There’s no question: The energy market is hot. Since the beginning of 2004, oil prices have soared more than 50%, while natural-gas prices have lingered well above historical averages. Likewise, energy stocks have posted dramatic returns as expected future cash flows have risen.
Naturally, our energy stock valuations are highly contingent upon the oil and natural-gas prices that we assume companies will realize in coming periods.
Here at Morningstar, we use a simple model. In essence, we assume that oil and natural-gas prices will trend toward normalized levels over a 24-month period, with adjustments for inflation. Our current forecasts incorporate a midcycle NYMEX WTI benchmark oil price of $30 per barrel, and a midcycle NYMEX Henry Hub natural-gas price of $4 per thousand cubic feet (mcf). Given that current prices for both commodities are significantly higher, our forecasts feature a steady decline for both commodities over the next two years.
Because we’re looking for stocks that are trading at meaningful discounts to our fair value estimates, the fantastic performance of energy prices and stocks has left us with few compelling investment recommendations. As of Jan. 14, the average price/fair value ratio for the 105 oil- and gas-related stocks that we cover sat at a stark 1.22. Highlighting this overvaluation, only one of these stocks, TransCanada (NYSE:TRP – News), currently holds a 5-star Morningstar Rating for stocks. Just another five stocks are currently rated 4 stars.
That said, here are five stocks, operating in various segments of the industry, that we think are worth keeping an eye on. While none are currently available at what we would consider to be bargain prices, we would eagerly invest if prices fell to attractive levels. These stocks are smaller and have lower profiles than many big industry players, but they represent companies with distinct competitive advantages and solid underlying business fundamentals, which is precisely what we are looking for.
Cimarex (NYSE:XEC)
Analyst: Eric Chenoweth
Fair Value Estimate: $35; Buy Price: $27
Cimarex is an oil and gas producer with more than 75% of its current reserves located in Oklahoma, Texas, and Kansas. Unlike many of its upstream peers, Cimarex doesn’t seek growth through acquisitions. Instead, the firm relies on its exploration and drilling program to replace reserves and boost production. Given the intense competition among would-be acquirers, the firm thinks a good deal is hard to find. In its short history, it has made a habit of being outbid by competitors. We admire Cimarex’s disciplined approach to acquisitions and focus on exploration. In response to higher oil and gas prices, the firm has been drilling wells that produce rapidly but deplete quickly. These projects have been generating nice returns relative to the cost of capital employed. Furthermore, this Denver-based company is the only small oil and gas firm we cover that doesn’t hedge any of its natural-gas or oil production, which we think makes a lot of sense for Cimarex. Of all the small oil and gas companies we cover, it also appears to have the greatest level of financial flexibility. That said, if exploration efforts stumbles, it could spell trouble for Cimarex. Aware of this risk, management has boosted capital spending from about $160 million in 2003 to $270 million in 2004.
FMC Technologies (NYSE:FTI)
Analyst: Mark Weber
Fair Value Estimate: $27; Buy Price: $20.80
FMC Technologies makes a bewildering array of products for airports, food processors, and offshore oil producers. However, while these product segments may lack synergies, they have advantages in their respective markets that we believe constitute a narrow economic moat. The firm’s Jetway boarding bridges and citrus extractors enjoy the largest shares of their markets and provide a sizable installed base for aftermarket sales. Energy systems, the largest segment, is the growth engine. FMC manufactures a variety of offshore equipment for the production of oil and natural gas. The segment’s crown jewel, however, is its subsea systems business. Oil- and gas-production companies are increasingly tapping deep-water reserves, requiring larger equipment. With space on offshore platforms limited, systems are being placed on the ocean floor. Deep-water production activity should continue to grow for the next several years, expanding the market for FMC’s equipment. FMC’s dominant share of the subsea market and its alliances with major oil producers endow the firm with one of the few economic moats we’ve seen in oil services. The firm has consistently generated free cash flow in four of the past five years and enjoys returns on invested capital that are above its cost of capital, which is more than most oil-services companies can claim.
Talisman Energy (NYSE:TLM)
Analyst: Mark Uptigrove, CFA
Fair Value Estimate: $23; Buy Price: $17.70
We think international expertise gives this Calgary-based exploration and production company a leg up on its competition. The company uses cash flows from lower-risk North American operations to fund higher-risk international growth. Spun off from BP (NYSE:BP – News) in 1993, Talisman has been an active international oil and gas driller for more than a decade. The company has a solid operational record in the North Sea, Southeast Asia, and Africa, and we believe this makes Talisman much better positioned to increase production abroad than competitors that have more recently embarked on an international hunt for resources. Compared with other small producers, Talisman appears quicker to explore and acquire new properties as well as dispose of those it deems less attractive. In the North Sea, a strategy of acquiring properties and significantly boosting production has made Talisman the third-largest producer in the region. In North America, Talisman has also demonstrated that it can extract value from oil and gas properties that many other players cannot. Recent exploration efforts in western Canada have yielded results. These deep gas discoveries will help maintain production growth in this mature basin. Nonetheless, oil and gas reserves in North America are declining, and finding new resources will become increasingly difficult.
EOG Resources (NYSE:EOG)
Analyst: Justin Perucki
Fair Value Estimate: $69; Buy Price: $53.20
Houston-based EOG is focused on North American natural gas. Consumption is growing 4% per year, while reserve depletion has been running about 5% annually, boosting gas prices. EOG’s low-cost strategy helps the firm generate above-average margins and returns. We believe EOG can remain profitable even if gas prices drop to $1.50 per mcf, a level we doubt will ever be reached again. The firm has several unconventional fields in Texas, including the Barnett Shale in Fort Worth, that should provide very substantial returns. EOG prefers to target coal bed and shale gas deposits that many producers find unappealing. Over time, the firm has developed expertise using techniques to tap these hard-to-reach reserves. By focusing their efforts on these fields and drilling hundreds of wells, EOG is able to extract large quantities of gas very cost effectively. The firm is also diversifying its core operations by investing in Trinidad and the North Sea. This simple strategy helps the firm earn returns greater than its cost of capital. Though EOG has a highly cyclical business, it has kept its bottom line black during past troughs in natural-gas prices, indicating that it may indeed be among the low-cost producers.
Enbridge Energy LP (NYSE:EEP)
Analyst: Michael Cumming, CFA
Fair Value Estimate: $51; Buy Price: $39.30
We love pipelines’ wide economic moats and stable cash flows, and Enbridge Energy LP is one of the largest crude-oil transporters in America. Cash distributions currently yield 7.1%, which ranks highest among the master limited partnerships that we cover. The company’s crown jewel is its ownership of the U.S. portion of the Lakehead pipeline system, the world’s longest crude pipeline. This system stretches 3,100 miles from the Canadian oil fields in Alberta to Chicago and points east. Lakehead owns an impressive share of its market, with about three fourths of the crude transport capacity coming out of western Canada, and is especially well positioned for growth. Unlike natural-gas production in western Canada, which is showing signs of reaching a plateau, oil production–particularly from oil sands–is increasing in this area. Although we would prefer that the company steered away from natural-gas gathering and processing activities, which are less economically attractive, Enbridge Energy LP plans to use its tax-advantaged status to continue to scoop up energy transportation and processing assets that provide stable cash flows in order to limit volatility for its unitholders. As is the case with most pipeline companies organized as partnerships, the yield provides a more compelling reason to buy the units than potential appreciation in the unit price.
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By Mark Uptigrove, CFA – from Morningstar.com
Source: Yahoo Finance
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