Fight The Crowd… And Avoid This Overvalued Sector

But this drilling does little to add new reserves — it simply helps exploit in-ground oil and gas that’s already been identified.

Companies at this stage usually struggle to grow. If you can buy such a firm below asset value, you can make money as reserves are converted into cash flow. But buying a treadmill company at a premium to its reserves value is a risky proposition. The growth just isn’t there to backfill the valuation.

That’s why I took advantage of the currently high share price and sold Chesapeake.

Whiting Petroleum Corp (NYSE:WLL) also looks like it may have hit the treadmill. The company had been performing well from 2009 to 2011 — during this period, each dollar the company spent in the field generated $1.90 in reserves value, an excellent recycle ratio.

However, 2012 was less stellar. The company spent $2.2 billion and added only $1.5 billion in net after-tax reserves.

This indicates the firm may be entering the phase where capital-intensive drilling is required in order to maintain production — without necessarily adding reserves.

The market however, is still pricing Whiting as a growth stock. The company’s enterprise value of $9.9 billion is significantly higher than its end-2012 after-tax reserves value of $5.3 billion.

The underperformance in 2012 could be a one-off. But until I see more evidence that Whiting is able to grow its reserves to backfill the current valuation, I’d rather watch this one safely from the sidelines.

I sold Range Resources, Chesapeake Energy and Whiting Petroleum on Aug. 30. Since then, Range and Chesapeake have remained flat, while Whiting has gained ground — but I don’t expect that to continue for long.

If you own any of these stocks, it might be time to think about booking profits. You should also evaluate any other oil and gas stocks in your portfolio, looking at enterprise values, reserve values and growth projections to see if they’re worth holding on to right now.

This article was originally written by Dave Forest and posted on StreetAuthority.

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