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Quarter-End Insights

Our Outlook for the Energy Sector

We've raised our long-term oil-price forecast and uncovered some new values.

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We raised our long-term oil price outlook in November, boosting our fair value estimates for many firms with significant oil production. Our long-term outlooks for natural gas and coal have not changed since the end of the third quarter. The short-term outlook for oil is mixed, as a number of factors should cause prices to weaken in the short run from recent highs nearing $100 per barrel. OPEC's output hike should start to hit the market, adding 500,000 barrels per day in supply. Additional production gains are soon expected from Saudi Arabia, as it starts flowing new production from Khursaniyah (adding another 500,000 barrels per day of capacity). Finally, economic weakness in the U.S. could spread, potentially reducing oil demand in early 2008. Despite the potential for some short-term softening in oil prices, we think the long-term pricing outlook is still attractive for some of the companies we cover. (We recently wrote a Stock Strategist outlining these opportunities in greater detail: Four Picks in the Oil Patch.)

The short-term outlook for North American natural-gas prices is also mixed. Natural-gas storage levels in the U.S. are still running very high (about 2.6% above last year and 8.7% above the five-year average). However, cold winter weather could quickly bring storage back in line. If we have another mild winter, like we have the past two years, then natural-gas prices could be somewhat weak again in 2008. Two offsetting supply trends also bear mentioning. Overall supply could get a boost from the Rockies Express West pipeline, which will lift takeaway capacity from the gas-rich Rockies and move more Rockies gas to the Midcontinent. On the flip side, Alberta announced higher royalty rates at the end of October, potentially reducing future oil and natural-gas activity there.

The biggest oil and gas news so far this quarter has been Alberta's decision to raise royalty rates. Kish Patel, our Canadian oil and gas analyst, wrote a detailed Analyst Note on the decision when it was announced. Alberta will essentially claim a larger portion of the upside in oil and natural-gas prices from producers, with a new sliding scale that increases the government's take at higher commodity prices. Marginal oil sands projects may eventually be scaled back or canceled, and investments in conventional production may be reduced;  Canadian Natural Resources (CNQ), one of Canada's largest oil and gas producers, has already drastically reduced its drilling program in Alberta as a result of the changes. Capital may also be reallocated outside of the province, as can be seen by  EnCana's (ECA) purchase of partner Leor Energy's assets in Texas. Alberta-focused firms that fail to adjust to the new royalty regime may see limited potential for outsized returns on capital.

Valuations by Industry
The median price/fair-value estimate equals 0.94 across the energy sector, suggesting that the sector is undervalued. The table below shows that three subgroups are undervalued while the other two are fairly valued to overvalued. Pipelines appear the cheapest as a group, followed by oil and gas and oil/gas products. Oil and gas services firms look fairly valued, and coal is the most overvalued.

 Energy Industry Valuations
Segment

Current Median
Price/Fair Value

Three Months
Prior
Change
(%)
Coal 1.05 0.99 6%
Pipelines 0.89 0.89 0%
Oil and Gas 0.94 1.01 7%
Oil/Gas Products 0.98 1.03 5%
Oil and Gas Services 1.00 1.23 19%
Data as of 11-16-07.

Energy sector market valuations moved up and down over the past year, but we're seeing more investment opportunities presently than in past quarters this year. Based on our valuations, energy stocks looked especially cheap in late 2006, particularly the U.S. 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 U.S. natural-gas producers and pipelines, but ended the quarter fairly valued overall. 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. Two of our picks are large, independent oil and gas producers:  Devon Energy (DVN) and Canadian Natural Resources.  ConocoPhillips (COP) is a major integrated oil and gas company that went 5 stars following the decision to boost our long-term oil price forecast, but has appreciated a bit since then. We are also highlighting two 5-star pipelines this quarter:  Crosstex Energy LP (XTEX) and  NuStar GP (NSH).

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

P/FV

Canadian Natural Resources  $96 Narrow Avg 0.70
ConocoPhillips $102 Narrow Avg 0.81
Crosstex Energy $48 Narrow Below Avg 0.71
Devon Energy $122 Narrow Avg 0.72
NuStar GP Holdings $47 Narrow Avg 0.60
Data as of 12-07-07.

 Canadian Natural Resources (CNQ) 
Despite the challenges posed by the new Alberta royalty framework, cost pressures, and a strong Canadian dollar, we still think Canadian Natural Resources will be able to wring excess returns on capital from its portfolio of opportunities. The company has a disciplined approach to spending that is underscored by its decision to reduce near-term capital from newly uneconomic prospects in Alberta. In late 2008, the company will begin to reap the benefits of its wholly owned Horizon oil sands project. 

 ConocoPhillips (COP)
With countries wanting greater control of their natural resources and a more competitive landscape, ConocoPhillips has a challenging road ahead of it. However, Conoco's technical and project-management expertise still makes an attractive partner for large-scale projects and gives it a leg up on the competition.  Berkshire Hathaway (BRK.B) owns 1% of the outstanding shares.

 Crosstex Energy (XTEX)
We're still big fans of Crosstex Energy, and we think the company's third-quarter earnings only confirm our thesis that Barnett Shale investments will lift cash flows and distributions nearly as fast as producers ramp up their drilling programs there. As many of the Barnett Shale producers continue to surprise us on the upside, we remain excited about Crosstex's potential.

 Devon Energy (DVN)
Over the past several years, Devon has been shedding unwanted assets. As a result of all these sales, Devon now has a highly concentrated but eclectic group of assets. Key project startups in Brazil, Azerbaijan, and Canada, along with the continued success in the Barnett Shale should translate into double-digit production growth in 2008 and 2009.

 NuStar GP Holdings (NSH)
Another midstream MLP we like is NuStar GP Holdings, general partner of  NuStar Energy (NS). With a solid network of refined products pipelines, storage tanks and marine terminals, NuStar is well-positioned to benefit from refined products imports. And we see the company's recent purchase of Citgo's asphalt refineries and terminals as a savvy strategic move that could generate significant cash flows as domestic supply and demand for asphalt move further apart.

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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.