the broad selloff in the global equity market.

Such unsettling conditions have typically led investors to focus on larger, more liquid stocks. Moreover, as investors increasingly focus on E&Ps that are generating free cash flow, larger-cap E&Ps are often prioritized over growth-oriented, smaller-cap names.

Meanwhile, a relative lack of scale weighs on smid-cap names as it relates to negotiating for oilfield services, such as rigs and pressure pumping; the cost of a top in-house technical team can be disproportionately heavy for smids; and building out midstream facilities can be more onerous.

Not surprisingly, the deep chill that descended on investor interest in smids in December translated into some remarkably inexpensive valuations by historical standards. For example, in early December, even as analysts factored in markedly lower commodity-price decks, some oil-oriented smid stocks were trading at multiples of EV/EBITDA for 2019 that ranged from a low of about 2x to up to 5x. This compared to an EV-to-2018-EBITDA multiple of between 4x and 8x in mid-2018, when WTI was more than $74.

Welles Fitzpatrick, managing director and equity analyst at SunTrust Robinson Humphrey Inc., highlighted PDC Energy Inc. as a good performer at 2019’s start.

In addition, based on EV per flowing barrel of production, E&P valuations had, in some cases, fallen to levels not far from metrics used in asset transactions in the period prior to crude’s 2014-2016 collapse. Some analysts cited $40,000 per flowing barrel as a benchmark for such transactions.

Against the wreckage strewn over the smid E&P sector, Oil and Gas Investor asked analysts for their top picks.

PDC Energy Inc. Welles Fitzpatrick, managing director and equity analyst at SunTrust Robinson Humphrey Inc., zeroed in on PDC Energy Inc. (NYSE: PDCE). Based in Denver, the company’s largest asset is in the Wattenberg Field in the Denver-Julesburg Basin of Colorado. In addition, PDC has production and significant acreage being developed in the Delaware Basin.

“At around $34 per share, PDC is in the cheapest decile of the E&P group, trading at a multiple of about 2.9 times EV/2019 EBITDA,” said Fitzpatrick. “This is despite the fact that its cash flow per share is projected to grow by 39% in 2019 on a year-over-year (yoy) basis, while net debt is expected to come down below 1.0 times EBITDA next year.”

In addition, Fitzpatrick pointed to free-cash-flow yield, a metric of possibly greater appeal to generalist investors. PDC’s is projected to be 7% in 2019, growing to 16% in 2020, he said.

SunTrust’s forecast assumes WTI of $61.42 in 2019 and $59.77 in 2020. Its assumption for natural gas is $3.31 in 2019 and $2.92 in 2020.

For a “stock that’s already dirt cheap,” Fitzpatrick added that it may sell its midstream assets in the Delaware Basin by mid-2019, possibly bringing in hundreds of millions of dollars. Further, in the Wattenberg, PDC is optimistic about a new completion technique that adds two extra stages and could boost EURs some 10%.

In addition, midstream line pressure in the Wattenberg may be resolved and there is hope for permanent resolution of anti-drilling ballot initiatives that cloud the industry outlook and repeat with Colorado elections every two years.

On the line-pressure issue, Fitzpatrick cited a “massive” expansion underway of midstream facilities to alleviate constraints on Wattenberg producers. This is projected to increase takeaway 74%, from 2.3 billion cubic feet per day (Bcf/d) to 4.0 Bcf/d by the end of this year. Factoring in E&P growth in production, the subsequent capacity utilization is expected to be 70%, allowing E&Ps to “free flow” onto the system.

“There’s a really strong setup going into 2019 in the Wattenberg—and for PDC specifically,” he said.

On the political front, Fitzpatrick was confident the industry and Democrat-controlled legislature in Colorado would be “able to find a solution in the first half of 2019.” Democratic Party leader KC Becker and newly elected Gov. Jared Polis “have indicated they want to make sure that the setback initiative doesn’t come back again in 2020. That’s their goal.”

While setback-related Proposition 112 was defeated this past fall, Fitzpatrick suggested the industry could negotiate on stricter setback provisions for schools, for example, as well as on local control legislation. Acreage held by industry within municipalities was “de minimis,” and “local control doesn’t typically prevent E&Ps from drilling in the most productive parts of the plays,” he said.

PDC, for example, “would have essentially no impairments with local control,” Fitzpatrick said.

Ultimately, striking a “grand bargain” with Gov. Polis may well be the right step for the industry, if only to eliminate an overhang of uncertainty that has led to heavily discounted E&P valuations.

“Frankly, even a so-called ‘bad deal’ for the industry—for example, agreeing to a higher severance tax or other concessions—is probably a pretty good deal for the public E&Ps, given the discounts that have been priced into their stocks [as a result of ongoing ballot-initiative overhang],” observed Fitzpatrick.

Also sharing an enthusiasm for PDC was Mike Kelly, senior analyst with Seaport Global Securities LLC, who counted the Denver-based company among his top smid-cap picks. PDC offered an “extremely compelling” value, he said, at $31 per share, which ascribed value to just its PDP (proved developed producing) reserves—i.e., zero value given to PUD (proved undeveloped) or probable reserves.

The fact that the stock “is trading just above PDP value is crazy to us,” commented Kelly. And talks on a possible monetization of the company’s Delaware midstream assets “appear to be far along,” he added.

“We’ve pegged a valuation at $450 million in the event of an outright sale,” equating to almost 20% of the company’s recent market cap and potentially reducing its midstream capex.

In the low $30s, PDC offers the potential for a double if his price target of $75 proves correct.

At SunTrust, Fitzpatrick added another point: PDC’s EV per flowing barrel of production was just under $32,000 on 2018 production when the stock was $34. With production growth in 2019, the valuation falls to a yet cheaper level: about $25,000.

SRC Energy Inc. For those able to play a smaller stock that is also based in Colorado, Fitzpatrick offered SRC Energy Inc. (NYSE MKT: SRCI). His target is $14 per share, offering upside of well over a double from $5-ish in early December.

SRC is “basically in the same mold in the small sector as PDC is in the smid-cap sector,” he said. The setup is very similar, with the stock’s valuation almost as cheap, trading at an EV-to-2019-EBITDA multiple of 3.2x, despite projected growth of 32% in yoy cash flow per share. The company has “essentially no debt,” and it is expected to have a 5% free-cash yield in 2019.

“With SRC, you can be confident that [CEO Lynn] Peterson is not going to be accelerating and giving up that free-cash-flow yield. The CEO sticks to his guns, and there’s no indication that he’s going to move off that position. And I think that’s what the market wants right now.”

Rosehill Resources Inc. Fitzpatrick splits E&P coverage at SunTrust with managing director, Neal Dingmann. One of Dingmann’s smid-cap picks is Rosehill Resources Inc. (NASDAQ: ROSE), whose operations are focused on the Delaware Basin.

“With WTI in the low $50s, the majority of our smaller names are certainly not going to be generating free cash flow this year, and probably not next year [either],” said Dingmann. “If you’re a new or smaller company, you’re probably going to be in a growth mode, and that makes it very difficult to generate free cash flow in the current year.”

With that caveat, Dingmann pointed to Rosehill, “a micro-cap that we think is exceptionally cheap,” trading at an EV/2019 EBITDA multiple of just 1.8x. “I can’t recall a time in my career—other than with an offshore name—that I had an oily onshore E&P trading at less than 2.0 times,” he commented.

Led by CEO Gary Hanna, Rosehill operates in Loving and Pecos counties, where it holds some 11,000 net acres. Both the company’s and offset operators’ wells have shown strong productivity, and Rosehill has net production of more than 20,000 barrels of oil equivalent per day.

What puts Rosehill “in the penalty box” in terms of valuation, according to Dingmann, is its “tiny size” and an unduly complex capital structure. Unusual for a $180-million-market-cap E&P, Rosehill has two tranches of common stock, two preferred issues, warrants, term debt and a revolving credit agreement. The less-than-simple capital structure has resulted in “an incredibly low valuation” for the company.

“In the past, if an E&P got down to a valuation of about a 2.5 times EBITDA, and it was an oily, onshore name, you’d have investors come into the stock,” he said. “But that’s just not happening now.”

While trading at about $3.50 in early December, Dingmann had an $8 target for Rosehill.

Lonestar Resources Ltd. Dingmann’s other top smid-cap pick is Lonestar Resources Ltd. (NASDAQ: LONE), which has more than 60,000 net acres in the Eagle Ford Shale.

Trading at an EV/2019 EBITDA of 2.8x, Lonestar is not at the same “rock bottom” valuation, but stands out for being able to generate free cash flow while running a one-rig program with WTI in the low $50s, Dingmann said. “That’s almost unique for a small-cap E&P.”

Lonestar continued to see better and better wells in the Eagle Ford each quarter, he said, and the company has the option of running one or two rigs this year. With a single rig, Lonestar would chalk up “moderate growth of around 20%” and stay free-cash-flow positive. Alternatively, it could add a second rig and take the growth “much higher,” but at the expense of outspending cash flow.

Dingmann’s target for Lonestar is $13 per share; in early December, it was about $6.

“When it comes to smid-caps, a number of investors have told us that the sector is too small for [them] to play in terms of the market cap or float,” said Dingmann. “That’s not to say that won’t change. But, unfortunately, a lot of the smid and micro-caps are being excluded because of their size.”

Whiting Petroleum Corp. Seaport’s Kelly, in addition to his previous selection of PDC Energy, also has Williston Basin-focused operator Whiting Petroleum Corp. (NYSE: WLL) as a top pick. Selections are based on a new modeling approach and ranking system that incorporates a “full-cycle returns approach” focused on corporate returns, cash-flow-per-share growth and free-cash-flow generation.

Whiting’s appeal lies in the fact that it is having “really outstanding well results across the Bakken and will generate pretty solid free-cash-flow growth over the next few years,” Kelly said. Despite this, the stock trades at an EV/2019 EBITDA multiple of 4.5x, which represents about a 15% discount to the average 5.3x multiple for its midcap peers.

In addition, under the company’s new management team, led by CEO Brad Holly, Whiting’s “operational momentum has turned decisively to the positive,” said Kelly. “This is a very disciplined, well-oiled operational machine. It’s not the Whiting of a few years ago that just wanted to grow and outspend.”

Whiting is also benefiting from improved oil takeaway and pricing in the Bakken. Recent rail-capacity additions are helping to narrow differentials, with the Clearbrook-Cushing discount for WTI improving to $5 a barrel from as high as $21 in early November. Further relief may come from the Dakota Access Pipeline expansion due to come online in the second quarter, as well as from Alberta’s forced production cuts, Kelly added.

At early-December WTI, his target price for Whiting was $60 per share.

Callon Petroleum Co. In the Permian Basin, Kelly is a fan of Callon Petroleum Co. (NYSE: CPE), which recently added to its management team Jeff Balmer, formerly with Encana Corp., in the role of COO. The company has more than 80,000 net acres in the Permian, which equates to an estimated 22.2 years of inventory—assuming a steady seven-rig program—and compares to a median of 18.4 years for its Permian peers.

Kelly noted that strong execution and productivity by Callon last year had prompted Seaport to give greater credit to Callon’s inventory. Further, Callon and offset operators have posted “very prolific” well results in the Delaware. This has contributed to a marked improvement in Callon’s recycle ratio—that is, cash flow divided by finding and development costs—putting Callon among the Top 10-ranked E&Ps.

While Callon’s EV/2019 EBITDA is in line with its peers, at 5.5x, the company is viewed as having a higher organic-growth outlook. Kelly estimates 22% compounded annual growth in the company’s debt-adjusted-per-share production growth, while cash flow is projected to grow by 25% annually. This compares with growth of between 19% and 22% for its Permian peers.

Kelly’s target for Callon is $13 relative to the early-December price of about $8 per share.

Chris Sheehan can be reached at csheehan@hartenergy.com.

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