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Our Outlook for the Energy Sector

We see fewer buying opportunities after a swift spring rally in energy stocks.

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Our long-term outlooks--and consequently, our price assumptions--for oil, natural gas, and coal haven't changed during the second quarter. After improving considerably in the first quarter, the short-term outlook for North American natural-gas producers has remained bright. The short-term outlook for oil has also improved. In mid-June, OPEC announced that it saw no need to boost output despite prices rising into the mid- to high-$60s per barrel. Domestic refiners also profited enormously during the second quarter. Nationwide gasoline prices hit an all-time nominal high in May due to unexpected refinery outages across the country, limited imports, and strong demand. Prices began to subside after Memorial Day as some capacity was restored, but they will likely remain high until after the summer driving season ends around Labor Day. After that, we'd expect gasoline prices to retreat.

The re-emergence of the upstream master limited partnership (MLP) is currently one of the more important trends in U.S. energy markets, in our opinion. Exploration and production (E&P) MLPs have been building momentum over the past year and continued to gain a lot of traction in the second quarter. Our Canadian oil and gas analyst, Kish Patel, recently wrote a Stock Strategist column on E&P MLPs that provides an informative introduction to this topic. In short, the tax-advantaged MLP structure appears to be luring more small- and mid-cap E&P firms--which make up a large portion of our energy coverage--to consider either adopting the structure themselves or selling assets to an existing MLP. CEOs we spoke with at a recent E&P conference are compelled by what they see as a potential increase in the market valuation of these assets under the MLP structure, citing a potential 9-10 times EBITDAX (earnings before interest, taxes, amortization, and exploration) multiple for them in an MLP, versus a 4-6 times EBITDAX multiple in a traditional corporation.

Valuations by Industry
The median price/fair-value estimate equals 1.11 across the energy sector, suggesting the sector is overvalued. Digging into the sector (below), we see every segment is overvalued to some degree. Pipelines are the most fairly valued, followed by the oil and gas producers. Coal, oil/gas products (including the refiners, ethanol producers, and propane distributors), and oil and gas services are the most overvalued.

 Energy Industry Valuations

Star Rating

Price/Fair Value
Stocks Covered
Coal 2.45 1.31 11
Pipelines 2.93 1.02 28
Oil and Gas 2.54 1.15 71
Oil/Gas Products 2.00 1.29 22
Oil and Gas Services 1.66 1.53 31
Data as of 06-15-07.

Based on our valuations, energy stocks looked especially cheap in late 2006, particularly the domestic natural-gas producers. Despite a nice rally in the first quarter of 2007, we still saw compelling values in oil and gas, pipelines, and coal in last quarter's sector outlook. However, this most recent rally across the energy sector appears to have recognized much of this value and then some, leading to the rich market valuations of many names in the sector, as we see above. Despite a significant reduction in the number of 5-star names in the energy sector over the past quarter, we still see a handful of compelling buying opportunities.

Energy Stocks for Your Radar
We've picked five stocks from our 5-star and 4-star list to keep on your radar. Two of the three North American natural-gas producers have been 5 stars since late last year.  Ultra (UPL), currently rated 4 stars, would look especially attractive if it tripped 5 stars, given its low-cost properties in Wyoming. One of our 5-star pipes has a significant stake in the Barnett Shale, a region experiencing rapid growth in natural-gas production volumes. The final pipeline company offers a unique portfolio of general partner interests in some of the best pipeline assets in the U.S., and we think it's cheap.

 Stocks to Watch--Energy
Company Star Rating Fair Value Estimate Economic


Cimarex Energy  $57 Narrow Average 0.72
Compton Petroleum $15 Narrow Average 0.73
Ultra Petroleum $71 Narrow Above Avg 0.79
Crosstex Energy $48 Narrow Below Avg 0.71
Enterprise GP Holdings $54 Wide Average 0.70
Data as of 06-22-07.

 Cimarex Energy (XEC)
Cimarex had a challenging year with the drill in 2006, posting a far lower success rate than what the firm is accustomed to. Although it's rebounded significantly from our last outlook (when it was closer to $35 per share), we think Cimarex is still a bargain at its current market price. If the company can improve its drilling success from 2006 levels, which we think it can, then the shares look cheap.

 Compton Petroleum (CMZ)
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.

 Ultra Petroleum  (UPL)
Thanks to its impressive position in the Pinedale Anticline in southwest Wyoming, over the past five years Ultra has posted the lowest per-unit costs of any of the North American natural-gas producers we've covered, translating into impressive operating margins and returns on invested capital. Even more impressive, Ultra has plenty of drilling ahead of it in the Pinedale and looks poised to reinvest its growing cash flow at attractive returns for many years to come.  Kinder Morgan's (KMP) Rockies Express pipeline should help boost Ultra's takeaway capacity and average selling prices for its gas starting in 2009.

 Crosstex Energy LP (XTEX)
We expect to see the first evidence that this partnership's massive investment in the Barnett Shale is paying off during 2007 as cash flows ramp up in tandem with wellhead connections and natural-gas processing and transportation volumes. Additionally, we believe that management is focusing appropriately on wringing cost savings and efficiencies out of its troubled south Louisiana processing assets. We think that both the limited partnership and its general partner,  Crosstex Energy (XTXI), are significantly undervalued in the marketplace at this time.

 Enterprise GP Holdings  (EPE)
Enterprise GP's general partner interests in multiple partnerships should help it achieve above-average distribution growth compared with other pipeline master limited partnerships. Since the company owns general partner interests in its subsidiaries, Enterprise GP is entitled to receive a greater share of the subsidiaries' cash over time. Risk is reduced thanks to the company's diversification in terms of geography and asset type. We expect cash distributions to rise 13% per year over the next five years.

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Eric Chenoweth does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.