Before delving into today’s article, allow me to comment briefly on yesterday’s OPEC announcement. As I expected, in cooperation with Russia and some other key non-OPEC members, OPEC’s deal for oil production cuts will be extended by nine months to March 2018. As I have argued many times, I don’t believe they had much choice. The only real question in my mind was whether they would make additional cuts.

I had a slight concern that if OPEC surprised everyone and abandoned its strategy, we might see a quick 20% drop in the price of oil. By maintaining the status quo, I think what we will see is a decent floor under oil prices, perhaps in the mid to upper $40s, and an upside to maybe $60/bbl as the cuts start to deplete global crude oil inventories. 

The market was at least somewhat disappointed that OPEC didn’t deepen the cuts, as oil prices dropped by 5% on the news. I don’t expect prices to remain depressed. OPEC’s decision is good news for U.S. oil and gas producers, but it seems like in the current market only great news will do.

On to an analysis of first quarter results. There is nothing more frustrating than investing in fundamentally sound companies that deliver solid results and then watching shares go sideways or down. That has been the case across the energy sector this year, even for the best companies in the sector, as sentiment remains negative. But this has created many bargains in the energy sector. 

Each quarter I look for several things as earnings are released. If earnings disappoint, I need a convincing case for why things are going to improve soon, or I am selling the company. If they meet or exceed expectations, I want to determine if the companies are fairly priced given current and future expectations. 

There are numerous metrics for evaluating a company. Among other things I look at earnings (with its many different variants), enterprise value (EV), proved reserves, production, split between oil and gas, debt, and cash flow. Because there are so many metrics, there is a mind-boggling number of ways to rank companies.

I always look for disconnects between performance and valuation. One way to find these disconnects is to examine how much cash a company is generating relative to its EV. Why EV and not market capitalization? 

The full calculation for EV is Enterprise Value = Market Capitalization + Book Value of Total Debt + Book Value of Preferred Stock + Book Value of Minority Interest – Cash & Short-Term Investments. This calculation provides a better representation of the “real” market value of a company than does market capitalization.   

EV tells us about the market value of the company, but cash flow tells us a lot about whether the company is delivering results. Earnings are seldom straightforward, as there are often non-cash items that can impact them. Cash flow gets closer to the truth.

Operating cash flow, or cash from operations (CFO), refers to the difference in the generated revenues and the cost of generating those revenues, excluding capital expenditures. The primary difference between CFO and free cash flow (FCF) is that the latter includes the effect of capital costs.

So one measure of a company’s health is to look at the generated cash flow. If you saw this week’s Energy Letter article First Quarter Cash Flow Champs, I highlighted several companies based on Q1 performance. The highest CFO for the quarter came from PetroChina, with Q1 CFO of $10.6 billion. Royal Dutch Shell (NYSE: RDS-A) was in the 2nd spot with Q1 CFO of $9.5 billion. ExxonMobil (NYSE: XOM) came in 3rd with CFO of $8.2 billion but topped the Q1 FCF list at $4.6 billion. 

But those numbers tell us nothing about value. If there are two otherwise identical companies generating the same cash flow, but one is trading at half the EV of the other, that is a potential disconnect that we can exploit. I say “potential,” because there could be extenuating factors that explain the discrepancy.

My stock screening/evaluation tool is well-suited for ranking companies based on custom metrics. So I decided to evaluate major North American and European energy companies by CFO generated relative to the enterprise value (EV) of the company.

If I look at the 30 largest companies in this category, two names stand out. The first, as identified in the previous article, was Appalachian Basin natural gas producer (and portfolio holding) EQT Corporation (NYSE: EQT), which generated Q1 2017 CFO equivalent to 3.3% of its EV. By comparison, ExxonMobil came in at 2.1%. The average of the Top 30 was 2.3%. EQT shares have traded down this year along with the rest of the energy sector, but the company still appears to be delivering.

One outlier in the Top 30 was Norway’s Statoil ASA (NYSE: STO), which trailed only ExxonMobil for FCF at $4.4 billion. It was also ranked right behind ExxonMobil’s CFO with $6 billion for the quarter, but because Statoil’s EV is only $74 billion — versus ExxonMobil’s $394 billion EV — Statoil’s CFO was equivalent to an astounding 8.1% of its EV. No other company in the Top 50 comes close to this, and only two companies in the entire screen beat that number.

The two companies that beat Statoil on this metric are worth a mention here. Topping the list is a company that hasn’t been on my radar before. PrimeEnergy Corporation (NASDAQ: PNRG) owns leasehold, mineral and royalty interests in oil and gas properties across the continental United States and the Gulf of Mexico. The Company operates ~1,500 wells and owns non-operating interests in 850 additional wells.

PrimeEnergy is one of the smallest companies on the list with an EV of $130 million. But the company has a low debt/EBITDA ratio of 1.0, an EV/EBITDA ratio of only 7.2 (about half the average of all companies screened), and it generated positive FCF in three of the past four quarters. For Q1, PrimeEnergy generated CFO equal to 12.7% of its EV. This was good for the top spot in Q1, and for the past 12 months, the company’s CFO/EV was beaten only by the next company on the list.

SandRidge Energy, Inc. (NYSE: SD) will be a familiar name to most, but much has changed. SandRidge was originally founded in 2006 by Tom L. Ward, who had previously cofounded Chesapeake Energy (NYSE: CHK) with Aubrey McClendon. Like McClendon, Ward loved leverage. Ward was forced out in 2013, but when commodity prices turned down the leverage pushed the company over the edge. A year ago this month, SandRidge was forced into a Chapter 11 bankruptcy reorganization.

Last October SandRidge Energy Inc. emerged from bankruptcy, shedding $3.7 billion in its reorganization. SandRidge came out of bankruptcy with zero net debt and more than $500 million in liquidity. Eliminating the debt saved the company about $300 million a year in interest payments, which is the key reason SandRidge is now generating strong CFO. In Q1 2017, SandRidge produced 4.0 million barrels of oil equivalent (28% oil, 22% NGLs and 50% natural gas). This strong production, combined with the bankruptcy reset, allowed SandRidge to generate CFO over the past year equal to 30% of its EV. This was good for the top spot (and against an average of all screened companies of 8% for the past year). 

SandRidge is a perfect example of why I sift through results at the end of each quarter. It is a company that I wouldn’t have touched in the past because of its high debt. But the reorganization has created a company that is cheap according to every metric on my screen, yet has strong financial performance. It has an EV/EBITDA of only 3.3, and an EV/proved reserves ratio of only $3.71 per barrel of oil equivalent.  The company has a distinct advantage over competitors as a result of the reorganization. 

The market has yet to recognize the new and improved SandRidge. The company initially rose nearly 40% coming out of bankruptcy, but the negative energy sentiment this year has dragged the price back down despite the company’s excellent performance. At present this one can be picked up for a price within 1% of its post-bankruptcy price. Companies that produce similar amounts of oil and gas are trading at 5-10x the EV of SandRidge. It’s worth adding to the portfolio for growth-oriented investors. Buy SandRidge up to $23. 

I am not going to make a recommendation to buy PrimeEnergy, but I am going to be watching it closely. For now, it’s just too small, volatile, and unknown for most investors.

Beyond SandRidge and PrimeEnergy, there were a few companies worth watching. Statoil is one, but there were a few others I will analyze in more depth. A scan of the portfolio indicates healthy CFO/EV measures for most holdings. The coal holdings continue to perform well, while the oilfield services companies were weak this quarter. Over the next few weeks, I will evaluate all portfolio holdings in depth, and adjust the Best Buys list as warranted.