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Stock Strategist

Five Energy Stocks to Keep on Your Radar Screen

From pipelines to propane, these firms are trading at a discount.

As a whole, there are not many fat pitches in the oil patch today. Despite an oil-price pullback in the aftermath of hurricanes Katrina and Rita, the average price/fair value ratio for the 100-plus energy-related stocks we cover stood at 1.4 as of Dec. 8.

That said, we think investors would benefit from keeping a few energy companies on their radar screens. Many of the stocks are volatile, and even a small decline in oil and gas prices can send them down significantly. During these sell-offs, the good firms typically get punished along with the bad. This creates an opportunity for investors to purchase these stocks at a more reasonable price.

We highlight five companies below that are currently trading at a discount to our fair value estimate, and two of them are currently 5 stars:  TC Pipelines  and  Northern Border Partners .

Northern Borders and TC Pipelines have been beaten up since the spring after announcing that the pipeline they co-own was not pumping at full capacity due to recontracting problems and seasonal fluctuations in demand. Morningstar analyst Michael Cumming feels that the news is overblown and expects that both companies will be able to recoup lost profits through a future rate hike. Shares have also suffered as the Fed has raised interest rates, because both firms are structured as interest rate-sensitive master limited partnerships (MLP). We think so highly of TC Pipelines right now that two of our newsletters--Morningstar StockInvestor edited by Paul Larson and DividendInvestor edited by Josh Peters, CFA--own it in their model portfolios.

Although the other three firms on our list are not currently a "buy," they have flirted with our 5-star rating over the past couple of months, and we wouldn't hesitate to scoop up their shares at an appropriate discount to our fair value estimates. Propane distributor  AmeriGas Partners   is another MLP that is currently yielding close to 8%, while  Apache (APA) and  Royal Dutch Shell (RDS.A) are two of the biggest and most profitable firms in the oil patch.

Here's what our analysts have to say:

Northern Borders Pipeline 
Analyst: Michael Cumming, CFA
Fair Value Estimate: $50
Consider Buy: $42.60
From the  Analyst Report: A pure pipeline company focused on natural gas, Northern Border owns an attractive portfolio of stable assets that generate substantial free cash flow and are insulated from commodity price swings. The crown jewel is a 70% stake in its namesake Northern Border Pipeline. Stretching from the Canadian border of Montana to Chicago, this system transports 22% of the natural gas Canada exports to the United States. The company received Federal Energy Regulatory Commission approval last year to expand capacity on the last leg of this line by 15% to satisfy rising demand in the Chicago area, which will add to the pipeline's profitability. Northern Border Partners reported record earnings and free cash flow in 2004, aided by rising demand for energy in its markets. We like the partnership and would buy the units at the right price. The upshot is that Northern Border's operations generate substantial, predictable free cash flow. In 2004, Northern Border created $201.2 million in free cash flow, which equates to 34% of sales. This stable cash flow from regulated operations supports the company's large partnership distributions, which amount to a yield of 6.7% at the current unit price.

TC Pipelines LP 
Analyst: Michael Cumming, CFA
Fair Value Estimate: $38
Consider Buy: $32.40
From the  Analyst Report: As a holding company with exactly two investments, TC is easy to understand. Its larger investment, responsible for 86% of the firm's income last year, is its 30% stake in the Northern Border Pipeline system. Stretching 1,250 miles from the Canadian border of Montana to Chicago, this system is responsible for transporting roughly 22% of the natural gas that Canada exports to the United States. Northern Border Partners owns the other 70%. TC's other investment is its 49% stake in the Tuscarora pipeline in northern Nevada and California. It is a relatively short 240 miles and has a small throughput. Last year, it transported 24.7 billion cubic feet of gas, compared with the 845 bcf the Northern Border Pipeline carried. Tuscarora has experienced tremendous growth in throughput and profitability, with net income rising 25% over the past three years. TC's parent company and general partner, TransCanada TRP, owns 1% of Tuscarora, while utility Sierra Pacific Resources SRP owns the final 50%. TC's simple structure and steady assets give the firm a lower risk profile relative to the rest of our coverage universe, and these changes adjust for this. At the current distribution rate of $2.30 annually, the stock would yield 6.1% at our fair value estimate.

AmeriGas Partners LLC 
Analyst: Elizabeth Collins
Fair Value Estimate: $36
Consider Buy: $27.80
From the  Analyst Report: AmeriGas has a lucrative business with high customer switching costs, and the firm's units yield 6.2% in distributions at our fair value estimate. With an adequate margin of safety to account for its acquisitive nature and exposure to volatile propane prices, AmeriGas would be a sound purchase for income-oriented investors. Most people who use propane to heat their homes don't own the tanks on their properties--they're leased from suppliers like AmeriGas. Switching providers is a pain because the customer has to arrange for the new company to swap tanks with the existing provider. Therefore, it would take a sizable price difference to motivate AmeriGas' clients to switch. It's also unlikely that customers would switch to another fuel. Electricity is generally more expensive than propane for heating. Fuel oil is comparable, but appliances are built for one or the other, so switching would mean expensive new appliances and installation. As a result, propane providers generally earn attractive returns on invested capital, and AmeriGas is no exception. Over the past five, returns on invested capital have averaged more than 11%.

Apache (APA)
Analyst: Justin Perucki
Fair Value Estimate: $76
Consider Buy: $58.60
From the  Analyst Report: As a growing exploration and production company, Apache is different from its reserved and more mature peers. Apache has chosen to sell stock and reinvest most of its cash flow to expand, instead of buying back shares and paying out a robust dividend. Most of Apache's growth has been through purchasing legacy properties piecemeal from the oil majors such as BP (BP) and ExxonMobil (XOM), instead of exploring for reserves itself. Apache's asset base has more than doubled in size since 2000. About 70% of Apache's reserves are in North America. Consequently, the firm's political risk is below average; however, this comes at a price. In general, North American reserves are older and more difficult to produce, resulting in higher fixed costs. This increases the company's leverage to cyclical and volatile commodity energy prices. But Apache is one of the lowest-cost producers in the oil patch, which helps it remain profitable even when commodity prices decline. Over the past three years, Apache's average lifting costs were only $6.36 per barrel of oil equivalent produced. Enabling them to earn returns on capital of 15% over the same time period, by our calculations.

Royal Dutch Shell Petroleum (RDS.A)
Analyst: Elizabeth Collins
Fair Value Estimate: $67
Consider Buy: $57.10
From the  Analyst Report: In January 2004, the company stunned investors with a sharp downward revision to its inventory of proven oil and gas reserves, ultimately slashing the figure by one third. The incident highlighted fundamental weakness in the firm's most profitable segment, exploration and production. Although Shell's short-term outlook is relatively unaffected, the longer-term implications are serious. In the years to come, as the company must replace lost reserves, it faces an uphill battle relative to its larger peers. Nonetheless, we expect Shell to continue generating solid returns. Despite the reserves setback, Shell benefits from huge economies of scale, has made progress with cost-cutting initiatives in recent years, and has not had an unprofitable year in decades. Shell has emerged from the incident bruised but not beaten. To restore investor confidence, management is attacking weak internal controls, revamping the compensation scheme, and simplifying the organizational structure. Management has also responded with a strategy designed to regain lost ground, which we think can work, albeit gradually.

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