Second Half Could Reward the Patient Energy Investor

Can energy stocks re-energize and add some power to your portfolio?

Following a rally in 2000 and a brief push for more in the first several weeks of 2001, energy stocks lost power in the second quarter. The decline was sharp, broad and painful as the stocks followed a sharp correction in the price of both crude oil and, especially, natural gas.

If you haven't looked at the major energy indices, you may be surprised. Only the Amex Oil Index, or XOI, has outperformed the S&P 500. Both natural gas and energy services have underperformed the broader market by more than 10%, with both the Natural Gas Index, or XNG, and Energy Services Index, or OSX, down nearly 20% since January. Only the oil index remains in positive territory, with a gain of just over 2% since the beginning of the year, signaling the fact that major integrated oil companies such as BPAmoco (BP) and ExxonMobil (XOM) have been the only companies to hold on to any gains since January.

Sputtering Along Only oil is up for the year, and by a slim barrel

The recent selloff has followed a decline in the price of crude oil and, especially, a steep decline in the price of natural gas.

That decline is closely tied to supply and, more importantly, demand. Recent reports have shown a surprising amount of natural gas continuing to flow into storage, and the same is true for crude oil and distillates. The increase in supply is attributable to a number of issues, including slowing demand from a slowing economy.

Regardless of the reasons, increased supply and slowing demand have put pressure on commodity pricing, in turn pushing the prices of stocks that profit from higher commodity prices lower. "The significant drop in natural gas prices since the start of the year has led to fears that drilling activity ... will fall as well," noted UBS Warburg analyst James Stone.

There now is little doubt that energy stocks were overextended as the new year began. Now, however, many argue that the sector has become awash in worry that is similarly unjustified. If so, the second half of the year could provide at least short-term profits for patient energy investors. Here's a look at some specific themes.

The Key Is Natural Gas

The key to understanding the current action in energy stocks is understanding the natural gas markets. Gas prices have been slashed almost in half in less than six months, moving from above $6 per mmBtu to below $3.50.

That rapid decline has investors concerned that prices may fall further, even through the magical $3 mark, a figure many exploration and production companies use to project break-even pricing for new capital expenditures and earnings forecasts.

"Today the wall of worry is natural gas," notes J.P. Morgan energy analyst Michael LaMotte, suggesting such a drop could push the stocks even lower. "Although the drop in gas prices would be relatively short-lived, the loss of earnings momentum would likely last a couple of quarters. This is not a pretty picture for the stocks."

Fortunately, he doesn't see the gas picture developing that way. "There are several factors, however, that are likely to keep this scenario from unfolding," he concludes.

Specifically, LaMotte thinks that the recent natural gas-demand weakness is a result of two events. First, as gas prices soared above $6, demand responded to the price. Large natural gas users such as fertilizer and aluminum companies either shuttered operations or switched to cheaper fuels where possible. Simply, demand elasticity was tested and gas lost.

While fuel-switching continues to impact natural gas demand, current prices will change that. "What investors seem to be forgetting is that price elasticity of demand is a two-way street," LaMotte notes. "Should the price of natural gas decline substantially from here, we would expect to see a positive demand response from switchable capacity." Hence, support for gas in the $4/mmBtu range seems reasonable.

The second reason for a decline in demand is the general slowdown in the economy. That hurt natural gas and also pulled down demand for refined crude products, including gasoline. While the economy remains a wild card, many analysts believe recent rate cuts by the Federal Reserve will slowly remove the macroeconomic pressures on energy demand.

Natural gas is likely to recover faster than oil, because supply is still tight and demand likely will increase as summer heats up. Natural gas demand from power generation alone is expected to grow more than 10% this year. Estimates suggest natural gas demand will grow about 3.3% this year, vs. supply growth of only 3.1%. And when demand grows faster than supply, prices typically spark up.

Some analysts say production growth will be even slower. "We still see only 1-1.5% production growth [this year]," notes Merrill Lynch analyst John Herrlin. "As companies report [second-quarter results], we'll also see that gas output from major integrated [companies] and E&Ps aren't growing at 3% rates."

Rebound Ahead

If that commodity price scenario comes true and gas returns to $4/mmBtu levels, the stocks of both exploration and production companies and energy services companies with a focus on natural gas should find their footing and provide nice appreciation potential for patient investors.

"Larger cap [E&P] stocks are down 5%-35% since the start of the year," notes Herrlin. "They're back at or nominally below January-February lows. At the margin there is little investor conviction and lots of opportunity."

Names to watch in the E&P space include companies such as Apache (APA), Anadarko (APC), Devon Energy (DVN), EOG Resources (EOG) and Mitchell Energy and Development (MND). All of those companies have four important characteristics: good development risk; management able to nimbly respond to price fluctuations in the natural gas markets; low finding and lifting costs; and long-term drilling prospects.

On the energy services side, investors also want to focus their energy on companies with significant natural gas exposure. They are likely to rebound first. "As last week's selloff was brought about purely by natural gas concerns, we believe the stocks -- especially the harder-hit gasier names like Nabors Industries (NBR), National Oilwell (NOI), Smith International (SII) and BJ Services (BJS) -- will leap back at the slightest hint of positive natural gas news," notes J.P. Morgan's LaMotte. He rates BJ Services long-term buy and the others buy; his firm has not provided banking services to the companies mentioned.

All of these companies should by buoyed by strong second-quarter earnings and positive comments about future prospects for the balance of the year. "In our view, investors, mainly institutions, have already discounted pretty dour price outlooks that don't reflect the industry's ability to self-adjust," notes Herrlin. "In a market that still wants tech, defensive names may not be the favored du jour, but we believe second-quarter results will be good and that second-half price expectations for natural gas will improve."

The key now is patience. As long as natural gas data show storage increasing at an above-average pace, these stocks will feel the pressure. But, once that trend reverses -- and it will as the weather heats up and power companies for the first time use natural gas in the summer months in a big way -- natural gas prices will move higher and the stocks will follow. (For more on how to spot the turn in the energy markets, see my recent checklist.)

The market has moved from overly optimistic to far too worried. With that worry should come opportunity for energy investors.

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