Conservative energy investments have their place as decent dividend income plays and steady builders of incremental value. But the energy industry is also fertile soil for aggressive growth stories, empires that seem to rise from obscurity seemingly overnight when the right management team deploys  its edge to bring out the full value of discounted assets.

The risks are large but then so too are the potential rewards. When Continental Resources (NYSE: CLR) raised $442 million in 2007 in its initial public offering, the shares priced at $15, below the forecast range. Not quite seven years later, the share price has increased  more than sevenfold now that  Continental is a $20 billion driller.

Today, some upstarts offer attractive risk-adjusted opportunities even if they’re unlikely to become the next Continental. We’re adding to our Aggressive portfolio two that look especially promising at their current price.

The first of these, Rice Energy (NYSE: RICE) is a family affair. Started by top energy portfolio manager Daniel J. Rice III, its employs his sons as the CEO, the COO and chief geologist. The elder Rice resigned from Blackrock in 2012 after The Wall Street Journal questioned potential conflicts of interest between his fund manager job and role at the family firm. At this point, he probably has no regrets about that.

Rice was early in identifying the sweet spots of the Marcellus and the Utica shales, and in acquiring drilling rights on prime acreage in each while they were cheap.  And unlike other explorers who’ve hedged their bets by expanding their initial positions outward, Rice then acquired more drilling rights near the initial purchases to end up with a compact core position.

The strategy maximizes the geological advantages of the sweet spot while minimizing drilling and infrastructure costs. The drilling rigs don’t need to rove as far from one well site to the next, and the gathering pipes don’t have to cover as great a distance. This is important because another pillar of Rice’s strategy is to develop its own midstream infrastructure rather than depending on third-party providers.

The proof is in the well results, which place Rice at the head of the Marcellus gas rush with rates of return of 100 percent and up. Its wells have grown impressively more productive since it started drilling three years ago, and only EQT (NYSE: EQT) appears to have hit a similar proportion of underground jackpots. In fact, some of the wells Rice drilled last May appear to have already returned their entire cost. Rice uses the most sand in the industry’s shortest fracking stages, known factors in stimulating output. The company also prides itself on the precision of its horizontal drilling, which allows it to access the optimal rock layers.

Source: Rice Energy IPO presentation 

Rice is only now shifting from delineating its position to fully exploiting it. As of Dec. 1, it had only drilled 40 wells out of its more than 1,300 identified Marcellus, Utica and Upper Devonian drilling locations on  43,000 net acres in the Marcellus and 46,000 in the Utica. This year, it plans to drill more than double the number of wells completed in 2013, and to increase the total horizontal length of its producing wells by 158 percent.

It’s hard to properly value a business growing this fast. When Rice came public on Jan. 24 amid a brutal market sell-off, its shares priced at the top of the preliminary range, valuing the entire company at some $2.6 billion. In the three weeks since, the share price and the valuation have increased 14 percent, giving  Rice a roughly $3 billion price tag.

This renders retrospective valuation exercises largely pointless, but suggests the company is a bit less expensive based on book value and trailing sales than Antero Resources (NYSE: AR), another well-regarded Marcellus driller that we recommended in November. And that leaves plenty of upside given Rice’s multi-year growth trajectory on its compact turf, and finding and development costs that are already the industry’s lowest.

Future production is extensively hedged at the floor of $4 per mmBTU, which is the benchmark price Rice requires to put up those triple-digit rates of return. The family retains a one-third equity stake in the company after the IPO, which has by some estimates made the elder Rice a billionaire.

The skills and the incentives are in place to continue creating value via cost leadership , which will be bolstered by pad drilling in the years ahead. And while some have criticized Rice for not expanding its turf more aggressively, the advantages of its focused strategy are already apparent. Buy RICE below $27.  

If Rice is pricey based on trailing metrics, Jones Energy (NYSE: JONE) is ostentatiously cheap, fetching perhaps 4 times its likely 2014 EBITDA based on the enterprise value.  Jones is a small-cap driller (market cap of $800 million) focused on exploiting the Cleveland play in the northeast corner of the Texas panhandle, where shallow wells cost less than half what they do in the Marcellus but promise similarly juicy profits, with Jones estimating the internal rate of return at 150 percent when West Texas Intermediate is priced at the current $100 a barrel.

Jones was founded in 1988 as the latest incarnation of a family business that had prospected in Texas since the 1920s; the current CEO is a former BP geologist and a respected figure in the industry. The company came public in July in a poorly received IPO, and the price was further hurt in November when Jones unveiled an advanced fracking design that could boost well costs by a third, presumably for an even bigger production kick that has not yet been quantified.

Jones ‘ share price has also been hurt by the fact that its public float is a tiny $200 million. The company’s private equity sponsor, Metalmark Capital, retains a 44 percent stake, and the CEO owns another 25 percent, via a separate voting share class that gives insiders a bigger say in company policy.

 The CEO actually bought shares in the IPO, which analyst and Jones investor David Edwards points out is virtually unheard of. (I’m indebted to Edwards for his insights into Jones.)

Despite the market’s cold shoulder and low valuation, Jones Energy production has grown at a 55 percent compounded annual growth rate over the last four years, and output in the core Cleveland play doubled year-over-year in the third quarter.


Source: company presentation

Jones has been the cost efficiency leader in its area and, very unusually for an explorer of any size, financed its 2013 drilling program entirely from cash flow. If this year’s costs are higher as a result of the new fracking design, I expect them to be more than offset by production gains. Expect more information on that score in the quarterly results due shortly. In the meantime, Jones remains an under-followed and undervalued growth play, Buy JONE below $21.