Friday, May 1st, 2009

Gain On 07 Recommendations: 44.16% Gain On 08 Recommendations: 45.39% Gain/Loss to Date On 09 Recommendations: 19.09% (Based on $20 million portfolio*) 09 Indices Gains/Losses to Date: Dow Jones: -9.10%, NASDAQ: 5.33%, S&P 500: -5.83% OIH: 17.19%, XLE: -5.76% Avg. of OIH & XLE**: 5.71% SterlingAccount: 19.09%***
*Except when the Fund is fully invested, the SterlingAccount assumes that interest from the money market offsets commissions. Percent of Fund in Money Market or Cash Equivalents: 10% Percent of Fund Invested: 90% ***The OIH is composed mostly of large hydrocarbon service companies, contract drillers and several major oil companies. The XLE is composed mostly of large hydrocarbon exploration and production independents and major oil companies. ***Total gains or losses are included from positions originated and closed out in09, which contributed a net gain of $3,817,065.22. For detail see track record published at the end of each month. The latest issued 09 track record can be seen here. Click at top on the 07 and 08 gains to see detailed yearly track records.

How to Value E&P Companies

As any investor has learned in recent market times, landing the big catch among publicly traded E&P stocks is a function not only of patience, but of applying the right financial criteria when analyzing the annual reports or 10-Ks of upstream independents. Just what are these criteria? E&P analysts use several yardsticks to determine if a companys shares are worth buying. In the main, they pay attention most to these factors: James Sterling 1

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A producers present and potential cash flow per share; Total capitalization or total enterprise value/EBITDA (earnings before interest, taxes, depreciation and amortization); Full-cycle return on investment; and Share price versus a companys breakup value or appraised net worth.

The managements of E&P companies arent being judged by the market on their ability to generate net income, but rather on their ability to take the cash they generate from production and invest it in existing or new properties to improve the underlying asset value of their companies. Annual earnings numbers is an unreliable tool for comparing upstream companies because some operators use successful-efforts accounting whereby they expenseor subtract from earningsexploration costs in the same year they occur; those using fullcost accounting, on the other hand, fully capitalize and then amortize their exploration costs over future years. With cash-flow analysis, add back in the exploration expenses for successful-efforts companies, thereby creating more of a level playing fieldone that allows for similar comparisons. But theres a more compelling reason to place a premium on cash flow. Thats what an operator must use (to fund drilling or acquisitions) to replace the reserves he produces in a given year. As such, it serves as a gauge of his ability to grow his asset base. The future success of upstream companies depends on their ability to ward off production declines by cost effectively finding new reserves with cash flow generated from current sales. Those that that can grow their cash flow by growing their production profiles are the ones that are going to improve their bottom line and the ones in which you want to invest. E&P analysts, however, dont regard cash flow analysis as the stand-alone tool for measuring an upstream operators investment worthiness. On the contrary, they believe an investor should also place a premium on a companys share price versus its net asset value (NAV). Every now and then, you come across a situation where an independent has hit a home run or is about to tremendously increase the underlying value of its reserve basebut the market hasnt recognized this yet in the companys share price. When valuing E&P companies, an analyst may focus on total enterprise value (stock market equity plus debt and preferred shares)/EBITDAX (earnings before interest, taxes, depreciation, amortization and exploration expenses).

James Sterling

Friday, May 1st, 2009 Its a debt-adjusted ratio that takes into account a companys unlevered cash flow. Thats a useful equalizer in comparative valuation analysis in that it eliminates the effect of varying high- to-low-debt capital structures on cash flow. This valuation yardstick, also known as total capitalization/EBITDA, can be an eyeopener for investors. Heres a hypothetical example: Alpha Oil Co. and Beta Oil Co. both have EBITDA of $10 million. But while Alpha has $100 million of equity and no debt, giving it a total capitalization of $100 million, Beta has $100 million of equity and $100 million of debt, giving it a total capitalization of $200 million. Thus, the total cap/EBITDA multiple for Alpha is only 10 while the same multiple for Beta is 20. Having compared both companies on the same debt-adjusted cash flow basis, and having recognized the financial leverage of both and their ability to fund drilling programs, youd rather invest in the hypothetical Alpha company with the total cap/EBITDA multiple of 10. Among other investments used are NAV to identify stocks that are trading below their inherent asset or liquidation value. Similarly, scrutinizing stock price/discretionary cash flow helps identify stocks that are comparatively undervalued, this time on an afterinterest, after-tax, cash-flow multiple basis. In addition, look at cash flow per unit of production/finding costs. The reason? This ratio is a good proxy for return on investment and implied growth rates. However, an investor should be wary of operators with declining or flat production, high finding costs versus cash flow generated per unit of production, lack of high-growthpotential areas, and too much debt. Emphasizing yet another valuation metric, place a high premium on full-cycle return on investment (cash flow per barrel equivalent divided by multi-year average finding costs). Cash flow growth means nothing unless a producer is making money on that incremental dollar that it invests. Calculating a full-cycle return on investment directs investors toward those companies that are making efficient capital investments and away from those that are making inefficient investments. Put another way, it helps investors avoid paying five times cash flow for upstream stocks with poor returns versus paying five times cash flow for those with tremendous returns. When it comes to cash flow or NAV analysis, investors should pay particular attention to underlying pricing assumptions for oil and gas, given the volatility of these commodities. The way to deal with the problem of volatility in our analysis is to use price-normalized cash flow and asset values, that is, use historical five-year-average oil and gas price assumptions in our valuationsnot current spot prices. This can lead to a better perception of investment opportunities. James Sterling 3

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Another caveat the analyst advances: when investors today scrutinize a producers discretionary cash flow, they should pay more attention to how much maintenance capital spending is needed just to keep that companys asset base flatand how much free cash flow is actually left over to grow that producers reserve base. If two operators each have $100 of discretionary cash flow, and one of them has to use all of it just to replace what has already been produced, then that company is just standing in place. If the other, meanwhile, has finding and development costs only half as much as the former producer, its clear thats the one thats going to have the free cash flow to grow. If an investor can buy a producers reserves in the stock market for less than what an independent engineering report says theyre worth, then theres an opportunity to make money as those reserves are produced and sold in future years. If the net present value of a producers future oil and gas cash streamplus the value of its other assets less debtis $1 per share, and that companys stock currently trades at 50 cents per share, then youve discovered a stock thats selling for half its breakup value. Naturally, also focus on cashflow analysisand with good reason. You might be looking at the greatest bargain in the world as far as the discount-to-breakup value of a producers reserves in the ground, but if the company doesnt have the money or wherewithal to produce and sell those reserves at a profit, then those reserves cant really be fully exploited. And neither can the investment.

Onsite Due Diligence

14 Important Things to Check On 1) Check local transportation. See if gas pipelines are nearby and determine the cost of connection and the cost of compression necessary to equalize company wellhead pressure to pipeline pressure. 2) Talk to members of the drilling crew, including the tool pusher, to see if there are problems associated with any of the companys wells, such as sanding, casing defects, and swelling of clay finds in perforated zones. 3) See if any environmental complaints have been filed concerning any of the companys operations.

James Sterling

Friday, May 1st, 2009 4) If necessary, do an independent check for pH levels at nearby rivers, streams and nearby bodies of water, since the company can be accused, fairly or unfairly, of environmental damage. 5) Use any one of a number of information sources to provide production history of nearby wells or analog fields. 6) Production history and test results of each analog or offset well are analyzed. 7) In-house or third party engineers and geological staff project future production, revenues, operating cost and net cash flow from proposed wells. 8) A preliminary physical inspection is performed including testing and environmental assessment of existing wells, well sites and equipment. 9) Potential gas purchasers are contacted for likely wellhead prices, transportation, availability and costs and potential for future price changes. 10) Local and national engineering firms independently review estimated reserves and projected net income. 11) In-house cost accountants review financial and accounting data for accuracy and consistency. 12) Investigations are conducted of key personnel who may be retained. 13) Title checks and property searches are conducted to ensure that all leans, mortgages and UCC filings are known. 14) A final physical inspection is conducted, including tests of existing wells that are part of the deal.

James Sterling

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James Sterling
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