Our Outlook for the Energy Sector
Pockets of opportunity exist among pipelines and North American natural-gas producers.
Stock Strategist
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We raised our long-term outlook for natural-gas prices in July, boosting our fair value estimates for many of our North American natural-gas producers. Our long-term outlooks for oil and coal did not change during the third quarter. The short-term outlook for natural-gas producers has weakened, as we recently matched last year's record high storage levels. We think the natural-gas producers' short-term pain is likely to provide investors with opportunities to purchase a number of these companies at reasonable prices this fall. (We've recently written two Stock Strategists laying out these opportunities in greater detail: Natural-Gas Producers on Sale and Energy Stock Picks for the Long Haul.)
The short-term outlook for oil remains bright, but as volatile as ever. Despite OPEC's recent decision to boost supplies by 500,000 barrels per day, oil prices remain high, and the OPEC cartel remains in the driver's seat, thanks to above-ground disruptions in Iraq, Nigeria, and Venezuela, as well as the potential for trouble in Iran. The possibility of a housing-led recession in the United States, the world's largest consumer of oil, further increases the likelihood of oil price volatility in upcoming quarters. As we expected, nationwide gasoline prices have fallen from an all-time nominal high reached in May. Despite low current inventory levels for refined products, we expect gasoline prices to remain relatively low for the rest of the year barring any hurricane-related disruptions or other unplanned refinery outages.
The upstream master limited partnership (MLP) trend continued to power ahead in the third quarter, despite some broader market turbulence. In early September, Encore Acquisition launched its MLP IPO, Encore Energy Partners . EXCO Resources (XCO) filed its S-1 for a $1.7 billion MLP IPO, EXCO Partners LP (which will use the ticker XP). EXCO Partners LP would be the largest upstream MLP IPO to date and would likely debut in early 2008. In July, Pioneer Natural Resources (PXD) also filed an S-1 to IPO its upstream MLP, Pioneer Southwest Energy Partners LP (which will use the ticker PSE). It expects the IPO to raise about $300 million sometime before year-end. Quicksilver Resources discovered a new way to capitalize on the MLP trend, which may become a trend in itself over the next year. Quicksilver sold its mature Antrim Shale properties in Michigan (as well as other properties in Indiana and Kentucky) to BreitBurn Energy Partners LP , taking half of the consideration in BreitBurn stock. Quicksilver is now the largest shareholder of BreitBurn shares (at over 30% of total ownership). If BreitBurn finds success with its upstream MLP, then Quicksilver can profit without the headache of forming its own MLP structure.
Valuations by Industry
The median price/fair-value estimate equals 1.00 across the energy sector, suggesting that the sector is fairly valued. The table below shows that one subgroup is undervalued while the others are all fairly valued to overvalued. Pipelines appear cheap as a group. Earlier this quarter we published a Stock Strategist on opportunities in general partner (GP) stakes of pipelines and master limited partnerships (MLPs). Oil and gas producers, coal, and oil/gas products are just slightly overvalued. Oil and gas services remain the most overvalued.
| Energy Industry Valuations | |||
 | | | |
| Segment | Average | Median Price/Fair Value | Stocks Covered |
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| Coal | 2.40 | 0.99 | 10 |
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| Pipelines | 3.74 | 0.89 | 27 |
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| Oil and Gas | 2.98 | 1.01 | 73 |
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| Oil/Gas Products | 2.76 | 1.03 | 14 |
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| Oil and Gas Services | 1.97 | 1.23 | 29 |
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| Data as of 09-19-07. |
Based on our valuations, energy stocks looked especially cheap in late 2006, particularly the domestic natural-gas producers. The energy sector rallied in the first half of 2007, more than correcting for the relative value we saw late in 2006. The median price/fair-value estimate for the sector shot up to 1.11 at the end of the second quarter. Energy sector market valuations cooled a bit during the third quarter, offering up some compelling investment propositions among the domestic natural-gas producers and pipelines. Other than these pockets of opportunity within specific segments of the energy sector, many of the companies we cover look fairly valued now. We've highlighted some of our best ideas below.
Energy Stocks for Your Radar
We've picked five stocks from our 5-star list to keep on your radar. The two North American natural-gas producers have been 5 stars since late last year, Cimarex Energy and Compton Petroleum . We have two 5-star pipelines that we want to highlight this quarter. NuStar GP is a fairly new addition to our 5-star list, and Enterprise GP Holdings has looked attractive for a couple of quarters now. Finally, after selling off to about a third of where it was priced near its IPO a little over a year ago, our lone 5-star ethanol producer and distributor, Aventine Renewable Energy Holdings , looks like a good opportunity for investors.
| Stocks to Watch--Energy | |||||
| | | | | |
| Company | Star Rating | Fair Value Estimate | Economic Moat | Risk | P/FV |
| |||||
| Aventine Renewable Energy Holdings |  | $21 | None | Above Avg | 0.49 |
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| Compton Petroleum | | $16 | Narrow | Average | 0.58 |
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| Cimarex Energy | | $63 | Narrow | Average | 0.58 |
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| NuStar GP Holdings | | $47 | Narrow | Average | 0.67 |
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| Enterprise GP Holdings | | $54 | Wide | Average | 0.71 |
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| Data as of 09-25-07. |
Aventine Renewable Energy Holdings
High corn prices and weak ethanol prices (tied largely to gasoline prices) are mercilessly punishing ethanol industry margins currently. If present conditions persist, many marginal players should be forced out, to the long-run benefit of more financially sound companies such as Aventine. Further, if gasoline prices rebound, ethanol producers will likely be among the larger beneficiaries. Though we don't expect the fat profit margins of the recent past to return, Aventine's prospects are brighter than what the market is projecting, in our opinion.
Compton Petroleum
Weak natural-gas prices coupled with steep service costs in Canada created a stiff headwind for Compton over the past 12-18 months. Although natural-gas prices have been relatively weak the past several weeks, service costs have dropped dramatically in Alberta, Canada--the firm's base of operations. We believe natural-gas prices will rebound from recent levels of around $5 per thousand cubic feet. Consequently, the winds should now be at Compton's back. Compton can boost production at an annual rate in the midteens over the next five years, in our opinion.
Cimarex Energy
Although this company is recovering nicely from its operational struggles in 2006, exploration success remains elusive for Cimarex. At its recent stock price, the stock appears cheap if it is able to regain success with the drill bit sometime in the next few years. Its conservative financing strategy should allow it to weather a prolonged drop in natural-gas prices better than some of its competitors.
NuStar GP Holdings
As the general partner of NuStar Energy LP (NS), NuStar GP Holdings is poised to enjoy leveraged claims on strong cash flows generated by a steady but growing refined products master limited partnership (MLP). Thanks to continued investment in new facilities and expansions, we think NuStar Energy will be able to raise cash distributions by nearly 10% annually over the next five years. And because of the structure of incentive distributions, we expect NuStar GP Holdings to see its general partner distributions increase twice as fast.
Enterprise GP Holdings
If you could buy only one general partner MLP, this may just be your ticket given its diverse holdings. Enterprise GP Holdings owns the general partner stake of Enterprise Products Partners (EPD), Duncan Energy Partners , and TEPPCO Partners , as well as a minority interest in Energy Transfer Equity (ETE), the general partner of Energy Transfer Partners . Enterprise GP Holdings is therefore leveraged to the performance of a tremendously broad network of pipeline and storage assets stretching across America.
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