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Seeking Energy Bargains As War Clouds Loom

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Investment Philosophy

Barron's Online: Please break things down by sector. What's the hottest area looking ahead 12 months?
Petrie: Let me start by saying I am not sure there is a hot area. Somebody asked me, 'Gee, why are oil stocks going down when oil and gas prices are going up?' Through August, we had oil prices up 50% and oil and gas stocks down between 12% and 15%. So, there's been quite a divergence. That said, my answer has been the problem with oil stocks is that they're stocks, and when you have a bear market going as we do, you cannot expect any segment to do particularly well swimming against the tide. But they are a source of relative value.

Q: Why?
A: There's been less loss of value in this segment than [in] many other segments for a couple of reasons. Number one: They didn't get overvalued in the last up cycle. You know, the growth stock players basically ignored the energy sector -- in some cases, even despised it. And so, there was less to give up because they weren't overvalued in the first place.
Number two: With the notable exception, perhaps, of the merchant power sector, the companies are generally pretty conservative on their accounting, so their earnings and cash flow numbers are inherently more reliable. As the bear market has progressed and people build up more cash in their portfolios, there's been some selling pressure in this sector, but not nearly as much as in those segments that were patently overvalued.

Q: What kind of impact has the Enron scandal had on energy markets as a whole?
A: Well, it clearly has been very negative. It's been much more negative in the merchant power sector and to a degree in the natural gas pipeline sector -- certainly in the commodities trading sector. Enron in its trading function was providing a useful hedging mechanism for both transportation differentials for natural gas and various parts of the market, and when they got into trouble it was the beginning of the end for the depth of those markets. And obviously it's subsequently spread into much of the rest of the sector and caused a significant reduction of liquidity in commodity hedging functions.

Q: Do you think there are investment opportunities left in companies unfairly tainted for their energy trading function?
A: I think the degree of credibility that was lost for the whole sector will make it difficult to pursue opportunity in the merchant power sector at this point. There's a real tentativeness on both sides of any hedge as to whom people are dealing with and on what basis.

Q: So, what is attractive to you?
A: The most interesting are the neglected domestic integrated companies, the domestic majors, if you will. And three of those companies stand out in our minds. The three we recommend as Buys right now are Murphy Oil, Amerada Hess and Occidental Petroleum.

Q: On Murphy Oil [a domestic integrated company with exploration, production, refining and marketing businesses] you have a $110 price target, meaning upside near 38%. And you like their deepwater Gulf of Mexico and Malaysian exploration potential?
A: The deepwater Malaysian play in particular is very, very attractive. It reminds me of the early stages of the opening of the North Sea in the United Kingdom and Norway back in the 1970s. We're getting early indications that this may be a geologic play with a lot of running room. Murphy is by far the most leveraged player [there].

Q: Can you quantify that?
A: The company's current base is about 500 million barrels of reserves, and you can see anywhere from a billion to two billion barrels ultimately discovered in and around the acreage that Murphy controls. Now, I am not going to say that that's going to happen overnight, but in the next several years.
The deepwater Gulf of Mexico is excellent, and Canada is also intriguing. [Petrie Parkman analysts think Murphy is a good buy for its higher production growth than its peers have. On 2003 numbers, Murphy is trading at 14.8 times earnings and 5.1x discretionary cash flow, while its peers are trading at 10.4x earnings and 3.8x cash flow.]

Q: What about Occidental Petroleum and Amerada Hess?
A: In Amerada [an exploration and production company] the story is very similar. It's even more compelling on valuation. Amerada sells at 9.8x 2003 earnings and 2.8x discretionary cash flow, and so it's a $65 stock with upside to $100, we think.
The most interesting play there for Amerada is the success they are having in Equatorial Guinea off West Africa. This comes from their acquisition of an exploration and production company, Triton, last year.

Q: And Occidental?
A: Occidental Petroleum is a very different company. It's not out there looking with a drill bit for huge reserves as a rule. It has a compelling break-up value. It's a company with a very attractive yield [3.48%], and it sells at 4.3x 2003 discretionary cash flow and 8.4x 2003 earnings. So, it's really a deeply discounted value play. [Petrie Parkman analysts point out that Occidental is more leveraged than its peer group to chemical prices; the chemical markets are starting to turn around, so it captures that upside when its peers cannot.]

Q: Any other names?
A: Remington Oil & Gas, which is a small-cap independent producer in the Gulf of Mexico with high leverage to gas exploration projects. [Petrie Parkman analysts have a $25 price target on the stock, meaning the stock could more than double from current levels.] And Ocean Energy is in Equatorial Guinea and the deepwater Gulf; we like its visible multi-year production growth potential.

Q: Which would your top five picks be?
A: It would probably be Murphy, Amerada, and Occidental, and right now I'd probably say Remington Oil & Gas and Ocean Energy.

Q: You also mentioned Western Gas Resources (see Weekday Trader, "Gas Could Be a Natural," August 28, 2002). Can you elaborate?
A: Well, the stock at 30 is down from its highs. We have a 12-month objective of 45. That's almost a 50% appreciation from where we are today. We think they have visible gas production volume growth.

Q: Do you have an investment banking relationship with any of these companies?
A: Occidental Petroleum. All the others are research coverage only.

Q: And do you personally own any of the stocks?
A: No, I don't. Petrie Parkman's policy starting 14 years ago, when we formed the firm, was not to have our analysts or any employees of the firm own any stocks in oil and gas, or in any clients.

Q: It's been a pleasure talking with you.
A: Thanks.

Petrie's Favorite Stocks

Company Ticker Recent Price
Amerada Hess AHC 64.68
Murphy Oil MUR 86.21
Occidental Petroleum OXY 28.73
Ocean Energy OEI 18.57
Remington Oil & Gas REM 14.47
Western Gas Resources WGR 31.30

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