U.S. Buyside

By Toal, Brian A

Nationwide, buysiders are guarded in their macro-energy outlook for 2007 but are long-term bullish on industry fundamentals and company-specific investments.

CM Energy Partners’ Monroe Helm sees tough times ahead this year for the oil and gas industry but is longer term bullish on the fundamentals for the sector.

Starting last fall, it became clear even to casual industry observers that large oil and gas inventory overhangs weren’t going to bode well for commodity prices and energy-stock valuations going into 2007.

Then came the second consecutive milder-than-normal January and their expectations were fulfilled. The heady $78-plus oil markets of last August yielded to crude prices in the low $50s while gas- futures, in double digits last summer, dipped to below $6. Meanwhile, energy-stock values plunged 10% to 15% and even more.

Does this signal the end of the bull market in energy? Buysider consensus about this is best summed up in Bette Davis’ oft-quoted line from All about Eve: “Hold on to your seats, fellas; it’s going to be a bumpy ride.”

Translation: the early part of 2007 is going to be marked by high volatility and softness in the commodity markets, with oil prices trading in a broad range of $48 to $65 and gas prices moving in a band of $5.50 to $7.

Ultimately, however, as more momentum players exit the energy- stock playing field and more traditional oil and gas investors again become dominant, the energy-ticker tide on the corner of Wall and Broad streets will gradually begin to rise.

Says one energy buysider, “The world is looking at very tight supply/demand fundamentals beyond 2007, with [oil] demand outstripping supply during the next five years.” Observes another, “Despite the price of crude doubling since 2003, energy consumption worldwide has nonetheless increased, with 51% going into transportation today versus 39% in 1979. Meanwhile, since 1995, the average first-year production from U.S. gas wells has dropped more than 50%.”

To seasoned energy investors, the handwriting is on the wall: meaningfully higher commodity prices are on the horizon during the rest of this decade simply because the demand for oil and gas is inelastic and supply isn’t going to be able to keep pace.

This, of course, doesn’t mean a rising tide will lift all boats. On the contrary, bottom-up buysiders point out that investors need to separate the wheat from the chaff. Focus, they say, on those undervalued energy companies that have either a meaningful inventory of prospects for sustained growth, in the case of E&P companies, or that can control costs and hence, improve earnings visibility, in the case of service companies.

Difficult year

Based in Dallas, CM Energy Partners Inc. is a $60-million long/ short hedge fund typically 80% weighted to energy and 20% to basic materials such as steel and aluminum. Long term, it’s bullish on energy, with an outlook for $65 to $70 oil and $7 to $8 gas for the rest of this decade. However, the firm isn’t quite that optimistic about the oil and gas sector in 2007.

“This is going to be a difficult year for the industry versus the prior four years,” says Monroe Helm, CM Energy co-managing partner. “We have record levels of gas in storage, growing gas production in the Lower 48, a bit of excess in crude and products, non-OPEC productive capacity on the rise, and speculators reducing their exposure to oil and gas.”

He thus sees 2007 gas prices as low as $5 and as high as $7.50, with an average $6.75 to $7 for the year. Meanwhile, crude prices could range between $50 and $70 and average around $60.

This aside, the world is looking at very tight supply/demand fundamentals beyond 2007, with demand outstripping supply during the next five years. Helm asserts.

He notes that OPEC’s current spare productive capacity-although it might increase from 1- to 2 million barrels per day in a world market where demand is 86 million barrels per day-is the lowest spare capacity in the history of the industry. “And even though Saudi Arabia is spending $80 billion to expand its daily productive capacity by 2.5 million barrels by 2011, this won’t be adequate to meet daily world demand of 93.5 million barrels at that point, and prices will have to rise to above $75 per barrel to ration supply.”

In Chicago, pictured above, Harris NA’s Thomas C. Lewis predicts weakness in energy-stock valuations in the early part of 2007 and favors exposure to the bigger, more defensive oil and gas names.

The buysider, whose hedge fund cut its energy weighting in December, seeks during the next few months-based on a pull-back in stock valuations-to buy or add to positions in energy shares, particularly those with an oil bias given the current oversupply and price weakness in the North American gas market.

Among oily names in Canada, he likes Canadian Natural Resources and Nexen; in the U.S., Occidental Petroleum, due to its rapid production growth, and Devon Energy because of its significant deepwater position in the Gulf of Mexico.

On the oil-service side. Helm believes the best way to play the non-OPEC oil producers is to focus on deepwater drillers, especially those with international exposure such as Transocean, Diamond Offshore and GlobalSantaFe. ‘Their deepwater rigs are almost fully contracted for 2007 and 2008, and many of those contracts are being extended into the 2010-12 period. So these drillers have quite a bit of earnings and free-cash-flow visibility.”

Among midcap E&P stocks he follows, he’s targeting-based on a retreat in natural gas prices and stock valuations-those low-cost producers with exposure to gas plays that can grow annual production 20% to 40%. These inelude Southwestern Energy, Quicksilver Resources, Newfield Exploration, Parallel Petroleum and Range Resources.

Says Helm, “All these companies have finding costs in the $1.15 to $1.75 range, in contrast to operators that can’t grow their reserves and are out in the market paying anywhere from $2.45 to $3.35 for proved reserves,”

Early weakness

Headquartered in the heart of Chicago’s financial district is Harris NA, wholly owned by BMO Financial Group in Toronto, with total assets of $40.6 billion. Through its Harris Private Bank arm, which provides equity-investment exposure to foundations, trusts, mutual funds and high-net-worth individuals, the firm as of late 2006 had a 6% weighting to energy relative to the S&P 500.

“The energy sector has started off 2007 somewhat differently than the past couple of years in that we now have more oil and gas supply than demand and thus, commodity prices and energy-stock valuations have pulled back pretty meaningfully-a weakness we expect to continue in the early part of the year,” says Thomas C. Lewis, vice president, manager and senior analyst, equity research, for Harris NA.

Lewis looks for 2007 oil prices to average $50 to $55 and gas prices, $6 to $6.50 with hedge funds exerting less control over investment and trading activity this year; more traditional energy investors focusing on the long-term fundamentals of demand, supply and inventories; incremental supply coming from non-OPEC countries; and an expansion of OPEC production capacity.

In such an environment, investment in large integrated oils like ExxonMobil is a good defensive strategy, he contends. “The beauty of companies like these is that, if commodity prices pull back and profitability in their E&P operations is negatively affected, the margins in their downstream operations offset that.”

In addition, these companies generate the highest cash flows in the energy sector. Thus, in a period of declining commodity prices and stock valuations, they’re well positioned to take advantage of those events, either through buying oil and gas assets at attractive prices or initiating large share-buyback programs, Lewis explains.

The analyst also favors exposure to the oilfield-service group. He believes a lot of the recent oil-price decline has already been factored into these stocks. “Furthermore, major oil companies-the service sector’s biggest customers-are going to continue to spend in order to grow their production and reserves and keep cash flows and returns healthy.”

Within this group, he cites Schlumberger, which is financially strong, has global operating reach and has returned to its basic business focus. In addition, he likes exposure to worldwide, deepwater drillers like Transocean. “As major oils move more into deepwater environments to find oil and gas, Transocean is the “go to’ leader in the offshore-drilling sector.”

Also, with so many rigs having left the Gulf of Mexico in search of more lucrative contracts internationally, the whole rig supply/ demand picture in the Gulf has begun to tighten, which should help improve dayrates in that market. “Ensco International is well positioned to benefit from this tightening as we move further into 2007.”

Within the E&P sector, the analyst favors XTO Energy. “The company has a great inventory of low-risk prospects and has shown continued growth in production and reserves at well above average rates,” says Lewis, “It also generates high returns and earnings and has a significant portion of its 2007 and 2008 production hedged at above-average market prices. In short, it displays consistency across the board.”

Long-term focused

When it com\es to the energy sector, investors should focus less on short-term events like mild winters and flagging gas prices and more on the robust long-term supply/demand fundamentals for oil and gas.

That’s the thinking of Rodney Mitchell, founder and president of The Mitchell Group, a Houston-based registered investment-advisory firm focused exclusively on investments-several hundred million dollars worth-in publicly traded energy stocks.

“Looking long-term at worldwide oil and gas supply, we see the increasing depletion of old, giant fields; new oil-sands and LNG (liquefied natural gas) projects that are taking much longer to reach completion at shockingly high cost overruns; and the rise of petronationalism in places like Russia, Venezuela and Bolivia, which ultimately bespeaks more inefficiently run energy operations and lower levels of production,” says Mitchell.

“So the expectations for dramatic increases in global oil and gas supply during the next 10 years may be far too optimistic.”

Drilling in the U.S. will have to increase 15% to 20% annually just to maintain current production levels, says The Micholl Group’s Rodney Mltchell. On facing page, high-rise buildings in downtown Houston.

What’s also notable, on the demand side, is that, despite the price of crude doubling since 2003, energy consumption worldwide has nonetheless increased, with 51% going into transportation today versus 39% in 1979, he notes.

Meanwhile, as U.S. gas demand continues to rise, domestic gas production continues to decline. Since 1995, the average first-year production from U.S. gas wells has dropped more than 50%, a reflection of the increased exploitation of steep-decline, unconventional gas plays, says Mitchell.

“Some people don’t worry about this, pointing to the availability of LNG; however, there’s a lot of competition emerging for LNG, from places like China, India, Japan and more recently. Europe.”

With all these events pointing to tight supply/demand fundamentals long term, the veteran investment advisor recommends investors think more in terms of five- to 10-year increments and ignore what happens momentarily.

In the E&P sector, he foresees strong oil and gas prices far beyond what has historically been the case and suggests a focus on producers with a solid reserve base and good prospects with which to work in the future. The buysider notes that Devon Energy has excellent prospects, particularly in the deepwater Gulfs Lower Tertiary play. Also, Range Resources has amassed a large gas- resource position in Appalachia.

Mitchell also cites the long-term potential of North Sea-focused Endeavour International. “The company has about 10,000 barrels per day of production, which will provide enough cash flow to explore an attractive offshore prospect inventory.”

Since the buysider expects that drilling in the U.S. will have to increase 15% to 20% annually-just to maintain current production levels-he likes the long-term growth potential of Baker Hughes and BJ Services. Says Mitchell, “The cost of frac jobs is now running more than the cost of drilling.”

Eyeing undervalueds

A money-management firm with assets under management of $425 million and an overall 35% weighting to oil and gas investments, Ventura, California-based West Coast Asset Management is long-term bullish on energy today.

The firm, co-founded at the end of 2000 by Paul Orfalea-the founder of Kinko’s-also manages a $50-million hedge fund, West Coast Opportunity Fund LLC, primarily focused on energy investments, including private placements in the form of convertible preferred stocks and bonds, structured notes, microcap stocks, leveraged buy- outs and private equity.

“We take a top-down view of the macro-fundamentals of the energy sector, looking this year for at least $6 natural gas and $50 oil, with meaningfully higher prices longer term since we believe the demand for oil and gas is inelastic and supply won’t be able to keep pace,” says Atticus Lowe, partner and chief investment officer for West Coast Asset Management.

Drilling in the U.S. will have to increase 15% to 20% annually just to maintain current production levels, says The Micholl Group’s Rodney Mltchell. On facing page, high-rise buildings in downtown Houston.

“However, we’re ultimately a bottom-up investor focused on a small number of stocks that we believe have a high margin of safety and trade at a large discount to our assessment of intrinsic value.”

Since inception, the firm has invested in Prize Energy which was acquired by Magnum Hunter Resources in 2001, Howell Petroleum which was bought by Anadarko Petroleum in 2002, and Magnum Hunter which was purchased by Cimarex Energy in 2005. In each case, the acquisitions were made at significant premiums to where the target companies were then trading.

In its current portfolio, the most likely takeout candidate is Houston’s Carrizo oil & Gas. “We believe the assets of this $700- millionmarket-cap producer, which has 85,000-plus acres in the coveted core of the Barnett Shale in the Fort Worth Basin, are worth at least $1.2 billion in a sale today,” says Lowe.

Carrizo also has other valuable assets in East Texas, the Rockies, the North Sea and the Gulf Coast where it just drilled a 1- trillion-cubic-foot (Tcf) gas target on its Mega Mata prospect. “If this test is successful, it could add another $500 million to the company’s NAV (net asset value).”

The buysider also likes Canadian Superior Energy, a debt-free, $250-mil lion-market-cap Calgary-based operator with western Canadian assets worth at least $150 million, 2.6 million acres offshore Nova Scotia and two large acreage blocks offshore eastern Trinidad.

In Venture, California, West Coast Asset Management’s Attlcus Lowe focuses on smaller-cap stocks with a high margin of safety that trade at a large discount to his assessment of their intrinsic value.

In Boston, Eaton Vance Management’s Charlie Gaffney thinks natural gas prices this year could bottom at $5.50 to $6, while oil trades in a broader range of $46 to $65.

In New York, Valquest Capital Management’s Michael Crotell says investors are in that part of the oil and gas cycle where speculating on commodity prices Is no different than going to Las Vegas and betting on red or black.

In Trinidad, the company’s Block 5-C offsets the multi-Tcf Dolphin gas field operated by British Gas. There, it has identified, with seismic, three prospects that collectively have unrisked gas reserves of about 6.5 Tcf.

“We believe each prospect has a 40% chance of success,” says Lowe. “If we assume the government ultimately backs in for 50% and that each Mcf (thousand cubic feet) is worth $2 in the ground, this means that, on an unrisked basis, Block 5-C is worth $4.9 billion net to Canadian Superior, or $32.50 per share, and on a 40% risked basis, $2 billion or $ 13 per share.”

Among other undervalued E&P stocks, Lowe is focused on ATP oil & Gas, a Houston-based operator pursuing development drilling in the Gulf of Mexico and the North Sea. “The stock trades around $37, but it is worth at least $90 today based only on the present value of its proven and probable reserves.”

He also cites Contango oil & Gas, a small Houston-based operator that has a 10% interest in the Freeport LNG terminal under construction in southeastern Texas, 30,000 net acres in the Fayetteville shale play that could have a net present value of more than $500 million, and 66 prospective Gulf blocks.

Big is better

A mainly retail-oriented investment firm with about $130 billion of assets under management and a 9% to 10% weighting to energy equities, Eaton Vance Management based in Boston is also focused more on company-specific fundamentals rather than making broad industry or sector bets.

“We think natural gas prices this year could bottom around $5.50 to $6, with oil trading in a much broader range of $48 to $65,” says Char lie Gaffney, vice president and senior energy analyst for the firm. “However, our approach to investing has always been to focus on individual stocks and the catalysts that will drive their market performance.”

With a penchant for larger-cap, quality names in the energy sector, Gaffney likes ExxonMobil. “During the past couple of years, it has achieved 30%-plus returns on equity on an annualized basis, which is world class.”

Also, he points out, the company is very good at keeping large projects, such as those in West Africa, South America and North America, both on time and on budget. In North America, this includes its 2006 syncrude-upgrader expansion project in Canada, and for 2007, the first phase of its huge tight-sands gas project in Colorado’s Piceance Basin.

In addition, the company has a very solid financial foundation, with close to $30 billion of cash on its balance sheet, thus it’s well positioned to participate in a higher commodityprice environment as well as a contracting one, the analyst notes. “Since the stock is discounting around $45 oil, it represents good fundamental value-XOM could go as high $85 in 2007 as its production grows 4% to 6%.”

Gaffney is no less bullish about Schlumberger Ltd. This is the best technology provider in the service industry, he says, and as it becomes more difficult for E&P companies to find and develop reserves, the company will benefit from the amount and types of technologies that will be needed to extract more and more oil and gas out of the ground, he says.

Among offshore drillers, the analyst targets the go Mal h in that group-Transocean. He believes most of the company’s cost overruns have been priced into the stock and that it’s cheap on an absolute price/earnings ratio, trading at 10 times current earnings.

Says Gaffney, “We expect Transocean’s pershare earnings to grow from about $2.90 for 2006 to around $7 this year because the company has contracted its rigs at much higher dayrates going into 2007 than going into 2006.”

Among refiners, the energy seer favors El Paso, Texas-based Wes\tern Refining, which mainly serves the southwestern markets, including Arizona, New Mexico and parts of Texas. What is good about these markets, he says, is that refining margins are 20% to 45% higher than elsewhere in the country, in many cases. “Also, demand and population density there are growing.”

Global-minded

An sec-registered hedge fund with $1.3 billion of assets under management, Palo Alto Investors LLC in PaIo Alto, California, has about a 25% weighting to energy equities, predominantly in the upstream and oil-service sectors.

“We believe the supply/demand fundamentals for the energy sector continue to be strong and that we’re in a world where $50-plus oil and $7-plus gas are required to motivate the kind of E&P activity needed to satisfy growing global demand,” says David Anderson, partner and energy analyst for the firm.

“However, we don’t make oil and gas investments based on any specific commodity-price forecast; rather, we’re bottom-up stock- pickers seeking companies that are undervalued and have growth potential, without respect to what sector they’re in.”

On the service side, the buysider sees frac and pressure-pumping technology expanding into Canada and other international markets.

This is not a time for heroics, but for good homework, says Michael Grotell of Valquest Capital Management. Below, a view of midtown Manhattan.

In Palo Alto, California, Palo Alto Investors’ David Anderson is a bottom-up stock picker focused not on commodity-price forecast but on energy companies that are undervalued and have growth potential, without respect to what sector they’re in. On facing page, a view of downtown Boston.

A company poised to benefit from this trend is Calgary-based CalFrac Well Services Ltd., he says. “It not only has frac and pressure-pumping services in Canada, but also has recently received a contract to provide such services in the Fayetteville shale in Arkansas, plus they’ve moved into Russia, a huge market for this kind of technology.

Anderson similarly likes the growth potential of Houston-based Flotek, a supplier of proprietary chemicals for production enhancement and well stimulation, particularly important in tight- sands and shale gas wells. The company also provides downhole motors used in coalbed-methane wells and valves for the horizontal-well market.

“Right now, Flotek is focused in Texas, Oklahoma and the Rockies; however, it’s growing and has an opportunity to move into Canada and Appalachia where there’s a lot of tightsands gas activity.”

Within the E&P sector, the energy analyst looks for operators that can grow production and reserves in both high and low commodity- price environments, and that are pursuing international opportunities in areas where oil and gas are already known to exist.

Such a producer is ATP Oil & Gas. The company has experienced a huge ramp-up in production in both the Gulf of Mexico and the North Sea and continues to acquire leases where there’s already existing data about the oil and gas on those leases, the buysider says. “This is a tremendous growth story, yet the stock trades at less than three times 2007 cash flow versus a peer-group multiple of five.”

Anderson also cites Toreador Resources, another small-cap Houston operator that has had significant exploration success in the Black Sea offshore Turkey. “The company has provided guidance that it will double production every year for the next five years, and we’re looking for it to achieve 300% earnings growth in 2007 over 2006 and 50% earnings growth in 2008. While the stock is trading in the mid- $20s, this company’s reserves could be worth $70 per share.”

Yet another pick: Canadian Superior Energy. “The company’s multi- Tcf gas targets offshore Trinidad are adjacent to some very large 4- to 6-Tcf discoveries, so if it hits even 1 Tcf on its two prospects- where drilling will begin this March or April-that could be worth multiples of the operator’s recent $2 stock price.”

Bullish buysider

Moncrief Willingham Energy Advisers LP is a Houston-based investment firm with some $115 million of assets under management in its HedgEnergy Fund, a long-biased energy hedge fund open to both onshore and offshore investors.

This fund specializes in buying and holding the stocks of microcap, small-cap and midcap energy companies with expected growth rates of 20% annually. In 2005, the fund generated in excess of a 28% rate of return for investors, net of fees; in 2006, more than 10%.

“Since late 1998, we’ve continued to have a very bullish, long- term, macro-view of the energy space, recognizing the industry moves in very long cycles-25 years peak-to-peak and trough-to-trough-with periods of significant volatility,” says Lee Moncrief, the firm’s chief executive officer.

“With a higher drawdown greater than we’ve seen in years on U.S. crude inventories in the months going into 2007, we’re looking for a tighter supply/demand picture this year than the general market view, with oil prices trading in a range of $55 to $65.”

The buysider believes that surprises affecting oil prices in such a tight supply/demand market will most likely be to the upside. He cites Norway’s guidance that its oil output will be down this year by 400,000 barrels per day and Venezuela’s effective nationalization of its oil fields “which will not be conducive to increased production/exports from that country.”

Moncrief is also sanguine in his appraisal of the fundamentals for gas. “Although mild winter weather and high storage levels through late January depressed gas prices, overall new gas supply in North America-largely coming from resource plays with very steep decline curves in the first year-is flat to up only 1% annually at best while demand growth is greater than 2% per year.”

Assuming more normalized winter weather through the end of March and storage levels at that time below 1.5 Tcf, he looks for average gas prices this year of $6 to $8.

In Palo Alto, California, Palo Alto Investors’ David Anderson is a bottom-up stock picker focused not on commodity-price forecast but on energy companies that are undervalued and have growth potential, without respect to what sector they’re in. On facing page, a view of downtown Boston.

In Dallas, Moncrief Willingham Energy Advisers’ Lee Moncrief is looking for a tighter supply/demand picture for 2007 than the general market view, with oil prices trading in a range of $55 to $65. At right, a pump jack is silhouetted against a cloud-filled sky at sunset.

Given this outlook, and the fact that E&P and oil-service stocks experienced significant corrections this past December and January, Moncrief believes several companies in these sectors are positioned for gains in valuation later in 2007-assuming their managements can execute on growing production and reserves, in the case of producers, and can control costs and hence, improve profitability, in the case of service companies.

As of late January, such companies were Houston’s Petrohawk Energy Corp. and Austin, Texas-based Brigham Exploration on the E&P side, and Houston-based Hercules Offshore and BJ Services on the service side, says the 25-year veteran of energy investment banking.

“The expectations for dramatic increases in global oil and gas supply during the next 10 years may be far too optimistic.” Rodney Mitchell, The Mitchell Group

CAUTIOUS CONTRARIAN

Valquest Capital Management, a New York-bused long/short hedge fund with under $50 million of assets under management, takes a particularly cautious and selective view of the oil and gas sector. In the past two years, while growing its assets 75%, the investment partnership decided opportunistically to reduce its energy weighting from about 25% to 1.6% at year-end 2006, to 2.8% by late January.

“We built our 25% weighting to the sector a few years ago at a time when it was out of favor and was just starting to come back into favor.” says Michael Grotell, Valquest president.

“However, when the momentum players began chasing energy stocks and couldn’t buy enough of them-and market pundits started quoting $70 to $100 oil-we begun tiptoeing out the exit.

“Right now, we feel we’re in that part of the oil and gas cycle where speculating on the price of the commodity is no different than going to Las Vegas and betting on red or black.”

Formerly a portfolio manager with leading hedge fund Alpine Associates, a partner with Oppenheimer & Co. and an institutional broker with Lehman Brothers. Grotell is a disciplined contrarian investor.

“We focus on identifying and capitali/ing upon negative expectational discounts that are imbedded in the valuations of stocks, such as small- to midsize E&P or service companies, but where there are catalysts for value enhancement,” he explains.

“These catalysts could be near-term drillhit opportunities or turn-around situations that Wall Street isn’t differentiating at the moment hut that potentially would be of interest to strategic or economic buyers.”

Case in point: Calgary-based C. E. Franklin, a Canadian oil- service firm that distributes equipment for drillers and downstream companies. The company had gotten itself into financial trouble at the top of the prior energy cycle, but was viewed by strategic investor Smith International as an attractive turn-around situation.

“Smith bought 51% of C.E. Franklin, brought in new management, refocused the company, worked down bloated inventories, paid down excessive debt and brought in new contracts.” says Grotell. “Then, when the cycle turned in the energy sector and Franklin reported about six sequential quarters of profitable growth, the stock rose from $2 to S-J-the trading range where we had bought it-to north of $18.”

Although Valquest in recent years has deemphasized the upstream and service sectors, while achieving 40% equity returns in merchant- energy firms like Dynegy and Reliant, it nonetheless expects good stock-trading opportunities to emerge later in 2007 among companies in t\he former two energy segments, particularly as M&A activity heats up.

“Again, we would want to differentiate among these companies, focusing very much on their cash usage and their catalysts for near- term value enhancement.” says Grotell. “This is not a time for heroics, but for good homework.”

This said, the Valquest president remains cautious about the equity markets in general. Why? “Just look at what happened in the past eight months in the energy space alone when speculators overestimated their knowledge, underestimated risks and exaggerated the markel’s ability to control events.”

“While [Torreador Resources] is trading in the mid-$20s, this company’s reserves could be worth $70 per share.” David Anderson, Palo Alto Investors LLC

Copyright Hart Energy Publishing, LP Mar 2007

(c) 2007 Oil & Gas Investor. Provided by ProQuest Information and Learning. All rights Reserved.