Stack Sticks with Energy

01/30/2004 12:00 am EST

Focus:

James Stack

President, Stack Financial Management

Jim Stack is perhaps the most thorough analyst I know. Whether reviewing a specific stock, an industry, or a general market, you can be certain he will assess all the relevant facts. Here, he applies his technical, fundamental, and historical eye towards the energy sector.

"As the economy struggled in 2002 and early 2003, oil prices were widely expected to fall; instead, they rose in anticipation of an Iraqi War. Then they were expected to drop after the collapse of Saddam’s regime. Again analysts were wrong. There are several factors that point to a continuation of higher oil prices into the new year:

  • US crude oil stores are tight, with storage levels running persistently below the five-year average in 2003. According to the Energy Information Administration, US commercial oil inventories have dropped to 269 million barrels–the lowest since weekly data has been collected.
  • OPEC maintained a reduced production level at their December meeting and shows little inclination to change its policy in the near future.
  • Worldwide economic recovery is boosting global demand for oil. The International Energy Agency has revised its estimate of 2004 demand growth upwards, reflecting a faster economic recovery and soaring consumption in China–where demand grew 10% in 2003. In the US, petroleum demand is projected to grow 2.1% in 2004.
  • There could be unforeseen disruptions in supply, such as those experienced in Venezuela, Nigeria, and Iraq last year, as well as continuing unrest in the Middle East.

"Natural gas prices rose early last year as a cold winter depleted supplies in underground storage. When production kicked in to replenish these gas stores, prices were widely projected to drop. That hasn’t happened. As with crude oil, there are a number of factors that favor high gas prices in the year ahead:

  • A continuing economic recovery will boost demand. In addition to industrial use, nearly all new electric generating plants are now reliant on natural gas. Among residential and commercial users, there’s less incentive for fuel switching with the current high fuel oil prices.
  • Environmental restrictions continue to keep a substantial portion of domestic gas reserves off limits to production.
  • Domestic gas wells are less productive. In spite of the emphasis on drilling new wells, gas production per well actually peaked in 1971 at 435 thousand cubic feet per day. In 2002, the production rate per well was 70% below that peak figure, and continues to decline.
  • Unlike oil, natural gas is costly and difficult to ship. Although there are vast overseas gas reserves, primarily in Russia and Iran, gas has to be converted to liquefied natural gas, requiring special terminals, conversion plants, and ships.

"Bottom line, if oil and gas prices stay high, earnings will remain strong–and that is not reflected in the current stock prices or low valuations. Furthermore, any number of events such as stronger economic growth, a colder or extended winter, unrest in the Middle East, or another terrorist attack, could suddenly send energy prices higher. While energy positions have provided both stability and moderate gains for our portfolios in the past, this sector may become one of our more profitable investments during this election year. With this in mind, we could soon step up our energy allocation to 10-15% with the stocks under consideration listed below:

"ConocoPhillips (COP NYSE), BP plc (BP NYSE), and ChevronTexaco (CVX NYSE) are major integrated oil companies, positioned to capitalize on growing global demand in developing regions like China. They also could be big players in the rapidly expanding liquid natural gas development. These large-cap companies typically offer a reliable dividend yield and tend to be more stable, however, their sheer size could also mean slower growth.

"Encana (ECA NYSE) and Devon Energy (DVN ASE) are independent natural gas exploration and production companies, while Equitable Resources (EQT NYSE) and Questar (STR NYSE) incorporate all phases from gas production through distribution. These smaller companies offer more opportunities for expansion and merger. Most of their assets are concentrated in North America, which helps limit their exposure to political problems and terrorism."

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