High-Octane Outlook
A veteran investor finds some undervalued stocks in an energy market that will stay strong
By SANDRA WARD
An Interview With Jim Falvey -- Since April 2003, Falvey -- based in Boston -- and his partner Monroe Helm -- based in Dallas -- have been combining their 40 plus years of collective experience researching energy stocks to assemble winning portfolios for their Dallas-based CM Energy Partners with $73 million in assets under management. Falvey provides the global macro energy outlook and Helm drills down to the nitty-gritty on exploration and production companies, as well as oil-service stocks.
CM's Monomoy Natural Resources Fund, gained 21.4%, net of fees, in its first eight months of operation. In 2004, it returned 23.8% after fees. So far this year, the fund has delivered gains of 11.2%, again after fees, through February.
A veteran energy analyst, Falvey worked at Smith Barney and Morgan Stanley, where he met Helm. Falvey moved to the buy side in 2000 when he took the helm of the Putnam Global Natural Resources Fund. While the fund performed handsomely under Falvey, it proved to be an inauspicious time to join Putnam, which would soon find itself on the wrong side of regulators and mired in a burgeoning scandal surrounding practices in its mutual funds. Falvey decided the time was right to branch out.
To understand why he's got the largest net long position since Monomoy was started, listen in.
Barron's: What's your outlook for oil and commodities?
Falvey: We've been focused on commodities pretty intently, and I've been a big believer that the past decade was the period for paper assets -- spurred on by falling interest rates -- and the current decade is the period of hard assets. It is a function of underinvestment: Nobody has liked the basic-material stocks and energy stocks. Everybody was addicted to the tech drug. It was hard to attract capital to the sector. Also, we continue to see an oil-demand surprise.
Q: The China factor?
A: The market seems to be speculating on whether we get a hard landing or a soft landing in China. I don't think we are going to get any landing. People forget China is the No. 2 oil consumer in the world right now. And the Chinese often say one thing while doing another. Last fall, people came back from their summer vacations and China announced that growth in heating-oil imports had slowed and then reported, soon after, that oil consumption was actually up 24%. China had 15½%-to-16% oil-demand growth last year, and some people are expecting growth to be half that. I think growth will surprise on the upside. The weak dollar will help that. The global demand for oil will continue.
People are also overlooking the demand from countries besides China. Indonesia is now a net importer of oil, despite being a member of OPEC and because of underlying population growth and subsidized prices. The price of gas in Indonesia right now is much below what we're paying here in the States. Latin American demand last year was pretty strong, as well. Some of these producing countries are having pretty big population booms, and Latin American demand last year was up around 4%, and we expect similar growth and oil demand. And Brazil has price controls on its domestic gasoline. A lot of these producing countries subsidize their domestic prices. Iraq is a different situation admittedly, but consumers there pay 5 to 10 cents a gallon for gasoline right now, while the black market price is $2 a gallon. Increased military needs, domestic smuggling to surrounding countries, and damaged infrastructure now make Iraq a net importer of 400 million barrels a day of refined product.
"The market's speculating on whether we get a hard or soft landing in China. I don't think we're going to get any landing. China is the No. 2 oil consumer. And the Chinese often say one thing while doing another."
The price of gas in Indonesia right now is much below what we are paying here in the States. And Brazil has price controls on its domestic gasoline.
Q: What about Russia?
A: There are huge bottlenecks and logistical constraints in terms of getting incremental oil out of there. Turkey is not going to let any more tankers go through the Bosporus. Infrastructure needs to be built and the most straightforward way to do it is to build pipelines across the various republics. But politics makes that complicated. Putin's crackdown on the oligarchs in Russia and the government's seizure of Yukos is another complication. Many Western companies doing business in Russia have deals that get taxed at the export price, but they only realize the domestic price and that's a pretty big discount to the export price they are being taxed at.
Many people say Russia can get back to the 12½ million barrels a day it was producing in the mid-'Eighties. I'm skeptical of that because it needs capital to do it. Also I'm skeptical of the quality of the existing reserves. Russia is reluctant to relinquish too much control to the Western oil companies. A lot of the major oil companies face challenging fiscal terms in some of these producing countries.
West Africa is another great example where a lot of the oil deals were inked in the late 'Nineties when oil was at $20 a barrel. Now that it's at, say, 50, those governments want a little bit more of the take.
Q: Where do you see the price of oil settling? Is it in a new range?
A: We're a big believer in higher pricing parity for commodities overall. How does oil fit into that? A normalized price around $45 is realistic. Consensus is gradually creeping up from $25 a barrel a year or two ago to $33 right now. But somewhere in the mid-40s is definitely here to stay.
Q: But Exxon Mobil's CEO, Lee Raymond, is not a big believer in that.
A: Evidently, he is getting a lot of pressure from the administration in terms of what prices are right now, as are BP and Shell in the U.K. The biggest concern for these companies is that eventually high prices are going to impact demand. That's something OPEC is worried about as well. But they are also getting a lot of pressure to ratchet up their spending, based on these higher oil prices, and the opportunities are somewhat limited. People forget the big push into deepwater drilling in the late 1990s and early 2000 period. These are very capital-intensive projects. They take a long time to come to fruition and there has to be a pretty high oil price to justify doing them.
There has been a lot of froth and speculation in the commodities markets. Too many commodity funds are speculating, and $55 oil was probably a little bit of a stretch. But $50 a barrel in the near term is definitely realistic, given the underlying supply demand fundamentals. The International Energy Agency in Paris just raised its demand forecast again.
Last year, the average price of oil was more than $40 and demand was the highest it's been since 1976. But in the scheme of things, $40 oil isn't expensive when you consider inflation. In real terms, the price in 1980-81 would have been about $90 a barrel. So gasoline demand this year is up 1½% in the face of a $2-a-gallon pump price. People are spending less than 5% of their disposable income on gasoline and heating-oil needs. That's basically half of what they were spending back in the early 1980s.
Q: People have finally discovered energy stocks, which are up about 20% since the start of the year. Can that continue?
A: Seasonally, energy stocks typically do well coming out of the winter. Oil slid from 55 to 40 from October to December, and the stock market went up 9%. So, it would seem that the market was off to another good year this year. Oil, it was assumed, was going to continue to trend back to a more normalized price of around the mid-30s. As a result, investors were underweight energy and long sectors with heavier potential growth. But energy rebounded strongly, and many of people tried to reposition. As people got more comfortable with the higher oil price and ratcheted up their price assumptions, they realized many of the energy stocks are still relatively cheap. Exxon Mobil basically trades at 14 times forward earnings, whereas the market trades at 18 to 19 times forward earnings. Exxon has a 23% return on capital, and it should be trading closer to parity with the market.
Q: Do you own any Exxon?
A: We do not own Exxon. We own some other cheaper stocks. A smaller domestic integrated oil company such as ConocoPhillips trades at 9 times earnings. That's an extremely cheap stock and a very well-run company, and they are doing the right thing in Russia in terms of buying an equity interest in an existing Russian company, as opposed to sinking money into a straight production-sharing contract or field. We like the management team there very much, and we don't think they get a full value for their downstream business. ConocoPhillips is flush with cash, and we'll likely continue to see pretty aggressive dividend increases. The same thing goes for Occidental Petroleum. With $55 oil and the prospect of rising interest rates, the outlook is not great for the market and some of these big-cap names. Exxon has had a great move, partly a function of getting re-weighted. The weight of Exxon in the S&P Barra Growth Index went from 1% at the beginning of 2004 to 7% at the start of this year. More broadly in 1980, energy and basic materials were over 30% of the S&P 500, and right now they are around 11% of the S&P 500 and will probably kick in about 15% of the profits.
Q: But is the weighting going back to 30%?
A: No, because the impact of oil is half of what it was on gross domestic product. But we do think something in the mid-teens is realistic.
Q: What about dwindling reserves driving more mergers and acquisitions?
A: There is definitely something to that. The North Sea is in decline. Reserves in Alaska and the U.S. are in decline. We import about ten million barrels a day of oil right now. Up until recently, it was cheaper to buy reserves on Wall Street than it was in the oil patch because asset values had gotten so out of whack and these companies were flush with cash. Developing reserves is tricky because of geopolitical risk and geologic risk. Then there's execution risk in building big rigs and shipyards outside of a company's control, typically in faraway locations. Development times are five to seven years from first leasing and contracting the acreage to punching the hole in the ground to actually producing oil.
In West Africa, for example, we are looking at 10-year development times right now. When we talk about depletion, we're not just talking about quantity. We've depleted a lot of our light sweet crude oil, and you need higher oil prices to justify development of heavier crudes. There is a tremendous amount of oil up in the Canadian Oil Sands, but it's heavy in nature and very costly to develop.
Q: Where do you come down on the great debate about reserves?
A: There is some speculation that Saudi Arabia could produce 15 million barrels a day. They produce just under 10 million barrels a day now. We think realistic capacity for them is probably just over 11 million barrels a day.
Q: Does that eventually get you to $70 a barrel?
A: It could get there, but that would have a major impact on demand. The key question is what price will impact the U.S. consumer. It is a little frightening when you see people surveyed on various financial networks talking about oil going to $70-$80 a barrel and then Exxon Mobil's Mr. Raymond talks it down. But the higher oil goes, the more impact on demand it will have.
Q: And, at that point, the profile of these stocks changes?
A: The profile of the overall market will change, too, so relatively speaking, the profile of the oil stocks is fine, but on an absolute basis they are not.
Q: How are you picking the stocks in the sector right now?
A: Primarily on valuation. We are also looking for resource plays. Given the fact there is a question about reserves, we have to think about where the next potential resource play is. We have been a big believer in higher oil and natural-gas prices for the past few years. Coal has been a great resource play the last couple of years. One of our biggest holdings is Consol Energy It has 1 trillion cubic feet of gas reserves that aren't being recognized in its stock price. Consol will very likely spin off the gas business to shareholders.
Q: What about liquefied natural-gas stocks?
A: We haven't done much with liquefied natural-gas stocks because LNG projects are very capital-intensive and require long lead times. When we approach an investment, we are bottom-up valuation people and try to get to know management teams extremely well. We're interested in managements that use their cash and manage their balance sheets effectively. We try to identify potential resource plays. Lately, we've been trying to identify takeout candidates. There is going to be more consolidation in an industry throwing off $50 billion of free cash a year with effectively no debt.
Q: What's one of your picks?
A: Quicksilver Resources is an exploration and production company with acreage in the Barnett Shale outside of Fort Worth, Texas, and on the Manville and Horseshoe coal bed methane plays in Canada. It has about a $2 billion market cap. Barnett, which has been a hot resource play the past year, should continue to positively surprise investors going forward. Quicksilver is the third-largest acreage holder there. It has 1 trillion cubic feet of proven reserves. We think there is the potential for another 4 trillion cubic feet because of their acreage in Texas and Canada, which would effectively make the stock almost double. They would be a good fit for a large North American E&P company, such as Encana.
Q: Any other favorites?
A: We continue to like some of these Canadian oil companies, just on valuation relative to U.S. companies. U.S. investors are getting more educated and actually looking outside the U.S. for value and more liquidity in specific names. We've been optimistic about Canadian National Resources as a takeout candidate as well. It's a conventional exploration and production company with good exploration prospects in West Africa and Canada, and it is an oil-sands play, as well.
There has been speculation, too, about Chinese oil companies buying a U.S. oil company. I don't see that with a Bush administration in place. The Chinese will probably look north of the border instead.
FALVEY'S PICKS
Company Ticker Recent Price
ConocoPhillips COP $104.79
Consol Energy CNX 46.28
Quicksilver Resources KWK 47.04
Canadian Natl Resources CNQ 55.36
Cabot Oil & Gas COG 52.65
Gastar Exploration YGA CN C$4.20
Q: Anything else look attractive?
A: We've liked Cabot Oil & Gas, a smaller U.S. E&P company, with just under $2 billion in market cap. This has good resource potential. There has been a lot bearish sentiment in terms of natural-gas inventories. We think natural-gas production will probably continue to fall short of expectations and gas prices themselves will actually stay higher than people think. In the U.S., there's a dearth of new prospects, but we think Cabot is on to something in Louisiana, particularly in the Clear Branch project. Cabot trades around 4 times forward cash flow.
Q: What's a more normalized multiple on cash flow?
A: The E&P companies have traded historically at about 6 times cash flow. Therein lies the big debate right now in terms of what kind of normalized price assumptions people are using. We continue to believe that we are in a new era of higher pricing parity for both oil and gas.
People were using around $19 a barrel as the historical norm and gradually raised it to 21 and then to 23. In the past year, they raised it to 25. And now we've seen it go to 32.
The other thing we do is look outside the U.S. and try to take advantage of valuation relative to U.S. companies. We've been a big believer in BHP as the cheap natural resource play. It's a big metal and mining conglomerate in Australia with a nice oil and gas business attached to it that it wasn't getting full value for. It was at this time one of our biggest holdings.
Q: And it is something that people can still make money on?
A: It's had a pretty good run, but I think it will continue to trend higher, though I don't think it is going to see quite the move it's made in the past year and a half.
Q: Anything else outside the U.S. that is overlooked and represents pretty good value?
A: We own Posco, a Korean steel company that is very cheap, relative to its U.S. counterparts.
Q: How big a representation are the steel companies in your portfolio? There is also great debate that the steel companies might have peaked.
A: At the end of last year, there was a lot of debate about whether China was turning into a net exporter, not an importer. But you have to look at the quality of the steel they are actually putting in the market. And again, people are too focused on the rate of growth as opposed to the absolute demand and consumption. And then, too, people are forgetting about India and its potential. The potential there, if not as great as China, will be almost as great over the next 15-to-20 years.
There has been speculation, too, that we will see an increased supply of steel coming on in 2006 and 2007. Maybe there will be some increased supply, but we have big infrastructure and logistical problems globally. So the supply may come on, but there will be bottlenecks getting it where it needs to be.
Q: Any other picks?
A: Gastar Exploration is a small E&P company with a very promising development in the Deep Boosier trend in East Texas. This is an emerging and unconventional gas play. They also have a very attractive coal bed methane gas in Australia, which is not reflected in the stock at all.
Q: What about all the speculation about a sale of Unocal?
A: Unocal has been a take-out candidate for 10 years. It may ultimately happen. But if you look at some of the past acquisitions made by the big integrated oil companies, only a few have really been accretive. Big oil companies will want to see prices come in a little bit and they'll wait the cycle out a bit before coming in and buying this. Parts of Unocal are attractive, especially their Southeast Asia gas reserves in Taiwan.
Q: What are you expecting from the market as a whole?
A: I'm neutral on the market from here on out, given the backdrop of a higher oil price environment and potential for increasing interest rates. Longer term, the market will probably find a bottom once it gets comfortable with commodity prices in a new range. And we have had upward earnings estimate revisions coming from companies across the market for the past year and a half or so. It is a little bit stretched right now.
Q: Thanks, Jim. |
