PSCE - Small Cap Oil Stocks Are Compelling Here

Summary

• Small cap oil stocks are cheap.
• Some actually have higher ROCE and other key measures than their larger peers.
• Significant upside to a re-rate.

Small cap oil & gas equities continue to trade at a material discount to larger cap peers, despite some compelling advantages. In addition to their cheapness, small cap oil & gas equities, as proxied by the Invesco S&P SmallCap Energy ETF ( PSCE ), have lagged larger cap oil & gas companies ( XLE ), the oil price ( WTI ) and the broader market ( SPY ) over the last 10 years:

While share prices often underperform for good reason, small cap oil & gas equity fundamentals have improved faster than that of their large cap peers. Improving operating netbacks gave smaller producers free cash flow ((FCF)) leverage to rapidly rising oil prices, while equity valuations remained low, resulting in unusually high FCF yields on equity. Indeed, relative share price underperformance coupled with rapid fundamental improvement have rendered valuations more compelling, even after the rise in share prices from Covid lows.

Many of the worst positioned smaller cap oil & gas equities went bankrupt in the prolonged bear market of 2014-2020. This has cleared the field to some extent, leaving mostly better management teams, capital structures and assets in the public market. The persistent valuation discount seen in small caps may be explained, in part, by cognitive dissonance experienced by oil investors in the prior down-cycle, along with subsequent share price under-performance. This market PTSD presents a compelling opportunity in our view.

Private Market Transactions: The Best is Yet to Come for Public Equities

Larger operators clearly see what we are seeing, as they have been seizing the opportunity to buy smaller caps at lower multiples of cash flow, particularly on the private side:

As can be seen above, smaller companies are being acquired by larger operators at discounts to the larger company valuation multiples, which is highly accretive for the acquirors. And the market seems to be embracing these accretive acquisitions, as indicated by the 1-day share price outperformance for acquirors vs. a relevant oil and gas benchmark.

It is also noteworthy that the transaction multiples paid for these acquisitions have been increasing. The transaction market has been heating up and value is being recognized by larger producers:

The increasing valuations paid in these deals may be a function of positive share price performance on announcement of acquisitions. These positive market responses, along with rising transaction valuations, may be leading indicators of upcoming valuation increases for similarly sized small cap publicly traded oil equities. A potential catalyst to such a catch-up could be larger operators noticing depressed small cap public equity valuations and looking to acquire those at similar metrics as recent private market transactions.

The valuation discrepancy between small and large cap equities in the U.S, and the associated opportunity, is illustrated in the table below:

U.S. small cap E&Ps are discounted vs. large cap peers, particularly based on EV/EBITDA, as can be seen above. And while small caps generally have similar levels of debt, they are generating more cash flow, resulting in higher FCF/EV and FCF yield on equity.

Smaller oil producers have been experiencing higher FCF growth than larger caps due to more oil price leverage and relatively faster production growth – attractive attributes in acquisitions that are already compelling on valuation, and in public market revaluations. And it helps that management teams seem to have learned from previous down cycles, exhibiting capital discipline despite higher prices.

On Critiques of the Small Cap Oil Investment Thesis

There are several important critiques of small cap E&P equities worth addressing, as they highlight the attractiveness of the opportunity. The first is related to perceived asset and management quality. One prevailing argument is that larger caps are generally better capital allocators, and thus should command a premium for generating higher returns on capital over time. However, material differences in forecasted returns on capital employed (ROCE) between peer groups indicate the contrary, with Vital Energy (NYSE: VTLE ), a Bison portfolio position we recently shared our thesis on publicly , leading the pack:

Incidentally, the investment bank providing these estimates has taken a bearish view on small-cap oil and gas equities! One explanation for this improved ROCE phenomenon among small caps is that many of the poorly managed small cap E&Ps with weak balance sheets and poor returns went bankrupt in prior down cycles, leaving mostly the better managed ones remaining.

Another potential point of contention is the difference in inventory life and quality, which arguably, could help drive the valuation discrepancy between small and large caps:

As can be seen above, large caps have more depth of inventory with lower commodity price break-evens, which may justify the valuation premium for some. And given their inventory depth, large cap operators are more likely to remain profitable in a low-price environment and offer some downside protection as well.

This consensus view is biased towards reserve bookings, and penalizes smaller producers who show smaller proved reserves in their reserve reports. However, smaller producers have a higher cost of capital than large cap peers and often prioritize acreage they can develop in the near term in reserve bookings, rather than fully booking their inventory. And even with significantly less acreage than large caps, small cap equities are still markedly cheaper:

Sandridge Energy (NYSE: SD ), a Bison portfolio company for which we recently shared an update , is a prime example of a small cap producer with under-booked reserves. Sandridge had limited undeveloped reserve bookings after its bankruptcy emergence and management changes, which may have led to a belief that it would struggle to grow production, particularly of oil. However, in Sandridge’s hundreds of thousands of acres it has managed to find sufficient development inventory to grow its oil production by nearly 50% in 2022, as per management guidance, while also generating substantial free cash flow:

Lastly, some might argue that operational scale is needed to combat inflationary pressures. However, the bulk of inflation experienced by E&Ps has been in oilfield services, particularly rigs, pressure pumping equipment, labor, and other specialized equipment and parts. The simplest way to mitigate such cost inflation is not through scale, but through minimizing the re-investment that is necessary to maintain production – at least from an investor perspective. Incidentally, some small cap producers have lower production decline rates than large caps, which allow for lower reinvestment requirements to maintain production and reduce the impact of cost inflation.

Value Outperforms Over Time

Undervalued stocks tend to outperform over time, across a variety of market environments. The last 10 years have been tough for oil and gas equities, particularly small caps, and yet, select undervalued (in our view) publicly disclosed Bison positions have meaningfully outperformed the oil & gas equities ETF XOP since they were disseminated over the past few years:

At the time we disclosed each of these, we believed that these companies were trading at a meaningful discount, offering deep value. And even with many of these small cap equities having seen their share prices appreciate significantly since Covid lows, they still trade at a discount to large caps, as shown above. This is promising for the smaller cap oil & gas equities space, as the low valuations in the space may drive further outperformance as they “catch up” with larger producers and the broader market.

Looking Ahead: Smaller Cap Oil Equities May Re-Rate

Even with many small cap equities seeing their share prices rising, the small cap valuation discount persists. In our view, this valuation gap is likely to close over time as there is a broader realization of rapid fundamental improvements in small cap oil producer equities as compared to large cap peers, particularly as oil prices rise.

As small cap equities continue to generate significant FCF and continue to pay down debt, they may opt to return the excess in the form of buybacks and dividends, attracting a whole new set of yield-focused investors and pushing valuations higher. In fact, some analysts forecast small cap equities may generate more FCF relative to their enterprise value than large caps over the next two years. And with a greater proportion of that FCF not yet allocated, they may opt to return it to their investors.

As small cap oil equities cash flows become too costly to ignore, even among yield and ESG focused investors, new inflows may drive a re-rate in line with large-cap peers, and perhaps with the broader market. And even if this re-rate never comes to fruition, there are other paths to a successful investment outcome, notably buyouts, share buybacks and dividends.

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