The One Number Every Oil and Gas Investor Needs

I talked a little last week about the "recycle ratio".

This is a tool every oil and gas investor needs to understand. Without exaggeration, if you used only this one number to analyze stocks (and used it correctly-more on that in a moment) you'll beat the market. Simple as that.

The recycle ratio is a deceptively simple, but incredibly powerful tool for uncovering quality companies in the E&P space. It cuts through the reams of data we get today on corporate performance - elegantly combining reserves reporting and financial results into one, easy-to-understand number.

This figure shows just how much value your stock is creating when it comes to drilling and developing. It's far superior to many of the other measures analysts use:

•    Dollars of market capitalization per flowing barrel - Doesn't take into account that all flowing barrels are different. A barrel that flows for three years is worth a lot less than one that pumps for ten.

•    Finding, development and acquisition (FD&A) costs - Great for showing a company's performance on the micro level (i.e., per barrel) but doesn't give any indication of the scale at which this is being achieved.

•    Reserves growth - Growing reserves is great, but it's critical to know how much it costs. Anyone can grow reserves if they spend enough money drilling and buying properties.

None of these numbers give us a complete view of an E&P business the way the recycle ratio does.  

Value Creation At a Glance

Take a look at the chart below-a compilation of five-year recycle ratios for a selection of companies I've been looking at over the last couple of months.

Spotting the winners here is easy: the bigger the ratio, the better a company is performing in creating value through its drilling and acquisitions.

You can see from this chart that a company like Occidental Petroleum (NYSE: OXY) is an exceptional developer (the light blue line)-having a ratio several times higher than most of its peers.

I also wrote a few weeks ago about Gulf of Mexico player Energy XXI (Nasdaq: EXXI). Using the recycle ratio, it's obvious that EXXI (the dark blue line-the one that comes out on top for 2012) is doing something special when it comes to growing its reserves in a cost-effective way.

So, just what is the recycle ratio, and how do you calculate it?

You have to be careful here-there are several different metrics all called "recycle ratio" by different analysts. But the one I show above is the most revealing, by far.

It's calculated like this:

1)    Take the value of the company's reserves at the end of the most current year. Then subtract the reserves value at the end of the previous year to get the yearly change in reserves value. If a company has $100 million in reserves at the end of 2012, and had $50 million at the end of 2011, the growth is $50 million.

2)    Add in operating cash flow. Oil reserves deplete during the year, so we have to factor in how many barrels were monetized. If the company mentioned in step 1 cash-flowed $25 million during 2012, reserves growth was actually $75 million-they started with $50 million, depleted $25 million worth, but ended with $100 million. Implying that they added a total of $75 million.

3)    Divide the total reserves growth for the year by the company's capital spending. This figure is also available in annual financial statements. Be sure to include money spent on all forms of reserves additions-exploration, development, and property acquisitions.

That's it. The number you end up with is a simple ratio of reserves growth to spending. For each dollar the company put into the ground, how many dollars of reserves value did it create?

This isn't difficult to calculate-but you have to be careful to use the right numbers. Some companies report their reserves values on both a pre-tax ("PV-10") and an after-tax ("standardized measure") basis. If you're using after-tax reserves values (which are the most accurate picture of a company's worth) you need to factor in taxes paid when calculating operating cash flow in step 2.

Why Is This So Powerful for Investors?

Calculating recycle ratio tells you several things.

First, is your company making a positive return on capital? If the recycle ratio is above 1, they're spending their money wisely-each dollar spent is creating more than a dollar in reserves.

But if the ratio is below 1, the firm is spinning its wheels. If a company is spending a dollar to generate $0.75 in reserves, beware. You'd be better off putting your money in the bank and collecting interest (at a small, but at least positive rate) than having it deteriorate with such a firm.

(A negative recycle ratio means reserves value actually declined from the previous year-you can see this was common in 2008, when many firms took big write-downs because of falling natural gas prices.)

You'd think such situations would be rare. Surely most companies strive to ensure they're making a positive return on the money they're spending?

This is where this metric becomes invaluable. Look again at the chart above. How many firms languished below 1 in 2012?

Most of them. And this is another area where the recycle ratio is extraordinarily useful-spotting emerging trends in the overall industry. You can see from the chart that recycle ratios trended down notably in 2012. The average for the group dropped to 0.44, down from 1.55 in 2011.

I believe this is mainly due to rising costs. Drilling and other services got a lot more expensive over the past 18 months. That reduces the effectiveness of capital, as companies pay more to find the same amount of oil and gas.

The other thing that's always fascinated me is how most companies in the industry perform more or less at the same level.

Just look at how tightly values are clustered over the last five years. Most firms' performance is within 50% of the rest of the pack. The spread widened a little in 2012-with the wheat starting to separate from chaff as only the best management teams were able to cope with the higher-cost environment.

This makes it easy to see the outperformers-and makes you realize how extraordinary they are. Occidental's recycle ratios have been off the charts, although even this high-flyer hit a notable wall in 2012.

The most critical thing for investors is using the recycle ratio to see who is outperforming today. Energy XXI is clearly a leader in this regard, running a recycle ratio of 2 over the past year-at a time when most companies are struggling to get above a break-even return on capital of 1.

That-more than any other number-shows a company doing the right things to create shareholder value. If a firm can turn a buck into two, that's a place you want to be putting your investment dollars.