Five Energy Stocks for Your Radar Screen

Five Energy Stocks for Your Radar Screen We've changed our natural-gas assumptions, and some of these stocks look good. by Justin Perucki | 03-06-06 | 06:00 AM | E-mail Article | Print Article | Permissions/Reprints Despite the recent fall in natural-gas prices over the past two months due primarily to an abnormally warm winter, we recently raised our natural-gas price assumptions. Incorporating our new price assumptions and methodology changes, we now expect our natural-gas price benchmark, NYMEX Henry Hub, to average near $8 per thousand cubic feet (mcf) in 2006, $6.80 in 2007, and $6.20 in 2008. After 2008, we assume prices will grow at our projected long-term inflation rate of 3.6%. Despite our higher assumptions, we still consider recent prices exceeding $10 per mcf extremely high and ultimately unsustainable. In this article, we'll explain some of our observations that we based on our decisions on and highlight five firms that are trading at meaningful discounts to our fair value estimates. In an effort to cash in on the current price environment, companies have been ratcheting up development, exploration, and acquisition spending over the past two years. As a result, unit costs have risen dramatically. We don't see this trend changing over the next few years--firms are paying top dollar to acquire new properties, and day rates for rigs are still well above normal. Companies have also been investing heavily in historically marginal projects like shale gas and coal-bed methane. In a $3 per mcf price environment these types of reserves did not provide attractive returns. But improved technology and drilling techniques, as well as robust natural-gas prices have made these projects more appealing. New technology, drilling techniques, rigs, and a host of other factors will cause costs to eventually decline from their current levels, but they should remain above historical averages going forward. Higher costs translates into higher prices, because production companies will be quicker to slow down drilling activity when prices fall. All the activity around the Barnett Shale in Fort Worth, Texas, where EOG EOG, Quicksilver KWK and XTO XTO are big players is a prime example of the industry's attraction to unconventional reserves. Although shale gas resources are large, experts believe shale gas will only be sufficient to stabilize production and not reverse the natural decline curve. That is where liquefied natural gas (LNG) comes into play. LNG has been around for years; Japan relies upon it for almost all of its gas needs. However, North American reserves have always enjoyed a significant cost advantage so LNG has only been nominally imported for the past 30 years. Historically, the U.S. has relied upon Canadian imports to cover the supply/demand gap, but with Canadian imports expected to slow, LNG will be needed to fill that gap. We don't, however, expect to LNG to make a major splash domestically until 2008-2009 when the next wave of regasification terminals, like the ones being built by Cheniere Energy LNG and Sempra SRE, begin importing LNG. Although LNG could displace high-cost domestic producers, we think that it should improve the reliability of supply--helping to stabilize gas prices near our midcycle price, rather than creating a glut of low-cost gas. Some natural-gas bears point to declining industrial demand as a catalyst for lower prices. Industrial firms who consume large quantities of natural gas like the chemical and aluminum industry are concentrating new capacity in areas like Trinidad and the Middle East, where reserves are plentiful and prices are cheap. But, declining industrial demand is more of a long-term issue for a couple of reasons. One, there are long lead times required to build new facilities. Two, there is a significant amount of capacity in the United States, and despite robust gas prices these facilities remain competitive at prices well above historical levels due to transportation costs. Natural gas also faces pressure on the electrical generation front from coal and nuclear energy; both are viable long-term substitutes. The biggest problems facing these two fuel sources is the environmental concerns and high up-front capital costs for new plants. Consequently, we don't see coal and nuclear taking meaningful share away from natural gas for the next few years. Like industrial facilities, there are a plethora of natural-gas fired electricity plants, see Calpine's CPNLQ build out in the early part of this decade. These facilities could be restarted in the event natural-prices were to fall significantly, which further shapes a price floor for natural-gas prices. Over the long run, other supply and demand issues may materialize, but from what we can see today, natural-gas prices should remain strong for the foreseeable future. The change in our natural-gas price assumptions had a positive effect on our fair value estimates for several companies in our coverage universe. As a result, there is a handful of stocks trading below or near our "consider buy" prices. Here are five energy stocks to keep on your radar screen: Devon Energy DVN Analyst: Justin Perucki Fair Value Estimate: $80.00 Consider Buy: $61.70 From the Analyst Report: Devon has an eclectic group of assets. The 2003 merger with Ocean Energy made Devon one of the five largest leaseholders of promising deep-water Gulf of Mexico properties. A 2001 acquisition added large tracts of western Canada, including the largest gas holding in the untapped Mackenzie Delta. Although much of North America's gas deposits are mature, Devon's deep-water and Mackenzie Delta properties are still in their infancy. Even the company's developed reserves have a lot of life left in them. Devon is the largest producer in the still-prodigious Barnett Shale deposit in Texas. Whiting Petroleum WLL Analyst: Justin Perucki Fair Value Estimate: $51.00 Consider Buy: $39.30 From the Analyst Report: Without deep pockets to fund large-scale exploration efforts, Whiting relies on purchasing fields from other producers. After a very active 2004, when it doubled its reserves with seven acquisitions, Whiting doubled its reserves again with its recent acquisition of Celero's Permian Basin properties. At $1.09 per thousand cubic feet, Whiting paid an attractive price for Celero's reserves. Even though the firm estimates that it will have to invest an additional $534 million over the next five years to develop the properties, we still believe Whiting should recoup its investment within a reasonable amount of time. The Celero acquisition also transformed Whiting from a natural-gas company to an oil company, with a proved reserve base consisting of 75% oil and 25% natural gas. El Paso EP Analyst: Michael Cumming, CFA Fair Value Estimate: $17.00 Consider Buy: $13.10 From the Analyst Report: We think El Paso has turned the corner. The company has been slow to resolve its debt and litigation problems, but those issues are finally being addressed. Planned asset sales are nearly complete; when all is said and done, El Paso will be able to focus on its core pipeline and exploration and production businesses. Earnings will continue to be choppy for a while as the company completes its asset sales, but we think El Paso will emerge from that process poised for growth. Energy Partners EPL Eric Chenoweth, CFA Fair Value Estimate: $34.00 Consider Buy: $21.70 From the Analyst Report: Energy Partners sees potential in a place that many others consider mature: the Gulf Coast.The firm is planning to spend a record $360 million in 2006 on exploration and production. Given the big jump in spending, the success or failure of next year's drilling program could have a large effect on Energy Partners' value. While many of its projects hold low to moderate risk, several could have a much bigger financial impact. Denali, in the East Bay off the southeastern tip of Louisiana, is particularly important. The well will cost close to $20 million and require drilling to a depth of around 22,000 feet, making it one of the riskiest projects on Energy Partners' plate in 2006. But the potential reward is also estimated to be quite large, ranging from hundreds of billion cubic feet to 1 trillion cubic feet. Cimarex XEC Eric Chenoweth, CFA Fair Value Estimate: $51.00 Consider Buy: $39.30 From the Analyst Report: Cimarex is different from many of the other exploration and production companies we cover. In particular, its focus on return on invested capital, as opposed to many other firms' obsession with quickly boosting reserves, is a refreshing change. Cimarex's primary talent and strategy centers on the drill bit. It shuns unconventional projects like coal bed methane and sets its sights on conventional basins in the Mid-Continent, Texas, and Gulf of Mexico. Because its desire to earn high returns trumps its desire to expand reserves, the firm is lured to projects with sound economics in these areas that its competitors would probably avoid. As a result, Cimarex isn't likely to be one of the fastest-growing E&P companies, but it does have a decent shot at adding shareholder value over time. One of the potential risks in this strategy is that the firm may occasionally run low on new drilling prospects. Consequently, it may feel the itch to make acquisitions to replenish its portfolio.