New Energy for Coal

With oil prices touching a 13-year high of $38 dollars a barrel recently and OPEC set to meet March 31, it seems like a good time to check the meter on the energy sector. We asked Daniel Rice, manager of the $503 million ( SGLSX) State Street Research Global Resources Fund, to take us beneath the surface of crude oil, natural gas and coal stocks.

What are you telling investors right now looking to invest in energy stocks?

The major thing that we emphasize is that there is a general complacency in the U.S. energy market that we have more than enough coal to satisfy demand, and that can have serious ramifications for our entire industrial economy, if that assumption proves to be wrong. Fifty percent of our electricity is generated by coal, as opposed to 15% by natural gas and only 5% by crude oil. To put that in perspective, the U.S. uses 22 million barrels of oil a day in total consumption, and the oil equivalent of 10 million barrels of natural gas. When it comes to coal, we consume the oil equivalent of 8 million barrels a day to make electricity.

What's your outlook on the energy markets, with oil and natural gas prices trading at such high levels?

We are somewhat cautious on the near term but pretty bullish four to five months out. We think there will be a significant event later on this year -- that event being coal shortages in the U.S. -- that will lead to sharply higher natural gas prices late in the year.

How do coal prices affect natural gas prices? I see that you hold quite a number of coal stocks in your portfolio.

If you can't run your coal plants because you don't have coal, the only other way to make electricity in this environment is natural gas, which will create, in effect, spot shortages of natural gas. On a barrel of oil equivalence, crude oil is currently trading for $37 a barrel, natural gas is about $33 a barrel, and coal is about $15 a barrel. In the next six months, we see coal prices to continue to go up to $20 to $25 a barrel. Natural gas comes down a touch to $30 a barrel, and oil goes to around $30 a barrel.

State Street Research Global Resources
Top Five Holdings*
Consol Energy (CNX)
Western Gas Resources (WGR)
Arch Coal (ACI)
Penn Virginia (PVA)
Massey Energy (MEE)
*As of 3/23/04. Source: State Street

Demand for natural gas and oil is growing in the world, especially because of growth in China. What is the current state of supply?

On the oil side, that's an accurate assumption about demand. On the natural gas side, however, demand is coming from increased electricity consumption in the U.S. Last year, electricity demand was up 2%; so far this year it's up 3%. That's one indication that the industrial side of the economy is strengthening somewhat. It takes power to make electricity. To put it in perspective, 3% growth in electricity demand means consumption of an additional 60 million tons of coal or roughly 4 Bcf (billion cubic feet) a day of natural gas.

So where should investors go to play this increase in demand: oil, coal or natural gas stocks?

The best area is still coal. Our top choice is Consol Energy ( CNX). Even though spot coal prices have gone up dramatically, the market is assuming that coal prices will come down dramatically in the next one to three years. We think that's a wrong assumption, because we are not getting the supply response in the foreseeable future.

What about natural gas and crude oil?

We think the market is discounting natural gas prices to be $4 to $4.50. We believe natural gas prices will be $5 or so. That leaves you some upside, but the market has been pretty good about assessing the upside possibilities in natural gas. Our favorite in the group is Newfield Exploration ( NFX). But it has quite a bit less upside opportunity than say, Consol Energy. On crude oil, the market is assessing long-term prospects to be about $22 a barrel. We believe longer-term prices will be $26 to $28 a barrel, and in that environment, oil stocks are more attractive than natural gas stocks. The market has been much more conservative in its views for oil, which leaves much more upside in the oil stocks. And our two favorite names are Baytex Energy Trust (BTX: Toronto) and Plains Exploration and Production ( PXP).

Then why are prices so high now?

The price of oil right now is driven by two elements. One is that we now have a large amount of speculative commodity fund buying, which has boosted prices by about $5 to $6 a barrel -- this is short-term in nature. Then we have the geopolitical risk premium that's probably about $2 to $3 a barrel.

State Street Research Global Resources
Fund Profile
YTD Performance: 5.10%*
3 Year Performance: 21.28
5 Year Performance: 31.10
Expense Ratio: 1.30
Net Assets: $503 million
*As of 3/23/04. Source: State Street

With regard to geopolitics and oil, OPEC is meeting on March 31. What can we expect from it going forward -- especially with reports that Iraq is quietly increasing production; and how will that additional supply affect oil prices?

This will be the third year of OPEC having to delicately balance the oil markets. So far they've been successful. And this will be the last year of their balancing act. After the first quarter of 2005, OPEC's charter is going to be much easier. So this is the last hard year for OPEC, which is worth noting.

We are struck macro-wise by the lack of significant new oil finds in the world over the last couple of years. Most of the basins of the world have at least now been initially explored, and the results have been rather disappointing. So we feel that the world will have to rely more and more on OPEC sources, at least Middle East sources, of crude oil to sustain the growth of world oil demand.

I would take exception to the notion of Iraq dramatically increasing production. We think production out of Iraq will be anywhere from 2 million to 2.3 million barrels for the next six months or so, and exports will be 1.7 million to 2 million barrels a day. There won't be a surge in Iraq production that will undermine OPEC.

So what are the best names to buy if you want to play the energy sector?

We run a small-cap fund and small-cap names tend to be more sensitive to underlying commodity prices. I would rather own a small-cap name than any large-cap name like Royal Dutch/Shell or Exxon Mobil, where you are not getting such exposure to the underlying commodity because they have so many other diverse businesses and contrary businesses that kind of mute the effect of high or low gas prices.

What are some of the names you like in the small-cap energy arena?

On the E&P (exploration and production) side, we like Plains Exploration & Production, Baytex Energy and PetroKazakhstan Inc. ( PKZ). But it's worth noting that four of our top five holdings are coal stocks.

We keep hearing from analysts that energy stocks are currently overvalued in the market. What is your opinion?

I think if they are only discounting a $22 barrel crude price -- and we believe crude prices will be significantly higher than that -- then energy stocks are undervalued on a long-term basis. Same with perceptions on where natural gas prices will be and coal prices. So based on those market perceptions, we think prices are undervalued regarding where they will be on a long-term sustainable basis.

What about prices at the pump going into the summer? If they continue to go up, how might that trickle back to the stock market?

There's almost no correlation between what you see at the pump and the stocks. Although the higher the prices are at the pump, the stocks typically do better. But there is not a direct correlation, because what you are seeing at the pump is today's price and the stock market is a discounting animal and tries to guess where prices are going to be six months down the road.

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