Gang,
IMHO this is the kind of stock that AIPN will be in two years our sector is getting allot of attention lately and Dr. Faris has picked a good time to dog and pony. I just hope he has a dog and a pony
DrRisk bow wow
Highlighted Stocks
3-year vs. S&P
Barrett Resources Cabot Oil & Gas Kelly Oil & Gas Swift Energy Tom Brown Inc. Unit Corp. BJ Services Weatherford International Amoco
Phillips Petroleum Amerada Hess Unocal Coastal Corp.
Refining the Energy Sector
Mike Smolinski's record for oil and natural-gas forecasting is on the money. Now he's bullish on exploration.
By Eneida Guzman
It used to be that a little tension in the Middle East sent oil prices skyrocketing. But this time around, the needle has hardly budged. In fact, due to technological advances and alternative reservoir choices, oil costs less to find and refine today than it did 10 years ago.
Still, First Albany energy analyst Mike Smolinski feels that current oil and natural-gas supplies are not nearly enough to offset growing worldwide demand. And he believes that investors flocking to the drilling and oil-service stocks recently may be overlooking the most promising area of the energy sector -- exploration and production. It's a sector whose returns he projects at 55%-100% over the next year.
Smolinski, 51, has been following the energy business for 28 years. The inventor of the Smolinski Strip, a 12-month moving average tracking the price of natural-gas futures, talked to Investor about El Ni¤o, the Middle East and why neither has had much impact on energy stocks.
You invented a method of measuring future natural gas prices, called the Smolinski Strip. Tell us about it.
I look at the natural-gas futures market every day and throw away the first six months of the future prices, where the bulk of the volatility takes place, and average the next 12 months. The Smolinski Strip is the average price of natural-gas futures over the next 7-19 months. And right now the price of natural gas on the Smolinski Strip is about $2.35 compared to the current market price of about $3.15. So, in effect, the market is predicting, as reflected by the Smolinski Strip, that the price of natural gas is going to fall about 85 cents between now and next summer. Having used futures prices for years, we have learned that the futures market is a terrible predictor of the future. But it is a wonderful barometer of how the marketplace feels today.
El Ni¤o Effect
Contents
Focus On Exploration
Drillers Have Room to Run
Useful Indexes
Instead of having to have a production platform, you can put production facilities on the ocean floor.
El Ni¤o has a strong influence on your research. What kind of impact does El Ni¤o have on the overall energy outlook?
Right now, El Ni¤o is creating a perception that both the price of gas and oil will fall. So that's built into the stock-market assessments of those stocks. When I look at the supply-and-demand situation, what I see is new production failing to offset depletion and meet growing demand -- both for natural gas in the U.S. and also for oil in the world marketplace. Additional oil, even from Iraq, is going to require putting more holes in the ground. And that's where the drilling and the oil-service stocks come in. The marketplace is excited about those stocks. They've performed extremely well. The motivation there for investors is the technological improvements, which are just astounding. And that new technology is making it possible to look for oil and gas in places that you couldn't in the past, because the economics are so good. But my sense is that even with the new technologies we're simply not adding enough.
What are some of the new technologies that make exploration more efficient?
There are multiple technologies. The one I think that has the greatest advantages is the deep-water technology. It offers the ability to drill today in 2,000, 3,000, 8,000 feet of water, and explore with 3D seismic (technology) to find the reservoirs. You just couldn't do that until recently. New technology also offers the ability to do sub-surface production. Instead of having to have a production platform over the well, you can put production facilities on the ocean floor and bring that oil or gas up to where it can be processed, either by pipeline or, in the case of oil, into a floating vessel. That's an amazing technological improvement.
The exploration and production stocks have been one of the worst-performing groups in the S&P. Why are those stocks not responding to the increase in exploration ventures?
The Smolinski Strip's expectation of future gas prices today is about $2.35. That's only a few pennies higher than the market expected in January. We saw that expectation fall from about $2.35 in January all the way down to $2.05 in March. And that took the stocks down with it. We got a partial recovery, in the group, as that price went to $2.20. But then it plateaued at the $2.15-$2.20 level. And now we've only seen another 10 or 15 cents on top of that. It took the gas producers up, but they peaked in early October and have come down with the market. So the reason that the stocks haven't appreciated more is that the consensus expects the price of natural gas to remain unchanged at about the current level -- $3.15.
Focus On Exploration
The energy sector is probably the longest lead-time sector in the marketplace.
ÿ
Market fundamentals for the exploration and production stocks are terrific.
You believe that structural changes that have been going on for the past few years in the U.S. supply/demand balance should make exploration and production stocks top performers over the next five to 10 years. Why are you so optimistic?
The energy sector is probably the longest lead-time sector in the marketplace. It takes years to build refineries, to build big systems. And it takes years to rebuild a drilling fleet. The sector had experienced about a 15-year decline after the surpluses of the late '70s, early '80s. We put in so much surplus infrastructure that it took until 1992, 1993 to really begin to utilize all that surplus capacity. So, while we were drawing down the surplus capacity, we were also increasing our demand for oil and gas, which were very cheap. Our demand levels are much greater today. For example, the auto companies are now devoting more of their production to vans and four-wheel drive vehicles -- high users of energy. The demand for natural gas is growing more rapidly because we're clearly reaching the limits of nuclear and hydro power plants. But on the supply side, we're depleting this surplus inventory of wells. And we're utilizing all the rig equipment -- the rig-equipment surplus is essentially gone. So we're at a point where we can add to the demand very quickly. But we can only add supplies slowly. And it hasn't been this way since the 1970's.
What exploration and production stocks are likely to benefit from these technological advancements?
I follow six smaller-cap exploration and production companies that I believe will greatly outperform most of the stocks in their group. Barrett Resources (BRR), Cabot Oil and Gas (COG), Kelly Oil and Gas (KOGC), Swift Energy (SFY), Tom Brown (TMBR) and Unit Corp (UNT). I'm looking for these stocks to be the big surprise.
How much of a surprise?
The expectations for the exploration and production companies are extremely low. It's very similar to what the drillers were looking like back in March. They were the worst-performing group in the marketplace. The perception was, 'Why do I want to be in these stocks?' And at that time, I said market fundamentals for the drilling group are just terrific and they should be one of the best-performing groups again this year because of those fundamentals. I see the same thing in place here for the exploration and production stocks.
What are your target prices on those stocks?
My target on Barrett Resources is $60, Cabot Oil and Gas is $38, Kelly Oil and Gas is $7, Swift Energy is $50 1/2, Tom Brown is $36 and Unit Corp is $22 3/4. So I see these stocks increasing between 55% and 100% by year-end 1998.
Drillers Have Room to Run
In contrast to exploration and production stocks, the oil- and gas-drilling and services stocks have been two of the best-performing sectors of the S&P. What are your favorite picks there?
My favorite picks there are BJ Services (BJS) and Weatherford Enterra (WII). These are smaller-capitalization oil and gas service companies. These companies are in businesses that are absolutely critical to bringing additional oil and gas into production. Yet they're not in the exotic parts of the business. They're not doing the latest technology, extreme microchips and those kinds of things. These businesses are more mundane, but they are absolutely critical and therefore they have greater earnings potential.
These sectors have appreciated about 65% this year. How much higher do you expect to see it trade?
For BJ and Weatherford, I'm looking for about 20-30% appreciation over the next year. I think that people right now are becoming a little more concerned about the future growth of these companies, as they fear that producers are reacting to the higher service cost, higher drilling cost. As the months go by, the market is going to realize that we're still not drilling enough wells, that we still need even more to be put in the ground and that these companies have just excellent earnings potential well into the next decade. But near-term, these stocks are more like a 20-30% return to investors.
The tension in the Middle East is heating up again. What impact, if any, will this have on the oil sector?
I don't expect a huge event. But right now the marketplace says to me: We need Iraq's oil in order to have a price of oil in the low $20-per-barrel range. Without Iraq's oil, we're likely to see oil prices in the $25-or-higher range, which can cause investors to be nervous about the overall market. Either way, I think we'll see the exploration and production and the integrated oil companies do well, just because demand is growing and supply is getting tighter.
You say the weather appears to have less impact on energy companies. Why?
First off, on the oil side, if we look back to the late '70s, heating oil was a big part of the total demand for oil. But since then, we've done remarkable things on conservation and substitution. We've turned to natural gas, for example. We've put in a lot of insulation. And so the importance of the heating component of oil is greatly diminished. The other thing that's occurred is on the transportation side of oil. The diesel fuel part has really grown to dominate the market. That's a year-around market. And when we add in the airlines and the kind of growth they're experiencing, just from greater travel, we're getting an oil demand that's much less sensitive to the temperature. On the natural-gas side, we've had very mild winters this decade. We had, in 1991-92, the warmest winter in 100 years. And in 1994-95, the second-warmest winter in a hundred years. We've become used to the idea that all winters are warm. Also, the overall demand for gas is growing with the economy and becoming less dependent on the weather.
If an investor were to gauge the energy outlook for their own research, what barometer should they use for guidance on energy prices?
The AMEX Oil Index (XOI) and the AMEX Natural Gas Index (XNG) are two good measures of the overall energy group. In terms of oil, I think investors need to watch the current spot price. But also keep an eye on spot prices a year out. So, if you look at the December contract for crude oil, look at next year's December contract and keep a sense of where those two are to get a feel for what the market is expecting. And the same thing for natural gas -- contrast the price right now versus the view a year from now. It's very easy to be selling these stocks when you should be buying them, and buying them when you should be selling them. And by taking advantage of those relative indicators, you can do a better job of hanging onto your winners and buying more when they're under pressure and shedding losers or taking gains when you've got them.
What is your outlook for the integrated oil companies?
I've primarily concentrated on the integrated companies that have a real strong position in the U.S. natural-gas market. Their strength can be that they're a major producer, such as an Amoco (AN) or a Phillips (P) or a Unocal (UCL). But it also can be that they compete with natural gas by selling oil. That's the case for both Amerada Hess (AHC) and Coastal (CGP). Both of these companies have refining systems that focus primarily on the Northeastern U.S. They're not only selling transportation fuels, but they're also selling oil in competition with gas. And the market has a low value on the refining assets of these companies because they've had such big losses in the 1990s due to mild winters and low natural-gas prices. We have a much higher price of gas today than people expected back in January when prices for November were expected to be in the $2.20 range. That allows these companies to sell their oil at much better margins. And these companies will be able to enjoy higher and higher margins, not only from the transportation fuels they sell, but particularly the heating oil they sell which competes with natural gas.
Your favorites in that group?
Amerada Hess, Amoco, Coastal, Phillips, and Unocal. I'm looking for 30-45% price appreciation, in these stocks, over the next year.
What are the factors taking place that give us much faster energy demand growth than the consensus is looking for?
The whole world is working to improve their living standards. The former Communist countries in Eastern Europe, for example, have big improvements under way. Similar improvements are taking place in much of Latin America. They are willing to work toward living a better life. We've really got three billion people working very hard to improve their living standards and Western companies working to help them. Another factor in this growth is that we're coming into a marketplace that's going to use more energy per unit of GNP. During the decline of the 1980s and early 1990s, we were living off of the surplus investment of the 1970s and early 1980s. So we stopped building refineries and power plants and all those types of things. Going forward, we're going to see a lot more construction of power plants, of refinery systems. Energy demand is going to be growing from that structural perspective, as well as from the pursuit of a better living standard.
ÿ
|
