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Quarter-End Insights

Our Outlook for the Energy Sector

We've raised our outlook for oil and gas, coal, and deep-water drillers.

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Thus far, 2008 has seen unprecedented increases in energy commodity prices, driven by growing supply bottlenecks and persistent demand. Recognizing that some constraints are deep-rooted and that there are secular forces driving the cost of supply higher, we've raised our assumptions for oil, coal, and natural-gas prices, as well as our day rate assumptions for deep-water drillers.

Global factors have conspired to push up oil prices in 2008, and as we think many of these factors are here to stay, we've raised our long-term price assumptions. This year, the oil industry has experienced escalating violence in Nigeria that is hurting output, a surprise contraction in Russian production, and signals from Saudi Arabia that the country's long-term production will be lower than many authorities' previous expectations. Meanwhile, demand in the U.S. and other developed countries is falling, but demand in China and other emerging countries remains strong. Growing demand for diesel is a major factor: Backup diesel generators are filling the gap as the power sector fails to meet electricity demand with larger-scale coal, nuclear, hydro, or gas-fired generation.

We've also raised our natural-gas price assumptions on expectations of strong demand from the power sector and higher costs of supply. In North America, gas prices got a boost from a cold winter, and the failure of a large nuclear facility in Japan--plus power constraints across the globe--led to less liquefied natural gas (LNG) arriving on U.S. shores. Longer term, we expect the U.S. power sector to be a major source of growing demand for gas.

Our  higher oil and gas price assumptions boosted our fair value estimates for many firms in the industry. We also introduced a different valuation methodology. Our new pricing assumptions will incorporate the futures curve for the first three years of the explicit forecast period in our discounted cash-flow models. In year four (2011) and later, we're equally weighting three pricing scenarios in our models. We're excited about our new framework, as we think it will enhance the robustness of our valuations and company analyses. First, the three-scenario approach better approximates the distribution of potential oil and gas prices that could prevail over the next decade, leading to better company valuations. Second, the three-scenario approach will help us generate insights into which businesses will perform better or worse in especially high or low pricing environments. Third, we expect the three-scenario modeling exercise will better uncover investment risks and opportunities than could a single-pricing scenario--which uses a point estimation of future prices.

Elsewhere in the energy arena, we raised our  long-term coal price assumptions, boosting the fair value estimates for all of the coal companies we cover. As with our oil and gas companies, we're now employing a three-scenario approach. Historically, because of its low value-to-bulk ratio, coal was a local good, and world trade had little impact on the U.S. market. However, for the first time in decades, coal has become a global commodity, and its price is being driven higher by demand from developing economies. We think demand growth--driven by hungry factories and a more demanding middle class--will likely remain strong as long as the emerging Asian economies continue to perform well. Furthermore, because of logistical and political factors, supply additions will likely remain constrained. We'll keep a watchful eye on the rate of Asian demand growth and U.S. supply additions.

Finally,  we raised our long-term assumptions for deep-water day rates for many of the deep-water drillers we cover. Deep-water day rates have surged over the past few years as the demand for rigs has far outstripped supply. It seems customers are willing to pay almost any price to obtain a deep-water rig to exploit huge offshore discoveries.  Petrobras (PBR)--looking to develop its potentially vast offshore resources--has indicated that it is seeking to order up to 40 deep-water rigs, signaling that there is still a significant shortage of deep-water rigs. In addition, it seems rig construction cost inflation will continue to push day rates higher, thanks in large part to rising steel prices.

Valuations by Industry
The median price/fair-value estimate equals 0.87 across the energy sector, suggesting that the sector is undervalued. Oil and gas companies appear the cheapest as a group, followed by oil/gas products, pipelines, and oil and gas services. Coal is still the most overvalued subgroup.

 Energy Industry Valuations

Current Median Price/Fair Value

Three Months
Coal 1.35 1.26 7%
Pipelines 0.88 0.83 6%
Oil/Gas Products 0.85 0.93 -9%
Oil and Gas 0.82 0.92 -11%
Oil and Gas Services 0.95 1.04 -9%
Data as of 06-13-08.

The increase in our oil and gas price assumptions uncovered some new values, and contributed to the change in median price/fair value. In addition to the stocks featured below, there are a handful of 5-star oil and gas producers such as  Murphy Oil (MUR),  ConocoPhillips (COP), and  Apache Corporation  (APA) (as of June 20, 2008). Coal stocks have been on a tear, so despite raising our fair value estimates significantly, there was little change in median price/fair value.

Energy Stocks for Your Radar
We've picked five stocks from our coverage list to keep on your radar. Three of our picks are independent oil and gas producers:  Cabot Oil & Gas (COG),  Denbury Resources (DNR), and  Southwestern Energy (SWN). We are also highlighting two 5-star pipelines:  Enterprise GP Holdings (EPE) and  Nustar GP Holdings (NSH).

 Stocks to Watch--Energy
Company Star Rating Fair Value Estimate Economic
Fair Value Uncertainty

Fair Value

Denbury Resources $65 Narrow Medium 0.58
Enterprise GP Holdings $50 Wide Medium 0.62
Nustar GP Holdings $35 Narrow Low 0.68
Cabot Oil & Gas  $92 Narrow Medium 0.71
Southwestern Energy $64 Narrow Medium 0.71
Data as of 06-20-08.

 Denbury Resources (DNR)
What makes Denbury Resources special is its 2001 purchase of a naturally occurring deposit of carbon dioxide (CO2) at the Jackson Dome in Mississippi and its plan to use the dome as home base for a multiphase expansion program to inject CO2 into old fields to squeeze more oil out of the ground. Early project phases are tied to completing a new or converted pipeline to transport CO2 from Jackson Dome to mature oil fields. Denbury's tertiary oil experience helps, but we're more encouraged by the firm's ability to move ahead with pipeline construction amid rising material and labor costs. This is where discipline and grit comes in as the firm plans well in advance to secure work crews and orders for pipe, compressors, and other equipment.

 Enterprise GP Holdings (EPE)
If you could buy only one general partner master limited partnership (MLP), this may just be your ticket given its diverse holdings. Enterprise GP Holdings owns the general partner stake of  Enterprise Products Partners (EPD) and  TEPPCO Partners (TPP), as well as a minority interest in  Energy Transfer Equity (ETE), the general partner of  Energy Transfer Partners (ETP). Enterprise GP Holdings is therefore leveraged to the performance of a tremendously broad network of pipeline and storage assets stretching across America.

 NuStar GP Holdings (NSH)
As the general partner of  NuStar Energy LP (NS), NuStar GP Holdings is poised to enjoy leveraged claims on strong cash flows generated by a steady but growing refined products master limited partnership. Thanks to continued investment in new facilities and expansions, we think NuStar Energy will be able to raise cash distributions by nearly 10% annually over the next five years. And because of the structure of incentive distributions, we expect NuStar GP Holdings to increase its distributions almost twice as fast.

 Cabot Oil & Gas (COG)
Cabot Oil & Gas' long operating history and abundant lower-cost oil and gas properties in Appalachia and the Gulf Coast give it a leg up over competitors trying to buy their way into new fields. Recent success in finding new deeper gas-rich shale zones in old Appalachian fields has sparked drilling and acquisition activity in the region. Cabot Oil & Gas acquired its Appalachian properties long ago at lower costs, giving the firm an advantage over new entrants paying higher prices for drilling leases.

 Southwestern Energy (SWN)
Southwestern Energy got a head start building up its oil and gas drilling leases in the Arkansas-based Fayetteville Shale field in early 2002 and now has the largest lease position in the region. The firm was able to secure drilling leases at low costs, well before competitors caught wind of the area. Since the geology of Fayetteville is similar to the Barnett Shale, lessons learned in developing Barnett have been applied to this new field to lower operating costs and increase productivity. More intriguing is that Southwestern Energy has only tested and drilled in roughly a third of its property. Oil and gas production growth from this field should continue to impress as Southwestern Energy ramps up developmental drilling this year, with several more years of production growth to come.

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Elizabeth Collins has a position in the following securities mentioned above: PBR. Find out about Morningstar’s editorial policies.