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Quarter-End Insights

Our Outlook for the Energy Sector

Energy prices rise despite a dramatic slowdown in economic activity.

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After roughing out two warmer-than-expected winters, natural-gas producers finally got some cold weather this year. Natural-gas storage, which was at records levels this past fall, has been drawn down closer to average historical levels for this time of year (and are about 10% lower than where they were at this time last year). This trend suggests natural-gas prices should strengthen in 2008. Given the mild drilling and service cost environment we're seeing onshore in North America combined with the potential for higher gas prices, this year should be a profitable one for North American natural-gas producers.

As we discussed at the end of the third quarter, oil refiners' profitability has suffered considerably since peaking in May 2007. In the short run, it looks like the refiners will need an active maintenance season or unscheduled disruption like a refinery fire to see margins improve considerably in 2008. In the longer run, significant new refinery construction overseas should reduce the likelihood of a repeat of the industry's recent high levels of profitability.

Oil prices have continued to surprise us on the upside, with West Texas Intermediate (WTI) crude topping $110 in past weeks. A sharp weakening in economic activity does not bode well for oil prices this year, however. A plunging dollar and still resilient emerging-markets demand have thus far helped offset the demand destruction accompanying the economic decline in the United States. OPEC still has a tight grip on supply. Oil production gains that appeared imminent in December have been postponed, with the most notable project delay being Khursaniyah out of Saudi Arabia. As we discussed in our last quarterly outlook, Khursaniyah was expected to add 500,000 barrels of crude capacity in December. Based on recent comments from the Saudis, it's not expected to be a factor until this summer.

A number of natural events conspired to drive up coal prices in the first quarter. Blizzards in China, flooding and port congestion in Australia, and power outages in South Africa constrained output. The troubles in South Africa also drove precious metals prices higher, especially platinum and palladium. A looming power crisis in Latin America could threaten copper output this summer (about 45% of the world's copper output originates in Latin America). Hydro power is a leading source of generation in Latin America, and its summer season was very dry. With the supply of hydro power on the light side, natural-gas-fired generation will need to pick up the slack. Unfortunately regional natural-gas production and infrastructure have seen long stretches of underinvestment due to poor national resource policies (like price fixing in Argentina). If natural gas can't plug the gap, then a regional power crisis could be just around the corner.

Finally, Kish Patel wrote a topnotch Stock Strategist article on E&P MLPs (master limited partnerships) this quarter, asserting that patience will reward upstream MLP investors. We've discussed the E&P MLPs a fair amount in this column during past quarters. In particular, we thought that E&P MLP valuations looked rich this past summer, helped by a lot of hype and excitement over their prospects to make many accretive acquisitions in short order. The credit crunch, combined with a failure for retail investors to materialize as quickly as institutional investors had hoped, drove E&P MLP share prices down considerably in the first quarter of 2008. We think some opportunities have finally surfaced here given the recent pullback.

Valuations by Industry
The median price/fair-value estimate equals 0.93 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 to overvalued. Pipelines still appear the cheapest as a group, followed by oil and gas and oil/gas products. Oil and gas services firms look just slightly overvalued, and coal is still the most overvalued.

 Energy Industry Valuations
Segment

Current Median Price/Fair Value

Three Months
Prior
Change
(%)
Coal 1.26 1.05 20%
Pipelines 0.83 0.89 7%
Oil and Gas 0.92 0.94 2%
Oil/Gas Products 0.93 0.98 5%
Oil and Gas Services 1.04 1.00 4%
Data as of 03-14-08.

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. Natural-gas producers have again rallied considerably from their fall lows, as have coal producers. 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. Three of our picks are large, independent oil and gas producers:  Canadian Natural Resources (CNQ),  Forest Oil (FST), and  Marathon Energy (MRO). We are also highlighting two 5-star pipelines:  Kinder Morgan Management  (KMR) and  Magellan Midstream Holdings  (MGG).

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

P/FV

Canadian Nat Res  $96 Narrow Mid 0.73
Magellan Midstream $31 Wide Low 0.71
Forest Oil $64 Narrow Mid 0.69
Kinder Morgan Management LLC $70 Wide Low 0.74
Marathon Energy $65 None Mid 0.72
Data as of 03-17-08.

 Canadian Natural Resources (CNQ)
Canadian Natural Resources draws ever closer to achieving first production from its Horizon oil sands project in northern Alberta, adding another gem to an already-stellar portfolio. The company chose to go over budget in order to meet its schedule, which will give the firm plenty of time to work out the kinks by 2009. Often lost in the mix are the company's diverse natural-gas assets; Canadian Natural could drill up its prospects if it so desired, but why risk the royalty uncertainty when its heavy oil assets are currently generating such attractive economics? Herein lies the beauty of strong assets and a disciplined management team.

 Magellan Midstream Holdings (MGG)
Magellan Midstream Holdings is the general partner of  Magellan Midstream Partners (MMP), one of the largest refined product master limited partnerships in the U.S. We're big fans of MMP's business model and growth strategy, and we think MMP's high-yielding and consistently growing distributions are attractive to income investors. These same dynamics make MGG a very attractive option for investors willing to trade some income for much greater growth potential. We think the market is underpricing MGG's distribution growth prospects, which we expect to grow by 15%-20% per year. Add that to a current 5.5% yield, and you're looking at very attractive total return prospects.

 Forest Oil (FST)
Forest Oil has done a good job zeroing in on five major growth areas after taking bold steps to transform into an onshore North American oil and gas producer. Its unwavering focus on operating efficiency and cost-cutting has netted impressive gains at Houston Exploration properties acquired in 2007. Management made this acquisition work simply by adding much-needed equipment and best practices. This is why we look for major production gains at Forest Oil in 2008 with solid annual growth well into the next decade.

 Kinder Morgan Management LLC (KMR)
We think Kinder Morgan Management is a standout among the midstream master limited partnerships. We think the market is discounting too steeply the torrent of cash flows Kinder Morgan will generate from Rockies Express and other marquee projects. With one of the largest asset footprints in the industry, a solid organic growth project portfolio, and better access to capital than some of its peers, we think Kinder Morgan is a bargain at its current price.

 Marathon Oil (MRO)
Marathon is an integrated oil company with a host of upstream, midstream, and downstream assets. Marathon has gotten cheap over the past few months due to delays at some of its major project startups and concerns about refined product demand given the weakening economy. Although delayed, these projects should begin producing during the first half of the year, resulting in strong production growth in 2008 and 2009. Marathon's integrated business model should help it weather the storm on the refining front. 

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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.