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Pump Them Up

This screen finds energy firms with good long-term prospects despite short-term challenges.

John Zecy, 04/16/2013

In this issue’s stock screen, we look for attractive oil and gas companies that can rise above bearish criticism and provide lucrative growth opportunities.

Sector = Energy

Some investors have understandably strayed away from the energy sector because of the interplay of political, economic, technological, and natural factors that cause unsettling volatility. These conditions continue to shape the global oil and gas market and do not appear to be changing anytime soon. However, Morningstar’s equity analysts remain bullish on domestic natural gas and continue to see considerable upside to current gas prices. While oil and gas companies operate in an enormously complex and challenging business environment, we think periods of mediocre performance have caused investors to overlook companies with long-term growth prospects. To that end, we aim to look for energy names with superior asset quality that offer attractive discounts to our fair value estimates.

And ( Economic Moat = Narrow
Or Economic Moat = Wide )

Our analysts use the Morningstar Economic Moat Rating to describe a company’s ability to generate returns in excess of their cost of capital through the use of sustainable competitive advantages. Moats are typically earned through intangible assets, cost advantages, switching costs, network effects, and efficient scale. Asset quality, as measured by resource potential and per-unit production costs, is the biggest determinant of competitive position in the exploration and production space. Thinking about E&Ps in terms of economic moats can help cut through the short-term macro noise and identify which companies are best positioned for longer-term outperformance.

And PCF <= 12

While a firm may carry sustainable competitive advantages, we want to ensure that we are paying a reasonable valuation. Consequently, we set the cutoff at companies trading at less than 12 times their current price to cash flow.

And Morningstar Rating = 5

To expand on our valuation screen, we used the Morningstar Rating for stocks. In this case, we searched for companies with a 5-star rating, which means they are trading at a significant discount to their estimated intrinsic value on a discounted cash flow basis. Ratings are forward-looking in nature, as they are based on analysts’ explicit forecasts. A recent update to our analytical approach for estimating the marginal cost of domestic natural gas led to a reduction in forecasted costs. The result was a revaluation of our covered companies that are most leveraged to gas production. However, oil and liquids exposure provides insulation from any meaningful change to fair value estimates for the majority of our upstream coverage universe, and some of our most attractive names still hold a 5-star rating.

And Stewardship >= Standard

Our final screen is for businesses run by a quality management team. Our analysts assign each company a Morningstar Stewardship Grade based on a number of factors. In the case of energy firms, management teams that exhibit focused capital discipline, operational efficiency, and a capacity to generate long-term shareholder value will earn Standard or Exemplary ratings. As the oil and gas industry evolves, we believe a quality management team that is effective in allocating capital to cash-flow-generating assets while quickly shifting this allocation in response to market dynamics will be critical.

We ran this screen in February using Morningstar Principia. Here are some of the results.

Canadian Natural Resources CNQ
We consider Canadian Natural Resources to have a narrow economic moat. The company holds a dominant land position in Western Canada, where it is Alberta’s largest producer of primary heavy oil and a pioneer of polymer flooding. By using its size to achieve economies of scale in its core operating regions, the firm has become a low-cost producer in natural gas and polymer floods and is an average to slightly below-average cost producer in heavy oil. As a result, it can acquire competitors’ properties and improve the economics of the properties. The company profits by leveraging its expertise and infrastructure in the region. The company has 100% interest in most of its projects, giving the firm the flexibility to allocate capital among projects of its choosing. This is a significant advantage. It allows the company to choose the optimal project, given market conditions, and to generate excess returns.

Devon Energy Corp DVN
Devon’s portfolio comprises an established base of U.S. natural gas assets, a number of emerging unconventional oil and gas plays, two Canadian oil sands complexes, and various other plays throughout North America, along with a sizable network of midstream assets. It offers compelling full-cycle economics across a variety of oil and gas price scenarios. Accordingly, we assign Devon a narrow moat rating. Devon has been disciplined regarding leasehold acquisition—in part by being the first or an early mover in most of its plays. Devon’s production mix—which we expect to remain 55% to 60% gas throughout our forecast period—provides an additional boost to the firm’s economics, as do the firm’s midstream assets, which help the firm maximize the prices received for its oil and gas production.

Ultra Petroleum Corporation UPL
Ultra’s leasehold, with its strong price realizations, exceptionally low cost structure, and extensive drilling opportunities, should continue to support top-tier growth, profitability, and returns during the next decade and beyond. Accordingly, we assign Ultra a narrow economic moat rating. Alongside other U.S. gas producers like Chesapeake Energy CHK, Ultra recently announced plans to dramatically scale back dry gas drilling, given the difficult natural-gas price environment. We applaud management’s move and hope that other gas-focused E&Ps announce similar plans. Regardless of a lower-than-expected production number, we remain bullish on Ultra over the long term, given the quality of its assets and depth of drilling inventory. We believe that a handful of catalysts that could lead investors to revalue the company over the coming quarters, including better execution from Ultra’s operating partners, which includes working through the large backlog of wells waiting for completion, continued outperformance from Marcellus type curves, and the planned sale of Ultra’s Pinedale liquids gathering system.

Suncor Energy SU
Since the merger with Petro-Canada, Suncor has started to take on the feel of an integrated company with a significant portfolio of minable and in situ oil sands assets. These assets are long-life, plateau-producing assets that do not suffer from declining production, and the minable assets should provide significant free cash flow for decades. The in situ assets are high quality relative to Suncor’s peers, while its mining quality is a mixed bag of assets. FH and its base mine are high quality, while North Steepbank is a lower-quality mine, with production from the base mine helping offset some of the quality issues. JM and the Voyageur South mine are lower-quality assets and thus scheduled for later-stage development. Unlike conventional assets, the minable resource bears little exploration risk. However, development and operational risk can be significant, with cost overruns being a headwind. Its international and offshore assets should continue providing Suncor with cash flow that can be reinvested in the development of its oil sands projects.

John Zecy is an associate equity analyst at Morningstar.

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