Yields on ten-year US Treasury bonds are currently hovering around 4.5 percent. Meanwhile, the Philadelphia Utility Index yields just 3.5 percent and the Bloomberg REIT index just 5.0 percent. Utilities, REITs and bonds are the go-to sectors for investors looking for income, but none are offering high yields right now.

Fortunately, the energy sector offers an alternative. Publicly traded master limited partnerships (MLPs) can hand investors high tax-advantaged yields, outstanding growth opportunities and relatively low exposure to volatile oil and gas prices. MLPs are traded right on the major US exchanges just like common stocks. And the better-placed MLPS offer annual distribution growth (payout increases) of 5 to 10 percent on top of yields between 6 and 8 percent.

Better still, changes to the US tax code are allowing mutual funds and other institutional investors to more freely buy MLPs. This is a whole new class of investor, previously shut out of the group. As this institutional capital begins to find its way into MLPs, the buying pressure will push up prices for the best-placed partnerships.

In short, the bull market in MLPs is just getting started and this is my top slow-but-steady income idea for the next few years.

I already hold four MLPs in the income-oriented Proven Reserves Portfolio: Teekay LNG Partners (NYSE: TGP), Enterprise Product Partners (NYSE: EPD), Penn-Virginia Resource Partners (NYSE: PVR) and Natural Resource Partners (NYSE: NRP). All remain buys at current levels.

I’m adding another MLP to Proven Reserves, Valero LP (NYSE: VLI), and I’ve picked up coverage of several additional MLPs in How They Rate–please see this table (click the “Portfolios” tab on the Web site) for my latest advice.

A few stocks in the oil services, independent E&P (exploration and production) and drilling groups are at attractive levels right now in the wake of the recent selloff. I’m adding E&P company Occidental Petroleum (NYSE: OXY), Gulf of Mexico-focused driller Rowan Companies (NYSE: RDC) and North American services specialist BJ Services (NYSE: BJS) to the Wildcatters Portfolio.

To summarize, I’m adding or reiterating my buy recommendations on the following stocks:

· Enterprise Products Partners (NYSE: EPD)
· Natural Resource Partners (NYSE: NRP)
· Penn-Virginia Resource Partners (NYSE: PVR)
· Teekay LNG Partners (NYSE: TGP)
· Valero LP (NYSE: VLI)
· Rowan Companies (NYSE: RDC)
· BJ Services (NYSE: BJS)
· Occidental Petroleum (NYSE: OXY)
· ExxonMobil (NYSE: XOM)
· Total (NYSE: TOT)

As highlighted in recent Flash Alerts, we’ve been stopped out of several stocks in the recent selloff, mainly for nice gains. Those stop-outs are reflected in the Portfolio tables; the gains reported are based on the stock’s initial recommendation in the Portfolio.

Before I turn to a detailed analysis of these stocks, let’s take a look at MLPs and their advantages in more depth.

An MLP Primer

MLPs are partnerships that trade directly on the major exchanges just like common stocks. Most of the MLPs I follow trade on the New York Stock Exchange and can be purchased easily through any discount or full-service broker at the same commissions you’d pay to buy any stock. Just like common stocks, MLPs offer limited liability for unitholders (shareholders). That means that you’re not responsible for any charges or losses beyond your investment in the MLP.

MLPs raise capital by issuing units–the rough equivalent of shares in a common stock–and are permitted by US law to own certain specific types of assets. Pipelines, gas processing facilities, coal properties and production platforms are just four of the most common assets owned in MLPs.

Most MLPs are owned jointly by one or many general partners (GP) and limited partners (the unitholders). The GP is responsible for the day-to-day operation and management of the MLP’s assets. The GP makes all decisions related to acquisitions of new assets and sales of existing assets. Normally, the GP also owns a small stake in the MLP and receives what’s known as an incentive distribution for managing the partnership’s assets. Incentive distributions are, in almost all cases, based on a pre-set tiered system–the more money the GP generates to pay out to unitholders, the higher their take of those cash flows. The idea is that this incentivizes the GP to make more distributable cash for unitholders–the more they make for the LP, the more they get to keep as an incentive distribution.

Some GPs are themselves publicly traded partnerships. But in most cases, the GP is a normal corporation; some of the largest firms in the energy business such as Williams, Teekay Shipping and Valero act as GPs for publicly traded MLPs. A GP’s incentive distribution can be as little as 1 to 5 percent for the first distribution tier to as high as 50 percent of cash flows for the highest tier known as the high split. Obviously, GPs don’t get the high splits until they achieve some significant distribution growth over time for the LPs.

When you buy an MLP you become an LP unitholder. This entitles you to no control or voting rights over the operation of the MLPs assets; you can, of course, sell your MLP units at any time just as with a common stock. However, you do have ownership rights over the majority of those assets and receive regular distributions of cash from the partnership.

This brings us to taxation. The advantage of an MLP is that unlike a corporation, these securities don’t pay corporate-level tax. Instead, the majority of their cash flows are simply passed on to the LP unitholders; individual unitholders are, in turn, responsible for paying tax on their share of the MLPs income. In most cases, 85 to 90 percent of all operating profits earned by the MLP are passed along to limited partners (before the GP’s take). This is behind the high yields offered by the sector.

Better still, unitholders are not responsible for paying tax in the same way they would be for dividends on a common stock. That’s because the IRS treats some of the distributions as a return of capital, not normal income. Typically, roughly 10 to 25 percent of the annual distributions from an MLP come in the form of ordinary income and are taxed at the full income tax rate. Because the MLP is able to pass on part of the depreciation tax shield to unitholders, the rest of the annual distributions are considered a return of capital.

Return of capital distributions lower your cost basis in the MLP; ultimately, this will raise the capital gains you have to claim when you sell the MLP. That gain would be taxed at the capital gains tax rate (currently 15 percent for long-term gains). However, until that time, this income is untaxed. The ability to defer income taxes is an obvious and attractive advantage for many yield-seeking investors.

It’s worth mentioning that this taxation system does add a level of complication to annual tax returns. MLPs issue to all unitholders a Form K-1 that details the split between regular income distributions and return of capital distributions. Form K-1 and accompanying documentation have become clearer in recent years, however, it does require filing additional forms with your annual return and keeping records of your cost basis.

The New Era Of MLPs

While the tax advantages of MLPs are certainly a clear long-term advantage for yield-hungry investors, the real beauty of MLPs isn’t just yields but total return. As I mentioned above, MLPs are likely to offer 5 to 10 percent annualized increases in payouts coupled with yields of 6 to 8 percent over the next few years.

A perfect example of this total return phenomenon is Proven Reserves holding Enterprise Products Partners. This particular MLP has boosted its distributions at an annualized rate of just less than 10.5 percent over the past five years. Five years ago, the annualized distribution was around $1.10 per unit; now, that distribution has grown to about $1.63, an increase of roughly 50 percent. Enterprise has pushed through a long series of steady quarterly payout hikes.

In addition, the MLP itself has appreciated significantly. The combination of steadily rising distributions coupled with capital appreciation has resulted in some impressive performance. The chart “Growth of $10,000” illustrates just how well $10,000 invested in Enterprise has performed over this period.



Source: The Energy Strategist

And this performance isn’t just a product of the bull market in oil and natural gas prices that began in 2002-03. Consider, in particular, that Enterprise performed well even in the midst of the 2001-02 recession and during the massive pullback in energy prices in 2001. In fact, during the big natural gas bear market of 2001, Enterprise hiked its distribution by more than 13 percent. That’s testament to just how isolated this MLP is from volatile gas and crude prices.

MLPs also offer an obvious yield and total return advantage over other income sectors like utilities, REITs and bonds. The chart “Income Investments” illustrates the current average yield and historical annualized dividend/distribution growth for several traditional income investments.



Source: The Energy Strategist

There are few indexes that track the performance of oil and gas-related MLPs. To calculate the numbers above, I simply took a straight average of the 12 largest energy-related MLPs in the US. Over the past five years, the average MLP has boosted its distributions at an average annualized rate of nearly 10 percent. The current average yield on my basket of MLPs stands at 6 percent.

Compare that to real estate investment trusts (REITs). The Bloomberg REIT index contains a total of 180 publicly traded REITs. The average REIT in the Bloomberg Index currently yields just 5 percent. I also calculated the average annualized dividend growth for the 150 REITs in the index with at least five years of dividend history. The result: the average REIT has boosted its payout by just 2.73 percent annualized over the past 5 years. REITs are currently yielding less than the basket of MLPs and historical dividend/distribution growth has been less than one-third as much.

The utility stocks in the benchmark Philadelphia Utility Index (UTY) fare even worse on this comparison. The average utility yields just 3.47 percent right now and has managed less than 0.50 percent annualized dividend growth over the past five years.

I illustrate these statistics not to say that bonds, utes and REITs are bad investments. My point is that MLPs, even ignoring their tax advantages, have to be considered at least as attractive for income-seeking investors. MLPs, as a group, offer not only high dividends but also the potential for growth in distributions and capital appreciation.

I also see some near-term catalysts for the MLP space. Perhaps the most important is a subtle and rather overlooked change to the US tax code that opens up MLPs for more institutional investment. Specifically, mutual funds must derive 90 percent of their income from certain qualified sources to qualify as “regulated investment companies.” Until 2004, this did not include MLPs. Funds could place no more than 10 percent of their respective total assets in MLPs.

The American Jobs Creation Act of 2004 (the “Act”) changed all that. The Act specifically allows funds to put up to a quarter of their assets into MLPs provided a single MLP accounts for no more than 10 percent of total assets.

Some of the most popular funds in recent years have been income-focused funds. Given the paltry returns now available from REITs, bonds (even high-yield bond yields are near record lows) and utilities, you can bet that MLPs will become a more attractive asset class. There’s even some chatter concerning a few funds that will start up specifically intended to hold MLPs (up to the maximum legal limit).

To date, MLPs have been mainly a retail investor’s game. Because institutions were effectively barred from owning these publicly traded partnerships, the MLPs did not benefit from the huge quantity of institutional money that’s been looking for high yield plays. Changes to the tax law will mean that institutional money begins to gradually move into the sector alongside retail cash. That will undoubtedly push the MLPs higher.

A second legal issue that paves the way for an MLP bull market is the so-called “Lakehead Decision” issued by the Federal Energy Regulatory Commission (FERC). This decision makes it easier for MLPs to hold regulated pipeline networks.

Under such a scenario, pipeline owners charge regulated rates for shipping natural gas across their pipelines. These regulated rates are set such that the pipeline operator is deemed to earn a relatively fair rate of return on their network. But prior to this decision, some shippers were arguing that because MLPs have special tax status the rates should be altered to reflect that advantage. The Lakehead Decision closes that door for the most part–MLPs can hold regulated pipeline systems and will be treated the same as corporate owners of pipelines. This makes the MLP structure even more attractive.

Finally, I’m encouraged by the recent shift in incentive distributions for GPs. There’s been some consternation about incentive distributions from older MLPs. These MLPs that have been in existence for many years and have seen steady distribution increases. While that’s a good thing for the unitholders, it also means that the GP is entitled to the high split on incentive distributions. Because that split can be as high as 50 percent, this seems rather unfair for unitholders.

In contrast, a newly issued MLP isn’t faced with the same high incentive distributions. The reason is that it takes time for the GP to grow distributions enough to earn that higher cut.

But that’s been changing. A handful of older MLPs have revised their partnership agreements to cut their high split levels. One of the first was Proven Reserves holding Enterprise Products Partners. Enterprise has a split of 25 percent, roughly half the group average. This makes Enterprise units an even more attractive investment.

Despite these notable tailwinds for the MLP class at large, it’s a mistake to suppose that all MLPs are equally attractive. It’s also a big mistake to simply troll through the group looking for the MLPs paying out the highest yields.

I look for two key traits in an MLP: potential for distribution growth and relatively low commodity price risk. When it comes to distribution growth, the key is to look for MLPs that will see strong organic growth from their existing assets or have the potential to acquire new assets and boost cash flows.

Shipping LNG

A perfect example of a growth-oriented MLP is Teekay LNG Partners (NYSE: TGP), which currently owns four operating liquefied natural gas (LNG) tanker ships.

Natural gas can be super cooled until it becomes a liquid; that liquid is easily transported by tanker ship. Japan, a nation with few domestic sources of natural gas, is already a major importer of LNG. LNG will also become the most important source of natural gas imports in the US over the next decade or so. Demand for LNG will explode globally. (For more details on the LNG growth story, see TES, July 13, 2005, Liquid Energy.)

All that LNG needs to be transported and that transport is conducted via specially fitted tanker ships. In Teekay LNG’s case, all four of its currently operating LNG tankers are leased out to large international oil and gas companies on long-term contracts. The company doesn’t operate on the more volatile spot market (short term single journey contracts)–in fact, Teekay LNG’s shortest term contract has another 17 years to run. These long-term contracts are mainly fee-based, offering Teekay LNG stable, dependable revenues and cash flows over time. These dependable cash flows spell steady distributions to unitholders.

Teekay LNG’s GP is Teekay Shipping, one of the oldest and largest crude oil tanker shipping companies in the world. Teekay Shipping also owns about 70 percent of the outstanding units in Teekay LNG. The power and management expertise of this GP is a key advantage for Teekay LNG.

Existing contracts are profitable. But the growth will come from new ships; at this time Teekay has seven new ships under construction, all scheduled for delivery over the next two-and-a-half years. This will bring the MLP’s fleet to a total of 11 LNG tankers.

And Teekay LNG is not taking a gamble by building the ships. All are already contracted out to major international firms on contracts of at least 20 years. Teekay LNG has contracted customers long before the ships are actually built. The MLP could easily sign additional contracts to build still more ships provided it can identify customers willing to hire those ships on contracts of at least 20 years’ duration.

Because the company went public in May of this year, it has only paid out one quarterly distribution to date, $0.24 per unit. The next payment will likely come in November and should be higher. I expect Teekay LNG’s dividends to total approximately $1.60 over the next year, equating to a yield of 5.8 percent.

But that will grow quickly as the new LNG tankers are built and put out on contract. Given that the size of Teekay LNG’s fleet will nearly triple between now and mid-2008, the potential for distribution hikes is obvious–Teekay LNG will likely see some of the fastest distribution growth of any major MLP. And because the ships are all on long-term contracts that are primarily fee-based, there is little commodity price risk associated with the MLP. That means that even if natural gas prices drop significantly, the impact to Teekay LNG’s bottom line should be minimal.

The Coal MLPs

Proven Reserves holding Natural Resource Partners (NYSE: NRP) has similarly strong prospects for distribution growth. Natural Resource owns coal-producing properties with approximately 1.8 short tons of proven reserves. Coal MLPs like Natural Resource do not actually mine or produce coal; these companies simply lease out their land to miners like Peabody Energy and Arch Coal, earning a royalty fee in the process.

Coal is far from a dead energy source (see TES, September 1, 2005, King Coal). Not only is power produced from coal far cheaper than natural gas-fired but it’s not as polluting as you may think. Specifically, the use of low-sulphur coal can cut sulphur dioxide emissions from coal-fired plants by as much as 80 to 90 percent.

The US is blessed with considerable domestic reserves of coal, some of the largest and highest quality reserves anywhere in the world. The most extensive reserves of low-sulphur coal are located in the Powder River Basin (PRB) in the Western US. The PRB is the key growth market for the low-sulphur coal that coal-fired power plants need to meet increasingly strict pollution guidelines.

Natural Resource Partners has reserves in the PRB region, as well as considerable reserves of primarily low-sulphur coal in Appalachia. Hot demand for coal spells rising royalty fees for coal MLPs and, of course, rising distributions for unitholders. Natural Resource Partners recent distribution hike was its eight quarterly hike in a row, and brings the yield to just shy of 5 percent.

The same basic story holds for fellow coal MLP and Proven Reserves denizen, Penn-Virginia Resource Partners (NYSE: PVR). This MLP’s coal reserves are mainly located in Appalachia and are primarily low-sulphur. The company’s quarterly payout (due November 14 to unitholders as of November 3) currently stands at about $0.65, a roughly 5 percent yield.

Coal MLPs do have some commodity risk: If coal prices were to drop precipitously, royalty revenues would likely fall, hitting distributions. But I just don’t see that happening any time soon. Peabody Energy, the largest coal mining company in the US, recently reported in its quarterly earnings conference call that 15 to 20 major plants nationwide have less than 15 days of coal supply on hand. And a handful of those have less than five days’ supply in their coal yards. This is drastically below the comfort level. Normally, 50 or more days of coal supply are kept on hand this time of year. There is a very real risk that there’ll actually be a shortage of coal in the Northeast this winter if it’s a cold season.

This scarcity has driven a 150 percent increase in low-sulphur coal prices in 2005 alone. And coal prices and coal-related stocks barely felt the recent correction that swept across the energy space. I see coal as a far more defensive market at this time than either oil or natural gas and the coal MLPs are a great way to play the trend.

Oil & Gas

Proven Reserves holding Enterprise Products Partners (NYSE: EPD) is one of the oldest and largest MLPs in the US. This partnership concentrates on midstream natural gas assets–pipelines and natural gas processing facilities. Enterprise Products owns more than 17,000 miles of natural gas pipelines and more than 13,000 miles of pipelines designed to carry natural gas liquids (NGLs), a valuable by-product of natural gas processing (for more on Enterprise Procucts Partners, see TES, June 8, 2005, Gas, Pipelines And Dividends).

Enterprise Products Partners owns a large network of gas processing facilities. Natural gas in its raw state is not suitable for burning in either power plants or as a source of domestic heat. Certain impurities, such as sulphur pollutant and water vapor, must be removed.

What’s more, the NGLs, including propane, butane and natural gasoline, can be separated from the gas and sold separately. The best part about this is that LNG and deepwater natural gas–some of the fastest growing sources of gas–contain a large amount of NGLs that must be separated. That means more potential processing business for Enterprise.

On the growth front, Enterprise’s network of offshore production platforms is an attractive asset. These platforms are used to process and produce offshore gas and oil fields. It would be too expensive for these platforms to handle production from just a single company’s wells so they normally produce fields owned by several different companies. The hubs are, in turn, connected to pipelines, which can transport gas back to shore for further processing and use. Enterprise has seven offshore hubs in operation and an eight under construction. Energy companies pay a fee to use these platforms.

Finally, Enterprise rarely actually takes ownership of the gas it processes and ships, instead earning a fee for processing and/or transporting gas. This reduces or effectively eliminates commodity pricing risk. Enterprise Products Partners is a buy.

I’m adding a fifth MLP to the Proven Reserves Portfolio, Valero LP (NYSE: VLI), a play on crude oil and refined product pipelines. Please note the distinction between Valero Energy (NYSE: VLO) and Valero LP. As the name implies, Valero LP’s general partner is controlled by Valero Energy, the largest refiner in the US. In fact, Valero LP was spun off from Valero back in 2001 when the latter acquired Ultramar Diamond Shamrock. Valero still owns just less than one-quarter of the MLPs outstanding units and 100 percent of the company’s GP.

Valero LP has four basic businesses: Refined product pipelines, crude oil pipelines, refined product terminals and crude oil storage facilities. Pipelines are the MLP’s largest business. In total the network of product and crude oil pipelines is over 9,100 miles in length with a few expansions currently underway. Pipeline-related revenues account for just under half of total revenues.

Refined product pipelines carry processed products like gasoline, jet fuel and kerosene from refiners to third-party pipelines or terminal/storage facilities. Traditionally, most of the network was hooked up to Valero Energy refineries; Valero paid fees under long-term contracts for transporting the products. The key is that these fees are not based on the value of the products shipped and the LP does not take ownership of the refined products that travel along its pipes. Instead, the fee charged is based on the number of barrels shipped over the pipeline grid. That means that there is little commodity price sensitivity–as long as Valero keeps pumping through the network, the fees keep rolling in.

But in July, Valero LP completed the acquisition of Kaneb Pipeline Partners, an LP with extensive assets of refined product pipelines. The result: the company now serves other refining companies and has diversified its customer base.

For the most part, crude oil pipelines owned by the LP are designed to carry crude oil from ports or storage facilities to refineries for processing with a similar per barrel arrangement as the refined product pipes. Just as with the refined products pipes, Valero Energy is no longer the sole customer (though still a major one) after the Kaneb acquisition.

Several of these pipelines fall under either state or federal regulation. These regulatory bodies require that access to the company’s pipeline grid be non-discriminatory and allows challenges over rates. To date this has never occurred and the main customer, Valero Energy, has agreed not to challenge Valero LP’s rates until at least April 2008. Close relationships between the LP and its customers make a rate challenge rather unlikely.

The final two businesses are crude oil storage and terminal operations. Terminals are designed to store and blend refined products. Kaneb derived well over half its revenues from terminal operations; the acquisition helped beef up the combined LP’s exposure to terminal operations. In fact, with 94 terminal facilities located all over the US as well as operations in the Carribbean, United Kingdom, and New Zealand, Valero LP is one of the largest terminal operators in the world. Customers pay a per barrel fee for the storage of crude and refined products as well as additional fees for blending and handling product.

While this asset base is expansive and impressive, it’s not the main reason I’m recommending Valero LP. The more important point is that there is scope for major growth in distributions over the next few years. This growth will be supported by operations that are not sensitive to changes in crude oil or refined product prices.

Valero Energy’s association with Valero LP is a crucial factor in that regard. Valero Energy’s management team is among the most respected and experienced in the energy business; this team’s association with Valero LP is very encouraging. More important, however, is potential for Valero to sell additional assets to Valero LP. The key to this is that Valero has a number of pipelines, terminals and other assets that throw off dependable cash flows–these assets can be sold to the MLP.

Because MLPs are tax-advantaged such a move would reduce Valero’s own tax liability on those assets. Assets inside an MLP also tend to earn higher market values due to the tax-advantaged structure. At the same time, Valero’s control of the GP and ownership stake in the LP means it would not have to give up much control or cash flows derived from those assets. Such a sale would free up capital for other uses.

This is even more true following Valero Energy’s takeover of Premcor on September 1. While it’s a little early to identify just how many assets Premcor owns that are suitable for sale into the MLP, the potential is substantial. In their conference call back in July, management was guarded on this point because the Valero/Premcor deal had yet to close. But with the Premcor acquisition out of the way, I expect to hear more about Premcor assets on the upcoming conference call. I would not be at all surprised to start hearing of new asset sales into Valero LP by year’s end.

Direct assets sales aren’t the only potential synergy between Valero Energy and the MLP. In the past the two companies have formed strategic relationships to build new pipelines or facilities; this allows Valero LP to leverage its GP’s size and access to capital. In most cases, such projects also connect in some way to Valero’s own operations. A perfect example is the recent pipeline built from Texas (near key Valero refining assets) to a Pemex plant in Mexico.

One final point worth mentioning is Valero LP’s high split. Like Enterprise Products, Valero LP has a maximum incentive distribution of just 25 percent to its GP. As stated above, that’s about half the industry average. This means that the LP unitholders get to keep more of the cash flows from LP operations. Valero LP is a buy.

To summarize, the MLPs are a great, defensive play on growth in the oil and gas business. These partnerships do benefit from growth in energy demand–after all, the more demand there is, the more gas or crude oil that needs to be shipped and/or processed. But the better-managed MLPs don’t have much exposure to actual commodity prices because they don’t own the oil and gas shipped.

Other Portfolio Moves

The recent correction in oil and gas prices precipitated a significant decline in related energy stocks. While I see the potential for more bloodletting over the next few months for the sector at large, some stocks are attractive at current levels. The key to finding the winners in the space right now is to look for shorter-term growth catalysts that can offset the effect of any further decline in oil and gas prices. With that in mind, BJ Services (NYSE: BJS) and Rowan Companies (NYSE: RDC) are added to the Wildcatters Portfolio as buy recommendations.

I outlined the catalysts behind both stocks in the last issue (see TES, October 12, 2005, A Look Back, A Look Ahead) but will summarize my logic below.

The hottest growth market for driller right now is jackup rigs. Jackup rigs are designed for drilling in relatively shallow waters and are supported by “legs” that actually rest on the bottom. The problem is that there’s a major supply shock right now exacerbated by the recent Gulf of Mexico hurricanes. Pre-Katrina, the global jackup market was already in a slight deficit. Several producers have stated that rig availability has been their main problem in recent quarters.

But the hurricanes destroyed or severely damaged a number of shallow water jackup rigs. Many of these were to be shipped abroad for use in other markets. Because the jackup market is global right now–rigs have been moved to get higher day-rates aboard–the effects of hurricane-related damage are being felt thousands of miles away, in Asia and the Middle East.

Commodity jackups are now seeing day-rates of as high as $100,000 per day while premium jackup rigs are pushing $200,000. These are 20 to 30 percent higher than pre-hurricane levels and roughly double year-ago levels. The strength is global. A recent conference call from Noble Energy highlighted an acute shortage of rigs in Saudi Arabia and West Africa; both regions are seeing day-rate increases similar to what’s evident in the Gulf of Mexico.

Rowan drilling lost several rigs during the Gulf hurricane season, more rigs than any other company. But it maintains one of the strongest positions in the Gulf market with a stable of mainly commodity and premium jackups as well as a few land and deepwater rigs. Analyst earnings estimates are still not reflecting the recent jump in day-rates that will power Rowan’s bottom line. Rowan is now a member of the Wildcatters Portfolio.

The oils services business is dependant on drilling activity; the more drilling activity, the higher the demand for services. The best measure of drilling activity is the rotary rig count, basically a measure of the number of active drilling rigs in a particular market. The chart “Active Rotary Rig Count” shows the count for North America.



Source: Baker Hughes

It’s clear that the North American rig count has been jumping rapidly of late. In fact, the rig count is growing faster in this market than most international markets; services companies that primarily serve North America have the most upside over the next quarter or two.

BJ Services is a leader in North America. BJ held up very nicely in the recent correction, largely because earnings estimates continue to rise sharply. BJ Services is also added to the Wildcatters Portfolio as a buy.

Steady Hands

By Yiannis G. Mostrous

Occidental Petroleum (NYSE: OXY) has come a long way from its humble beginnings in the 1920s and, most importantly, from its sorry state of the early 1990s.

After disposing of its non-oil and gas assets, a move that allowed it to basically solve its liquidity crisis of the early ‘90s, Occidental Petroleum reduced its geographical presence in an effort to focus on core projects. Oxy narrowed its oil and gas focus from 27 countries and 17 states in 1997 to nine countries and five states today, and it now generates among the highest free cash flows among within its peer group.

Oxy’s main business is enhanced oil recovery (EOR). The company applies these techniques to mature oil fields to recover additional reserves or prolong production after primary recovery methods have run their course. By increasing production efficiency, EOR techniques can prolong the economic life of older fields by as much as 30 years. Approximately 74 percent of Oxy’s reserves are located in the US, 17 percent in the Middle East, and the remainder in Latin America.

Oxy’s future growth will come from abroad, mainly the Middle East and North Africa. Its already considerable presence in the Middle East is expanding based on its involvement in big projects in Qatar and Oman. Oxy increased its visibility in the region when it started developing the Idd El Sharqi North Dome (ISND) oil field, a mature field offshore Qatar.

The field was discovered in 1961, went into production in 1963 and peaked at 50,000 barrels of oil per day in 1970. When Oxy took over production in October 1994, average daily production had fallen to 20,000 barrels. With the application of advanced drilling systems and new technologies, Oxy was able to boost production to more than 138,000 barrels per day, nearly three times the previous peak achieved a quarter of a century earlier. Given the management team’s strong relationships in the Middle East, and Oxy’s track record of execution, expect the company to continue to increase its presence in the region.

Its latest move overseas has been in Libya. In early 2005, Occidental was awarded interests in nine exploration blocks in Libya’s first licensing round since US-imposed sanctions were lifted. Given Libya’s resources, the relationship could become a very profitable one for Oxy.

Acquisitions have also been a key element in Occidental’s growth throughout its history, and they remain an integral part of the company’s growth strategy today. Oxy announced its most recent acquisition–Vintage Petroleum–on October 13. Oxy’s petrochemical business is also one of its critical assets, given its solid and growing cash flows it offers.

Oxy is very oil-sensitive–80 percent of its reserves are weighted toward crude oil, while its hedging of commodity prices is minimal. When it comes to earnings and cash flows, the company’s results will be magnified (at least in the short term) depending on the price of crude oil and natural gas. Oxy is reporting earnings at the end of the month, and therefore might experience some short-term volatility.

A genuine turnaround story with good future potential, Occidental Petroleum is added to the Wildcatters Portfolio; buy under 90.

Two For Keeps

Given the recent selloff in the market (especially in energy), investors have been asking two questions: Is it over? and What should one own when it comes to the majors?

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.

We expect the problems to come from the demand side, especially if the global economy experiences a slowdown entering 2006. As noted in the last issue (see TES, October 12, 2005, A Look Back, A Look Ahead), early indications are that demand might be weakening already. If this proves to be true, and as production in the Gulf of Mexico is restored, the price of oil will decline.

When it comes to the majors we recommend that new funds be committed primarily to two names, ExxonMobil (NYS: XOM) and Total (NYSE: TOT). Both remain Proven Reserves Portfolio stalwarts. Buy EXXONMOBIL under 65 and TOTAL under 140.