The TSC Energy Roundtable

Energy investors had plenty to celebrate in 2000 as oil, gas and power companies were some of the few bright spots in an otherwise dark year for equity investors. However, with a new year comes new challenges, and, with the benchmarks all equal on Jan. 2, energy stocks will once again have to prove themselves.

Hoping to shed light on energy companies in the new year, TheStreet.com contributing editor, Christopher Edmonds, took a reprieve from last-minute holiday shopping to convene the first-ever TSC Energy Roundtable.

Edmonds gathered six leading analysts and investors in the energy field and quizzed them about the year that was and the year to come. The Roundtable included Marshall Adkins, managing director of Energy Research at Raymond James; Jeffrey Dietert, vice president and energy convergence analyst at Simmons & Co. International; G. Bryan Dutt, portfolio manager at Ironman Energy Capital in Houston; Doug Hohertz, principal and portfolio manager at The Mitchell Group, an energy advisory firm in Houston; Daniel Pickering, managing director of Energy Research at Simmons; and John Segner, vice president and portfolio manager of The Invesco Energy Fund.

Over the course of two hours, participants discussed the state of the oil and gas industries, the price outlook for oil, gas and power, politics and energy, as well as the best investment ideas for the coming year. And, if the outlook of the Roundtable is as clear as the view from the 50th floor of Houston's Bank of America Tower, the site of the first TSC Energy Roundtable, the panel's thoughts and suggestions should be enlightening.

As always, let us know what you think.

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Christopher Edmonds: Until 2000, energy and energy stocks had spent a good portion of two years in a real funk. Then, instantly, the stocks of oil and gas companies began to show signs of life. Obviously commodity prices increased, but what else fundamentally changed to lure investors back to the sector?

Doug Hohertz: I think we've reached an inflection point in both oil and gas. For years we've had ample supplies. And cheap prices encourage consumption, so we've had a growing consumption base for many years. Recently that excess supply eroded and demand has continued to grow, especially for natural gas. Growing demand, especially for gas, has been hidden the past couple of years by warmer than normal weather, but it has been building over time.

That's also true for oil. Consumption has been growing over the past several years. And now that's beginning to show up in the price of the commodities and, ultimately, in the price of oil and gas stocks.

Christopher Edmonds: Dan, we've discussed the sustainability of recent price action recently. What does history tell you about the potential of sustaining these price levels?

Dan Pickering: I think history would tell you that we're now clearly outside a band of normal price expectations. That band has ranged from $22 to $24 on the upper end, to $16 to $17 at the bottom. In the last 18 months, we've been outside that band in both directions. I think what history would tell you is that you need to be skeptical about the current price, whether that's the price of oil or natural gas.

I do think, however, there's another thing we should take from history, and that is that you don't add supply quickly. So now the question is, when do we get back to an equilibrium point? What we haven't seen since 1970 is a situation where we don't have any excess capacity in either oil or natural gas. Supplies of both are very tight. And now power is also rapidly becoming another commodity where you don't have excess capacity.

So history suggests you have to be skeptical about the sustainability of the commodity prices so far outside of the band. I think history would also say that the industry is more mature than it has been. History also would tell you that regaining equilibrium can take time. So, while I think expectations for almost everyone are lower prices for gas and oil in the next year, the question is how much lower and for how long? I think that has been the wake-up call for investors, that it's taken longer to see a price correction, and there's growing belief, I think, among energy analysts, including ourselves, that equilibrium prices will probably remain a little bit higher over the next couple of years. "Investors still vividly remember the shock they experienced in late 1997-98, when the stocks absolutely collapsed."

Christopher Edmonds: Bryan, I think one of the issues that has frustrated investors, at least recently, is that while the prices of the underlying commodities -- oil and natural gas -- have continued to push higher, the stocks of companies in the industry haven't kept pace. In fact, after third-quarter earnings were announced, many of the stocks tumbled. What happened?

Bryan Dutt: Well, there has been a disparity for two reasons. First of all, the market doesn't look at what prices are today or tomorrow, but what they're going to be or what they think they're going to be six or nine months from now. There have been great expectations that we would see a "hard landing" in oil, for example.

But more importantly, and let's talk about the [exploration and production] companies and the oil services industry. They have not, at least recently, returned or earned a reasonable return on capital. Investors still vividly remember the shock they experienced in late 1997-98, when the stocks absolutely collapsed. That's very fresh in their minds, and they're not willing to go back as eagerly and as vociferously as they have in the past. It's going to be a show-me situation. Investors are going to have to believe commodity prices are going to stay up and that these companies will not overbuild and attempt to overcapitalize themselves. And, on the E&P side, they're not going to leverage up and create another disaster scenario like late 1997, early 1998. And, remember, that was only a year and a half or so ago, so investors still remember that.

Christopher Edmonds: John, you run a large mutual fund dedicated to energy. How have you positioned your fund to take advantage of rising commodities prices? Did you see this coming and do you think it is sustainable?

John Segner: I don't think that anyone who has been involved in the energy business over the last couple of years is terribly surprised that prices have moved higher, especially natural gas. We all might be surprised at $9 per MMBtu [Million British Thermal Units], but we're not surprised that they're higher than $2 per MMBtu.

I have positioned the fund with the biggest weighting in oil service companies, which are approximately 35% of the fund. I see continued strong earnings growth in these companies over the next several years, at least. And that's even if commodity prices were to weaken.

I'm like everyone, thinking prices probably will come down somewhat from these levels, but I think we're going to be at higher sustained levels for a multiyear period until we build excess capacity again for both crude oil and natural gas. Natural gas will probably take longer.

So I think there is earnings growth in these companies, even if commodity prices were to come down from these levels. And I think the market will pay for increased earnings. That may not be true with some of the E&P names, depending upon how much commodity prices were to go down.

Remember, too, that commodity prices, at least for crude oil, have already started to come down. I'm not sure how much more they're going to come down. And the fact of the matter is, they might very well creep back up into the 30s if we don't see inventory build. And that means inventory builds in the West not maybe, could be in China. "California is a great example of what's taking place throughout this business: You wake up to a problem, and then you wake up to the fact that the fix is years away."

Christopher Edmonds: Marshall, what are your thoughts on oil supplies? Is there more supply available, say from China, than we are factoring into prices or are the markets really as tight as they appear?

Marshall Adkins: I think the consensus out there is that there is a glut of oil on the market. Certainly the Chinese situation suggests -- if that analysis is right, which I don't think it is -- that there's going to be a big glut later this year. Our numbers show just the opposite. You pull out the strategic reserve or maybe even half of that out of U.S. inventories, then we'd be at exceptionally low levels, and I think in the next two months inventories will continue to drift down.

So our near-term view of oil is, next two months, things probably get better for oil prices. Certainly, in the spring, seasonally, things could come off a little bit. But are they going to be coming off of $40 or off of $30? My bet would be it's going to be closer to $40 before we start coming off.

Christopher Edmonds: The one issue that always surfaces in discussions about oil is OPEC and its continued importance in oil supply. Clearly, OPEC remains important symbolically, but how much impact does it have on oil prices in the U.S.? Does the cartel still hold pricing power?

Doug Hohertz: OPEC still holds probably 90% of the excess capacity of crude left in the world. And most of that is in Saudi Arabia.

I think OPEC would prefer to have lower prices. They're pumping as much high-quality crude as they can right now. And the world apparently is consuming it. So the only way that lower prices will happen is to build excess capacity, which over time will happen, but it will take a number of years. Then we return to possibly lower prices, say in the midteens. But that's down the road.

Christopher Edmonds: But if OPEC is currently pumping at capacity and we are consuming it all now, absent an economic downturn, do we build inventories?

John Segner: In the short term, we have a recession. Seriously, in the short term, we can't, and I think that's beginning to creep up on investors. The initial or the common assumption is that when prices rise, you snap your fingers and a lot of supply appears and prices normalize. That's not how it happens.

To get oil or gas you have to drill wells. And you have many projects that take several years to complete. So, short term, you can do very little, you end up with tight markets and it simply takes time to recover, to regain lost inventory.

You're seeing the effects of that everywhere, in everyday life. You wind up with power outages in California because you can't get enough gas there. And oh, by the way, we don't have enough generation capacity, but it takes two or three years to get new generation capacity. In a very understandable way, California is a great example of what's taking place throughout this business: You wake up to a problem and then you wake up to the fact that the fix is years away.

Christopher Edmonds: But that's a specific problem involving gas and power, which isn't necessarily applicable to the entire energy industry.

John Segner: It's really all the way through the whole energy chain. I mean, it's an oil problem, it's a natural gas problem, it's a refinery problem, it's an electrical generation problem. All of these things are very, very tight.

And California's electrical demand has been soaring. And they have been very reluctant to build any new generating capacity. And now the excess power that they have relied on from the Pacific Northwest, Arizona and Nevada is tapped out.

The lesson here is that there's not any free lunch. You have to build the capacity to meet the needs. It won't happen by just assuming that it's going to just get there if we do nothing. That has become very clear this year.

Marshall Adkins: Well, your first question was what has changed in the system? And, really, what's changed in my mind is that for 20 years you've had this glut of excess capacity in every element of the energy chain. That's all running out at exactly the same time. It's running out in the power world. It's running out in natural gas and, of course, in oil. But again, all through the supply chain. It's not just OPEC, but it's the tankers and the refineries and everything else.

Does OPEC have the same power it used to? Not if there aren't ships to get the oil over here. Then that's your bottleneck. Or maybe refineries would be your bottleneck. At the end of the day, OPEC is going to be the source of incremental supply and it will take a long time to do it. In the meantime, I think a lot of the power has shifted away from them. "And, really, what's changed is that for 20 years you've had this glut of excess capacity in every element of the energy chain. That's all running out at exactly the same time."

Bryan Dutt: I think Marshall is dead right and I want to make one quick point. And that's that the past 20 years of undercapitalization in the industry was economically rational because the rates of return have been abysmal. We're, frankly, a politically incorrect, dirty, polluting, mean-spirited industry, in the U.S. at least. And now we're having to pay for 20 years of underinvestment in this industry. And it's a commodity, despite what we say, it's marginal supply and demand, and we've gotten to the point where supply is just not meeting the demand.

Christopher Edmonds: But it seems odd to some, at least to me, that we didn't have signs of this impending shortage? It seems we should have been smart enough to see this coming? Why didn't we?

Dan Pickering: It's the commodity nature of the business. If you have one excess molecule, it's one excess molecule too much. Well, right now, we've run out of those excess molecules.

John Segner: Look at where the average observer of any industry looks for certain clues about the health of the business. In energy, one would certainly be commodity prices. Look at 1998. Look at early 1999. Look at $10 a barrel. You're down 50% or 75% year on year in early 1999. And what were the industry participants -- particularly the big companies like Royal Dutch Shell (RD Quote - Cramer on RD - Stock Picks) and Exxon Mobil (XOM Quote - Cramer on XOM - Stock Picks) -- doing? They're slashing budgets and slashing headcount. And they're getting ready to exist forever in a world of $10 to $15 oil. Remember the cover of the March 1999 The Economist, "Drowning in Oil."

How does an average observer predict something like that, like what's occurring, when literally, almost yesterday, we had incredibly low prices and everybody in the business is telling you it's going to be like that for a long time. So I don't think the industry has historically done a good job of analyzing its own supply and demand and preparing for it. Part of it is what Bryan was talking about, you get beat up forever in both the stock market and your daily operating environment. You get very used to thinking the good times won't last very long and then the bad times will come back, and you get ready to slash and burn all over again.

Christopher Edmonds: Does that mean we're back to the top of the cycle, where pricing leads to euphoria and drilling at all costs and the same bust-follows-boom predicament that seems to haunt the industry?

Dan Pickering: Well, the industry is being a whole lot more constrained, as the spending pattern is actually pretty slow. Most companies are still assuming we're going to go back to the $18 or $17 kind of world.

Now you're starting to see some spending increases occurring. Eventually, we'll go to too much capacity, but that's years off. And we'll go through a prolonged period where we'll have to build additional capacity. The length of the process isn't really that unusual, as there have been very long up-cycles and very long down-cycles.

Bryan Dutt: I don't think there's any euphoria in these stocks. I don't see any euphoria among the companies; the only two people that have been euphoric have been my esteemed colleagues Dan Pickering and Marshall Adkins. And, to date, they have been correct.

John Segner: There are a couple of other things I think are important to think about here. One is, energy companies don't believe it yet, and you can see that in budgets. Oil company budgets are being set at mid-to-high teens oil prices and $2.50 to maybe $3.50 gas prices, depending on the size of the companies. Bigger companies are more conservative.

So the companies don't believe it yet, so there's no boom going on, per se. I mean, activity levels are rising, but I wouldn't call it a boom mentality yet. "We're, frankly, a politically incorrect, dirty, polluting, mean-spirited industry, in the U.S. at least. And now we're having to pay for 20 years of underinvestment in this industry."

Christopher Edmonds: There's one other aspect to the oil problem that we should discuss and that's logistics. In addition to supplies of crude oil, many of you suggest we have problems with refining, with tankers and delivery and other issues. Bryan, are these issues we should be concerned about?

Bryan Dutt: Well, two of my biggest holdings are tanker companies right now, so I guess I would say absolutely. Tanker companies are trading right now around three or four times 2001 earnings because people are afraid OPEC is going to decrease production next year with an economic slowdown and inventory builds. So it's an industry that is very attractively priced.

It's also the only oil field industry that I know that's really an environmental play because of the double-hull issues with potential tanker problems and polluting. You know, another Exxon Valdez.

So you have old tankers that are leaving the market in an already extremely tight market. You've got an environmental issue that suggests that you have to retire these old, single-hull tankers, and they're trading at incredible multiples. One play is Nordic American Tanker (NAT Quote - Cramer on NAT - Stock Picks), which is trading at about $20 and will have roughly $1.35 distribution this quarter. So it's yielding close to 30%.

Another one is Frontline(FRONY Quote - Cramer on FRONY - Stock Picks), trading at about $13. They'll probably have earnings close to $6 in 2001.

Christopher Edmonds: Jeff, what about refining bottlenecks? Does that problem remain?

Jeff Dietert: On a worldwide basis, refining utilization is about 90%, with the U.S. at about maximum capacity. Other than some outages for plant maintenance, Europe isn't far behind. The only excess capacity, really, is in Asia. And then you have to navigate around the tanker issue. Asia is a long haul from the U.S., which is where most of the real demand is growing rapidly. Without the refining infrastructure growing to meet increased demand in the U.S., the supply issues will continue.

Christopher Edmonds: What about capacity creep, the ability of refiners to increase refining capacity without building new infrastructure? Does that kind of expansion hold any hope?

Jeff Dietert: Refiners are constantly trying to eliminate bottlenecks, so you do see existing refining capacity in the U.S. creep up a little bit without the addition of any new refineries. However, most of the refiners have done all the de-bottlenecking they can do, and they're much more constrained in their ability to expand their existing refining capacity. That's changed in just the last two years, when many of the independents had a slate of internal growth projects. We're not seeing very many of those this year. It's been a big change over the last two or three years.

Christopher Edmonds: So the consensus is it's not only actual oil supply, but there are other issues that are important in price determinants.

John Segner: You know, just like California hasn't built a power plant, refining, we haven't built a new refinery since the Valero Refinery was finished in 1983 in Corpus Christi [Texas]. And today, you probably couldn't get one even approved under existing regulations.

Christopher Edmonds: Or permitted, or even sited for that matter?

John Segner: Or sited or permitted. Yet demand has continued to increase. We put heavier regulations on the refineries all the time. We reformulate gas and other things and all these things are basically taking, sometimes, very old plants and trying to dress them up and keep them running, and it's not always the most efficient.

To find out where each Roundtable participant thinks oil prices will end the year 2001, read Part 2, or leap ahead to Part 3.