The TSC Energy Roundtable, Part 3

This is Part 3 of the convocation of Chris Edmonds' TSC Energy Roundtable. To return to Part 2, click here. To return to Part 1, click here.

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Christopher Edmonds: As with crude oil, let me put you on the spot about natural gas prices. Where, as we wrap up 2001, do you think natural gas prices will finish the year?

Bryan Dutt: Well, unfortunately, 12 months from now will be the middle of winter, so it'll probably be high again. I'd say $4.80 per MMBtu. Probably around $5 for the year average, as well.

Doug Hohertz: If we just overlay last year's withdrawals out of storage, which was an incredibly warm winter, we'll get down from where we stand currently, we'll be down to 440 Bcf in storage. And if we overlay injections from last year that would only put us back up a little under 2.2 Bcf at the end of October. Hopefully we'll do better than that, but I don't think we're going to get a whole lot better.

So I'd say we're probably going to be around, at this time next year, $6.50 to $7. And that for the year we're going to average a little over $5.

Marshall Adkins: We just raised our official Raymond James' forecast to $5.75 for the year. Again, front-end loaded. That's our official forecast, but I personally think you're going to see it meaningfully higher. I think we could probably average some high single digits -- $8 is not an unreasonable guess.

John Segner: You're talking to somebody who's been doing this for a while and used to be glad when I would see gas over $2. So I'm going to take the conservative view. I tend to agree with Bryan. I think we'll see an average price around $5 next year. Maybe somewhat above that at the end of next year and the bias is probably higher. We have had a lot of rigs drilling. We have not seen a supply response particularly, and that's because the existing depletion of existing production is so high that we may need to have higher sustained drilling activity to regain some balance. Nevertheless, I wouldn't be surprised to start seeing some production increases as we get into the new year. And that, along with higher prices that may minimize demand growth for natural gas, may keep natural gas where it doesn't go quite as high as $8 or $9.

Dan Pickering: $4.30 for the year. $4.10 for the fourth quarter, with an upward bias to both numbers. I'm skeptical of the high number. Not because the supply side is going to overwhelm us, because I don't think it will, but we see too many things on the industrial demand side that are falling out of the equation in glass plants, aluminum and other industrial companies. I think there are other alternatives right now, like $28 crude, that look much cheaper. So I'm a little skeptical of the superhigh prices, although I completely agree with the whole issue of inelasticity of demand. We could have a $30 first quarter that makes an $8 average look light. After all, when Grandma's cold, she turns on the heat. She doesn't say, "I wonder what it's going to cost me to stay warm?"

Christopher Edmonds: But won't the fact that large industrial customers will quit using gas offset inelasticity at the consumer level?

Dan Pickering: That didn't happen in California. They were at $50 gas for a while. With Kaiser selling into the grid like a wild man.

Marshall Adkins: It will certainly start to impact over the course of a year, but for the winter, industrial consumption is maybe 20 Bcf a day. Our numbers are showing the second half of this winter, you could be about 10 Bcf a day short. So assume you knock out half of all industrial use -- and you really can't knock out more than 20% without dire consequences -- if you knocked out half, then you're still just getting close to balance.

Christopher Edmonds: Marshall, your numbers are predicting we come up 300 Bcf short by the end of winter I think. And doesn't that assume a normal winter?

Marshall Adkins: Right, if we assume normal weather for the balance of the winter.

John Segner: And the stocks don't reflect anything near those prices or those storage numbers.

Dan Pickering: Right, you have the stocks reflecting $2.75 to $3.50 gas, maybe.

Bryan Dutt: Well, I've got to give credit to Dan and Marshall. On the sell side, it's extraordinarily difficult to go up and put out high commodity prices, because you can lose so much credibility. I think a lot of the Street is very reluctant to go out and use numbers like these, even if they think they're right. They may talk about them privately, but they won't publish them.

Christopher Edmonds: Before we get to stock picks, I do want to ask you about the California situation. Let me ask this generally. We know what the problem is: There is not enough power to meet the demand. But, what's the solution?

Jeff Dietert: The problem is that we have not been investing capital in this business for over 10 years. If you look at when deregulation has come into effect, just recently, over the last couple of years, now we have over 300,000 megawatts of announced generation under development. The capital spending is coming back and it will eventually solve the shortage, but it's going to take some time and we have to battle through getting permits and siting facilities in areas where the people in the immediate vicinity don't want plants.

But the capital is coming back into the business and the problems are being solved. It just takes a lot more time than we'd like it to. "I mean, the regulators could go pat themselves on the back, because that caused an enormous part of the problem right there alone."

Christopher Edmonds: But it doesn't appear the timing is very good. Almost 100% of this generation is gas-fired generation at a time when natural gas prices are at all-time or near all-time highs. Doesn't that put a lot of additional pressure on gas prices?

John Segner: Well, what other plants are we building in this country? Deregulation isn't the reason we're building natural gas plants. That's the only plant that can pass regulatory scrutiny. We're not going to build coal plants. You can't build a dam in this country. You're not going to build a nuclear power plant in this country. And wind is a small percentage of overall generation. It probably works in some regional areas, but remember, the windiest times of the year are the fall and the spring and the big issues of electricity are in the summer and winter, so it doesn't match.

That's why virtually every plant being built in this country is natural gas -- it's almost by default.

Doug Hohertz: I also think regulators can take a fair share of the blame. Every state has its own standards. This patchwork set of standards is causing a lot of confusion. That also creates a lot of unknowns. And, in such a capital-intensive business, you're unlikely to commit significant capital until you know, with some certainty, what your returns are likely to be.

So you have some delay that goes on just because, from a federal and state level, primarily a state level in terms of the utility, there are too many unknowns out there for companies to be able to commit that type of capital, because they have no idea what their return on capital is going to be. And they have to answer to their shareholders.

So there was some delay there. And then you get, in California's case, restrictions on the use of long-term contracts and having the power exchange set up whereby the highest bidder set the price. I mean, the regulators could go pat themselves on the back, because that caused an enormous part of the problem right there alone.

Marshall Adkins: In other words, you deregulated parts, but not all of them.

Doug Hohertz: But not all, yes. And that doesn't work.

Marshall Adkins: Jeff, with 300,000 megawatts now planned, what could that mean for natural gas demand in the next couple of years?

Jeff Dietert: We're looking at adding between 1.8 and 2 Bcf a day, on average, over the next two to three years, per year. And remember that that doesn't come ratably across the year, because a lot of those are peakers in the summertime, so you may see 4 Bcf a day added to the July and August numbers and a smaller number during the rest of the year.

Marshall Adkins: So, in 2001 and 2002 you're looking anywhere from 4 to 7 Bcf per day?

Jeff Dietert: That's about right.

Christopher Edmonds: That's raises an important point about gas storage. Traditionally, gas usage has peaked in the winter and the rest of the year has provided time to rebuild reserves. Now, gas will peak twice, in the winter, as is traditional, and again in the summer. When do we build supply?

Doug Hohertz: You're going to inject in the shoulder months, spring and fall.

Jeff Dietert: But if your summer demand does approach your winter demand, you're going to need twice as much natural gas storage capacity as what we've got now.

Christopher Edmonds: This is a significant change in demand dynamics. As an investor, are there ways I can play this emerging trend?

Jeff Dietert: I don't think there's a company that's better situated than El Paso Energy (EPG Quote - Cramer on EPG - Stock Picks) in the natural gas business. They've got an E&P business, so they do have some commodity exposure, but most of their business is gathering, processing, transportation, marketing, trading and risk management. They play throughout the natural gas chain, with very little crude oil price exposure. And I think they are, by far, the best way to play what we believe are extremely strong natural gas fundamentals.

Christopher Edmonds: Anybody else?

Doug Hohertz: I think you can play a lot of the E&P companies, because assets in the ground are valued very cheaply with this sector. However, if gas prices rise and remain at higher levels, as we all expect, then the value you place on reserves these companies hold in the ground will rise dramatically. And, with utilities looking to lock in gas supplies over long periods of time, those values can be sustained. So E&P companies, those that have a lot of gas exposure -- especially longer-life gas -- are going to be very interesting to look at. "I don't think there's a company that's better situated than El Paso Energy in the natural gas business."

Christopher Edmonds: Any names?

Doug Hohertz: Anadarko Petroleum (APC Quote - Cramer on APC - Stock Picks) and Apache (APA Quote - Cramer on APA - Stock Picks) are doing quite well. Ocean Energy (OEI Quote - Cramer on OEI - Stock Picks) still has a lot of gas exposure both onshore and offshore. Also, a name that's still pretty cheap, that just came out recently, a little company called Westport Resources (WRC Quote - Cramer on WRC - Stock Picks) has good gas exposure onshore. Another name that everyone probably knows is EOG Resources (EOG Quote - Cramer on EOG - Stock Picks). It has been doing very well but is a very, very reliable gas play.

So there's quite a few names out there. Devon Energy (DVN Quote - Cramer on DVN - Stock Picks) is another one that has tremendous gas exposure in the U.S. But the group itself is going to do very well, as natural gas valuations rise.

Christopher Edmonds: Let's wrap up with three questions. I'd like your thoughts on where the three major equity indices will finish the year -- the Philadelphia Stock Exchange Oil Service Index, or OSX, the American Stock Exchange Oil Index, or XOI, and the American Stock Exchange Natural Gas Index, or XNG.

Marshall Adkins: Since I focus primarily on the oil service stocks, I'll stick to the OSX. But the OSX, I think the end of next year is going to be pushing 200. I'll stick to the land drillers, mostly larger companies. Nabors Industries (NBR Quote - Cramer on NBR - Stock Picks) is one of our favorites. UTI Energy (UTI Quote - Cramer on UTI - Stock Picks) and Patterson Energy (PTEN Quote - Cramer on PTEN - Stock Picks) would be the other two. All three share the same, basic story, just different sizes. All three of those I think have very, very good earnings visibility, not only in the short term, but will see great earnings progression through the year.

Christopher Edmonds: Bryan?

Bryan Dutt: I believe the OSX will be at 195. In terms of my three picks my favorite would be Maverick Tube (MVK Quote - Cramer on MVK - Stock Picks), which is trading just above $20. It was $30 eight weeks ago; I think it could be $30 in a very short period of time, trading at about 11 times 2001 earnings. It's the only company I know of that actually benefits from a worldwide recession because its feedstock is steel -- steel stocks are going down, and that's a tremendous bottom-line benefit to them.

I mentioned before, Nordic American Tankers. Again, that's going to yield roughly 30% next year, with some tax advantages to that yield.

And on the gas side, there's a small, but exponentially growing E&P company called Ultra Petroleum (UP:Toronto). They just had a sweetheart merger with Pendaries Petroleum, which got a concession in China. So you take the North American unhedged exponential gas growth they have, combined with a world-class Chinese concession. It's going to be listed in the U.S. I think there's going to be a lot of very avaricious investment bankers are going to push this stock.

On the short side, I would have a paired trade: short Spinnaker (SKE Quote - Cramer on SKE - Stock Picks). They have 120 Bcf, with a market capitalization of $800 million. And I've paired that off against Westport Resources, which has almost twice the reserves and still doesn't have the same market capitalization.

Christopher Edmonds: Doug, I think you have long positions in both those stocks. Any thoughts?

Doug Hohertz: Well, we like both those names. Petroleum Geo Services (PGO Quote - Cramer on PGO - Stock Picks) recently sold their Spinnaker holdings and the stock has had a tremendous rebound, and we've done very well with that.

A high valuation on prudent reserves, no doubt, with the company, but they have a tremendous growth profile and are having very consistent success with their exploration and development activities in the Gulf.

Westport is a true value play. Top management, good long-life assets and you can get it for a good price. So I say we like both of them for different reasons. One has a high-growth profile and the other is a well-run company that's a good value play at these prices.

Christopher Edmonds: Any other names that intrigue you and your thoughts on the energy markets, in general?

Doug Hohertz: Ocean Energy, which I mentioned earlier, is a name we've been with for a long time. They not only have a lot of North American oil and gas exposure, a lot of gas exposure in the shelf, and they are a very prospect-rich E&P company. One of the things we're looking at right now is who has the prospect. That's because in a sustained commodity price environment like this, acquiring new properties or acquiring companies is going to be very expensive. And it's likely to get more expensive.

And those who have the inventory in-house and the acreage to develop and work already in-house are going to do very well. And Ocean fits that well. They have tremendous international exposure with West Africa, Egypt and Bangladesh. They have tremendous amount of international exposure as well as very strong plays here in the U.S.

We also like Tidewater (TDW Quote - Cramer on TDW - Stock Picks). We like a little company up in Canada, Ensign Drilling (ESI: Toronto), which is a land driller up there. Ensign stands to benefit dramatically from what should be a prolific drilling season up in Canada.

And for an oil play on the service side, we like Coflexip (CXIPY Quote - Cramer on CXIPY - Stock Picks). It's a little longer term, looking out there a little further, but given the magnitude of the focus in the deep water around the globe on exploration, they will benefit tremendously over time.

As for the broader energy index, I think the OSX will be at 180 or above by the end of the year. That would be a solid year. "Ensign stands to benefit dramatically from what should be a prolific drilling season up in Canada."

Jeff Dietert: I'll say the natural gas index, XNG, will finish 2001 up about 30%. We talked about El Paso Energy as a way to play the natural gas side of the business. For an electricity play, I'd take a look at Dynegy (DYN Quote - Cramer on DYN - Stock Picks). And I would add independent refiner, Valero (VLO Quote - Cramer on VLO - Stock Picks).

As far as companies to avoid, I would say Pacific Gas & Electric (PCG Quote - Cramer on PCG - Stock Picks) and Edison International (EIX Quote - Cramer on EIX - Stock Picks). I think that there's a high chance they'll seek bankruptcy protection. I think the state will come to their rescue and guarantee the electricity payments, but when you're focused on the regulatory issues as much as they're going to have to be, you're not going to be focusing on business issues.

Christopher Edmonds: You leave Sempra Energy (SRE Quote - Cramer on SRE - Stock Picks) out of that mix?

Jeff Dietert: Yes, I think Sempra -- for a number of reasons -- has less exposure than the other two California utilities. But, overall, it's not a constructive situation right now.

Dan Pickering: I think I may be the most conservative on where we're going to be by the end of the year. I'll hedge my predictions by saying that if we hit a recession, I don't think you'll make money in energy. I think you will outperform the market but I don't think you'll make money. That's not my base scenario, but I just want to note that.

Having said that, given a more moderate economy, I think the oil index, or XOI, will be flat, the natural gas index, or XNG, will be up 25% and the oil services index, or OSX, will rise 35%. That's my guesstimate, so that makes a 160 OSX, a 315 XNG and a 510 XOI. And those returns significantly outperform the broader markets. I think we'll have a fairly flat stock market and big oils tend to perform in line with the market, so I'm saying I think they'll be flat.

My three favorite ideas. First, Apache. A solid E&P company. Decent internal and external production growth with a valuation that reflects something a little bit south of $3 gas and our expectation is that the market is going to discount more than $3 gas. The stock is currently in the mid-60s and we think it trades to around $80.

Idea number two, in the oil service area, is Smith International (SII Quote - Cramer on SII - Stock Picks). This is a company that will earn a buck and a half in 2000 and over two and a half in 2001. In total, over 80% earnings growth trading around 26 times 2001 numbers. We think the Street's estimates are light, probably a dime or more at this point. Fourth quarter looks solid, so you're talking about a $70 name with upside to $90.

Our third idea is Global Marine (GLM Quote - Cramer on GLM - Stock Picks). It's trading at less than eight times peak earnings and we think it can get 10 to 12 times peak earnings. A $25 stock, we think it trades to $40. Great near-term earnings visibility. Sixty-five cents this year; goes to a $1.45 next, so you're more than doubling your earnings, about 125% growth.

And I'll throw out here that the names that we're talking about are on the larger-cap side. It's argued that there's enough uncertainty on the macroeconomic picture that, right now, from a casual investor's perspective, dipping down the market cap spectrum is probably a little bit too risky. I think you can make decent money in the bigger market caps -- you have some liquidity so you can flee if you need to.

So the names we talk about here are slightly more expensive than some of the smaller caps, but I think the liquidity issues and, frankly, the visibility issues, the execution issues, are more on your side with some of the larger cap names.

I do buy into, by the way, the land-drilling thesis. The name I have there is Precision Drilling (PDS Quote - Cramer on PDS - Stock Picks). There I think you have the same macro that Marshall talked about with his picks, with a little bit cheaper valuation, a little bit better liquidity than an Ensign, and $35 stock with $50-something upside.

Given what I just said, there are a couple of things I'm nervous about. I'm nervous about the offshore construction business over the short term. I'm not really afraid about it as an investment. I'm nervous about putting money there in the short term, because I think early-cycle stocks are going to outperform late-cycle stocks over the next two quarters. And so I'd be nervous about offshore construction and I'm also a little bit nervous about the offshore supply boat business. That's mainly because capacity is being added there. But I guess I'm more nervous about that 12 months from now than I am six months.

Christopher Edmonds: Gentlemen, thank you. 2001 is already shaping up to be another interesting year for energy investors. We'll check back with you in a few months.