Energy plays still a good bet

www.globeandmail.com By DEBORAH YEDLIN Friday, February 28, 2003 - Page B2

Closing Markets - Thursday, Feb. 27 S&P/TSX 73.86 6582.19 DJIA 78.01 7884.99 S&P500 9.73 837.28 Nasdaq 20.26 1323.94 Venture -2.23 1102.34 DJUK -.87 145.22 Nikkei 2.57 8359.38 HSeng 17.96 9134.24 DJ Net .37 38.85 Gold (NY) -7.90 346.20 Oil (NY) -0.50 37.20 CRB Index -4.09 246.09 30 yr Can. +0.00 5.46 30 yr U.S. -0.01 4.73 CDN$ buys US$ -0.0008 0.6688 Yen +0.1800 78.6400 Euro +0.0011 0.6213 US$ buys CDN$ +0.0017 1.4952 Yen +0.4000 117.5800 Euro +0.0027 0.9290

It's tough to imagine a better scenario in the oil patch: Natural gas prices flirting with $10 (U.S.) per thousand cubic feet (mcf), crude prices stuck well north of $35 a barrel and energy companies posting record numbers for earnings and cash flow.

On a year-over-year basis, oil prices are ahead 50 per cent this year while natural gas is trading at 1.5 times what it was a year ago.

Last week EnCana Corp. announced earnings of $1.25-billion (Canadian) and cash flow of $4.2-billion for 2002, and on Wednesday fourth-quarter results posted by Canadian Natural Resources Ltd. exceeded the consensus estimates for both cash flow and and boosted its annual dividend by 20 per cent to 60 cents.

In the old world of investing parameters, all the fundamentals are pointing in the right direction for energy stocks -- high commodity prices, low debt levels and tight supply.

And all that should translate into lofty stock prices for the sector.

After all, investors paid up for tech stocks that offered but a promise of earnings and cash flow at some time down the road while the oil and gas companies are delivering both in spades today.

Instead, the big-cap companies are looking at stocks that reflect commodity prices of about $23 (U.S.) for oil and $3.75 per mcf for natural gas and stingy trading multiples of about 3.5 to 4 times cash flow when they should be higher by two points or more.

So what is it?

Part of what is going on simply has to do with the fact that stocks are mired in a major bear market and equities simply don't respond the way they used to -- even if the fundamentals are good.

The situation is exacerbated by the overriding uncertainty of the current geopolitical environment.

The other part of the equation relates to the market's psyche and its lack of faith regarding the sustainability of high commodity prices.

That might be true for crude prices, because a war premium is helping to push prices skyward, but as soon as the situation in the Middle East is resolved, expectations are that prices will settle back down below $30 a barrel because that is what happened during the last go-round in the Persian Gulf.

Then again, the situation today, from a supply and production capacity standpoint, is different than it was in 1991.

Back then, excess OPEC production capacity was in the order of six million barrels a day; today that number is closer to 2.8 million barrels. Add to that the continued disruption in Venezuela and the expectation that only two-thirds of its production will come on stream by year-end, and the possibility of a scorched-earth policy pursued by Iraq with regard to its oil fields, and the result is an oil price that is likely to average $26 or $27 this year.

The market might think it is clever by looking through the existing noise, but the reality is that crude oil supplies remain tight, the industry is plagued by a lack of growth and there is limited excess capacity.

What makes the current situation with energy stocks even more confusing is that natural gas prices are at levels only dreamers expected.

While oil is a global commodity and subject to the health of the global economy, natural gas remains a North American commodity and to see prices of almost $10 per mcf in the absence of a roaring economy serves as a clear indication that growth in demand is clearly outstripping growth in supply.

That means -- to the delight of the Alberta government, but not its citizens -- the high prices are likely to stick around for a while.

What's an energy company to do if the market doesn't want to pay up for its shares?

Well, if big earnings, cash flow, boosting dividends and paying down debt doesn't work, they can always turn to buying back their shares.

On the one hand, proponents of this strategy argue that buying back shares constitutes a vote of confidence in the company's prospects and is a more effective use of cash than paying ridiculous prices for assets -- which is what happens when commodity prices are high.

Moreover, share buybacks, because they lower the number of shares outstanding, boost the latest industry yardstick -- production per share. This new measure is almost a reaction to the previous philosophy that advocated production growth at any cost; now the focus is on value -- through adding production per share and showing investors a return on capital.

Still, it's doubtful share buybacks will be enough to inspire institutional investors to make the necessary leap of faith and pay up for energy stocks.

Bitten by the tech wreck, the pendulum has swung too far back in the opposite direction and investors are scared to buy in at what they perceive to be the top of the cycle for commodity prices.

But that presupposes the market can be timed.

Better to buy the long-term fundamentals and have a little patience, and in that case, the energy sector remains a good bet -- even at these levels.