Taking Stock Of 2005
This year has certainly been a profitable one for the energy patch and The Energy Strategist portfolios. As 2005 winds to a close it’s an opportune time to reflect and review some of our key calls and investing themes.
In this issue, I’ll review some of the year’s most memorable recommendations and calls, both those that turned out profitably and those that didn’t work out quite as well as expected. I’ll also take a closer look at the current positioning in the portfolios and some of the key themes as we head into the New Year.
Before I delve into this week’s issue, a brief administrative note: Subscribers will find a detailed description of the goals of each of our portfolios–the Wildcatters, Proven Reserves and How They Rate–at the end of this issue. In this section I briefly outline how the model portfolios can be used to make investing decisions.
A Nuclear Age
Generating almost one-fifth of the world’s electricity, nuclear power is a major contributor to the global energy pie. Nonetheless, while investors follow every twist and turn in the oil and natural gas markets, nuclear power and uranium prices remain largely ignored.
But ignoring nuclear power is a big mistake for investors; uranium stocks have been among the best and most reliable performers in The Energy Strategist Portfolios in 2005. Most of these stocks held up remarkably well even when oil and gas stocks corrected sharply in October and the top pick, Canada’s Cameco (NYSE: CCJ), is up more than 60 percent from our original recommendation back in March. And this trend is far from over; I see major catalysts for uranium stocks and uranium prices as we head into 2006.
I first featured the nuclear industry in the May 26 issue, The Other Yellow Metal. I followed up with a detailed review of uranium mining and processing in the July 27 issue, Keeping The Lights On. To summarize: Nuclear power is cheap and environmentally friendly. And unlike gas or oil, the US is not dependant on imports of uranium from a politically unstable Middle East.
China and India have both recognized the value of nuclear power and are aggressively building out their nuclear generating capacity. China has plans to build 40 new nuclear reactors between now and 2025 while India has committed to building at least another eight by the end of this decade on top of its existing 14 reactors.
Back in July I attended a speech by Prime Minister of India Dr. Manmohan Singh at the National Press Club in Washington, DC. The speech was billed neither as a discussion of energy nor India’s need for new electricity generating capacity. However, Dr. Singh made nuclear power a centerpiece of his remarks and his discussions with President Bush. Dr. Singh stated:
Dr. Singh is completely correct. If India is forced to rely on traditional hydrocarbons for all its energy needs, this wall of demand will spell much higher prices globally. Demand for electricity from China and India has been growing rapidly for more than a decade and is set to explode over the next 20 years (see chart).
Source: Energy Information Administration
By 2025, China’s demand for electricity is projected to exceed that of all of Western Europe combined, approaching the consumption of the United States. India will move from being only a marginal consumer of electricity in 1990 to a major demander in 2025.
Natural gas will undoubtedly meet some of that demand. But if India and China were to rely solely on gas-fired power to meet future needs there simply would not be enough gas production globally to fill the gap.
Coal will likely play a prominent role in both countries; coal-fired power does, however, raise environmental concerns. China already has a big pollution problem in some of its major cities and doesn’t have the low-sulphur coal and advanced scrubber technologies widely employed in the developed world. And as I explained in depth in the July 27 TES, Keeping The Lights On, alternative energy technologies such as wind power are not a suitable large-scale solution for India or China.
Bottom line: China and India are pursuing nuclear power because it’s the only viable way for these countries to meet their vast populations’ electricity needs.
And nuclear is far from dead in the developed world. While no new nuclear reactors have been built in the US since the 1970s, some prominent utilities are examining the possibility of siting a new plant. The energy bill recently passed by the US Congress also contains incentives designed to encourage the building of a nuclear plant in the US. Meanwhile, France continues to generate more than three-quarters of her electricity using nukes and there are plans to build new reactors. And the United Kingdom and Germany have shelved plans to phase out their existing capacity; in both countries nuclear power is a major contributor to energy supply.
There are a couple of different ways to buy into the nuclear story. The most obvious beneficiaries of an expansion in nuclear power capacity globally are uranium miners and companies that process uranium into nuclear fuel.
Uranium is currently in short supply and the utilities are working off very thin inventories. This marks a dramatic change from the ‘90s when inventories and supply were more than sufficient to meet demand. In recent years, global uranium demand has hovered near 180 million pounds annually; total global mine production is, however, only around half that amount. The world’s utilities hold some stocks of uranium and have been drawing down those stocks to meet their needs, consuming roughly 30 to 40 million pounds out of inventories annually.
With the utes sitting on dwindling inventories of uranium, they’re looking to secure new supply. Like coal, uranium is often sold under multi-year supply contracts to utilities–the utes are increasingly paying up to secure uranium under long term contracts from reliable suppliers. This is precisely why my favorite plays in the nuclear patch are the mining firms.
Companies with reliable production of uranium will gradually see their legacy supply contracts roll off over the next few years. As those contracts expire, the better miners will be signing new contracts at much higher prices. This is obviously a big earnings driver.
Mining Information
Our top uranium stock has long been Cameco (NYSE: CCJ), a stock we added to the Wildcatters Portfolio when it was trading in the upper 30s. Cameco’s quarterly conference calls are truly informative; the company discusses not only its own prospects, it also frequently offers commentary on the nuclear and uranium industries at large. Because Cameco is the world’s largest miner of uranium and sits on more than 65 percent of the globe’s known reserves, its management team is uniquely positioned to comment on the nuclear industry.
Cameco has long held that 2008 will be a critical year. Many utilities have projected supply needs that will arise after 2007. They simply do not have the inventories or supply agreements to cover their uranium fuel needs.
In Cameco’s most recent call, management stated that the duration of uranium supply contracts is getting longer. A few years ago, utilities were willing to accept uranium supply contracts of roughly three to five years duration, a sign that the utes were relatively confident in their ability to obtain supply. But now the utes are increasingly looking to sign 10-year or longer supply contracts. They’re desperate to secure long-term supply of nuclear fuel.
Perhaps even more interesting, Cameco offered some color on the contracts it’s been signing. Increasingly, the company has been able to sign long-term contracts at a premium to prevailing spot rates: Utilities are willing to pay premium prices to secure supply from a reliable producer. And Cameco is also signing contracts with escalation clauses.
In roughly 40 percent of its contracts, Cameco receives a fixed price that moves up by a pre-set escalator amount each year. The other 60 percent of contracts are based on the prevailing spot prices at the time of delivery. In most cases the spot-based contracts have a price floor–this limits Cameco’s downside if spot prices fall. But the company has also been able to sign contracts without a price ceiling–there’s no pre-set limit to the prices the utes would have to pay for uranium. In this way, Cameco has been able to participate in rising spot prices via its long-term supply contracts.
We were early in recommending Cameco and the stock has proved one of the best recommendations in 2005. Nevertheless, it’s still the blue chip play on the nuclear industry and one of the only miners with scope to dramatically ramp up capacity over the next few years; Cameco has promising projects in Canada, Australia, the US and even Kazakhstan. With some of the lowest mining costs of any miner globally, Cameco will see tremendous growth in profitability over the next few years.
Better still, even if there is a temporary dip in energy demand from China and India, I doubt we’ll see any major delays in scheduled plant construction; these projects are multi-year investments. And if electricity demand in the US sags due to an economic slowdown, nuclear plants are still likely to continue running at near full capacity because the economics of these plants are so favorable for the utes. Continued demand for uranium means lean uranium inventories will still be a problem for the nation’s utes. I see uranium and nuclear power as a good play even if we see a temporary pullback in oil and natural gas prices or an economic slowdown in 2006. Cameco (NYSE: CCJ) remains a Wildcatters Portfolio stalwart and is a buy under 65.
Cameco was not the only recommended play on nuclear energy. I also added Canadian miner Denison Mines (TSX: DEN) to the Wildcatters Portfolio back in May; that move turned out to be a mistake as the stock was eventually stopped out of the Portfolio at roughly breakeven.
A few years ago, there were only a handful of uranium plays listed in Canada. But with prices rising rapidly, there are now literally hundreds of small exploration and development companies listed. Many are still years away from mining their first pound of uranium. In playing the nuclear story, my strategy has been to focus on companies that are already in production or are close to production.
I selected Denison because the company is an established producer; in fact it’s the only major producer in Canada apart from Cameco. While I was correct in forecasting higher uranium prices and tight demand, Denison never performed up to expectations.
There is no single reason I can point to why the stock hasn’t performed well or at least followed uranium prices higher. However, the company’s existing reserves aren’t of as high a quality as Cameco’s and current exploration activity will probably take more time to bear fruit than in Cameco’s case. The company is barely profitable, due mainly to high exploration costs. Denison will have spent about CD3.5 million on exploration in 2005 and will likely spend even more in 2006.
Another problem for Denison this year is that it’s still running through some legacy contracts signed years ago at much lower prices. Next year the company will re-sign contracts covering nearly one-quarter of its production at higher prices. Longer-term, I see upside for Denison stock as it re-prices current contracts, but for now the stock is an underperformer. I’m maintaining my hold recommendation on Denison (TSX: DEN) and will continue to track it in How They Rate.
For an even more direct play on uranium spot prices, I recommended Uranium Participation Corporation (TSX: U) in late July. This company does not mine; it simply buys and stockpiles uranium at approved warehouses. The stock is up nicely from that recommended price.
As of the end of November, Uranium Participation held roughly 2.5 million pounds of uranium and had contracted to buy another 1.4 million at prevailing prices to be delivered between December of 2005 and April of 2006. Based on the uranium held in storage and the current spot prices for uranium, the company’s net asset value is roughly CD5.50 per share. As the only means for many investors to purchase uranium, the shares tend to trade at a premium to that net asset value (NAV); I do see the mid-CD5 range as a solid support level. Longer term, I think uranium prices will exceed $50 per pound. In that event, Uranium Participation will see its NAV climb into the CD7 to CD8 range.
In essence, I expect uranium prices to trend higher and Uranium Participation should broadly track the price of uranium. I continue to recommend Uranium Participation as a buy.
I also made some more speculative recommendations in July–Uranium Resources (NSDQ: URIX) and UEX Corp (TSX: UEX). Uranium Resources is a small US-based uranium producer and is up slightly from my original recommendation.
Uranium Resources trades at less than $1 per share and on the over-the-counter bulletin board (OTCBB); suffice it to say this stock is highly speculative and you should invest only a small amount of capital in it. Nonetheless, the company is not just an explorer but has actual production of uranium; total production in 2005 should exceed 600,000 pounds of uranium.
With uranium prices around or under $10 for much of the ‘90s, Uranium Resources couldn’t mine profitably because its mining costs are over $11 per pound. To stay alive, the company raised capital via a succession of share offerings. This high share count is one reason the stock has languished for so long.
But with uranium prices on the rise, Uranium Resources is signing longer-term supply contracts at far more favorable prices. And if some of its current mine expansion plans pan out, the company should be able to easily sell that production at higher prices. Uranium Resources remains a buy for the high-risk tolerant, and I’ll continue to track it as a trade recommendation in How They Rate.
UEX is a pure exploration company and has done particularly well since my July recommendation, rising more than 60 percent. The main attraction of the stock remains its investors: Cameco and Cogema (owned by the French government) both have large stakes in this stock. Cameco has repeatedly highlighted the potential of some of UEX properties in recent conference calls.
The catalyst for the recent rally in UEX stock is some positive results from exploratory drilling at the company’s Shea Creek project. While it will be some time before Shea Creek’s full potential is known, UEX found some high-grade uranium deposits on the property.
While I generally prefer companies with actual production and revenues, Cameco and Cogema see value in UEX, and early drill results are positive. Despite the significant run-up, UEX remains a buy for the high-risk tolerant and I’ll continue to track it as a trade recommendation in How They Rate.
Sometimes avoiding pitfalls is as important as picking winners–one of the best calls made in The Energy Strategist last July was to avoid Usec (NYSE: USU), a position explained in depth in the July 27 issue, Keeping The Lights On. The stock is down roughly 20 percent since that time.
My main problem with Usec remains that it’s not a direct beneficiary of rising uranium prices; the company doesn’t mine uranium but simply enriches it for use in power plants. Even worse, the American Centrifuge Project, a new centrifuge for uranium enrichment, is costing in excess of $1.5 billion. That’s quite a mouthful for a company with a market cap of barely $1 billion.
Eventually, it will be a good play on the nuclear industry but there’s too much risk surrounding the centrifuge project. Until then, Usec (NYSE: USU) is a hold in How They Rate.
The Other Black Gold
I’ve outlined my bullish take on coal in great depth (see TES, December 14, 2005, Stock-Picking; new subscribers interested in another detailed account of the coal story should check out TES, August 31, 2005, King Coal).
Coal will remain the world’s pre-eminent source of electric power for years to come. And while it’s generally considered an environmentally dirty fuel, the use of low-sulphur coal from the Powder River Basin (PRB) of the Western US can go a long way towards reducing sulphur dioxide emissions. Peering a bit further into the future, I see the potential for coal liquefication and coal gasification technologies to bear fruit (a detailed look at these technologies is available in a December 9, 2005, TES Flash Alert).
Source: Energy Information Administration
Rising coal prices spells higher profits for coal miners. But even if prices were to more than double from current levels, producing coal-fired power would remain cheaper than power produced by natural gas; coal could rise a great deal from current levels without choking off demand. Better still, the US has 200-plus years’ worth of coal reserves and isn’t dependant on imports.
Our first play on coal was Proven Reserves holding Penn-Virginia Resources (NYSE: PVR). Penn-Virginia doesn’t actually mine any coal; rather, the company owns major coal-producing properties and leases these properties to miners in exchange for a royalty fee. This fee is based on the value of the coal produced; Penn-Virginia participates in some of the upside in coal prices. Better still, Penn-Virginia doesn’t have to foot the bill of hiring miners or paying for expensive raw materials and mining equipment.
And as a master limited partnership (MLP), Penn-Virginia pays out most of its cash flow as distributions to unitholders (for more on the MLP structure, check out TES, October 26, 2005, The Next Big Income Investment). Penn-Virginia has a remarkable history of boosting its payout. Over the past three years, the MLP has managed to grow its payout at an annualized pace of 10.5 percent. The current yields stands at just shy of 5 percent.
Since our original recommendation in early June, Penn-Virginia stock is up roughly 21.6 percent assuming dividends reinvested, or about 19 percent in price appreciation alone. Penn-Virginia remains one of the best income-oriented plays on coal and remains in the Proven Reserves Portfolio as a buy.
Among the miners, my favorite play remains Peabody Coal (NYSE: BTU), the world’s largest miner and the largest coal producer in the PRB. Peabody also wins points for its forward-thinking investments in new coal technologies. While Peabody Coal is flat since my recommendation, it’s still a buy in the growth-oriented Wildcatters Portfolio.
In addition to Penn-Virginia, I recommended a derivative play on coal–the railroads–in the September 14 issue, The Selloff Consensus. My favorite rail remains Burlington Northern SantaFe (NYSE: BNI), a stock that’s up roughly 30 percent from that September 14 recommendation.
Burlington has the largest network of rail in the Powder River Basin. Low sulphur coal from the region is in increasingly high demand by eastern utilities; by burning the low sulphur coal they’re able to comply with the Clean Air Act. Burlington now has considerable pricing power; the utes are willing to pay high transport rates to ensure reliable supplies of coal from the PRB and adequate investment in rail capacity in the region. I’ll continue to track Burlington (NYSE: BNI) as a trade recommendation in How They Rate.
In addition to Burlington, I continue to favor regional rail operator Genesee & Wyoming (NYSE: GWR) and barge operator American Commercial Lines (NSDQ: ACLI) as derivative plays on coal. I explain these recommendations in great depth in the December 14 and November 30 issues, respectively. Both Genesee and American Commercial are up from their recommended prices and remain trade recommendations in How They Rate.
While the coal theme has been a winner overall, not all of my picks have panned out as expected. MLP Natural Resource Partners (NYSE: NRP) has been one of the Proven Reserve’s worst-performing picks this year, falling some 17 percent since my late August recommendation. This fall has come despite its near 6 percent yield and 18 percent boost to its payout for 2005.
As I’ve stated previously, I believe the problem with Natural Resource Partners is based on unit supply, not any fundamental weakness. The situation is a bit complex and involves two classes of traded units: Natural Resources Partners has a separate class of unit that began trading publicly in August under the symbol “NSP.” The NSP is a subordinated unit–unlike the common units trading under the symbol “NRP,” subordinated units have no voting rights and no minimum guaranteed distribution. For this reason, the units trade at a small discount to NRP.
In reality, the NSP units have always existed but were owned by a single shareholder and never publicly traded. The MLP is now following a schedule to convert (a mandatory, automatic conversion) all these NSP units into common NRP units on a fixed schedule; the first conversion of 25 percent of NSP units occurred in November and the next conversion is scheduled for November 2006.
It’s likely that some NRP holders sold out of the NRP units to buy NSP units and take advantage of the slight price discount. In addition, when the NSP units were converted in November there was some selling pressure, as investors feared this represented a dilution of existing unitholders (the MLP equivalent of shareholders). There was no dilution because NSP units were retired as new NRP units were issued–the effect was psychological only.
On a broader scale, a number of MLPs issued new units in November to raise capital. All that new issuance put pressure on the MLP universe at large. But this is not an issue longer term because MLPs issue units to fund new investments; in most cases these investments add almost immediately to distributable cash flows. Additionally, the MLP shareholder base is widening to include more institutional shareholders. Eventually, this will reduce volatility.
At any rate, NRP still retains the potential to increase its distributions markedly over the coming year if coal pricing stays at anything close to current levels. My timing in recommending this stock was not good, but I firmly believe that the company represents good value at current levels. I’m maintaining my buy recommendation on Natural Resource Partners (NYSE: NRP).
Services And Drillers
When it comes to oil and gas, my favorite plays right now are in oil services and drilling. “Oil services” is a broad term used to describe all sorts of work related to oil and gas exploration and development. This includes seismic mapping–the use of sound waves to analyze underground rock formations. Also included are wireline services–lowering special equipment into wells to analyze reservoirs. I describe the industry in TES, August 10, 2005, The Great Wall Of Cash, and November 30, 2005, Not So Easy, respectively.
Oil and gas producers contract with the services firms to perform vital tasks. The simple fact is that when oil producers start spending more on exploration and development, a good chunk of that cash finds its way into the oil services industry.
And oil producers don’t actually own the drilling rigs used to drill wells. Instead, rigs are owned by contract drillers. Contract drilling firms, in turn, lease out these rigs to producers for a daily rental fee known as a day-rate. Some contract drillers specialize in land rigs–truck-mounted drilling equipment used for drilling over land. Others own rigs designed for drilling over water of various depths. In the April 27, 2005, TES, Offshore and Overseas, I took a detailed look at the contract drilling business (new subscribers should check out that issue for a detailed explanation of the industry. As you might imagine, when exploration activity steps up, contract drillers too are able to charge higher day-rates for their rigs.
Since last spring, I’ve been making the case for a new boom in exploration and production activity. The reason is simple: The world’s major oil companies did not invest much cash into new exploration during the ‘90s because energy prices were too low to justify the investment. Now, as demand for all sorts of energy commodities surges, producers are struggling to keep up with demand. Most of the majors have reserve replacement ratios of less than 100 percent–in other words, they’re not finding new reserves fast enough to keep pace with their production.
The good news is that higher energy prices mean the world’s oil companies are flush with cash, and their rising incomes are funding investment in new developments. This includes both the exploration and development of brand new reserves as well as the use of advanced technologies to squeeze more production from existing fields. That rising tide of cash spells rising profits for the oil services industry.
The easiest way to see that this exploration-and-development spending boom is underway is to watch the rotary rig count. The rig count is a measure of all drilling rigs currently working around the world.
Source: Baker Hughes
As you can see from the chart above, drilling activity globally hasn’t been this robust since the 1980s. With so many producers of all sizes looking to step up their drilling activity, contract day-rates have been rising rapidly for all types of rig.
On the drilling front, two of this year’s best calls were Todco (NYSE: THE) and Noble Corporation (NYSE: NE). Noble is a contract driller with a focus on deepwater, offshore rigs. The fact is that most of the really large reserves found over the past few years are located in deepwater, sometimes well over a mile beneath the ocean. The reason for this is simple: Deepwater reserves require advanced technology to be exploited so this was the last major frontier for explorers.
There is a global shortage of deepwater rigs and producers have been scrambling to lease out rigs so that they can move forward with development plans. Such rigs are extraordinarily expensive to build, costing upwards of half of a billion dollars for a new rig and take several years to build—this limits the potential for a new supply of rigs to come to market and push down day-rates anytime soon. Day-rates for these deepwater rigs have been rising rapidly to record levels.
I favored Noble because the company owned several baredeck hulls, partially constructed rigs that could be finished for a fraction of the cost of building new rigs. Noble was able to arrange for these rigs to be finished and place them under highly lucrative long-term contracts with major producers. These partly built rigs made Noble a leveraged beneficiary of higher day-rates as the company had the scope to bring new capacity to bear in a record strong day-rate environment.
I finally recommended selling Noble in August for a 28 percent gain as the company arranged to refit its baredeck hulls and put them out on contracts–the catalyst for the stock had passed. But even as I no longer recommend Noble, I haven’t abandoned the deepwater contract drillers–my favorite name in the space is now Wildcatter Transocean (NYSE: RIG).
At this time there are 19 deepwater rigs that don’t yet have contracts for 2006 and/or 2007. Most of these rigs are partially contracted in those years, but their available working days aren’t yet fully accounted for. That means the drillers could sign new contracts for these available 19 rigs.
Most of the 19 are currently working on contracts signed some time ago, on day-rates that are much lower than what the market will bear at this time. As these legacy contracts expire and new contracts are signed the day-rate upside is tremendous. Much of this will drop straight to the bottom line of the best-positioned contract drillers.
Of the 19 available, Transocean has eight uncommitted rigs, by far the largest book of uncommitted rigs in the industry. According to Transocean’s own rig report data, many of these rigs are now contracted out at day-rates much less than the current market price.
Transocean’s deepwater Nautilus rig will be available at the end of 2006, but is currently working a contract for Royal Dutch Shell in the Gulf of Mexico at a day-rate of $220,000. A more normal day-rate for that rig: $400,000 to $500,000 per day, more than double the current rate. And then there’s the Richardson, a deepwater semisubmersible rig on a contract in Africa at $85,000 per day. When that contract expires in mid-2006, the company should see a day-rate more than four times that figure.
Transocean has more leverage to the deepwater drilling boom than any of the other contract drillers right now. What’s more, deepwater developments are conducted mainly by the major integrated firms or the large independents and are part of multi-year projects. Even if oil prices fall back further, major deepwater developments are unlikely to be postponed or canceled–demand for Transocean’s rigs should remain high. Transocean (NYSE: RIG) remains a buy in the Wildcatters Portfolio.
I recommended Todco back in June as a play on the red-hot Gulf of Mexico drilling market. Todco owns two types of drilling rig: inland barge rigs and jackups. Inland barges are used for drilling in shallow, swampy waters–this type of rig has seen some upside in day-rates but hasn’t been very strong in the Gulf.
Jackups are a different story. These rigs have legs that actually rest on the seabed and are suitable for drilling in water up to a few hundred feet deep. These rigs are commonly used for drilling in the shallow water Gulf and are a real workhorse in the global drilling market.
Day-rates for jackups began rising rapidly this year in the Gulf due to strong demand. In prior cycles, when Gulf of Mexico drilling activity would pick up, jackups would be towed from elsewhere in the world to meet demand. This would depress day-rates; that’s why some are quick to dismiss the jackup market as a low-margin drilling market.
This time, however, most of the world’s jackups are busy in other parts of the world–jackups are in very high demand in markets like India, the North Sea and Africa. In fact, while drilling demand is very strong in the Gulf of Mexico, some rigs have actually been leaving the region to meet demand elsewhere in the world.
Given the strong market and tight supply, some companies have had trouble locating rigs to handle their new drilling activity. Some producers are starting try and lock away rigs on long-term contracts at very high day-rates. They are doing this because they are desperate to make sure they have rigs available when needed.
Todco was uniquely positioned to benefit because it’s the only firm with a large number of coldstacked rigs–rigs in long-term storage. The rigs were initially coldstacked in the weak drilling market of the late ’90s. By storing them, Todco was able to cut costs. Now, for a relatively small investment in reactivation, the rigs can be brought back into working condition.
This year’s nasty hurricane season served to exacerbate the shortage of jackups. Several jackups were destroyed by this year’s hurricanes while others were damaged severely and will require extensive repairs before going back into service. The result: Day-rates for jackups in the Gulf exploded in the late summer. Todco was a prime beneficiary of the trend. I finally recommended selling the last piece of Todco in late September for a 70 percent gain–the stock was already pricing in the strong day-rate environment and had spiked higher due to hurricane damage reports. This marked an opportune time to sell Todco for a nice profit.
But while I no longer recommend Todco, I see value in Rowan (NYSE: RDC), another driller focused on the Gulf. Rowan was hit hardest by this year’s hurricanes, losing a total of four rigs. Nevertheless, it remains one of the largest players in the Gulf, especially when it comes to the most advanced jackup rigs. As such it will benefit from still high day-rates for jackups in the region.
Rowan also trades at a discount to Todco and Ensco, the company’s most direct competitors in the region. Rowan rates a buy in the Wildcatters Portfolio.
On the services front, the key consideration is geographic exposure—there’s a huge difference between companies focused on the international markets and those focused on North America. Relatively small independent firms dominate North American production. Such companies tend to be more commodity-sensitive–a relatively small decline in oil or gas prices can result in delayed or canceled projects.
Internationally, projects tend to be of a larger scale and take many years to plan and develop. These projects are far less likely to be delayed or canceled even if there’s a relatively severe decline in energy prices. A perfect example is Saudi Arabia: The country’s national oil company, Saudi Aramco, has committed to spending money on developing new reserves and increasing its production capacity. It’s unlikely that such plans would be revised if oil falls into the 40s.
As I pointed out in the November 30 issue, Not So Easy, growing global production of oil to meet demand is becoming more difficult. In the early ‘80s, Saudi Arabia was able to increase production simply by opening up the taps on some of its supergiant fields. Now, to add a comparatively small amount of capacity, the Desert Kingdom is spending billions. The same is true all over the world. Adding to reserves and growing production is a complex, technically advanced process because the easiest-to-produce reserves have already been largely exploited. This is just another way of saying that producing oil and gas is becoming more service-intensive. That is, of course, music to the ears of the services business.
I have long focused on the internationally levered services and infrastructure plays. These companies are in the best position to profit from major international spending plans currently underway in regions such as the Middle East. And, as noted above, these names are not as sensitive to drops in commodity prices because international projects are relatively price-insensitive.
The early call to buy internationally levered services and infrastructure names was successful. Some of the winners included Schlumberger (NYSE: SLB) and Cooper Cameron (NYSE: CAM). Schlumberger is the world’s largest services firm and has the most advanced technology–it is, therefore, uniquely positioned to benefit from the growth in international services demand. Cooper Cameron makes subsea equipment, equipment used to produce deepwater reserves. Subsea is a major beneficiary of the current boom in deepwater development. I continue to recommend Cooper in the Wildcatters Portfolio.
Also on the services side, I recommend Weatherford International (NYSE: WFT). Weatherford specializes in services used for brownfield development; the company is a leader in technologies and services used to squeeze more oil out of older, mature reserves. This includes, for example, underbalanced drilling. Drilling into mature reservoirs can actually damage the reservoir rock itself and impair production; underbalanced drilling is a technique for drilling into such reservoirs without causing damage. Weatherford remains a buy in the Wildcatters Portfolio.
Not all of the recommendations in the services business panned out. In the spring I recommended shorting pressure pumping specialist BJ Services (NYSE: BJS).
Oil and gas do not exist underground in giant caverns or lakes. These hydrocarbons are trapped inside the pores of rocks such as sandstone. Geologists use two terms to describe reservoir rocks: porosity and permeability. Porosity refers to the number of pores in a given rock sample. The more porous a rock, the more oil and gas it can hold. In contrast, permeability refers to how well connected the pores in a rock are to one another; the more permeable a rock, the easier it is for hydrocarbons to flow out of their pores and into a well.
To improve permeability, services firms will perform hydraulic fracturing by pumping a gel-like substance into the reservoir rock itself under tremendous pressure. Sometimes literally hundreds of pressure-pumping trucks are used for a single well. This fluid under pressure actually fractures and cracks the rock, creating channels through which oil and gas can flow.
BJ Services is the leader in North American pressure pumping. In the spring, I felt that BJ Services would have trouble raising their prices because capacity–pressure pumping trucks and equipment–rose rapidly in 2005. I expected this additional pressure pumping supply to push down prices for pressure pumping services and intensify competition. I also believed that small North American producers were beginning to balk at high pressure pumping fees.
I was completely wrong on both counts: Demand was so tight that any additional supply was easily absorbed and high commodity prices meant that producers were more than willing to pay up for pressure pumping. Several major price increases were pushed through in 2005 and margins at BJ Services continued to rise. Over the summer, we were stopped out of the stock at a loss of 15 percent.
I’ve totally changed my tune on this stock. High natural gas demand in the US and limited import capacity spell a strong North American drilling market. This is good news for the pressure pumping business. I now recommend BJ Services (NYSE: BJS) as a buy in the Wildcatters Portfolio.
Stock Talk
The Energy Strategist Portfolios are designed to be the investor’s guideline to the industry. The aim of the portfolios is to offer the best ideas in the sector and advice of when to buy, hold or sell. Stop-loss (stops) recommendations are protection against huge drops, especially in more volatile stocks like those of drillers and service companies.
As the portfolios are constructed, the suggested stocks will try to capture in the best way possible our thinking regarding the short- and long-term direction of the energy market. Investors should evaluate the rationale behind each theme and decide if they want to add the suggested stock in their portfolio. And once again, pay attention to the stops as well as the “buy under” recommendations suggested in the portfolio tables.
On the “Portfolios” tab of the Web site, you’ll find three tables labeled Proven Reserves, Wildcatters and How They Rate. The Proven Reserves Portfolio consists of more defensive income-oriented picks. The list includes, for example, some integrated oil giants as well as several high-yielding Master Limited Partnerships. The Wildcatters is a more growth-oriented model portfolio. These are my favorite picks for growth and capital appreciation potential. Some of these companies pay small dividends but that’s not the focus of this portfolio.
Finally, there’s How They Rate. This table is NOT a model portfolio; rather it’s a guide to The Energy Strategist’s coverage universe. I realize that many subscribers own energy stocks not currently in the TES portfolio; this table offers my latest buy, sell or hold advice on those names.
In addition, I occasionally offer some more aggressive recommendations that I call trades. In most cases, I intend to hold trades for six to nine months or less and am playing a specific catalyst. I will make these recommendations via flash alerts and update the recommendations in How They Rate.
A Look Back
By Yiannis G. Mostrous
In the first issue of this publication we wrote, “The thesis of The Energy Strategist is that cheap oil prices are a thing of the past.”
Nothing has changed this assessment.
For the past nine months, we’ve offered our projections for the prices of oil and natural gas because the short-term prices for each can affect portfolios, particularly at the margin. A well-explained short-term forecast is more important as investors’ interest in a specific sector increases.
If we can reduce to one material fact for long-term investors, it would be this: The per barrel price of oil has established a plateau–$40–higher than was thought possible just a couple years ago, when many observers pegged the price at $20. We’ve made the case for higher oil prices on numerous occasions, and are confident in our assessment. Suffice it to say the world is entering a new era where the two most populous nations (China and India) are trying to join the word’s economic system–their parallel aspirations will undoubtedly affect the world’s resources at the margin. It is imperative that investors understand this fact: The impact these two countries are having on the world economy is unprecedented; not even a young United States brought such force to bear as it became an industrialized nation.
We’ve been fairly accurate in our predictions since TES came to life in late March 2005. In the first issue, we cautioned that oil would correct in the short term. Two months later, on May 20, oil hit its low at $46.80. In May we recommended buying, as we thought oil was turning around (see TES, May 26, 2005, The Time Is Now. Over the next three months, oil rallied to almost $70.
In the May 26 issue, and in the two September issues (see TES, September 14, 2005, The Selloff Consensus, and September 29, 2005, Energy Infrastructure), we suggested oil prices would stay closer to $60 this year than to $50; oil has spent seven months in 2005 above $55. In October (see TES, October 12, 2005, The Majors) we cautioned again: “As these latecomers have raised their oil price projections for this year and next, we have become a bit more concerned. This newfangled optimism could lead the market to overshoot, a time-honored reality when the latecomers try to make a quick profit.”
Since then oil went from $64 to $58. Finally, writing about the weakness in oil prices we wrote: “Regarding the weakness in the market, the per barrel price of oil (WTI) can go lower in the current correction. Our base case calls for $55, but we would not be surprised to see it at $50.”
When it comes to natural gas, we’ve made our biggest bet with our most recent assessment: “Current weakness in the natural gas market will develop into a more serious correction: Prices could correct all the way down to $10 per thousand cubic feet, if not lower, based on old-fashioned supply and demand.”
Many questioned that call a month ago, especially since gas prices went from $12.68 to $15.42 immediately after TES came out. And yet natural gas is currently trading at $11.20, and still looks quite vulnerable in the short term. We will revisit this issue in the coming year.
There is now much discussion of $40 (or lower) oil. Although oil could reach such levels if there is a global recession next year, we believe it’s still too early to make such a definitive call. That said, one of our aims is to anticipate big changes and suggest ways to profit from down moves, or simply to avoid the more slippery stocks. (See, for example, our short recommendations throughout the year. In addition, we’ve found segments within the energy sectors that look promising, like the coal sector.) This is another way of working around the entrenched idea that “oil is all” in the energy investing universe.
As things stand (geopolitical and recession worries notwithstanding), our view is that oil prices will stay above $50 in 2006. In other words, we differ from the overexcited $60 per barrel crowd, though we are not as bearish as the $40 folks.
ConocoPhillips And Burlington Resources
Much has been written about ConocoPhillips’ (NYSE: COP) acquisition of Burlington Resources (NYSE: BR). The deal is complex, and time will tell if it was a wise move. Given ConocoPhillips’ current management’s success in acquisitions in the past, we’re prepared to wait a bit before offering a verdict. It’s obvious such a mega-deal will have good and bad aspects, but we’re looking at the positives first.
The new entity will be the leader in the US natural gas market, boasting high-quality reserves. There should also be a lot of synergies in the operational front as consolidation of regional operations commences. ConocoPhillips will gain by the transfer of Burlington’s knowledge and widely admired disciplined investment policies. Quite a few of Burlington’s top managers will sit on the new board and the new entity should retain a good portion of important Burlington personnel.
On the other hand, very few analysts like the move. And yet very few liked Conoco’s purchase of Arco’s Alaskan assets in 1999, or its purchase of TOSCO’s refining assets in 2001. In retrospect, of course, these acquisitions look solid since oil prices have appreciated so much. Then again, long-term gas prices should go much higher from current levels, in which case ConocoPhillips will look good–again.
Another critique reasons the price is too high. This may be true, but who’s to say that with lower gas prices–say, in the spring–ConocoPhillips would manage to avoid a price-raising bidding war?
At the end of the day there is one way to assess a deal like this: the future price performance of the new entity’s stock. Both have done very well, so there’s a strong possibility a successful implementation of the merger can, in due course, produce the same good results. ConocoPhillips (NYSE: COP) remains a hold.
In this issue, I’ll review some of the year’s most memorable recommendations and calls, both those that turned out profitably and those that didn’t work out quite as well as expected. I’ll also take a closer look at the current positioning in the portfolios and some of the key themes as we head into the New Year.
Before I delve into this week’s issue, a brief administrative note: Subscribers will find a detailed description of the goals of each of our portfolios–the Wildcatters, Proven Reserves and How They Rate–at the end of this issue. In this section I briefly outline how the model portfolios can be used to make investing decisions.
A Nuclear Age
Generating almost one-fifth of the world’s electricity, nuclear power is a major contributor to the global energy pie. Nonetheless, while investors follow every twist and turn in the oil and natural gas markets, nuclear power and uranium prices remain largely ignored.
But ignoring nuclear power is a big mistake for investors; uranium stocks have been among the best and most reliable performers in The Energy Strategist Portfolios in 2005. Most of these stocks held up remarkably well even when oil and gas stocks corrected sharply in October and the top pick, Canada’s Cameco (NYSE: CCJ), is up more than 60 percent from our original recommendation back in March. And this trend is far from over; I see major catalysts for uranium stocks and uranium prices as we head into 2006.
I first featured the nuclear industry in the May 26 issue, The Other Yellow Metal. I followed up with a detailed review of uranium mining and processing in the July 27 issue, Keeping The Lights On. To summarize: Nuclear power is cheap and environmentally friendly. And unlike gas or oil, the US is not dependant on imports of uranium from a politically unstable Middle East.
China and India have both recognized the value of nuclear power and are aggressively building out their nuclear generating capacity. China has plans to build 40 new nuclear reactors between now and 2025 while India has committed to building at least another eight by the end of this decade on top of its existing 14 reactors.
Back in July I attended a speech by Prime Minister of India Dr. Manmohan Singh at the National Press Club in Washington, DC. The speech was billed neither as a discussion of energy nor India’s need for new electricity generating capacity. However, Dr. Singh made nuclear power a centerpiece of his remarks and his discussions with President Bush. Dr. Singh stated:
“Our current dependence on hydrocarbons will have to be diversified in favor of a broader energy mix. I discussed with the President prospects for the resumption of our cooperation on civilian nuclear energy…
“We need nuclear energy because if we don’t get adequate energy supplies, we will put pressure on hydrocarbons. And if the world demand for hydrocarbons goes up because of economic activities in countries like India, even the United States will suffer because oil prices rise…So it is in the interest of the rest of the world to help India meet its energy plans; to, among other things, expand nuclear energy.”
Dr. Singh is completely correct. If India is forced to rely on traditional hydrocarbons for all its energy needs, this wall of demand will spell much higher prices globally. Demand for electricity from China and India has been growing rapidly for more than a decade and is set to explode over the next 20 years (see chart).
Source: Energy Information Administration
By 2025, China’s demand for electricity is projected to exceed that of all of Western Europe combined, approaching the consumption of the United States. India will move from being only a marginal consumer of electricity in 1990 to a major demander in 2025.
Natural gas will undoubtedly meet some of that demand. But if India and China were to rely solely on gas-fired power to meet future needs there simply would not be enough gas production globally to fill the gap.
Coal will likely play a prominent role in both countries; coal-fired power does, however, raise environmental concerns. China already has a big pollution problem in some of its major cities and doesn’t have the low-sulphur coal and advanced scrubber technologies widely employed in the developed world. And as I explained in depth in the July 27 TES, Keeping The Lights On, alternative energy technologies such as wind power are not a suitable large-scale solution for India or China.
Bottom line: China and India are pursuing nuclear power because it’s the only viable way for these countries to meet their vast populations’ electricity needs.
And nuclear is far from dead in the developed world. While no new nuclear reactors have been built in the US since the 1970s, some prominent utilities are examining the possibility of siting a new plant. The energy bill recently passed by the US Congress also contains incentives designed to encourage the building of a nuclear plant in the US. Meanwhile, France continues to generate more than three-quarters of her electricity using nukes and there are plans to build new reactors. And the United Kingdom and Germany have shelved plans to phase out their existing capacity; in both countries nuclear power is a major contributor to energy supply.
There are a couple of different ways to buy into the nuclear story. The most obvious beneficiaries of an expansion in nuclear power capacity globally are uranium miners and companies that process uranium into nuclear fuel.
Uranium is currently in short supply and the utilities are working off very thin inventories. This marks a dramatic change from the ‘90s when inventories and supply were more than sufficient to meet demand. In recent years, global uranium demand has hovered near 180 million pounds annually; total global mine production is, however, only around half that amount. The world’s utilities hold some stocks of uranium and have been drawing down those stocks to meet their needs, consuming roughly 30 to 40 million pounds out of inventories annually.
With the utes sitting on dwindling inventories of uranium, they’re looking to secure new supply. Like coal, uranium is often sold under multi-year supply contracts to utilities–the utes are increasingly paying up to secure uranium under long term contracts from reliable suppliers. This is precisely why my favorite plays in the nuclear patch are the mining firms.
Companies with reliable production of uranium will gradually see their legacy supply contracts roll off over the next few years. As those contracts expire, the better miners will be signing new contracts at much higher prices. This is obviously a big earnings driver.
Mining Information
Our top uranium stock has long been Cameco (NYSE: CCJ), a stock we added to the Wildcatters Portfolio when it was trading in the upper 30s. Cameco’s quarterly conference calls are truly informative; the company discusses not only its own prospects, it also frequently offers commentary on the nuclear and uranium industries at large. Because Cameco is the world’s largest miner of uranium and sits on more than 65 percent of the globe’s known reserves, its management team is uniquely positioned to comment on the nuclear industry.
Cameco has long held that 2008 will be a critical year. Many utilities have projected supply needs that will arise after 2007. They simply do not have the inventories or supply agreements to cover their uranium fuel needs.
In Cameco’s most recent call, management stated that the duration of uranium supply contracts is getting longer. A few years ago, utilities were willing to accept uranium supply contracts of roughly three to five years duration, a sign that the utes were relatively confident in their ability to obtain supply. But now the utes are increasingly looking to sign 10-year or longer supply contracts. They’re desperate to secure long-term supply of nuclear fuel.
Perhaps even more interesting, Cameco offered some color on the contracts it’s been signing. Increasingly, the company has been able to sign long-term contracts at a premium to prevailing spot rates: Utilities are willing to pay premium prices to secure supply from a reliable producer. And Cameco is also signing contracts with escalation clauses.
In roughly 40 percent of its contracts, Cameco receives a fixed price that moves up by a pre-set escalator amount each year. The other 60 percent of contracts are based on the prevailing spot prices at the time of delivery. In most cases the spot-based contracts have a price floor–this limits Cameco’s downside if spot prices fall. But the company has also been able to sign contracts without a price ceiling–there’s no pre-set limit to the prices the utes would have to pay for uranium. In this way, Cameco has been able to participate in rising spot prices via its long-term supply contracts.
We were early in recommending Cameco and the stock has proved one of the best recommendations in 2005. Nevertheless, it’s still the blue chip play on the nuclear industry and one of the only miners with scope to dramatically ramp up capacity over the next few years; Cameco has promising projects in Canada, Australia, the US and even Kazakhstan. With some of the lowest mining costs of any miner globally, Cameco will see tremendous growth in profitability over the next few years.
Better still, even if there is a temporary dip in energy demand from China and India, I doubt we’ll see any major delays in scheduled plant construction; these projects are multi-year investments. And if electricity demand in the US sags due to an economic slowdown, nuclear plants are still likely to continue running at near full capacity because the economics of these plants are so favorable for the utes. Continued demand for uranium means lean uranium inventories will still be a problem for the nation’s utes. I see uranium and nuclear power as a good play even if we see a temporary pullback in oil and natural gas prices or an economic slowdown in 2006. Cameco (NYSE: CCJ) remains a Wildcatters Portfolio stalwart and is a buy under 65.
Cameco was not the only recommended play on nuclear energy. I also added Canadian miner Denison Mines (TSX: DEN) to the Wildcatters Portfolio back in May; that move turned out to be a mistake as the stock was eventually stopped out of the Portfolio at roughly breakeven.
A few years ago, there were only a handful of uranium plays listed in Canada. But with prices rising rapidly, there are now literally hundreds of small exploration and development companies listed. Many are still years away from mining their first pound of uranium. In playing the nuclear story, my strategy has been to focus on companies that are already in production or are close to production.
I selected Denison because the company is an established producer; in fact it’s the only major producer in Canada apart from Cameco. While I was correct in forecasting higher uranium prices and tight demand, Denison never performed up to expectations.
There is no single reason I can point to why the stock hasn’t performed well or at least followed uranium prices higher. However, the company’s existing reserves aren’t of as high a quality as Cameco’s and current exploration activity will probably take more time to bear fruit than in Cameco’s case. The company is barely profitable, due mainly to high exploration costs. Denison will have spent about CD3.5 million on exploration in 2005 and will likely spend even more in 2006.
Another problem for Denison this year is that it’s still running through some legacy contracts signed years ago at much lower prices. Next year the company will re-sign contracts covering nearly one-quarter of its production at higher prices. Longer-term, I see upside for Denison stock as it re-prices current contracts, but for now the stock is an underperformer. I’m maintaining my hold recommendation on Denison (TSX: DEN) and will continue to track it in How They Rate.
For an even more direct play on uranium spot prices, I recommended Uranium Participation Corporation (TSX: U) in late July. This company does not mine; it simply buys and stockpiles uranium at approved warehouses. The stock is up nicely from that recommended price.
As of the end of November, Uranium Participation held roughly 2.5 million pounds of uranium and had contracted to buy another 1.4 million at prevailing prices to be delivered between December of 2005 and April of 2006. Based on the uranium held in storage and the current spot prices for uranium, the company’s net asset value is roughly CD5.50 per share. As the only means for many investors to purchase uranium, the shares tend to trade at a premium to that net asset value (NAV); I do see the mid-CD5 range as a solid support level. Longer term, I think uranium prices will exceed $50 per pound. In that event, Uranium Participation will see its NAV climb into the CD7 to CD8 range.
In essence, I expect uranium prices to trend higher and Uranium Participation should broadly track the price of uranium. I continue to recommend Uranium Participation as a buy.
I also made some more speculative recommendations in July–Uranium Resources (NSDQ: URIX) and UEX Corp (TSX: UEX). Uranium Resources is a small US-based uranium producer and is up slightly from my original recommendation.
Uranium Resources trades at less than $1 per share and on the over-the-counter bulletin board (OTCBB); suffice it to say this stock is highly speculative and you should invest only a small amount of capital in it. Nonetheless, the company is not just an explorer but has actual production of uranium; total production in 2005 should exceed 600,000 pounds of uranium.
With uranium prices around or under $10 for much of the ‘90s, Uranium Resources couldn’t mine profitably because its mining costs are over $11 per pound. To stay alive, the company raised capital via a succession of share offerings. This high share count is one reason the stock has languished for so long.
But with uranium prices on the rise, Uranium Resources is signing longer-term supply contracts at far more favorable prices. And if some of its current mine expansion plans pan out, the company should be able to easily sell that production at higher prices. Uranium Resources remains a buy for the high-risk tolerant, and I’ll continue to track it as a trade recommendation in How They Rate.
UEX is a pure exploration company and has done particularly well since my July recommendation, rising more than 60 percent. The main attraction of the stock remains its investors: Cameco and Cogema (owned by the French government) both have large stakes in this stock. Cameco has repeatedly highlighted the potential of some of UEX properties in recent conference calls.
The catalyst for the recent rally in UEX stock is some positive results from exploratory drilling at the company’s Shea Creek project. While it will be some time before Shea Creek’s full potential is known, UEX found some high-grade uranium deposits on the property.
While I generally prefer companies with actual production and revenues, Cameco and Cogema see value in UEX, and early drill results are positive. Despite the significant run-up, UEX remains a buy for the high-risk tolerant and I’ll continue to track it as a trade recommendation in How They Rate.
Sometimes avoiding pitfalls is as important as picking winners–one of the best calls made in The Energy Strategist last July was to avoid Usec (NYSE: USU), a position explained in depth in the July 27 issue, Keeping The Lights On. The stock is down roughly 20 percent since that time.
My main problem with Usec remains that it’s not a direct beneficiary of rising uranium prices; the company doesn’t mine uranium but simply enriches it for use in power plants. Even worse, the American Centrifuge Project, a new centrifuge for uranium enrichment, is costing in excess of $1.5 billion. That’s quite a mouthful for a company with a market cap of barely $1 billion.
Eventually, it will be a good play on the nuclear industry but there’s too much risk surrounding the centrifuge project. Until then, Usec (NYSE: USU) is a hold in How They Rate.
The Other Black Gold
I’ve outlined my bullish take on coal in great depth (see TES, December 14, 2005, Stock-Picking; new subscribers interested in another detailed account of the coal story should check out TES, August 31, 2005, King Coal).
Coal will remain the world’s pre-eminent source of electric power for years to come. And while it’s generally considered an environmentally dirty fuel, the use of low-sulphur coal from the Powder River Basin (PRB) of the Western US can go a long way towards reducing sulphur dioxide emissions. Peering a bit further into the future, I see the potential for coal liquefication and coal gasification technologies to bear fruit (a detailed look at these technologies is available in a December 9, 2005, TES Flash Alert).
Source: Energy Information Administration
Rising coal prices spells higher profits for coal miners. But even if prices were to more than double from current levels, producing coal-fired power would remain cheaper than power produced by natural gas; coal could rise a great deal from current levels without choking off demand. Better still, the US has 200-plus years’ worth of coal reserves and isn’t dependant on imports.
Our first play on coal was Proven Reserves holding Penn-Virginia Resources (NYSE: PVR). Penn-Virginia doesn’t actually mine any coal; rather, the company owns major coal-producing properties and leases these properties to miners in exchange for a royalty fee. This fee is based on the value of the coal produced; Penn-Virginia participates in some of the upside in coal prices. Better still, Penn-Virginia doesn’t have to foot the bill of hiring miners or paying for expensive raw materials and mining equipment.
And as a master limited partnership (MLP), Penn-Virginia pays out most of its cash flow as distributions to unitholders (for more on the MLP structure, check out TES, October 26, 2005, The Next Big Income Investment). Penn-Virginia has a remarkable history of boosting its payout. Over the past three years, the MLP has managed to grow its payout at an annualized pace of 10.5 percent. The current yields stands at just shy of 5 percent.
Since our original recommendation in early June, Penn-Virginia stock is up roughly 21.6 percent assuming dividends reinvested, or about 19 percent in price appreciation alone. Penn-Virginia remains one of the best income-oriented plays on coal and remains in the Proven Reserves Portfolio as a buy.
Among the miners, my favorite play remains Peabody Coal (NYSE: BTU), the world’s largest miner and the largest coal producer in the PRB. Peabody also wins points for its forward-thinking investments in new coal technologies. While Peabody Coal is flat since my recommendation, it’s still a buy in the growth-oriented Wildcatters Portfolio.
In addition to Penn-Virginia, I recommended a derivative play on coal–the railroads–in the September 14 issue, The Selloff Consensus. My favorite rail remains Burlington Northern SantaFe (NYSE: BNI), a stock that’s up roughly 30 percent from that September 14 recommendation.
Burlington has the largest network of rail in the Powder River Basin. Low sulphur coal from the region is in increasingly high demand by eastern utilities; by burning the low sulphur coal they’re able to comply with the Clean Air Act. Burlington now has considerable pricing power; the utes are willing to pay high transport rates to ensure reliable supplies of coal from the PRB and adequate investment in rail capacity in the region. I’ll continue to track Burlington (NYSE: BNI) as a trade recommendation in How They Rate.
In addition to Burlington, I continue to favor regional rail operator Genesee & Wyoming (NYSE: GWR) and barge operator American Commercial Lines (NSDQ: ACLI) as derivative plays on coal. I explain these recommendations in great depth in the December 14 and November 30 issues, respectively. Both Genesee and American Commercial are up from their recommended prices and remain trade recommendations in How They Rate.
While the coal theme has been a winner overall, not all of my picks have panned out as expected. MLP Natural Resource Partners (NYSE: NRP) has been one of the Proven Reserve’s worst-performing picks this year, falling some 17 percent since my late August recommendation. This fall has come despite its near 6 percent yield and 18 percent boost to its payout for 2005.
As I’ve stated previously, I believe the problem with Natural Resource Partners is based on unit supply, not any fundamental weakness. The situation is a bit complex and involves two classes of traded units: Natural Resources Partners has a separate class of unit that began trading publicly in August under the symbol “NSP.” The NSP is a subordinated unit–unlike the common units trading under the symbol “NRP,” subordinated units have no voting rights and no minimum guaranteed distribution. For this reason, the units trade at a small discount to NRP.
In reality, the NSP units have always existed but were owned by a single shareholder and never publicly traded. The MLP is now following a schedule to convert (a mandatory, automatic conversion) all these NSP units into common NRP units on a fixed schedule; the first conversion of 25 percent of NSP units occurred in November and the next conversion is scheduled for November 2006.
It’s likely that some NRP holders sold out of the NRP units to buy NSP units and take advantage of the slight price discount. In addition, when the NSP units were converted in November there was some selling pressure, as investors feared this represented a dilution of existing unitholders (the MLP equivalent of shareholders). There was no dilution because NSP units were retired as new NRP units were issued–the effect was psychological only.
On a broader scale, a number of MLPs issued new units in November to raise capital. All that new issuance put pressure on the MLP universe at large. But this is not an issue longer term because MLPs issue units to fund new investments; in most cases these investments add almost immediately to distributable cash flows. Additionally, the MLP shareholder base is widening to include more institutional shareholders. Eventually, this will reduce volatility.
At any rate, NRP still retains the potential to increase its distributions markedly over the coming year if coal pricing stays at anything close to current levels. My timing in recommending this stock was not good, but I firmly believe that the company represents good value at current levels. I’m maintaining my buy recommendation on Natural Resource Partners (NYSE: NRP).
Services And Drillers
When it comes to oil and gas, my favorite plays right now are in oil services and drilling. “Oil services” is a broad term used to describe all sorts of work related to oil and gas exploration and development. This includes seismic mapping–the use of sound waves to analyze underground rock formations. Also included are wireline services–lowering special equipment into wells to analyze reservoirs. I describe the industry in TES, August 10, 2005, The Great Wall Of Cash, and November 30, 2005, Not So Easy, respectively.
Oil and gas producers contract with the services firms to perform vital tasks. The simple fact is that when oil producers start spending more on exploration and development, a good chunk of that cash finds its way into the oil services industry.
And oil producers don’t actually own the drilling rigs used to drill wells. Instead, rigs are owned by contract drillers. Contract drilling firms, in turn, lease out these rigs to producers for a daily rental fee known as a day-rate. Some contract drillers specialize in land rigs–truck-mounted drilling equipment used for drilling over land. Others own rigs designed for drilling over water of various depths. In the April 27, 2005, TES, Offshore and Overseas, I took a detailed look at the contract drilling business (new subscribers should check out that issue for a detailed explanation of the industry. As you might imagine, when exploration activity steps up, contract drillers too are able to charge higher day-rates for their rigs.
Since last spring, I’ve been making the case for a new boom in exploration and production activity. The reason is simple: The world’s major oil companies did not invest much cash into new exploration during the ‘90s because energy prices were too low to justify the investment. Now, as demand for all sorts of energy commodities surges, producers are struggling to keep up with demand. Most of the majors have reserve replacement ratios of less than 100 percent–in other words, they’re not finding new reserves fast enough to keep pace with their production.
The good news is that higher energy prices mean the world’s oil companies are flush with cash, and their rising incomes are funding investment in new developments. This includes both the exploration and development of brand new reserves as well as the use of advanced technologies to squeeze more production from existing fields. That rising tide of cash spells rising profits for the oil services industry.
The easiest way to see that this exploration-and-development spending boom is underway is to watch the rotary rig count. The rig count is a measure of all drilling rigs currently working around the world.
Source: Baker Hughes
As you can see from the chart above, drilling activity globally hasn’t been this robust since the 1980s. With so many producers of all sizes looking to step up their drilling activity, contract day-rates have been rising rapidly for all types of rig.
On the drilling front, two of this year’s best calls were Todco (NYSE: THE) and Noble Corporation (NYSE: NE). Noble is a contract driller with a focus on deepwater, offshore rigs. The fact is that most of the really large reserves found over the past few years are located in deepwater, sometimes well over a mile beneath the ocean. The reason for this is simple: Deepwater reserves require advanced technology to be exploited so this was the last major frontier for explorers.
There is a global shortage of deepwater rigs and producers have been scrambling to lease out rigs so that they can move forward with development plans. Such rigs are extraordinarily expensive to build, costing upwards of half of a billion dollars for a new rig and take several years to build—this limits the potential for a new supply of rigs to come to market and push down day-rates anytime soon. Day-rates for these deepwater rigs have been rising rapidly to record levels.
I favored Noble because the company owned several baredeck hulls, partially constructed rigs that could be finished for a fraction of the cost of building new rigs. Noble was able to arrange for these rigs to be finished and place them under highly lucrative long-term contracts with major producers. These partly built rigs made Noble a leveraged beneficiary of higher day-rates as the company had the scope to bring new capacity to bear in a record strong day-rate environment.
I finally recommended selling Noble in August for a 28 percent gain as the company arranged to refit its baredeck hulls and put them out on contracts–the catalyst for the stock had passed. But even as I no longer recommend Noble, I haven’t abandoned the deepwater contract drillers–my favorite name in the space is now Wildcatter Transocean (NYSE: RIG).
At this time there are 19 deepwater rigs that don’t yet have contracts for 2006 and/or 2007. Most of these rigs are partially contracted in those years, but their available working days aren’t yet fully accounted for. That means the drillers could sign new contracts for these available 19 rigs.
Most of the 19 are currently working on contracts signed some time ago, on day-rates that are much lower than what the market will bear at this time. As these legacy contracts expire and new contracts are signed the day-rate upside is tremendous. Much of this will drop straight to the bottom line of the best-positioned contract drillers.
Of the 19 available, Transocean has eight uncommitted rigs, by far the largest book of uncommitted rigs in the industry. According to Transocean’s own rig report data, many of these rigs are now contracted out at day-rates much less than the current market price.
Transocean’s deepwater Nautilus rig will be available at the end of 2006, but is currently working a contract for Royal Dutch Shell in the Gulf of Mexico at a day-rate of $220,000. A more normal day-rate for that rig: $400,000 to $500,000 per day, more than double the current rate. And then there’s the Richardson, a deepwater semisubmersible rig on a contract in Africa at $85,000 per day. When that contract expires in mid-2006, the company should see a day-rate more than four times that figure.
Transocean has more leverage to the deepwater drilling boom than any of the other contract drillers right now. What’s more, deepwater developments are conducted mainly by the major integrated firms or the large independents and are part of multi-year projects. Even if oil prices fall back further, major deepwater developments are unlikely to be postponed or canceled–demand for Transocean’s rigs should remain high. Transocean (NYSE: RIG) remains a buy in the Wildcatters Portfolio.
I recommended Todco back in June as a play on the red-hot Gulf of Mexico drilling market. Todco owns two types of drilling rig: inland barge rigs and jackups. Inland barges are used for drilling in shallow, swampy waters–this type of rig has seen some upside in day-rates but hasn’t been very strong in the Gulf.
Jackups are a different story. These rigs have legs that actually rest on the seabed and are suitable for drilling in water up to a few hundred feet deep. These rigs are commonly used for drilling in the shallow water Gulf and are a real workhorse in the global drilling market.
Day-rates for jackups began rising rapidly this year in the Gulf due to strong demand. In prior cycles, when Gulf of Mexico drilling activity would pick up, jackups would be towed from elsewhere in the world to meet demand. This would depress day-rates; that’s why some are quick to dismiss the jackup market as a low-margin drilling market.
This time, however, most of the world’s jackups are busy in other parts of the world–jackups are in very high demand in markets like India, the North Sea and Africa. In fact, while drilling demand is very strong in the Gulf of Mexico, some rigs have actually been leaving the region to meet demand elsewhere in the world.
Given the strong market and tight supply, some companies have had trouble locating rigs to handle their new drilling activity. Some producers are starting try and lock away rigs on long-term contracts at very high day-rates. They are doing this because they are desperate to make sure they have rigs available when needed.
Todco was uniquely positioned to benefit because it’s the only firm with a large number of coldstacked rigs–rigs in long-term storage. The rigs were initially coldstacked in the weak drilling market of the late ’90s. By storing them, Todco was able to cut costs. Now, for a relatively small investment in reactivation, the rigs can be brought back into working condition.
This year’s nasty hurricane season served to exacerbate the shortage of jackups. Several jackups were destroyed by this year’s hurricanes while others were damaged severely and will require extensive repairs before going back into service. The result: Day-rates for jackups in the Gulf exploded in the late summer. Todco was a prime beneficiary of the trend. I finally recommended selling the last piece of Todco in late September for a 70 percent gain–the stock was already pricing in the strong day-rate environment and had spiked higher due to hurricane damage reports. This marked an opportune time to sell Todco for a nice profit.
But while I no longer recommend Todco, I see value in Rowan (NYSE: RDC), another driller focused on the Gulf. Rowan was hit hardest by this year’s hurricanes, losing a total of four rigs. Nevertheless, it remains one of the largest players in the Gulf, especially when it comes to the most advanced jackup rigs. As such it will benefit from still high day-rates for jackups in the region.
Rowan also trades at a discount to Todco and Ensco, the company’s most direct competitors in the region. Rowan rates a buy in the Wildcatters Portfolio.
On the services front, the key consideration is geographic exposure—there’s a huge difference between companies focused on the international markets and those focused on North America. Relatively small independent firms dominate North American production. Such companies tend to be more commodity-sensitive–a relatively small decline in oil or gas prices can result in delayed or canceled projects.
Internationally, projects tend to be of a larger scale and take many years to plan and develop. These projects are far less likely to be delayed or canceled even if there’s a relatively severe decline in energy prices. A perfect example is Saudi Arabia: The country’s national oil company, Saudi Aramco, has committed to spending money on developing new reserves and increasing its production capacity. It’s unlikely that such plans would be revised if oil falls into the 40s.
As I pointed out in the November 30 issue, Not So Easy, growing global production of oil to meet demand is becoming more difficult. In the early ‘80s, Saudi Arabia was able to increase production simply by opening up the taps on some of its supergiant fields. Now, to add a comparatively small amount of capacity, the Desert Kingdom is spending billions. The same is true all over the world. Adding to reserves and growing production is a complex, technically advanced process because the easiest-to-produce reserves have already been largely exploited. This is just another way of saying that producing oil and gas is becoming more service-intensive. That is, of course, music to the ears of the services business.
I have long focused on the internationally levered services and infrastructure plays. These companies are in the best position to profit from major international spending plans currently underway in regions such as the Middle East. And, as noted above, these names are not as sensitive to drops in commodity prices because international projects are relatively price-insensitive.
The early call to buy internationally levered services and infrastructure names was successful. Some of the winners included Schlumberger (NYSE: SLB) and Cooper Cameron (NYSE: CAM). Schlumberger is the world’s largest services firm and has the most advanced technology–it is, therefore, uniquely positioned to benefit from the growth in international services demand. Cooper Cameron makes subsea equipment, equipment used to produce deepwater reserves. Subsea is a major beneficiary of the current boom in deepwater development. I continue to recommend Cooper in the Wildcatters Portfolio.
Also on the services side, I recommend Weatherford International (NYSE: WFT). Weatherford specializes in services used for brownfield development; the company is a leader in technologies and services used to squeeze more oil out of older, mature reserves. This includes, for example, underbalanced drilling. Drilling into mature reservoirs can actually damage the reservoir rock itself and impair production; underbalanced drilling is a technique for drilling into such reservoirs without causing damage. Weatherford remains a buy in the Wildcatters Portfolio.
Not all of the recommendations in the services business panned out. In the spring I recommended shorting pressure pumping specialist BJ Services (NYSE: BJS).
Oil and gas do not exist underground in giant caverns or lakes. These hydrocarbons are trapped inside the pores of rocks such as sandstone. Geologists use two terms to describe reservoir rocks: porosity and permeability. Porosity refers to the number of pores in a given rock sample. The more porous a rock, the more oil and gas it can hold. In contrast, permeability refers to how well connected the pores in a rock are to one another; the more permeable a rock, the easier it is for hydrocarbons to flow out of their pores and into a well.
To improve permeability, services firms will perform hydraulic fracturing by pumping a gel-like substance into the reservoir rock itself under tremendous pressure. Sometimes literally hundreds of pressure-pumping trucks are used for a single well. This fluid under pressure actually fractures and cracks the rock, creating channels through which oil and gas can flow.
BJ Services is the leader in North American pressure pumping. In the spring, I felt that BJ Services would have trouble raising their prices because capacity–pressure pumping trucks and equipment–rose rapidly in 2005. I expected this additional pressure pumping supply to push down prices for pressure pumping services and intensify competition. I also believed that small North American producers were beginning to balk at high pressure pumping fees.
I was completely wrong on both counts: Demand was so tight that any additional supply was easily absorbed and high commodity prices meant that producers were more than willing to pay up for pressure pumping. Several major price increases were pushed through in 2005 and margins at BJ Services continued to rise. Over the summer, we were stopped out of the stock at a loss of 15 percent.
I’ve totally changed my tune on this stock. High natural gas demand in the US and limited import capacity spell a strong North American drilling market. This is good news for the pressure pumping business. I now recommend BJ Services (NYSE: BJS) as a buy in the Wildcatters Portfolio.
Stock Talk
The Energy Strategist Portfolios are designed to be the investor’s guideline to the industry. The aim of the portfolios is to offer the best ideas in the sector and advice of when to buy, hold or sell. Stop-loss (stops) recommendations are protection against huge drops, especially in more volatile stocks like those of drillers and service companies.
As the portfolios are constructed, the suggested stocks will try to capture in the best way possible our thinking regarding the short- and long-term direction of the energy market. Investors should evaluate the rationale behind each theme and decide if they want to add the suggested stock in their portfolio. And once again, pay attention to the stops as well as the “buy under” recommendations suggested in the portfolio tables.
On the “Portfolios” tab of the Web site, you’ll find three tables labeled Proven Reserves, Wildcatters and How They Rate. The Proven Reserves Portfolio consists of more defensive income-oriented picks. The list includes, for example, some integrated oil giants as well as several high-yielding Master Limited Partnerships. The Wildcatters is a more growth-oriented model portfolio. These are my favorite picks for growth and capital appreciation potential. Some of these companies pay small dividends but that’s not the focus of this portfolio.
Finally, there’s How They Rate. This table is NOT a model portfolio; rather it’s a guide to The Energy Strategist’s coverage universe. I realize that many subscribers own energy stocks not currently in the TES portfolio; this table offers my latest buy, sell or hold advice on those names.
In addition, I occasionally offer some more aggressive recommendations that I call trades. In most cases, I intend to hold trades for six to nine months or less and am playing a specific catalyst. I will make these recommendations via flash alerts and update the recommendations in How They Rate.
A Look Back
By Yiannis G. Mostrous
In the first issue of this publication we wrote, “The thesis of The Energy Strategist is that cheap oil prices are a thing of the past.”
Nothing has changed this assessment.
For the past nine months, we’ve offered our projections for the prices of oil and natural gas because the short-term prices for each can affect portfolios, particularly at the margin. A well-explained short-term forecast is more important as investors’ interest in a specific sector increases.
If we can reduce to one material fact for long-term investors, it would be this: The per barrel price of oil has established a plateau–$40–higher than was thought possible just a couple years ago, when many observers pegged the price at $20. We’ve made the case for higher oil prices on numerous occasions, and are confident in our assessment. Suffice it to say the world is entering a new era where the two most populous nations (China and India) are trying to join the word’s economic system–their parallel aspirations will undoubtedly affect the world’s resources at the margin. It is imperative that investors understand this fact: The impact these two countries are having on the world economy is unprecedented; not even a young United States brought such force to bear as it became an industrialized nation.
We’ve been fairly accurate in our predictions since TES came to life in late March 2005. In the first issue, we cautioned that oil would correct in the short term. Two months later, on May 20, oil hit its low at $46.80. In May we recommended buying, as we thought oil was turning around (see TES, May 26, 2005, The Time Is Now. Over the next three months, oil rallied to almost $70.
In the May 26 issue, and in the two September issues (see TES, September 14, 2005, The Selloff Consensus, and September 29, 2005, Energy Infrastructure), we suggested oil prices would stay closer to $60 this year than to $50; oil has spent seven months in 2005 above $55. In October (see TES, October 12, 2005, The Majors) we cautioned again: “As these latecomers have raised their oil price projections for this year and next, we have become a bit more concerned. This newfangled optimism could lead the market to overshoot, a time-honored reality when the latecomers try to make a quick profit.”
Since then oil went from $64 to $58. Finally, writing about the weakness in oil prices we wrote: “Regarding the weakness in the market, the per barrel price of oil (WTI) can go lower in the current correction. Our base case calls for $55, but we would not be surprised to see it at $50.”
When it comes to natural gas, we’ve made our biggest bet with our most recent assessment: “Current weakness in the natural gas market will develop into a more serious correction: Prices could correct all the way down to $10 per thousand cubic feet, if not lower, based on old-fashioned supply and demand.”
Many questioned that call a month ago, especially since gas prices went from $12.68 to $15.42 immediately after TES came out. And yet natural gas is currently trading at $11.20, and still looks quite vulnerable in the short term. We will revisit this issue in the coming year.
There is now much discussion of $40 (or lower) oil. Although oil could reach such levels if there is a global recession next year, we believe it’s still too early to make such a definitive call. That said, one of our aims is to anticipate big changes and suggest ways to profit from down moves, or simply to avoid the more slippery stocks. (See, for example, our short recommendations throughout the year. In addition, we’ve found segments within the energy sectors that look promising, like the coal sector.) This is another way of working around the entrenched idea that “oil is all” in the energy investing universe.
As things stand (geopolitical and recession worries notwithstanding), our view is that oil prices will stay above $50 in 2006. In other words, we differ from the overexcited $60 per barrel crowd, though we are not as bearish as the $40 folks.
ConocoPhillips And Burlington Resources
Much has been written about ConocoPhillips’ (NYSE: COP) acquisition of Burlington Resources (NYSE: BR). The deal is complex, and time will tell if it was a wise move. Given ConocoPhillips’ current management’s success in acquisitions in the past, we’re prepared to wait a bit before offering a verdict. It’s obvious such a mega-deal will have good and bad aspects, but we’re looking at the positives first.
The new entity will be the leader in the US natural gas market, boasting high-quality reserves. There should also be a lot of synergies in the operational front as consolidation of regional operations commences. ConocoPhillips will gain by the transfer of Burlington’s knowledge and widely admired disciplined investment policies. Quite a few of Burlington’s top managers will sit on the new board and the new entity should retain a good portion of important Burlington personnel.
On the other hand, very few analysts like the move. And yet very few liked Conoco’s purchase of Arco’s Alaskan assets in 1999, or its purchase of TOSCO’s refining assets in 2001. In retrospect, of course, these acquisitions look solid since oil prices have appreciated so much. Then again, long-term gas prices should go much higher from current levels, in which case ConocoPhillips will look good–again.
Another critique reasons the price is too high. This may be true, but who’s to say that with lower gas prices–say, in the spring–ConocoPhillips would manage to avoid a price-raising bidding war?
At the end of the day there is one way to assess a deal like this: the future price performance of the new entity’s stock. Both have done very well, so there’s a strong possibility a successful implementation of the merger can, in due course, produce the same good results. ConocoPhillips (NYSE: COP) remains a hold.
Stock Talk
Add New Comments
You must be logged in to post to Stock Talk OR create an account