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Finding Value With Energy

Learn why many names in the oil patch are still cheap.

With energy prices playing an ever-increasing role in a variety of markets and in the health of the overall economy, it's not a bad idea to turn to an expert for insight about where we've been and, more importantly, where we might be going.

John Dowd, a fund manager at Fidelity Investments since October 2005, manages the firm's Select Energy Fund, Select Energy Services Fund and the Select Natural Resources Fund. He just returned from a monthlong tour of oil and gas facilities in several countries, and I spoke with him about how he picks energy stocks, investors' unhealthy infatuation with commodity prices and current trends in the energy complex around the world.

Here's some of what he had to say about what he's watching and what he expects for the future. How do you pick stocks for your funds?

John Dowd

: You could say that I have a value bent. I try to buy companies whose stocks are cheaper than the cost of replacing their assets. I'm usually not trying to figure out whether natural gas stocks will outperform oil stocks. Instead, I try to determine if an exploration and production company is selling for less than its costs for finding and developing energy reserves. Is a refiner's stock selling for less than it would cost to initiate a physical expansion at its refinery?

If you overlay a chart showing recent price movements for


(CVX) - Get Chevron Corporation Report



(COP) - Get ConocoPhillips Report



(XOM) - Get Exxon Mobil Corporation Report

with the price of crude oil, the charts appear to be nearly identical. Doesn't this suggest that stock prices for oil and gas companies are tied to the price of oil?

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It is definitely fair to say that energy stocks move up and down with a commodity. However, the more you look at a company over the long term, the more earnings and cash flows count, and the less commodity price movements count.

In reality, they both matter. A stock's sensitivity to commodity prices varies significantly depending on the value of the stock. When oil stocks are expensive and oil prices decline, stock prices suffer. When stocks are cheap and the oil prices jump, stocks generally do well. When oil stocks are cheap and the commodity declines, stock prices generally don't decline much. Think of stock valuation as risk control.

In October 2005, natural gas was selling at $12 per million British thermal units. A year later, natural gas was selling for $8 per MBTU. However, over the same period, the S&P exploration and production index went up. That shows you that stocks and commodities don't always move in the same direction.

The catch to managing money correctly is to pick the right stocks and the right position sizes. You need conviction to do both. You get conviction by performing detailed earnings analysis. If I spent all my time trying to guess where gas prices were going, I wouldn't sleep at night, and I wouldn't have any conviction to do my job.

What subsectors within energy are currently attractive investments to you?

The E&P group looks attractive, as do the refining group, oil services and some rig companies. In each case, you have excellent companies that are trading well below their asset values. Looking for value is not an academic exercise.

Integrated oil companies deserve a space, but it really comes down to technical stock-picking in that group. The integrated firms are not as cheap as the independent E&P companies.

In refining, I see two trends. First, refining capacity is being expanded because the quality of the crude oil being produced is deteriorating. More and more crude oil is sulfurous and dirty. This crude oil is expensive to refine, and lots of existing refineries can't refine dirty oil in their existing conditions. Secondly, everyone engaged in new projects is finding that there is a shortage of engineering and construction labor. Costs are growing tremendously.

I just finished traveling around the Middle East, India and Mexico. I am amazed at the economic growth in the Middle East and India. I am not an economist, and I generally try to limit those issues from my decision-making. However, I admit that being constantly stuck in traffic in those places has changed my opinion for the projected growth of energy demand globally.

The oil services companies in those markets are very enthusiastic. The difficulty of drilling new fields is increasing. That bodes well for the sector.

You previously said that funding and development costs are an issue for E&P companies. Why are they important?

Funding and development costs are calculated by adding the costs of exploration and development and then dividing that number by the addition to proved reserves during the period. Comparing F&D costs to natural gas prices allow you to determine if it is economical to drill wells. Recently it hasn't been economical to drill in North America. Last year, there was a large inventory overhang, so natural gas prices fell in order to eat up that inventory.

F&D costs have been climbing steadily, and were north of $3 per thousand cubic feet this year. At that cost, natural gas prices need to be above $7.50 to earn a fair rate of return. Natural gas prices have recently been volatile, and were down near $6.50 per million British thermal unit at the beginning of this year.

When F&D costs are high, an alternative to drilling for new reserves is to acquire them. A comparable metric for acquisitions is to take the enterprise value of a company and divide it by its proved reserves.

Are there any subsectors of energy that are ripe for M&A activity?

The whole industry is set. I know that it seems crazy to think of energy as a value play when oil is so expensive, but it is. Compare stock prices to asset values. Energy stocks are cheap. Also, oil companies are generating lots of free cash. Acquirers can buy energy companies for a lower price than it would cost to replace them.

I've heard analysts say that the best M&A targets in energy are firms with high labor costs. Is that true?

It makes sense in a way. Labor is very tight right now. Everyone is looking for labor right now, so buy a company that has that labor. Also, everyone is looking for rigs to drill new wells, so buy companies that own those rigs.

A variety of technologies are in development to pursue stranded natural gas (natural gas deposits that were previously inaccessible). These technologies include gas-to-liquid, coal-to-liquid and gas-to-solid. Do any of these technologies offer good investment opportunities?

Fertilizer is the original way of monetizing stranded gas, and I think it is still the most economic vehicle. Natural gas is a feedstock for fertilizer. Exxon recently decided not to go ahead with a gas-to-liquid plant in Qatar. This suggests that new technologies like gas-to-liquid and coal-to-liquid systems are highly speculative and far from profitable.