Energy Stocks: Gusher or Dry Hole?

(page 2 of 2)

Betting on Occidental Petroleum

"Within the context of our recently increased (to $80 per barrel) oil price forecast, we would use the recent pullback as an opportunity to accumulate Hess shares," analyst Pavel Molchanov said in the note. Raymond James reconfirmed its outperform rating on Hess and said its $64 price target was based on a 17 times multiple of its new 2010 earnigs estimate. That's higher than the company's average multiple of 11 times earnings over the past 10 years but less than the proved net asset valuation of $88.69 a share, the note said.

Occidental Petroleum (OXY) is one of Lees' preferred names based on its asset base, quality management, and outlook. It traditionally generates among the best rates of return and has been a leader in driving costs back down. He thinks the company can grow production per share by 5% to 10% for a long time with its existing and prospective projects — from the Middle East to Monterey, Calif. — lined up for the next one to two years.

The prospects for the stocks of natural gas producers aren't nearly as promising in the near term, given the consensus that gas prices won't rebound any time soon. Many producers that focus on unconventional gas resources such as shale and tight sandstone aren't currently discounting much upside in their unconventional assets, says Joseph Magner, an analyst at Tristone Capital USA in Denver.

Debt-Laden Balance Sheets

"What it comes down to now is prices and costs, and which of these producers will effectively be able to adjust their cost structures so they will be able to effectively and economically develop that unconventional resource," he says. Right now there's little willingness among investors to discount those resources given the restrained expectations for natural gas prices, he adds.

Natural gas stocks are trading at parity with their current proved reserves, says Jonathan Wolff, an E&P analyst at Credit Suisse (CS). Although some companies have unconventional reserves they aren't yet getting credit for that could, once they're recognized as probable reserves, boost stock valuations, most of those producers aren't generating the cash flow needed to finance development of those properties because of currently low gas prices. Producers would be able to materially increase their booked reserves over time if the price of natural gas was to rise to $7 per thousand cubic feet, but at prices half that level, companies need to use debt and equity to fund development costs, he says.

Balance sheets for the natural gas industry, laden with debt, don't help make the case for investing in exploration and production companies right now, either. In the first half of 2009, these companies issued more than $17 billion in debt and equity in order to pay down outstanding debt on revolving credit lines at banks, which are at greater risk of being reduced the longer gas prices stay depressed, he says.

Another Year of Soft Prices

And earnings will be further challenged by likely production cuts in 2010. "The average natural gas producer, based on [prices] for next year, will have 13% less cash flow than their budgets are this year," says Wolff. "That means they have to spend 13% less next year or they have to finance it with equity or debt, unless the [gas] price bounces."

With gas supply up by about 5% and demand down 5% from last year, the market won't tighten much before mid- to late 2010, so he says he expects fairly soft prices for another 12 months or so.

Still, a few producers stand out based on their operational edge and dominance in certain markets such as the Fayetteville, Ark., shale resources. Lees at Invesco AIM, likes Southwestern Energy (SWN), which he sees as cheap on a net asset value basis despite seeming expensive based on price-to-earnings. "They're growing into their p-e," he says. Besides having 50% production growth so far this year, the company is lowering its cost structure based not only on falling oil service costs but by using what it's learned from prior development to save money through smarter drilling.

Unsettling Times Ahead

If a strict carbon capture regime emerges, the price premium that oil has enjoyed could disappear and natural gas producers would benefit. Wolff at Credit Suisse believes a carbon policy would be positive for natural gas in the long run since the fuel generates roughly one-half of the CO2 emissions of coal, which would help increase market share for natural gas as a fuel source for power plants. "The industry is doing a better job [than in the past] of promoting the fuel as being available and clean, and policymakers are getting the message," he says. "It's just a matter of time before it becomes obvious we should facilitate higher demand for gas. It's available and it is domestic."

That certainty fits the bill for people calling for reducing U.S. dependence on foreign oil in the future. But for now, gas producers, along with their petroleum-pumping peers and energy investors, will be sweating out some unsettling times.

Bogoslaw is a reporter for BusinessWeek's Investing channel.

Business Exchange

Track and share business topics across the Web.