With prices on the rise and a cold winter approaching, some gas names have already begun to rally. But Andrew Coleman of Raymond James takes a cautious approach—that's why he looks for oil and gas companies that can survive a tough market. In this exclusive interview with The Energy Report, Coleman shares how to gain exposure to promising shale plays using defensive investing tactics. Read on to learn which companies are measuring up with strong balance sheets, dominant acreage positions and top-tier technology.

The Energy Report: In your last interview, you talked about raising price targets on energy sectors and individual stocks with promising reserves and production growth. Is that still your view, or have circumstances changed?

Andrew Coleman: What we're more worried about at this point is that the U.S. economy has been slower to recover than we expected. Meanwhile, the situation in Europe is getting worse and China's growth is slowing. To help us evaluate oil and gas markets in this context, our team here at Raymond James put together a bottom-up supply model looking at the oil shales, which was a follow-up to work the team had done on gas shales a couple of years earlier.

"The forward curve on gas is getting better."

The gas outlook has remained cautious, although not nearly as bearish as it was a couple of years ago. We have, however, become much more nervous on the short-term outlook for oil. We have a $65 per barrel (bbl) forecast for West Texas Intermediate (WTI) and an $80/bbl forecast for Brent for 2013. The forward curve on gas is getting better, and certainly 2013 gas is over $4 per thousand cubic feet (mcf) right now. Oil is our big concern and back in June we downgraded virtually every name that we follow in the E&P space to the point where we now have no strong buys in our coverage group.

The uncertainty on the demand side and increased production growth due to the shale drilling technology indicates a significant inventory oversupply by the second quarter of 2013, which should lead to lower oil prices. Although prices have remained relatively robust in the U.S., we're waiting to see the supply and demand fundamentals even out before we get more constructive on the space.

TER: So, you figure that these prices are going to be affected worldwide, even with the difference between WTI and Brent?

AC: Yes, over time. We're still looking for a $15 differential between Brent and WTI. In North America, there's a lot of supply in just a few basins and transport options are still evolving to get those barrels to the most favorable markets. A reversal at the Seaway pipeline and the approval of Keystone XL would definitely help. The conclusion of the presidential election would remove one more big uncertainly, and the next step would be getting through any transition of power and seeing what happens with the fiscal cliff. Having a few more months of macro data never hurts either.

TER: Is the current gas supply and price playing any role in this?

"The current headwinds for oil point to it potentially falling by 25%."

AC: Yes and no. Generally speaking, oil is a transportation fuel. Natural gas is a power generation fuel. Natural gas and coal compete quite hardily. Gas prices have rebounded recently, but there was a tremendous amount of utilities switching from coal to gas. As natural gas goes higher, more plants might switch back to coal. Gas remains cheap relative to oil and my view is that oil is still probably a better medium-term commodity to be in. The current headwinds for oil point to it potentially falling by 25%, which would be very bearish for oil stocks in the short term.

The warmer than normal winter last year caused an excess supply of propane (and natural gas), which in turn put pressure on ethane. Average natural gas liquids (NGLs) prices followed gas prices lower, putting pressure on the entire gas value chain. With winter just around the corner, there is some optimism that normal weather will improve both the gas and NGL price outlook. If not, then weakness in oil prices would further hurt gas producers, as liquids revenues comprise up to 50% of total unhedged revenues for even the heaviest gas producers.

TER: Your downside price for oil is lower than what I've heard anyone else talk about. What's your upside for the next year or so?

AC: Longer term, we're looking for $80/bbl WTI, and with a $15 differential for Brent, so we're looking at $95/bbl. The current large crude stocks and diminishing storage for all that crude, along with continued production growth, mean that pricing could fall in the early part of 2013. We think the price will average $65/bbl next year, based on our math, which suggests $65/bbl is the price at which most U.S. oil drilling stops. Remember, in the fourth quarter of 2008, WTI averaged around $60/bbl followed by $40/bbl in the first quarter of 2009 before averaging $62/bbl for the year. We think that WTI may bottom at $60/bbl and then start rebounding back to $80/bbl by 2014.

TER: That will make for a lot of happy drivers, but isn't it going to change the planning for companies in the production business?

AC: We've continued to hear expectations of service-caused cost deflation from exploration and production (E&P) companies. A couple of years ago, everybody needed frack crews, frack sands, rigs, drill pipe and lots of other service components. Now with most companies not investing in any dry gas production and with oil price uncertainty and additional services capacity being brought to the market, we see an opportunity for service costs to come down a little, which would be a positive for the E&P guys.

TER: What factors are you considering most important in deciding which stocks look like the best buys at this point in time?

"We look at the major players and try to find nimble small or mid-cap peers positioned to succeed in those same areas."

AC: We definitely try to do a lot of work at the beginning when we select companies for coverage. Between nine analysts and fourteen associates, our energy team covers around 150 energy stocks. On the E&P side, we start by looking at where the most activity currently occurs and where we think that activity will be in a couple of years. We also look at the major players, like Anadarko Petroleum Corp. (APC:NYSE), Devon Energy Corp. (DVN:NYSE) and Chesapeake Energy Corp. (CHK:NYSE), and try to find nimble small or mid-capitalization peers positioned to succeed in those same areas.

Ultimately, we want to follow high-quality management teams because economic conditions continually change. If a management team can stay ahead of those tides, then shareholders benefit from growth, an improving asset mix and returns.

TER: Maybe we can look back on some of these companies that you talked about last year that you still cover and like, and you can bring us up to date on what's happened with them.

AC: Of the 21 stocks that I follow there are eight that I have an Outperform rating on. Because of our oil price call, we do not have any Strong Buys. My top three picks would be Continental Resources Inc. (CLR:NYSE), Energy XXI (EXXI:NASDAQ) and EOG Resources Inc. (EOG:NYSE) followed by QEP Resources Inc. (QEP:NYSE), Bonanza Creek Energy Inc. (BCEI:NYSE), Denbury Resources Inc. (DNR:NYSE), Devon Energy Corp. and Anadarko Petroleum.

When I look at companies, what I consider first is the commodity backdrop, which is currently cautious. I tend to pick names that have better balance sheets when we don't know about the direction of the commodity or we think it's down. All three of my top picks have excellent balance sheets. EOG's debt to EBITDA is less than one times. Continental Resources is around 1½ times and Energy XXI is around one times. They're some of the best-levered names in the group in terms of liquidity and their ability to take on debt, should their revenues fall because of quickly softening oil prices.

Continental Resources is the biggest landowner in the Bakken and at its analyst meeting last week, management highlighted additional inventory potential there.

"I'm looking for companies that have dominant acreage positions or top-tier technology in what they do."

Secondarily, I'm looking for companies that have dominant acreage positions or top-tier technology in what they do. Energy XXI is one of the highest oil-weighted players on the shelf in the Gulf of Mexico. This company has been a strategic acquirer of assets. It purchased about a billion dollars of assets from Exxon about a year and a half ago, which really expanded its footprint. At the time of that deal, it operated one of the top-thirteen biggest fields ever discovered on the shelf. After the Exxon deal, it now operates six [of the twelve largest oil fields in the Gulf of Mexico] and has a working interest on the seventh. So it's the third-biggest player in the Gulf of Mexico shelf and is 70% oil. Continental is 80% oil.

EOG is a gas story and one of the largest names I follow. It's been hugely successful in developing its Eagle Ford shale acreage and getting oil and liquids throughout that field. It's become a great stock to hold in an uncertain environment. Of the eight names that I follow, those three are the most interesting to me, given our commodity outlook. They have dominant acreage footprints, excellent execution and great balance sheets to withstand any price softness that could come down the short-term pike.

TER: They're more defensive stocks than they are aggressive buys. Is that right?

AC: Yes. When we look at our coverage in general, we don't have any Strong Buys. We define strong buys at Raymond James as outperforming the market over both a six and twelve-month basis. The Outperform rating is what we think will outperform the market over a twelve-month basis.

TER: How about some small- or micro-cap companies? I was looking at your coverage list and there are some that are fairly low priced compared to a lot of the others that are in the $50 to $100/share range. Do any look interesting?

AC: Bonanza Creek Energy Inc. is one I would point out. It went public last year and is a Niobrara oil shale producer. The Niobrara is outside of Denver, Colorado. Anadarko Petroleum has a huge footprint in the Niobrara. To incentivize the construction of the transcontinental railroad, the government granted right-of-way access to the railroads and Union Pacific, which ultimately became Anadarko, and the company now owns that acreage in what has turned out to be the heart of the play at the Wattenberg field.

Bonanza Creek has 30,000 net acres adjacent to some of Anadarko's lands in the core of the Niobrara, called the Wattenberg field. This is a company that has a great balance sheet with a one-time debt to EBITDA while it's ramping up its drilling program. It's basically following on what Anadarko or Noble Energy Inc. (NBL:NYSE) will do—those companies are the two biggest landholders in the Wattenberg. Bonanza is hoping to prove up its Niobrara oil shale acreage and almost double production this year, to almost 10,000 barrels per day (bpd), up from nearly 6,000 bpd at the start of the year.

"Shares of gassy E&Ps are up 10% in the past three months."

Shares at the time of the deal fell to $12 as this was IPOed in December 2011, which was a very difficult market at the time. It has now rebounded into the low-$20 range. From my conservative standpoint, it's worth between $25–40/share. The large range depends on whether you're evaluating the stock on a pre-tax or post-tax basis and on how much activity you're giving them credit for. We risk the acreage pretty heavily and think that getting into the upper twenties is really what happens when the company executes like its peer group.

The first hurdle it has to get over is to show investors that it can execute as well as everybody else. Then, the next step is to show that it can find and develop new plays, the Niobrara being one of them. Transitioning into a peer resource E&P then drives a lot more value creation, which can get you north of $30/share. I think Bonanza Creek is a small-cap name that has the right ingredients to outperform.

TER: Any other smallcaps worth looking at?

AC: You can also look at Swift Energy Co. (SFY:NYSE) and PetroQuest Energy Inc. (PQ:NYSE). I rate both as Market Performs.

PetroQuest is a more gas-weighted E&P company. It has a discovery well at the La Cantera prospect that adds more drilling inventory. The company also built a nice Mississippi Lime presence in Oklahoma to go along with their Woodford shale acreage in Oklahoma and their East Texas acreage in the Carthage field. It has attractive economics in the Mississippi lime and Woodford resulting from a joint venture with NextEra.

Swift Energy is a smallcap that has 78,000 net acres in the Eagle Ford shale in South Texas, South Louisiana, and 100,000 net acres in the Austin Chalk trend in south-central Louisiana. Some of its south-central Louisiana acreage could be prospective for the Tuscaloosa Marine shale, so we are watching players like Encana Corp. (ECA:TSX; ECA:NYSE), Devon, Goodrich Petroleum Corp. (GDP:NYSE), EOG Resources, Anadarko and Halcon Resources Corp. (HK:NASDAQ), which we do not cover. Swift recently closed its 2012 funding gap, but its higher beta would make it a stock to watch should (a) the pricing environment improve, and (b) the TMS data points surprise to the upside in 2013.

TER: What do you see in the near term for the O&G sector and how should investors approach this market to take best advantage of what lies ahead?

AC: Clearly, gas has some sex appeal at the moment. The forward curve has moved up north of $4/mcf and heading into earnings season, we'll be watching to see if these producers are adding price protection (e.g., hedges) for 2013+. On average, shares of gassy E&Ps are up 10% in the past three months, with a name like Southwestern Energy Co. (SWN:NYSE) leading the pack.

"If we think oil is going to suffer, perhaps gas can be the beneficiary as we go into the winter heating season."

In the short term, some exposure to gas certainly doesn't hurt. If we think oil is going to suffer, perhaps gas can be the beneficiary as we go into the winter heating season. We should get a sense in the next couple of months as to what winter weather will be like and if we can repair the NGL market, which is the next leg of the gas market. Then we'll get some views as to what's going to happen with oil, based on global demand, supply growth and this economic expansion. Heading out of winter, we'll have to see if we have enough data to say that the oil players can hold up, or if it is still time to be cautious. That's why we don't have any Strong Buys and remain defensive, with maybe a little bit of gas exposure, heading through year-end.

TER: When do you think there might be a turnaround in the whole picture?

AC: I'd still like to see gas production decline. No company that we follow is drilling any dry gas wells but they're still drilling wet gas wells to get the NGLs, and oil players are getting associated gas with their production. A meaningful slowdown in gas production should be positive for prices. Also, if we get increased demand due to colder weather, that would also help to underpin a more positive sentiment on the space.

From a funding standpoint, credit remains relatively accessible, but we are in the period when company credit facilities are reevaluated. Any pressure here could lead to more producer hedging, but overall we are not overly concerned. Recent high-yield deals have been done at rates between 5% (large-cap companies) and 7–8% (smallcaps). The improved sentiment for gas likely points to improved liquidity. While we're worried about the short term, we don't see a huge amount of distress right now.

TER: We appreciate your thoughts and insight today, Andrew, and we'll be watching to see how all this turns out.

AC: Thanks for having me.

Andrew Coleman joined Raymond James Equity Research in July 2011 and co-heads the exploration and production (E&P) team. Since 2004, he has covered the E&P sector for Madison Williams, UBS and FBR Capital Markets. Coleman has also worked for BP Exploration and Unocal in a variety of global roles in petroleum and reservoir engineering, operations, business development and strategy. Coleman holds a Bachelor of Science in petroleum engineering from Texas A&M University and a Master of Business Administration in finance and accounting with a specialization in energy finance from the University of Texas at Austin. He is a director for the National Association of Petroleum Investment Analysts (NAPIA) and a member of the Texas A&M Petroleum Engineering Industry Board, the Independent Petroleum Association of America's (IPAA) Capital Markets committee and the Society of Petroleum Engineers (SPE).

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DISCLOSURE:

1) Zig Lambo of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: Energy XXI Ltd. Interviews are edited for clarity.
3) Andrew Coleman: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview.