Friday, May 1st, 2009

Gain On ‘07 Recommendations: 44.16% Gain On ‘08 Recommendations: 45.39% Gain/Loss to Date On ‘09 Recommendations: 19.09% (Based on $20 million portfolio*) ‘09 Indices Gains/Losses to Date: Dow Jones: -9.10%, NASDAQ: 5.33%, S&P 500: -5.83% OIH: 17.19%, XLE: -5.76% Avg. of OIH & XLE**: 5.71% SterlingAccount: 19.09%***
*Except when the Fund is fully invested, the SterlingAccount assumes that interest from the money market offsets commissions. Percent of Fund in Money Market or Cash Equivalents: 10% Percent of Fund Invested: 90% ***The OIH is composed mostly of large hydrocarbon service companies, contract drillers and several major oil companies. The XLE is composed mostly of large hydrocarbon exploration and production independents and major oil companies. ***Total gains or losses are included from positions originated and closed out in’09, which contributed a net gain of $3,817,065.22. For detail see track record published at the end of each month. The latest issued ‘09 track record can be seen here. Click at top on the ‘07 and ‘08 gains to see detailed yearly track records.

How to Value E&P Companies
As any investor has learned in recent market times, landing the big catch among publicly traded E&P stocks is a function not only of patience, but of applying the right financial criteria when analyzing the annual reports or 10-Ks of upstream independents. Just what are these criteria? E&P analysts use several yardsticks to determine if a company’s shares are worth buying. In the main, they pay attention most to these factors: James Sterling 1

When valuing E&P companies. Those that that can grow their cash flow by growing their production profiles are the ones that are going to improve their bottom line and the ones in which you want to invest. fully capitalize and then amortize their exploration costs over future years.” The future success of upstream companies depends on their ability to ward off production declines by cost effectively finding new reserves with cash flow generated from current sales. those using fullcost accounting. and Share price versus a company’s breakup value or appraised net worth. taxes.Friday. James Sterling 2 . on the other hand. Full-cycle return on investment. 2009 • • • • A producer’s present and potential cash flow per share. add back in the exploration expenses for successful-efforts companies. but rather on their ability to take the cash they generate from production and invest it in existing or new properties to improve the underlying asset value of their companies. depreciation and amortization). however. Every now and then. On the contrary. The managements of E&P companies aren’t being judged by the market on their ability to generate net income. With cash-flow analysis. thereby creating more of a level playing field—one that allows for similar comparisons. they believe an investor should also place a premium on a company’s share price versus its net asset value (NAV). Annual earnings numbers is an unreliable tool for comparing upstream companies because some operators use successful-efforts accounting whereby they expense—or subtract from earnings—exploration costs in the same year they occur. it serves as a gauge of his ability to grow his asset base. E&P analysts. taxes. an analyst may focus on total enterprise value (stock market equity plus debt and preferred shares)/EBITDAX (earnings before interest.” But there’s a more compelling reason to place a premium on cash flow. depreciation. Total capitalization or total enterprise value/EBITDA (earnings before interest. amortization and exploration expenses). May 1st. you come across a situation where an independent has hit a home run or is about to tremendously increase the underlying value of its reserve base—but the market hasn’t recognized this yet in the company’s share price. don’t regard cash flow analysis as the stand-alone tool for measuring an upstream operator’s investment worthiness. As such. That’s what an operator must use (to fund drilling or acquisitions) to replace the reserves he produces in a given year.

May 1st. giving it a total capitalization of $100 million. Among other investments used are NAV to identify stocks that are trading below their inherent asset or liquidation value. However. Calculating a full-cycle return on investment directs investors toward those companies that are making efficient capital investments and away from those that are making inefficient investments. lack of high-growthpotential areas. This valuation yardstick. When it comes to cash flow or NAV analysis. and too much debt. In capital structures on cash flow. scrutinizing stock price/discretionary cash flow helps identify stocks that are comparatively undervalued. The reason? This ratio is a good proxy for return on investment and implied growth rates. But while Alpha has $100 million of equity and no debt. Put another way. that is. The way to deal with the problem of volatility in our analysis is to use price-normalized cash flow and asset values. James Sterling 3 . 2009 It’s a debt-adjusted ratio that takes into account a company’s unlevered cash flow. both have EBITDA of $10 million. an investor should be wary of operators with declining or flat production. and Beta Oil Co. Emphasizing yet another valuation metric. after-tax. high finding costs versus cash flow generated per unit of production. Here’s a hypothetical example: Alpha Oil Co. also known as total capitalization/EBITDA. this time on an afterinterest. Similarly. Having compared both companies on the same debt-adjusted cash flow basis. investors should pay particular attention to underlying pricing assumptions for oil and gas. Thus. you’d rather invest in the hypothetical Alpha company with the total cap/EBITDA multiple of 10. look at cash flow per unit of production/finding costs. Cash flow growth means nothing unless a producer is making money on that incremental dollar that it invests. This can lead to a better perception of investment opportunities. use historical five-year-average oil and gas price assumptions in our valuations—not current spot prices. it helps investors avoid paying five times cash flow for upstream stocks with poor returns versus paying five times cash flow for those with tremendous returns. given the volatility of these commodities. can be an eyeopener for investors. place a high premium on full-cycle return on investment (cash flow per barrel equivalent divided by multi-year average finding costs). That’s a useful equalizer in comparative valuation analysis in that it eliminates the effect of varying high.Friday. and having recognized the financial leverage of both and their ability to fund drilling programs. Beta has $100 million of equity and $100 million of debt. cash-flow multiple basis. the total cap/EBITDA multiple for Alpha is only 10 while the same multiple for Beta is 20. giving it a total capitalization of $200 million.

Onsite Due Diligence 14 Important Things to Check On 1) Check local transportation. 3) See if any environmental complaints have been filed concerning any of the company’s operations. casing defects. such as sanding. including the tool pusher. You might be looking at the greatest bargain in the world as far as the discount-to-breakup value of a producer’s reserves in the ground. and one of them has to use all of it just to replace what has already been produced. And neither can the investment. If the net present value of a producer’s future oil and gas cash stream—plus the value of its other assets less debt—is $1 per share. and that company’s stock currently trades at 50 cents per share. they should pay more attention to how much maintenance capital spending is needed just to keep that company’s asset base flat—and how much free cash flow is actually left over to grow that producer’s reserve base. then that company is just standing in place. has finding and development costs only half as much as the former producer. but if the company doesn’t have the money or wherewithal to produce and sell those reserves at a profit.Friday. Naturally. May 1st. and swelling of clay finds in perforated zones. 2) Talk to members of the drilling crew. to see if there are problems associated with any of the company’s wells. If the other. then those reserves can’t really be fully exploited. meanwhile. James Sterling 4 . See if gas pipelines are nearby and determine the cost of connection and the cost of compression necessary to equalize company wellhead pressure to pipeline pressure. If two operators each have $100 of discretionary cash flow. it’s clear that’s the one that’s going to have the free cash flow to grow. also focus on cashflow analysis—and with good reason. If an investor can buy a producer’s reserves in the stock market for less than what an independent engineering report says they’re worth. 2009 Another caveat the analyst advances: when investors today scrutinize a producer’s discretionary cash flow. then you’ve discovered a stock that’s selling for half its breakup value. then there’s an opportunity to make money as those reserves are produced and sold in future years.

9) Potential gas purchasers are contacted for likely wellhead prices. 2009 4) If necessary. including tests of existing wells that are part of the deal. 10) Local and national engineering firms independently review estimated reserves and projected net income. mortgages and UCC filings are known. revenues. May 1st. 12) Investigations are conducted of key personnel who may be retained. 5) Use any one of a number of information sources to provide production history of nearby wells or analog fields. transportation. James Sterling 5 . 13) Title checks and property searches are conducted to ensure that all leans. operating cost and net cash flow from proposed wells. of environmental damage. availability and costs and potential for future price changes. 6) Production history and test results of each analog or offset well are analyzed. streams and nearby bodies of water. do an independent check for pH levels at nearby rivers. well sites and equipment. since the company can be accused. 14) A final physical inspection is conducted. 7) In-house or third party engineers and geological staff project future production. fairly or unfairly. 8) A preliminary physical inspection is performed – including testing and environmental assessment of existing wells. 11) In-house cost accountants review financial and accounting data for accuracy and consistency.Friday.

Furthermore. 6 .” Sterling is not responsible for trades executed by subscribers to the services based on the information included in the website and any other publications from Sterling (collectively. from time-to-time make purchases or sales of the securities discussed or mentioned in the Publications. directors. Sterling relies upon an exemption from the registration requirements under the Investment Advisers Act of 1940. and should not be construed as personalized investment advice.Friday. verify or guarantee the suitability of any particular investment to any particular situation and the reader of the Publications bears complete responsibility for its own investment research and should seek the advice of a qualified investment professional that provides individualized advice prior to making any investment decisions. Specifically. Sterling. and may. Securities and Exchange Commission or any state securities regulatory authority. may have positions in. This exemption is available for the publisher of any “bona fide financial publication of general and regular circulation.S. All opinions expressed and information and data provided therein are subject to change without notice. as amended (the “Advisers Act”) provided for in Section 202(a)(11)(D). Sterling cannot assess. employees and/or affiliates. The Publications and the information contained therein do not represent individual investment advice or a recommendation to buy or sell securities or any financial instrument nor are they intended as an endorsement of any security or other investment. its officers. the Publications do not constitute an offer or solicitation to buy or sell any securities or individualized investment advice. the “Publications”). Any information contained in the Publications represents Sterling’s opinions. 2009 James Sterling Sterling Account (“Sterling”) is not registered as a securities broker-dealer or investment adviser with the U. May 1st.

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