Our Outlook for the Energy Sector
We see opportunities in North American natural gas and coal.
Stock Strategist
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Our long-term outlooks--and consequently, our price assumptions--for oil, gas, and coal haven't changed during the first quarter. Over the past few months, the short-term outlook for North American natural-gas producers has improved. Many of the small and mid-cap energy names we cover are focused on natural-gas exploration and production in North America. Last fall, a gas storage overhang resulting from a warm winter pulled the price of natural gas below our long-run estimate while drilling and service costs continued to rise. Both factors weighed heavily on gas producers' profit margins. Recently, these pressures abated as a frigid February helped draw down gas storage, and reduced activity helped stabilize drilling and service costs. So the profitability outlook appears brighter for these firms at the start of 2007.
Increasing resource nationalism and shifting oil and gas activity away from developed nations continue to be defining trends for the major integrated energy companies such as ExxonMobil (XOM), BP (BP), and Shell (RDS.A). As more of the world's giant oil and gas projects are located in less hospitable places--including OPEC countries--the majors have been forced to adjust. Shell, after feeling the bite of Russian regulatory pressure, agreed to sell half of its stake in Sakhalin II to Gazprom, the Russian gas giant. More recently, Exxon, Chevron (CVX), and ConocoPhillips (COP) all agreed to hand over control of heavy oil projects in Venezuela, complying with a decree issued by Venezuelan President Hugo Chavez. Many of the major oil and gas service firms have embraced the changes taking place in global energy. Most recently, Halliburton (HAL) announced it was moving its headquarters from Houston to Dubai, located in the United Arab Emirates. Adding credibility to the move, Halliburton's CEO, Dave Lesar, announced he'd be spending a great deal of time in the Dubai office.
Valuations by Industry
The median price to fair value estimate equals 0.99 across the energy sector, suggesting the sector is fairly valued. However, after digging into the sector (below), we see pockets of undervalued stocks in oil and gas, pipelines, and coal, and overvalued stocks in oil and gas services and oil and gas products.
| Energy Industry Valuations | |||
 | | | |
| Segment | Average | Average Price/Fair Value | Stocks Covered |
 | |||
| Coal | 3.09 | 0.99 | 11 |
| |||
| Pipelines | 3.24 | 0.98 | 26 |
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| Oil and Gas | 3.27 | 0.96 | 67 |
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| Oil/Gas Products | 2.82 | 1.07 | 23 |
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| Oil and Gas Services | 2.31 | 1.24 | 30 |
 | |||
| Data as of 03-15-07. |
After looking very expensive one year ago, following the hurricanes of late 2005, our average star rating for oil and gas stocks has climbed as a warm winter and a mild hurricane season in 2006 in North America kept many of these stocks from gaining ground. Also, coal stocks have had a rough time over the past quarter or two while our fair value estimates for many of these companies haven't changed significantly, leading to an increase in star ratings across the coal stocks that we cover.
Energy Stocks for Your Radar
We've picked five stocks from our 5-star list to keep on your radar. Three of the names are North American natural-gas producers that we think have looked cheap for at least a few months now. One is a pipeline company that has invested heavily in takeaway capacity in the Barnett Shale--a natural-gas play with growing production. Our last pick is a coal stock that recently tripped 5 stars.
| Stocks to Watch--Energy | |||||
| | | | | |
| Company | Star Rating | Fair Value Estimate | Economic Moat | Risk | P/FV |
| |||||
| Cimarex Energy |  | $57 | Narrow | Avg | 0.64 |
| |||||
| Compton Petroleum | | $15 | Narrow | Avg | 0.65 |
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| Newfield Exploration | | $57 | Narrow | Avg | 0.75 |
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| Crosstex Energy | | $53 | Narrow | Below Avg | 0.65 |
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| International Coal | | $8 | None | Above Avg | 0.64 |
| |||||
| Data as of 03-22-07. |
Cimarex Energy
Cimarex had a challenging year with the drill in 2006, posting a far lower success rate than what the firm is accustomed to. At a recent price of $35 per share, we think the market is assigning little, if any, value to the firm's Gulf Coast operations. If the company can improve its drilling success from 2006 levels, which we think it can, then the shares look cheap.
Compton Petroleum
We think Compton can boost production at an annual rate in the midteens over the next five years. Two positive rulings from the Alberta Energy and Utilities Board in 2006 should help provide a tailwind for Compton's drilling program. The rulings allow tighter well spacing and commingling, which should increase the quantity and size of the wells Compton can drill.
Newfield Exploration
Newfield has several high-potential projects that should start bearing fruit over the next few years and accelerate production. Initial drilling suggests that its Woodford Shale play has a similar production profile to the already-successful Barnett Shale and Fayetteville Shale. We also expect production gains from its offshore deep-shelf and deep-water prospects, and projects in the North Sea and offshore Malaysia.
Crosstex Energy LP
We think that Crosstex's significant position in the Barnett Shale midstream value chain far outweighs the poor performance of the partnership's South Louisiana processing assets. Crosstex is poised to grow lock-step with the Barnett as it provides gas gathering, processing, marketing, and transportation services to producers in this hot Shale play.
International Coal
International Coal had a rough 2006. A perfect storm of operational difficulties, dismal industry conditions, and the tragedy of the Sago explosion buffeted the firm. The market thinks there is little chance of recovery, but we disagree. Management took steps to rein in costs and improve pricing. We think this, combined with improving industry conditions, will expand margins in the years ahead.
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