Mr. Oil's Wild, Slippery Ride Continues

It hasn't been a great year for many sectors, but oil has bested most. We take a look at its future.
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After writing about oil and gas exploration companies in September, I followed up with a second and then a third piece. The common theme was that oil and gas producers might be a good long-term play, a sector that could reward investors during the next several years.

Since then, the so-called E&P companies have been on a roller coaster of a ride. As measured by the benchmark

American Stock Exchange Oil & Gas Index

, the XOI, the group has lost about 2.6%. That's not so bad when compared with what the

Nasdaq Composite has done in the period -- down 26%, or 10 times more.

But it's not great either, and certainly not on par with either the XOI rally of early 1999 or the surge this year from February through June. (If you're an institutional investor benchmarked to the

S&P or some other index, of course, 2.6% down in the past 10 weeks sounds pretty darn good. But, let's talk absolute return here for folks who spend real dollars when they shop or distribute real dollars to their partners.)

Meanwhile the oil service stocks, which I thankfully haven't written much about, have had a tougher time. Not as bad as the Comp, of course, but losers nonetheless, down a good 20%. From a technical point of view, the group as measured by the

Philadelphia Stock Exchange Oil Service Index

has broken below its longer-term moving averages, never a good sign in any sector.

Meanwhile, the fundamentals for the oil service companies have yet to improve much. This is worrisome in as much as oil in the past few years has risen from $10 to $35 a barrel, and there has yet to be a comparable surge in demand for rigs.

Obviously, the market questions the wisdom of the bet on oil and gas. Is the market saying that even with oil at $31-$36 a barrel and natural gas at $4.25-$6.25 per million BTUs, E&P stocks are not worth the risk? It's a bit more complex than that.

Bucking Trends

UBS Warburg

E&P analyst William Featherston sees three concerns bugging investors in recent weeks. The first, he notes, is doubt that $35 per barrel for oil is sustainable. The common wisdom on Wall Street is to assume oil in the mid-$20s. A second concern may be that energy stocks have in recent years been seasonally weak this time of the year. Many trend-following investors may be holding off until early next year, the season when these stocks have tended to bottom. And third, says Featherstone, some investors may worry that next year the E&P stocks will have a difficult time showing good earnings per share comparisons with this year.

Featherston is, as you might imagine, a bull on his sector. Back in September, he was recommending a small posse of E&P stocks. Here is how some of them have done since I mentioned them.

Anadarko Petroleum

(APC) - Get Report

is flat,

Apache

(APA) - Get Report

is down 2%,

Burlington Resources

(BR) - Get Report

is up 8%,

Devon Energy

(DVN) - Get Report

is down 10%, and

EOG Resources

(EOG) - Get Report

rose 10%,

Newfield Exploration

(NFX)

slipped 3% and

Swift Energy

(SFY) - Get Report

fell 6%. (UBS has a banking relationship with Devon, EOG and Newfield, according to Featherston.)

I'd add a fourth unspoken concern out there. A lot of oil stocks are up 50%-100% in the past year, and the value buyers who got in early have a hard time loading up at current prices even if they are off the highs. And growth investors, in the main, are not yet ready to pile in because they don't see the revenue growth prospects they need to see.

Nonetheless, I still like the oil and gas producers. So do Featherston, top-rated

Merrill Lynch

oil analyst

John Herrlin

and one of my favorite all-time market strategists, Byron Wien of

Morgan Stanley Dean Witter

.

Featherston says: "We are enthusiastic. We are not pounding the table. We would not characterize

the sector as easy money, but we still see a 30%-40% upside. I do agree that gas prices could play out over a multi-year period. Gas production has essentially been flat for six years, which has been masked by unusually warm winters and increased imports from Canada. But Canada itself is now beginning to see domestic demand catching up with Canadian production. And, despite last year's warm winter, we are staring at $6.45 per million BTU gas. In addition, a lot of new electricity generation plants are being built and almost all of them are gas-fired. That means the secular demand for gas will grow." (He forecasts 3% annual growth in the demand for gas at a price of $3.00-$3.25 per million BTU over the next several years. He looks for oil prices to remain in the $25-$30 per barrel range in 2001.)

Won't that improved demand and pricing lead to equal and offsetting supply increases? Featherston thinks not for quite a while. "Oil and gas production have been in decline since the early 1980s and bottomed in the 1990s. We need a giant pool of oil and gas to meet the demand going forward. The only places in North America are the Gulf of Mexico, Alaska's North Slope, Northwest Canada and water offshore eastern Canada."

He figures it will take a good five to seven years to get that oil and gas to market. So, he looks for higher prices, especially for natural gas, in the meantime. Higher prices translate into higher revenues. He notes also that some companies will be able to boost production via aggressive drilling programs or acquisitions of other companies with proved reserves. For example, he expects Apache to increase production 25% next year via acquisitions, which translates into an 18% a share boost in production.

Featherston also sees reasonable valuations among the E&P stocks. He figures that his universe of stocks trades at around seven times cash flow, slightly below the group's three-year average.

Raising the Bar

Merrill's Herrlin today increased his firm's natural gas price forecast to even higher levels than Featherston.

Herrlin said in a report that gas prices are more volatile than at any time in his career and should conservatively remain at the $4 level in 2001. "With respect to stocks," he writes, "we believe that the market will need to see that prices stay stable in the winter, not necessarily $6-$7/Mcf

thousand cubic feet, which is the equivalent of one million BTUs that some speculate about, but about $4/Mcf. If that occurs, oil prices stay firm and world economies absorb higher prices and the U.S. presidential election, we think that there will be a serious institutional move back into the E&P stocks because they're selling at record low

price/earnings per share or price/discounted cash flow per share multiples." (Merrill's Canadian oil and gas analyst Randy Ollenberger today also increased his oil and gas estimates. Merrill's new oil price assumption for 2001and 2002 is $25 per barrel.)

And then there is Morgan Stanley's Wien. He took a flier late last year by predicting, "The price of crude oil moves above $30 and stays there as growth throughout most of the world exceeds expectations and supply remains under control.... Oil service stocks rally,

Halliburton

(HAL) - Get Report

($40),

Schlumberger

(SLB) - Get Report

($56) and

Smith International

(SII)

($50) have big gains." Byron gets a star for the call, even if only Schlumberger and Smith rallied as predicted.

Wien still likes the sector, even though his firm is less enthusiastic. In a report this week, he writes, "I continue to like the energy sector because I do not think the oil price will decline to the $25 level expected by the consensus."

He still sounds right to me. Sometimes trends last longer than you think. Take a look at the energy sector. Obviously, there are many more stocks to choose from than I have mentioned. Drill down for yourself. You might be pleasantly surprised at what you find.