Jewish World Review April 29, 2003 / 27 Nissan, 5763
James K. Glassman
Is natural gas a natural?
Rigs, of course, are wells, and Adkins is not talking about the price of a gallon of gasoline at the pump. He's talking about colorless, odorless natural gas, and the prices are quoted in units of 1,000 cubic feet, or Mcf.
Natural gas is the second most abundant energy resource in the United States, after coal. It's used to power industrial plants, to generate electricity, and to heat homes and offices. And, just for reference, its average price last year was about $3.30, twice the level of the mid-1980s to mid-1990s. In December, the consensus estimate for 2003 was $3.43 per Mcf, but Adkins was predicting $5. In March, he raised it to $6. On Friday, the spot price for gas was $5.38.
What does this mean to investors? Well, if you believe Adkins and other experts who agree with him, the stock prices of companies in the natural gas business are going to go up. Maybe a lot.
Regular readers know that I'm not in the business of touting stocks or sectors for short-term gains. Most gas-related stocks are cyclical and volatile, rising and falling with energy prices; in other words, they are stocks for trading, not long-term investing. So why am I writing about them? It's a tale that I hope will intrigue and entertain. If you decide to buy gas stocks, remember that you're engaging in a high-risk speculation. I'm giving no encouragement and making no guarantees.
Marshall Adkins works for Raymond James & Associates as a managing director. He's an energy analyst. Of course, analysts have gotten a bad rap recently, but I love talking to good ones like Adkins. He doesn't push stocks; in fact, he's reluctant to give me any company names. He just knows his industry inside out -- and his passion is infectious. Plus, he has a great story to tell.
The story is that "the game's over for U.S. gas supply, same with Canadian." What he means is that demand keeps rising but supply can't keep up. "Supply is rolling over," he says. It has started to decline. That means prices will rise, and the increases, he asserts, aren't merely temporary.
But can't we develop more supply at home? Not soon, says Adkins. There are environmental -- or, some would say, political -- constraints that are limiting production, especially on the extensive federal lands in the Rockies. There's natural gas in Alaska but no pipeline to get it to the lower 48 states. And then there's the Arctic National Wildlife Refuge, a vast expanse that Congress, it seems, is placing off-limits.
What about the rest of the world? Gas is not like oil. You can't ship it cheaply from the Middle East. You have to convert it to a liquid, put it on a special tanker and then convert it back to a gas on the other end -- an expensive process. In 2001, the most recent year for statistics from the Energy Information Administration, the United States imported just 238 billion cubic feet of gas -- only a few days' supply. That doesn't include 3.7 trillion cubic feet (about one-sixth of our yearly use) from Canada via pipeline. Canada has the same problem as the United States: The wells are drying up. Meanwhile, the cold winter has depleted natural gas storage levels to about half their five-year average.
Colin Ferenbach, an investment manager with an excellent track record and no ax to grind, agrees with Adkins -- minus the jumping up and down. "I am a big believer in gas," he told me. Demand keeps going up, and the shallow wells being drilled in what are currently the most productive areas of the United States are suffering decline rates of 40 to 50 percent annually, which means that the gas runs out in about three years. Deeper gulf wells may be more productive, but they take time and money to drill.
So, the laws of economics being what they are, prices for gas will rise in what Adkins calls a "step change." From 1986 to 1995, the average price was $1.60 per Mcf; from 1996 to 1999, it was $2.35; over the past three years, $3.72. Now, it's going to $5 and beyond. "Five-dollar gas is very, very profitable," says Ferenbach, who for the past 19 years has managed the Tocqueville Alexis Fund (TOCAX), where he's been meeting his goal of beating the benchmark Standard & Poor's 500-stock index with a portfolio that carries below-average risk. Over the past five years, for example, he's whipped the S&P by an annual average of 4 percentage points at risk levels about one-third lower than the index's.
Ferenbach directs me to a new report from Bear Stearns, titled "The 'Other' Energy Crisis." Gas, of course. "The tide has finally turned," write analysts Ellen Hannan, John Kang and Scott Burk. "The maturing of the gas-producing basins in North America, combined with a market that has grown by more than 25 percent over the past 15 years, finds the industry in a difficult position to continue to provide a source of cheap, abundant energy." They predict gas prices of $4.25 to $5.50 per Mcf for the next two years -- not as high as Adkins's predictions but still awfully profitable for gas companies.
What about oil? The price of oil is linked to the price of natural gas because many industrial users and utilities can switch between the two. The rule of thumb is that a barrel of oil is equivalent to about 5,500 cubic feet of gas.
In late March, one of my favorite strategists, Byron R. Wien of Morgan Stanley, headlined his weekly commentary "Buy Energy Stocks Now." Yes, he said, the war with Iraq would bring oil prices down from their stratospheric highs, but the decline would not be nearly as much as most people were expecting. Supply remains tight, and demand, depressed by fear of war, would rise. He argued that fundamentals suggest a price of $27 per barrel for oil, which translates into $5 per Mcf for natural gas.
Adkins makes the case that the Organization of Petroleum Exporting Countries cartel -- "and by that I mean Saudi Arabia" -- is more powerful today than it was in 1991, after the Persian Gulf War. The Saudis want oil prices high enough to maintain economic growth in their own country but not too high to discourage consumption and deter economic growth in the rest of the world. That's a price of $25 to $30, says Adkins. "What happens in Iraq doesn't matter," he contends. "OPEC sets the price."
While these oil and gas prices are high, they are not high enough, Wien contends, to dampen demand or throw the nation into another recession. Economic growth "edging toward 3 percent is likely, and that should be good for earnings overall," he says.
So what's the big deal? Even if you haven't heard this story before, others have. If markets are efficient, then isn't the rising price of natural gas and the increased profits that will flow to gas companies already reflected in the prices of stocks? In a word, no.
The Bear Stearns analysts point out that the sector is trading at about 3.7 times cash flows -- "at the low end of historical ranges." Why so cheap? Investors seem to expect "an imminent decline" in gas prices. But the analysts disagree: "The earnings and cash flows of the sector are likely to be higher (and last longer) than the consensus view."
As Adkins says, "The market's a little complacent about this," referring to what he sees as the new gas-price plateau. And, more fervently, "Nobody believes it yet!"
Not even the gas companies believe it. Many of them, including Newfield Exploration (NFX), have hedged most of their production; that is, they have locked in prices that are a good deal lower than the gas bulls are predicting (in Newfield's case, $4.32 per Mcf on average).
But look at exploration and production (E&P) companies that haven't done much hedging -- that are, in the lingo, the most "leveraged" to price changes. Bear Stearns cites Devon Energy (DVN), which has gas and oil properties in Texas, New Mexico, the Rockies, the Gulf of Mexico and Canada. Bear Stearns estimates Devon will earn $7.09 per share in 2003; Value Line projects $7.50. The stock was trading April 24 at $49.50 a share for a year-ahead price-to-earnings (P/E) ratio of about 7. Devon, by the way, is among the best-managed and least volatile E&P stocks; it actually bounces around less in price than the market as a whole.
Also highly leveraged, says Bear Stearns, are Burlington Resources (BR) and two smaller companies, Chesapeake Energy (CHK) and Stone Energy (SGY).
While Adkins won't recommend stocks, he points me in the direction of Anadarko Petroleum (APC), whose stock has barely budged over the past three months and trades at a P/E, again based on 2003 projections, of less than 10; Apache (APA), ranked highest, along with Burlington and Pogo Producing (PPP), among the E&P stocks, by Value Line; and XTO Energy (XTO), a smaller company that's also in the transport and marketing business.
But the real excitement -- the big leverage -- is in the gas and oil service sector, the companies in the boom-or-bust business of drilling and supplying. When gas and oil are abundant and cheap, the rig count drops and they have little to do. But the rig count is up 30 percent in a year and, if Adkins is right, it will keep rising.
He points to drillers such as Nabors Industries (NBR) and Grey Wolf (GW) and to pipemakers Maverick Tube (MVK) and Lone Star Technologies (LSS). These are highly speculative stocks. For example, because gas prices dropped last year, Grey Wolf's revenue fell 42 percent.
In his concentrated 42-stock portfolio, Ferenbach, who prides himself on risk aversion, owns Ocean Energy (OEI), which is about to merge with Devon, as well as a couple of integrated petroleum companies, which explore, produce and sell at retail: ConocoPhillips (COP) and Royal Dutch Petroleum (RD), which has been part of Tocqueville's portfolio since 1984.
Doug Terreson, who heads the energy group at Morgan Stanley, also lists Conoco as a favorite stock, along with two other integrated companies, Exxon Mobil (XOM) and London-based BP (BP). Terreson likes Premcor (PCO) among independent refiners and marketers. In oil service, Wien's own favorite is GlobalSantaFe (GSF).
Adkins, however, thinks the best opportunities lie not with firms that are broadly international, such as GlobalSantaFe and the giant Schlumberger (SLB), but with companies that target the nation where gas supplies are low and demand is high: the United States.
This supply-demand imbalance won't persist forever. New gas will be found, pipelines will be laid, imports will fill the gap, and high prices will eventually encourage the use of other energy sources. But that mitigation won't happen overnight. In the meantime, "it has to get worse," says Adkins. And I can see him, 1,400 miles away, rubbing his hands with pleasure.
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04/16/03: Victory not enough