Exploration and Production Companies Stocks Analysis
Monday March 10, 1:38 pm ET
67 WALL STREET, New York--March 10, 2003-- In an in-depth (3,400 words) Analyst Interview, John A. Bailey, Vice President of Deutsche Bank Securites Inc., examines the outlook for the sector and shares specific stock recommendations. This interview excerpt is part of an interview from our 129-page Energy issue featuring in-depth interviews from seven analysts and top management from fifteen sectors firms discussing stock performance, rising costs, net net returns, commodity prices, industry consolidation, pricing outlook, drilling projects, industry risks, hedging strategies, selling non-core assets, stocks to avoid, stock recommendations and more. This issue is available to subscribers by telephoning 212-952-7400 x1799 or through The Wall Street Transcript
TWST: Would you begin with a quick overview of your coverage?
Mr. Bailey: We have 19 exploration and production stocks under coverage. The market capitalization ranges from just under $15 billion for EnCana Corporation (ECA) all the way down to $370 million for Magnum Hunter Resources (MHR) with a mix of natural gas leveraged names as well as oil leveraged names.
TWST: What determines the coverage?
Mr. Bailey: You have two considerations. One is critical mass from the standpoint of market capitalization and liquidity. You have segmentation among clients; those with focus on large cap names like to build large positions and so necessarily you want to focus on the handful of large cap names that we do have in the E&P sector. But then also there are some more interesting situations for the small caps, and that's driven just by the curiosity within various drilling strategies, exposure to new drilling plays, or drilling programs that are enabled through better technology and better land access.
TWST: What has gone on in the group over the past year or so?
Mr. Bailey: Over the past year, we have seen some fairly significant relative performance. Over the past 52 weeks our coverage universe is up 4% and that compares well against the broader industries. Year to date, outperformance relative to the S&P and the Dow has been roughly 4%. It's been interesting to see the group's flat performance year to date in the face of natural gas prices that are up 30%, and crude prices that are up 10%-15%, and crude has certainly maintained its levels above $30 without any difficulty.
In terms of natural gas prices, we keep seeing new highs and it seems like a near term $5 to $6 range is reasonable. So it's interesting to see the underlying energy price strength, yet the group has been flat, which suggests that equity performance has been driven by skepticism of sustainability or a greater perceived risk component to the broader equity markets.
TWST: So really that disconnect is the broader market rather than the industry itself?
Mr. Bailey: There certainly is the disconnect between the broader market, but another more interesting phenomenon which is different from past experience with the exploration and production sector is that investors have been much more long-term in focus on natural gas and oil prices when they formulate their investment decisions. That means that, historically, the stocks would move in tandem with oil and natural gas prices, as you saw in the near-term moves in either commodity, whereas now you are basically seeing investors willing to capitalize on what's perceived to be a longer-term sustainable price. Now, that said, we still have significant upside in the group just based on mid-cycle prices.
So the disconnect between the group and the commodity price, yes, you do have some of that driven by broader equity market uncertainty, but then you also have this issue of investors not wanting to capitalize on near-term pricing spikes, which are perceived to be just temporary.
TWST: What's it going to take to resolve some of those issues?
Mr. Bailey: Certainly persistence of pricing strength will ultimately benefit the shareholder as these companies generate excess cash flow. Just to give you a sense of bottom-line momentum, you have consensus estimates for natural gas prices right now of about $3.70 per Mcf, which is up from $3.50 six weeks ago. Oil prices have been forecast around $24 per barrel, so the current prices that we are seeing right now lead to further positive revision to cash flow through 2003. And so I think two things will happen. One, the benefits of the excess or free cash flow will become all too apparent in terms of debt reduction, share buybacks or perhaps accretive acquisitions. And two, as we see prices stronger for longer, that provides solid evidence that we are in a range for oil and natural gas prices that's much higher than what we have seen historically. Historically, it was thought that $20 per barrel and $3 gas were wonderful prices, but that said, now we are just in a new trading range for those commodities and we get more and more evidence of that every day.
TWST: What are you telling investors to do these days?
Mr. Bailey: Focus on exploration and production companies that have company-specific catalysts. It's quite easy to say that the group is cheap and you want to own an exploration and production company's stock simply because it is cheap relative to historic valuation parameters. But cheap stocks need catalysts to become expensive stocks, so they can break out of a historic valuation pattern or the current valuation pattern.
That said, one of our top picks has been Apache and a catalyst for Apache has been acquisitions because the company has a wonderful balance sheet, is in great financial position, with a net debt to capitalization below 40%, even after the BP acquisition. Also, Apache is accelerating their drilling activity after cutting back tremendously during 2002, so they should show some modest growth into 2003 from the base portfolio, and they also have some of the highest returns in the business. So, for Apache, the catalysts were and continue to be acquisitions. They can also use futures prices to ensure the accretion of acquisitions and then accelerate production. So that's a stock where some company-specifics have led to their doing quite well recently; they outperformed the group by about 10% over the last 30 days. It is trading in the mid-$60s and we think a $77 target price is not unreasonable for it.
We're also telling investors in the large cap space to focus on EnCana Corporation; that's the largest E&P company in North America. Based in Calgary, it's a combination of Alberta Energy and PanCanadian. Alberta Energy is the predecessor management team, but here you have one of the most opportunity rich E&P companies with a focus on North American natural gas, plus a wonderful international exploration program. The company is able to grow 10% per share during 2003; they should grow it at a double-digit pace over the next few years and the only difficulty with this investment thesis is that it's against the backdrop of other large cap companies that are unable to grow as rapidly. So there is just a lot of skepticism over EnCana's ability to post this growth because it is so well beyond its peers with the large cap peer group only growing a few percent. But with that said, we think that EnCana, between exploration potential and production growth from the base portfolio, is a stock that should trade from the low $30s up to the low $40s or perhaps even high $40s.
Also, you have an issue where historically US investors and investors in general were not as comfortable with the Canadian exploration and production companies because of disclosure, because of how they account for their reserves. Now they are much more compliant to SEC reporting. They are also trading on the New York Stock Exchange; EnCana is listed on the New York exchange, as well as Toronto. EnCana also has an independent reservoir engineer evaluate the reserve base. A lot of these companies do it internally, but EnCana made a move proactively to have an independent audit of its reserve position, and I think that should go a long way to instill confidence in the base assets, and those base assets again will be driving the production growth over the next few years.
Focusing on those companies that have exploration potential, as well as the ability to post production growth beyond that of the peer group, Pioneer Natural Resources (PXD) is one of our favorites in the mid-cap space - $31 target price; the stock currently trading in the mid $20s; tremendous exploration success. They're growing production from 35% to 45% during 2003; the range of that production rate will depend on the results from a development drilling program in the onshore US, complemented by deepwater Gulf of Mexico discoveries coming online. Also offshore South Africa they have another discovery coming online this year and then over a longer period of time, they have had initial drilling success onshore Tunisia that could be a significant project for the company. They also have a large discovery offshore Gabon in West Africa, which will extend well above average growth rates.
So those are the companies that we have been recommending to investors. Again, there are company-specific drivers plus exposure to natural gas and oil prices - Apache is a bit more oil leveraged and EnCana is a bit more of a natural gas emphasis. And then Pioneer among the mid-caps, where you just have wonderful exploration as well as production growth potential.
This interview excerpt is part of an interview from our 129-page Energy issue featuring in-depth interviews from seven analysts and top management from fifteen sectors firms discussing stock performance, rising costs, net net returns, commodity prices, industry consolidation, pricing outlook, drilling projects, industry risks, hedging strategies, selling non-core assets, stocks to avoid, stock recommendations and more. This issue is available to subscribers by telephoning 212-952-7400 x1799 or through The Wall Street Transcript .
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See bolded part, couldn'ta said it better myself.
Speaking of catalysts, ATPG is now just a month away from getting their first North Sea well in production (tested at 60 mmcfd and maxed out the rig capacity), plus they just found 197 feet of pay in a GOM well. Stock is now consolidating at around a dime under its 52-week high. You can listen to their presentation at the CIBC hype show tomorrow on their web site. |
