Stock-Picking With The CEO

?Seadily rising commodity prices during the past several years have made oil and gas investment selection relatively easy, as nearly all companies have benefited from favorable industry conditions. However, a slowing global economy of late has caused prices to retreat, and energy shares have followed.

The investor imperative to select companies that can outperform their peers then becomes more critical. An approach Vedanta Energy Fund uses to select potential industry stalwarts is to emulate the investment style of top-performing oil and gas private-equity firms that identify characteristics of successful companies.

?International exploration has driven Addax Petroleum Corp.’s annual growth rate of 28% in production per 100,000 shares. Founder and CEO Tracy Krohn holds 52% of W&T Offshore Inc.'s shares, a testament to his confidence in its steady growth in reserves per share.

Like private-equity firms, Vedanta invests in companies with managements that have proven histories of creating shareholder value, primarily by increasing reserves organically through the drillbit in a capital-efficient manner. This simple strategy has the potential to provide dramatic investment returns, but requires investor patience to see drilling programs and field-development plans successfully executed. Success is measured not in terms of months or quarters, but often in years.

Vedanta also seeks companies that have entrepreneurial CEOs who retain a high ownership interest in their companies. Investing alongside a significant stakeholder, as private-equity firms do, aligns shareholder interests. Finally, companies with large asset bases that possess sustainable growth potential are appealing to a long-term, tax-efficient investment style.

Within that overall thematic investment approach, Vedanta has identified a choice group of companies that offer potential shareholder-value creation. Some are newly public, aren’t generally well known or understood by the investment community and often sell at discounts to their appraised value, which can provide considerable downside-price protection.

Because the risks of investing in a single company are high, investors looking to participate in the should build a portfolio of at least several stocks to provide balance.

Own the owner. High ownership interest by a founding CEO in a well-run and established company is seemingly an easy investment choice. One example is Continental Resources Inc. (NYSE: CLR; $3.25-billion market cap).

Harold Hamm has served as CEO since establishing this rapidly growing Enid, Oklahoma-based oil producer in 1967. The company aggressively pursues unconventional oil- and gas-resource plays with a current development focus on the Williston Basin and Bakken oil prospects, where it holds a dominant acreage position. The company’s growth opportunities include interests in Oklahoma’s Woodford shale. An IPO was completed in 2007, and Hamm and his family control 82% of outstanding shares.

Another example is W&T Offshore Inc. (NYSE: WTI; $1 billion). The soft-spoken founder and CEO Tracy Krohn started this Gulf of Mexico gas producer 25 years ago with $15,000 and has grown the company against the challenging operating backdrop of high production-decline rates and low commodity prices of the 1980s and early 1990s.

With a limited staff, the company’s conservative approach of redeveloping primarily shallow-water fields that larger companies abandoned for the deeper water has yielded impressive growth. Krohn holds 52% of W&T’s shares, which made their public debut in 2005.

Nothing provides a louder or clearer signal to investors than the cash CEOs have directly invested in their companies. In another example, Tom Ward, the low-profile CEO of SandRidge Energy Inc. (NYSE: SD; $1.3 billion), invested $1 billion of his personal wealth—in a relatively high commodity-price environment—in this West Texas gas producer following his departure as COO of Chesapeake Energy Corp.

After cobbling together a controlling interest in the company’s primary asset, Pinion Field, Ward successfully led an equity offering in late 2007. An integrated operator, SandRidge plans to continue growing its production through exploration and development. Ward owns approximately 27% of SandRidge’s common shares.

Bet the jockey. Like the horse-and-jockey relationship in thoroughbred racing, an oil and gas company’s assets don’t necessarily matter as much as the CEO’s leadership, management and deal-making skills. Ram Energy Inc. (Amex: RAME; $76 million) and Exco Resources Inc. (NYSE: XCO; $1.26 billion) each have a great CEO as jockey.

Easily adapting to the spotlight of public life following Ram’s reverse-merger IPO in 2005, CEO Larry Lee owns 21% of this diversified Midcontinent oil and gas producer with operations ranging from an oil production-revitalization effort in Texas to an emerging Appalachian shale play. Lee and a partner started the company in 1987 with $2 million and have employed an opportunistic approach to creating value by buying and selling properties while growing overall production.

Meanwhile, Exco’s industry-maverick CEO Doug Miller easily maneuvers his way through the rough-and-tumble oil and gas business, willing to opportunistically create shareholder value either through asset sales or purchases while generally being agnostic to asset type. Miller and his seasoned management team have led both public and private oil and gas companies over their decades in the business.

Miller purchased his interest in Exco in 1997 and currently owns 6% of the outstanding shares. Exco returned to the public domain in early 2006 after Miller’s leveraged buyout of the predecessor public entity in 2003. Second time around. Some managements have previously worked with success the same basin in which their companies currently operate.

Since its inception in 2002 and IPO in 2004, Denver-based Rockies gas explorer and producer Bill Barrett Corp. (NYSE: BBG; $917 million) has assembled a large and wide-ranging portfolio of properties that have fueled significant production, reserves and cash-flow growth. Its founder and namesake, industry luminary William (Bill) J. Barrett, retired in 2006 and his two sons now run the company. Bill Barrett, as CEO, previously sold two Rockies-focused gas producers he founded to Williams Cos. Barrett family members own an estimated 3% of outstanding shares.

Also, Concho Resources Inc. (NYSE: CXO; $1.7 billion), an acquire-and-exploit conventional producer with an extensive low-risk drilling inventory, is the third Permian Basin-based company formed since 1997 by current CEO Tim Leach and his management team, which has more than 20 years of experience in the region. The prior two entities were sold to large E&Ps after posting impressive growth. Well-respected private-equity firm Yorktown Partners funded Concho initially and retains approximately 11% of the shares alongside 8% of shares owned by management and employees. The company went public in mid-2007.

Not just a U.S. phenomenon. Oil and gas entrepreneurship isn’t a U.S.-only phenomenon. A former Phillips Brothers oil trader, Addax Petroleum Corp. (Toronto, London: AXC; C$2.3 billion) CEO Jean-Claude Gandur founded his rapidly growing 140,000-barrel-per-day, West African and Kurdistan oil producer and explorer in 1994. He listed the Geneva-based company’s shares in Toronto in 2006 and London a year later.

A recognized diplomat, Gandur easily navigates the treacherous waters of securing deals in emerging countries and understands the risks of a large-scale exploration program. His world-class technical team is led by former high-level Chevron Nigeria operatives. Gandur owns roughly 25% of Addax shares through direct holdings and ownership interest in its private parent, the Addax and Oryx Group.

Also to be considered is mild-mannered CEO Ed Sampson, who has guided Calgary-based Niko Resources Ltd. (Toronto: NKO; C$2.5 billion) since 1992. This unique, high-growth-potential, South Asia-focused explorer and producer has its primary operations in the Krishna Godavari Basin offshore eastern India.

The company was an early entrant to the Indian energy industry and has participated in a number of world-class oil and gas discoveries. Sampson has successfully met the challenges of operating in the region and diversified the company’s asset portfolio to include Bangladesh, Pakistan, Indonesia, Madagascar and Trinidad. Sampson holds 10% of Niko’s shares directly and controls another 5%.

Like exploration or appraisal wells, not all oil and gas equity investments will be successful. However, investors aligned with incentivized CEOs in companies that hold superior assets and management teams can increase their chances of a favorable outcome, regardless of the commodity-price environment.

Mark S. Bononi is senior analyst at Vedanta Energy Fund, a New York-based global small- and midcap growth energy investor.