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Oil's Well

Way back in 1998, when stocks were hot, investment-biker and former Soros-partner Jim Rogers launched a commodity index fund, predicting a flat-out bull market in a wide range of commodities. How right Rogers was, again.

Way back in 1998, when stocks were hot, investment-biker and former Soros-partner Jim Rogers launched a commodity index fund, predicting a flat-out bull market in a wide range of commodities. How right Rogers was, again. (The Rogers International Commodity Index has nearly quadrupled since its inception.)

In his 2004 book, Hot Commodities (Random House, 2004), Rogers advises readers to stay the course: “Today the cycle has turned back to commodities,” adding that the bull market may last for another 12 to 15 years. “That also means seriously considering markets other than real estate, stocks and bonds, none of which are likely to appreciate significantly in the next decade. At this particular moment in history, it means taking commodities seriously.”

Sure, you can bet on sugar, copper, corn, wheat, whatever (of course, you can get your clients exposed to a basket of commodities via mutual funds). But the commodities most watched by retail investors (besides, say, the dollar or gold) are the price of oil and natural gas. In fact, raw materials, particularly oil, are presently spooking the market and caused a mini-meltdown in May. But the fear of inflation caused by high energy prices has made the present weakness in energy shares seem particularly uncalled for. After all, these are the same firms that are making so much money from increased energy prices that U.S. legislators have felt the need to jawbone about taxing away the group's “excess” profits.

It's Fundamental

There have been potholes in the rising road that energy shares have traveled over the past three years. Recent pullbacks in the Philadelphia Oil Service Sector Index (Amex: OSX Index) include a 9.4 percent decline in April 2005, a nearly 13 percent drop in October 2005 and a 15.3 percent fall in February of this year. The latest decline, which started on May 11, has taken the OSX down by almost 15 percent.

The last four dips turned out to be good buying opportunities. The same will likely hold true for the current dip. That's because the bullish longer-term fundamentals for oil and gas producers hasn't changed.

“Worldwide, oil production appears close to hitting a peak,” points out Todd Zehnder, vice president of oil and gas marketing at PetroQuest Energy. “With the continued growth of domestic and international consumption rates, we could well have a continued supply/demand imbalance.”

That would be a lack of supply. Exploration and production (E&P) firms should have no shortage of projects on their plates to discover new fields to meet demand from a world community scrambling to maintain the steady supplies of oil that power their economies. And with Chinese and Indian oil consumption expected to continue increasing at rates of 7.5 percent and 5.5 percent per year, respectively, the high demand should keep oil prices at historically high enough levels to make ever more marginal E&P projects economically attractive.

On the natural gas side, the warm winter that just ended has increased domestic stores of that commodity, and has put understandable pressure on prices. But longer term, Zehnder sees a similar supply/demand imbalance in gas, particularly if the U.S. continues to move slowly to erect more liquefied natural gas (LNG) terminals to accept farther flung natural gas supplies.

The “Smart Money” Confirmation

For their part, insiders (company executives and directors) and institutional investors in the energy sector still appear generally bullish on the oil services sector, even after the spectacular run that has sent the aforementioned OSX Index up nearly 200 percent since the third quarter of 2002. To be sure, there have been plenty of insiders selling over the past year. But that's to be expected given the profits — most of the smart money is sitting in their already-established energy bets. In fact, insiders selling stocks that have performed well is the most common activity, and is presently rife over many other industry sectors.

E&P Firms with Insiders Purchasing in May
Total Company Ticker Average Purchase Value No. of Insiders Relation to Company * Recent Purchase Price Price Then 52-Wk High 52-Wk Low Market Cap (mm) EV/EBITDA (ttm) **
McMoRan Exploration MMR $8,010,274 2 CB, VP $15.45 $17.10 $21.12 $14.37 483 23.8
Goodrich Petroleum GDP $2,101,296 1 D $24.84 $25.65 $29.60 $19.00 640 12.8
Helix Energy Solutions HELX $992,764 1 CB $39.71 $31.48 $45.61 $23.35 2,470 7.4
Exploration of Delaware TXCO $371,650 1 D $9.78 $10.01 $13.09 $3.90 330 14.8
Teton Energy TEC $231,924 2 CE, D $6.44 $6.12 $8.95 $3.21 74 (16.6)
Abraxas Petroleum ABP $135,251 3 D, D, D $4.52 $4.57 $9.25 $2.60 195 9.1
Forest Oil FST $75,279 2 CE, VP $33.46 $29.41 $54.76 $28.31 1,850 4.0
* CB=Chairman, CE=CEO, D=Director, VP=Vice President.
** Enterprise Value / Earnings Before Interest, Tax, Depreciation & Amortization.

What is unexpected — and therefore more significant from an insider-trading perspective — is that a healthy number of energy executives have been buying their company shares during the present dip, even though the purchases generally represent an averaging up in the price of their holdings. This also occurred during the other pullbacks over the past two years.

This recent bullish insider activity is most obvious at small- and mid-cap E&P firms, which stand to benefit from the higher revenues higher energy prices translate into. Forest Oil and Abraxas Petroleum are among the group with recent insider activity (see accompanying table). Eric Hagen, an analyst with First Albany Capital, rates them both “buys” — but for slightly different reasons.

“Forest is a much larger company with a more-balanced portfolio of projects and strong double-digit growth prospects over the next three years,” says Hagen. The fact that about 40 percent of Forest's product mix comes from oil should make the stock less vulnerable to the presently poor pricing environment for natural gas, and Hagen calculates Forest as having a lower valuation to its peers based on enterprise value/EBITDA. “It's a good growth-at-a-reasonable-price stock,” says Hagen.

Too Much Gas

By contrast, Abraxas is more of a longer-term asset play given that its earnings will be dampened by the presently low prices caused by the near-term glut of gas in the U.S.

Natural gas has already declined sharply from a spot price of over $15 per million BTU last December to a recent price of just $5.81. So the decline in natural gas E&P stocks is more understandable than weakness in oil drillers. But natural gas prices aren't likely to continue declining at this pace.

Hagen thinks the floor should be around $5.50 per million BTU. The floor is set by the fact that marginally profitable drilling projects are halted as prices decline — which naturally restricts supply. At the same time, the economics of power producers switching from coal to gas to fuel plants starts to increase demand for gas.

So, even though the natural gas glut may not be worked off until next spring and natural gas prices could have another leg down, value investors have good reason to think that the stocks of natural gas E&P firms are at or near bottom for now.

Not Done Yet

Another intriguing sign of just how bullish energy executives are comes from the booming business of another energy play: Seitel. Don't let this stock's bulletin-board listing scare you off. Its market cap is around $600 million and it's making a successful recovery from bankruptcy.

For good reason. Seitel has one of the largest libraries of seismic data, which it sells to explorers and drillers. The company's business is booming and is expected to stay very strong this year and next. That is a telling sign that E&P executives think oil and gas prices aren't about to fall very far for very long — good news for investors who choose to buy into the new reality of higher energy prices.

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