Some sub-sectors of the energy industry stand out for their growth prospects, analysts say.
Area of Coverage: Coal
Outlook: We think the outlook for coal is really good. The reason why we say it’s quite favorable is that the U.S. production of natural gas is continuing to decline. It would take the better part of 10 to 12 years to build a new nuclear power plant. Coal is the only thing we’ve got to bridge the gap for the power industry from gas generation to nuclear power generation.
There are several electric utilities turning to coal right now. Here are the exact number of megawatts of coal under construction and coming online by 2010: The coal industry has 400 megawatts coming online in 2006; 1,430 megawatts in 2007; 1,070 in 2008; 8,514 in 2009; and 20, 411 in 2010.
Only in the past three years have people acknowledged that it’s OK to build a coal plant. The whole idea of scrubbing technology has played an important part in this acceptance along with fact that the price of gas will not return to $2 anytime soon or for any sustained period of time. Even two years ago, no one thought it was for real that gas prices were on the move to a much higher level. Now it’s accepted. So when you do least-cost planning to build a new generation facility and you start to consider all the costs of the fuels as well as plant construction costs, coal makes economic sense.
Six years ago, every facility being built was natural gas. People have realized that the U.S. is running out. Liquefied natural gas is years away. I don’t think people can bank on it, and it’s not going to be cheap. We are not concerned about fuel switching at current natural gas prices. Coal inventories are more likely to increase than to decrease from here, and the harsh decline in coal prices is likely short-lived. We believe coal equities are set to rebound.
Outperforms: Alpha Natural Resources (ANR); Foundation Coal Holdings (FCL); International Coal Group (ICO) and Peabody Coal (BTU)
Top Pick: Peabody Coal
Why Peabody: Peabody has a great long-term fundamental story. It has scale, geographic diversification, a long-lived reserve base, and can play multiple coal strategies (e.g., clean coal, high sulfur coal, and metallurgical coal). The company’s pending acquisition of Australian producer Excel Coal will be accretive and represents a good use of cash.
Michael C. Heim
A.G. Edwards & Sons, Inc.
Area of Coverage: Gas Utilities
Outlook: We maintain a neutral stance toward the group as a whole with a positive bias toward those gas utilities with unregulated energy production. There were a number of developments that influenced our appraisal. Interest rates rose and could continue to rise. The yield on 30-year government Treasury bonds rose 6 percent during the quarter to 5.2 percent. We expect bond yields to continue climbing as higher commodity prices work their way into inflation numbers.
Gas prices have fallen, but the natural gas futures curve shows prices rising sharply this fall. While spot prices have fallen, upcoming winter contracts have remained above $10. The futures curve is not a perfect predictor of price movement, but it does indicate what price producers can receive for future production.
Consumers are conserving energy in reaction to higher utility bills. Gas distributors reported decreased weather-normalized gas usage in the first quarter. The decreases reported range from “mild” to 5 percent.
Gas utility stock valuations have come down from peak levels reached in September 2005 in response to rising interest rates and concerns regarding bad-debt expense and conservation. At current prices, gas utility stocks are trading at the mid point of our perceived trading ranges on both an absolute and a relative basis.
Buy-rated stocks: Energen Corp (EGN); MDU Resources Group (MDU); Questar Corp (STR); and Sempra Energy (SRE)
Top Pick: Questar Corp
Why Questar: Questar is a well run, integrated natural gas play in the Rocky Mountains — a rapidly expanding natural gas basin. We believe that Questar is only beginning to exploit its many assets and look for above-average earnings growth for many years. Our view of a company is always a question of valuation.
We think there’s a lot of near-term growth associated with Questar’s drilling activity. Questar owns 67 percent of the 18,000 acres that constitute the Pinedale Anticline, one of the newer, more prolific energy plays in the country. Questar has an aggressive drilling schedule planned for the next five to ten years.
We are looking at the forward natural gas market and seeing that while near-term spot prices have fallen, the 2006-2007 winter pricing remains very strong. Companies like Questar that have hedged most of their near-term production but remain exposed to 2007-2008 production and beyond should have good results.
Area of Coverage: Oil & Gas Exploration & Production
Outlook: Oil and gas stocks outperformed the S&P each year from 2003 through 2005, obviously driven by strength in oil and gas prices. Over the past six months, the sector has been choppy, reflecting weakness in natural gas prices and investor concerns about where prices are headed. Oil, of course, has been very strong year to date and, in fact, hit all-time highs at $80 a barrel. For 2007, we are looking for sustainability of near-record oil prices — $70 a barrel on average.
On the natural gas side, we are contrarians. Right now, the spot price of natural gas is about $7. Many analysts expect sustaining weakness on gas prices. We recognize that gas will probably be weak for the rest of this year. But then heading into next year, even with a normal winter, we expect gas to head toward the $10 level as the gas market normalizes. Given that, we are bullish on oil and very bullish on natural gas from these levels; we think stocks are set for a better second half of 2006 and then for a strong 2007. Right now, we are bullish on the sector as a whole.
Strong Buys: Bois D’Arc Energy (BDE); Chesapeake Energy (CHK); CNX Gas (CXG); Comstock Resources (CRK); Goodrich Petroleum (GDP); Occidental Petroleum (OXY); Range Resources (RRC); Ultrapetroleum (UPL); and XTO Energy (XTO)
Analyst Best Pick for 2006: Chesapeake Energy
Why Chesapeake: We consider it a relatively defensive play in oil and gas — specifically in gas, because it is a company that employs a very defensive hedging strategy. For example, for 2006, Chesapeake Energy had approximately 80 percent of its estimated production hedged at an average gas price over $9. Of course, right now, gas is at near $7. So this is a company with a very conservative hedging policy; and even if gas prices remain volatile, as they have been for the past six months, Chesapeake Energy is very well positioned, because of the hedges it already has in place.
Friedman, Billings, Ramsey & Co.
Area of Coverage: Oil & Gas Exploration and Production
Outlook: Long-term fundamentals for sustainability of commodity-price strength close to current levels remain intact. This should drive strong cash flows for the group and drive outperformance relative to the market. Near-term fears of slowing domestic and international economic growth in the second half of 2006 and 2007, and the potential implications of this slowdown on softening of supply and demand tightness, will keep downward pressure on energy equities near term. For the commodity, though, we believe that global geopolitical risk will act as a counterbalance to slowing economic growth. We also expect M&A to help put a floor on equity price declines.
Outperforms: Anadarko Petroleum (APC); Apache (APA); Bois d’Arc Energy, Inc. (BDE); Brigham Exploration Co. (BEXP); Comstock Resources, Inc. (CRK); Mariner Energy, Inc. (ME); Newfield Exploration Co. (NFX); Pioneer Natural Resources (PXD); Pogo Producing Co. (PPP); Range Resources Corp. (RRC); Rosetta Resources, Inc. (ROSE); Stone Energy Corp. (SGY); Swift Energy Co. (SFY); and the Whittier Energy Corp. (WHIT).*
One Top Pick: Anadarko Petroleum
Why Anadarko: After the close of the Kerr-McGee and Western acquisitions, Anadarko will be a near pure play North American asset base. We are fans of the combined deepwater Gulf of Mexico acreage position, where we believe that progress in technology is causing a breakthrough in the rate and size of discoveries, and of the stable cash flows and low-risk growth potential in the Rockies.
*As of July 31, Friedman, Billings, Ramsey & Co. and/or an affiliate own(s) 1 percent or more of the common stock of Whittier Energy Corp.