How to Play the Oil and Gas Recovery

RMP Energy Inc. (TSX:RMP) and Tamarack Valley Energy (TSX:TVE) are set to thrive as oil prices recover.

The Motley Fool

With oil hovering between $60-65 a barrel, prices have recovered by 20-25% from January’s lows but remain roughly 50% lower than last year’s highs. Predictably, there has been a dramatic drop in profits for oil producers, causing equally dramatic cutbacks in operating and capital expenditure budgets.

With the shares of smaller energy firms being hammered the most, here are a few reasons why two Canadian operators, RMP Energy Inc. (TSX:RMP) and Tamarack Valley Energy (TSX:TVE), could be your best bet to play rising energy prices.

Canadian junior operators have the most operating leverage

While larger oil companies have suffered less due to their diversified business lines, they will also be less responsive when prices rise. The smaller, junior players typically have a much higher operational leverage to the price of oil.

For example, a junior operator with a $50 a barrel cost of production would make roughly $10 a barrel at current prices. If oil rises to $70 a barrel, its profitability doubles.

Importantly, however, leverage works both ways. If oil prices stay depressed or fall further, its losses are magnified. Operators that will need to rely on the public market for funding are in a precarious position. Over-indebted firms will be forced to battle with bankers, paying high fees that could deprive them of the little funding they have.

Stick with quality operators

Both RMP Energy and Tamarack Valley Energy should be able to withstand the low-price environment, while also having long-term viability. If prices recover, both companies are poised to grow production dramatically in the next couple of years.

RMP Energy, for example, produces approximately 44% oil and 56% gas in west-central Alberta. Even though it has cut its capex program by half, the company still expects to grow its production by 10-20% in 2015. It is in a healthy financial position and capable of paying down all outstanding debt with only one year of cash flows. Even at $50 a barrel, RMP Energy expects to generate free cash flow of $100 million in 2015.

Tamarack Valley Energy, on the other hand, has a reputation for very tight cost control and some of the most productive wells in the Wilson Creek region. The company is on track to reduce its debt by almost $120 million this year, while recently announcing a 78% increase in reserves and record production volumes.

Choose carefully

It looks best to avoid most overleveraged companies, despite their dramatic share declines, sometimes 90% of more. While tempting, crushing debt loads have the potential to pull preciously needed funding away from production budgets.

Stick with experienced, well-regarded management teams that can grow production volumes even at lower prices. Also, purchase struggling competitors at a discount. Should oil prices rise, companies like RMP Energy and Tamarack Valley Energy will be best positioned to benefit.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Ryan Vanzo has no position in any stocks mentioned.

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