### Outperforming Jim Cramer's Nat Gas Stocks - Part 4 of my Energy Series - The simple formula

August 21, 2008
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RELATED TICKERS: XTO
, CHK
, SD

**While Jim Cramer has got you ***KILLED *in nat gas stocks. Some bloggers here at CAPS (Demon Doug, VTEngineer, myself, etc) **have been SPOT ON** regarding the "surprise" move in commodity stocks - particularly Natural gas.

As part of my series on natural gas stocks I've been sharing my stream of consciousness and my developing thoughts on how to value natural gas stocks.

This has easily been my favorite topic to blog on in recent months so I hope you enjoy it. Also please note that at the beginning of this series I wasn't sure if nat gas stocks were buys or sells... but as I've rsearched the investment thesis I've concluded **nat gas stocks are ****"raging buys" on a risk / reward basis unless **someone can disprove the marginal cost / floor for nat gas is ~$7.50.

FYI - later my last blog will debate the bear case for nat gas stocks... what if $7.50 isn't the floor??? That is a possibility especially if production increases don't slow or if oil and coal don't stay at high prices.

***** NOTE: PLEASE RECOMMEND THIS POST IF YOU FIND IT USEFUL**

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TABLE OF CONTENTS

- short cuts to this blog

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*1.) If you have read my previous blogs:* please skip right to the **"SIMPLE VALUATION FORMULA" **section of this post. I've got a very simple formula that is helping me measure risk reward at various natural gas / oil stocks.

**2.)** If you just want to SKIP RIGHT TO THE BOTTOM LINE - go to "THE BOTTOM LINE" section.

*3.) If you haven't read my previous blogs* - I can catch up up in the section below **"QUICK RECAP".**

**4.) What are my favorite natural gas /oil stocks stocks** (price I'd buy): STR ($50) , SD ($31) , WLL ($84), EOG ($93), TXCO ($8.50

See details on each of my favorite nat gas companies here (rec the blog if you do):

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**QUICK RECAP from Parts 1-3 of this blog series**

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**** See Previous Posts in My 5 Part Series Here ***

Many of you may have read my earlier blog "Why Cramer is getting you KILLED in nat gas stocks"

In that late night post riddled with mis-spellings I explained that nat gas in the U.S. is on the verge of over production in the near term and that there is **a**** real risk that the only floor in the price of nat gas will be the marginal cost of production.**

**Marginal cost of production - **is otherwise known as: the cost of producing the last cubic feet of gas demanded by the market - produced by a marginally viable or higher cost producer.

**THE BIG IDEA: **

*I've recently found a source online that suggest ***the marginal cost of production for nat gas is $7.50 **and the marginal cost of production for** oil is $63** (oil sands production). estimates: from *Sionna Investments & Sanford Bernstei......*

Since many natural gas stocks are being valued at around $6.50 natural gas I thought the market was creating a buying opportunity for natural gas stocks if not for oil stocks. Although as you'll see later I am also an oil bull - even though oil is well above marginal cost of production

**VALUATION:**

Some simple concepts:

1.) Energy stocks doen't trade on PE's but rather proven reserves - if you don't have oil / gas in the ground you will have no future earnings - so PE's aren't as important as reserves.

2.) Companies that grow reserves or who have reserves worth more than the company's stock should go up.

3.) Some people like me like to value energy stocks on the present value of thier current PROVEN reserves. Then assess the growth by looking at the companies PROBABLE reserves. Ideally I want to pay as little as possible for probable and possible reserves because they are not definite numbers.

4.) My Valuation Technique

- I take a companies gross margins on a hypothetically low natural gas selling price (the marginal cost of production) and then I figure the present value of the gross margins for the companies proven reserves and for the proven, probable, possible reserves. I look at the possible reserves to eyeball the potential upside for a stock.

**5**. **AN EXAMPLE OF HOW I VALUE NAT GAS STOCKS**

*Assumptions: *

*- Lets also assume nat gas co TXCO will sell that gas at a minimum of $7.50 *

*- Lets assume TXCO has 100Bcf in proven reserves ($290M worth of gas)*

*- Lets assume TXCO has finding costs of $2.50 *

*- Lets assume TXCO has possible reserves of 8Tcf (they claim they do!)*

*- Lets assume TXCO has an Enterprise Value of $495M*

*Conclusions:*

**TXCO's profit per mcf is $5.00 **/ This is the selling price ($7.50) minus finding costs ($2.50)

**TXCO's estimated profit on its 100Bcf reserve would be is worth $170M today. ** Calculation = $5 profit x 100Bcf = $500M, which has a present value (PV-10) of $170M

**TXCO's possible reserves would be worth $13.6B. **

**TXCO is a high risk / VERY high reward stock. **

(see my blog for more in depth long / short ideas)

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**SIMPLE FORMULA FOR VALUING NAT GAS STOCKS**

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As you can see from the recap above, there are several steps that you can walk through to establish rationale valuation on a natural gas stock. However there is a simpler formula you can use on the fly.

But I caution you to make sure that it's always worth verify the finding costs for the natural gas company you are looking at to make sure that this formula's gross margin assumption is correct. I only look at low cost natural gas producers ($2 cost per mcf or lower) so this is appropriate for most stocks I look at .

Basically my formula assumes floor in nat gas prices at $7.50, $2 finding costs, and gross margins of $5.50. Then I do a 10 year present value on that number to come to valuation per mcf that I can apply to the entire companies reserves.

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THE BOTTOM LINE

**HOW DO I VALUE NAT GAS COMPANIES:**

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I take a present value of $5.50 which = $1.93 per mcf. Some people are more generous they're using $2 or $2.25.

* Note: you can calculate present value here

**My 2 step valuation:**

1. I value ONLY the proven reserves to come up with a conservative valuation for co's reserves

2. I value the probable reserves - but I'll only do this if I have a high degree of confidence in management and in the prospect(s) they are drilling... for example I'll want to know that they successfully drilled that prospect before and that it's an onshore project (lower cost / lower risk).

**Example:**

*Sandridge (SD)*

- Sandridge is one of my favorite low cost nat gas producers (though I like STR better).

- SD produces an mcf of nat gas for less than $2... but I'm assuming two for the example.

* - Enterprise Value (value of company): $7B *

* - 2Tcf of proven gas - that has a present value of*

* - 5.5Tcf of proven + probable reserves*

The Value of SD's 2Tcf proven reserves are $3.8B ($1.93 X 2 billion mcfs)

The Value of SD's proven and probable reserves are $10.6B ($1.93 X 5.5 billion mcfs)

**Conclusion -**

Sandridge is being valued at about 1.75x it's proven reserves

Sandridge is being discounted at 30% below it's probable reserves.

If you believe that Sandridge can prove it's probable reserves and that nat gas has a $7.50 floor then SD is undervalued.

Fyi - SD has had over 200M of insider buying this year - so I think the insiders believe it's cheap...additionally Sandridge may have another 20-30Tcf in their big field.