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International Herald Tribune: Catching the bounce in energy stocks

By Conrad de Aenlle
Friday, September 14, 2007

Energy prices have been shaky, and so has the stock market. No wonder energy stocks, which were such standouts for so long, hit a rough patch. Shares of companies that hunt for oil and gas, drill for it, refine it and sell it recorded double-digit percentage losses from late July, when crude oil prices set records and commodities like heating oil and natural gas hit multimonth highs, through mid-August.

Analysts and fund managers tend to dismiss the decline as just a dip in an uptrend that is not close to running its course. As if to confirm this view, the stocks have regained a significant portion of the lost ground.

Before rushing out to buy, however, consider the caveats they add to their upbeat assessments: Continued falls in the stock market are not out of the question, and certain segments of the energy sector – the particular ones depend on whom you ask – are likely to do better than others.

The recent decline in the broad market averages has been attributed to the credit crunch ignited by difficulties with U.S. subprime mortgages. Dumping energy stocks along with everything else, even if commodity prices are softening, is unwarranted, some investment advisers say, because for the typical energy company there is nothing to crunch.

“What’s been happening is that the impact of the stock market has been spilling over into the energy patch, but these companies have very little debt and so they aren’t affected by the repricing of debt,” said Fred Sturm, the Toronto-based manager of the Ivy Global Natural Resources Fund.

“The energy industry is generating returns above the cost of capital,” he said. “As a result, these companies are enriching shareholders as time goes by.”

That enrichment is available at bargain prices, in Sturm’s view. He finds valuations very low, with some of the global conglomerates, known in the trade as integrateds, trading at less than 10 times annual earnings. At those levels, he said, there is little risk for long-term investors.

“The integrateds are all trading cheap enough that they will be higher over time,” he said, highlighting Conoco-Phillips as a particular favorite. “The surprise will be that these companies continue to generate good rates of return.”

That will be true even if energy prices continue to moderate for a while, Sturm said.

“We aren’t arguing for continually higher energy prices,” he said. “We’ve been saying that they will plateau at high levels, and they’re doing just that.”

Conoco is also a top pick of Tom Nelson, an energy analyst for the London fund management firm Guinness Atkinson. He declared himself “very keen” on the stock and noted that Conoco’s executives were also fond of it. Their plan to buy back shares worth $15 billion “is a very strong indicator to the market that the stock is cheap,” he said.

Another factor, he said, is Conoco’s “very shrewd” joint venture with Encana, a Canadian oil and gas company. Conoco gets a share of the output from Encana’s tar-sand fields and Encana gets access to Conoco’s refining capacity.

Nelson prefers his energy companies large, diversified and global, albeit occasionally troubled. A couple of selections, BP and Royal Dutch/Shell, have underperformed over the past couple of years after various missteps, especially in Russia.

Other integrateds that he likes include Petroleo Brasileiro in Brazil; the Norwegian company Statoil; ENI in Italy, and the American super-majors Exxon Mobil and ChevronTexaco.

Conoco aside, Sturm, at the Ivy fund, prefers refiners to integrateds. Refinery space is hard to come by these days, having failed to keep pace with demand for finished products. That has kept prices high, he noted.

“A number of refineries that were scheduled to be built in the years ahead have been delayed or mothballed,” Sturm explained. “Every oil barrel that comes out of the ground needs to be refined before it gets to your gas tank.” He said he believed that the gap between the costs of raw materials entering a refinery and the costs of the finished products will continue to grow.

Sturm said he likes “pure-play refineries” – companies that have few other lines of business – such as Valero, Sunoco and Tesoro in the United States and Thai Oil.

John Buckingham, chief investment officer of Al Frank Asset Management in Laguna Beach, California, is another fan of refiners, but he acknowledges that they are not cheap anymore. He also likes Valero and Tesoro, as well as Giant Industries, Holly Corp. and Marathon Oil.

“Refining margins have been steadily increasing, though refinery maintenance and outages and seasonal factors will still cause earnings to be volatile,” Buckingham said. After the big gains that the stocks have made in the last few years, he added, “I can see why some would not want to buy here.”

The gains are not quite as big as they were; the recent sell-off hit refiners more than other types of companies. In a report on the group, Doug Leggate, an energy analyst for Citigroup, said that the drop had “brought risk-reward back into balance,” enough for him to upgrade Marathon to a “buy.”

Sturm likes some of his fossil fuels in solid form.

“We still think coal assets in America are underpriced,” he said. “Look no further than the leader,” Peabody Energy, which does more international business than other U.S. coal producers. That comes in handy now that China is importing coal for the first time, he said.

Sturm’s ecumenical collection includes drilling and service companies like Smith International and Halliburton, but not Schlumberger. It is one of the biggest operators in its field and very highly regarded – but, for Sturm, maybe too highly.

“Schlumberger is a class act, a leading company without a doubt,” he said, “but its valuation is a little richer than the alternatives.”

Jerry Jordan, manager of the Jordan Opportunity Fund, has more than one-fourth of his portfolio in energy stocks, with a particular emphasis on drillers and exploration companies, whose growth prospects he finds stronger than those of the international giants.

“I’d rather have Transocean at 8 times earnings than the integrateds at 10,” Jordan said. Transocean, the world’s largest driller, has been trading between 8 and 9 times the earnings that analysts expect the company to record in 2008.

His other holdings include the American driller Ensco; Suncor Energy, a Canadian company that extracts oil from tar sands, as Encana does, and Devon Energy, an American exploration and production company.

Another reason that he likes smaller, specialized production companies is the potential for a “land grab” by big, multifaceted businesses as resources become scarcer.

“Some international oil companies will say that having production at any price is valuable,” Jordan said. “The classic endgame in any energy cycle ought to be more consolidation. That makes Encana, Devon and Suncor acquisition candidates.”

Endgame may be a misnomer. By Jordan’s thinking, the cycle that may be coming to an end is a mere blip in a very long-term ascent for energy prices as demand remains strong and supply continues to be more difficult to find. If the recent pullback in energy commodities and stocks continues, he does not expect it to last long.

“Anything’s possible; this business is not about certainty,” he acknowledged. “But we’re not ready to admit we’ve had peak oil. What we believe is that the global ability to supply oil is getting harder and harder. Energy companies have to reinvent the wheel every year and find a little bit more. It’s going to get increasingly difficult.” and its sister websites,,,,, and are all owned by John Donovan. There is also a Wikipedia article.

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