Magazine

The Pick of the Energy Patch


Energy prices have enjoyed an extraordinary run in the past 21/2 years, but this is an extraordinarily cyclical business. High prices lead to increased production and lower profits. Slowing global demand has caused prices of oil and natural gas to drift down from their highs of late last year. Energy stocks, after performing strongly for the past two years, began losing steam in mid-May.

Still, quite a few smart investors believe that this dip is just a breather in what will be a sustained period of higher energy prices. For one thing, a reenergized OPEC seems determined to keep oil at the high end of the organization's $22-to-$28-per-barrel targeted range. It's also clear that years of underinvestment in natural-gas wells, refineries, and power plants are leading to energy shortages and higher prices.

Jerome Castellini, founder of CastleArk Management in Chicago, believes oil will rise above $30 a barrel again in the next two years as the world's economies resume more rapid growth. He has steered his $1.5 billion portfolio into some of the most price-sensitive stocks in the business. Castellini owns drilling-rig operators Rowan (RDC) and Grey Wolf (GW) and such independent oil companies as Ocean Energy (OEI) and XTO Energy (XTO).

What if Castellini is wrong and energy prices do fall back to earth? There are companies that could prosper even in a more difficult pricing environment. Lehman Brothers oil analyst Paul Y. Cheng believes prices will sink to $21 a barrel by the end of this year. He likes Exxon Mobil (XOM) because it is somewhat insulated from the vagaries of prices. Cheng notes that Exxon Mobil has long-term contracts with countries such as Nigeria and Norway that adjust the taxes the company pays based on the price of the commodity. Exxon Mobil's profit per barrel thus stays relatively fixed when prices fluctuate.

Cheng also likes Chevron (CHV), which is in the process of merging with Texaco (TX). He says the cost savings will exceed the $1.2 billion that the company presently estimates. Cheng believes that the new company will enjoy a higher price-to-earnings multiple because of its size.

Charles Ober, manager of the T.Rowe Price New Era Fund, is a fan of USX-Marathon Group (MRO), a midsize oil producer and refiner. Marathon is in the process of ending a complicated relationship with its parent, USX. Investors in Marathon now own a tracking stock that only indirectly reflects the earnings stream of the company. In October, Ober expects that shareholders will vote to end that arrangement and turn their shares into conventional stock. That will boost the stock's value, he believes.

Ober also likes the prospects for coal companies, which are enjoying an uptick in commodity prices due to the increased demand for electricity. "Their technology is getting better, and they are benefiting from favorable energy policy," Ober says. He recommends Peabody Energy (BTU), the leader in the industry.

GOOD MIX. John Segner, manager of Invesco Energy Fund, looks for smaller companies that are ramping up big new fields. Two of his favorites are Murphy Oil (MUR) and Kerr-McGee (KMG). Both are active drillers in the Gulf of Mexico. Segner believes that increased output will allow Murphy's earnings to rise 70% by 2004, even if energy prices fall.

What about electricity? Is there a way to play the surge in prices without getting shocked if the cost of kilowatts crashes? For conservative investors, Kit Konolige, electric utility analyst at Morgan Stanley Dean Witter, recommends companies that have a mix of traditional regulated businesses and unregulated ones. In that category, he likes Reliant Energy (REI), Duke Energy (DUK), Dominion Resources (D), and TXU (TXU). "You can hedge your exposure to the pure marketplace," he says. Not a bad strategy in this volatile industry. By Christopher Palmeri


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