BARRON’S ONLINE: The Big Question for Big Oil: Where to Invest? — Part II

MONDAY, FEBRUARY 12, 2007  
Interview with Art Smith

Where would natural gas be more fairly priced?

It should be worth its BTU equivalents in crude oil. If crude oil is 55 or so, that would translate into $8 or $9 a million BTUs in natural gas. People have been worried about the inventory overhang that’s been a function of the very warm weather we had earlier in the year. But utilities are now burning gas and not oil. The supply of natural gas is still a tremendous issue and we’re running up the down escalator in terms of drilling more and more wells to produce the same amount of gas as we did last year.

What about liquefied natural gas?

A few years ago, it was thought the liquefied-natural-gas business was going to explode and there’d be all this cheap gas coming into the U.S.

It’s turned out the LNG business is not growing at all. Most of the plants that were on the drawing board have been scuttled, and LNG imports to the U.S. were down 8% last year because Spain and other European countries were willing to pay a higher price than was available in the U.S.

It looks very much like the LNG market will be driven by other areas such as Asia and Europe, and we are going to have to get in line and pay a world price. I was worried about the LNG market before, and I’m more worried about it now.

What’s happening with the operational plants?

There are five LNG regasification facilities that are operational now, and they are and have been chronically underutilized.

What are some of your picks in the natural-gas area?

The most undervalued on the basis of a reasonable price tag are the North American exploration and production companies. There are probably 50 companies, but among the ones that are most undervalued are Anadarko Petroleum [APC] and Chesapeake Energy [CHK] and Apache [APA].

We like some of the Canadian companies, EnCana and Canadian Natural Resources, which have tremendous resources in countries that are safe and where you can make a profit. In the case of Canadian Natural [CNQ], for instance, they have an enormous oil-sands investment whose substantial production and profit value is just becoming visible.

Royal Dutch Shell [RDSA], because of their impending purchase of Shell Canada, will be able to add in Shell Canada’s oil-sands reserves, which have been significantly upgraded. I’m still crazy about the oil sands. I keep telling anybody who doesn’t know about the oil sands to buy some and put it in your kids’ or your grandkids’ account and just forget about it, because it is clearly a unique asset that is economic at much lower oil prices. If prices go to $100 a barrel, it will be phenomenally profitable, because it goes on forever.

We are absolutely convinced the big players there, Suncor Energy [SU], Canadian Natural and Nexen [NXY], are likely to be acquired by the big companies. It is not surprising that Suncor is now starting to show up as rumored target for BP [BP].

That would be huge.

That would be a huge deal, but it wouldn’t surprise us in any way because BP’s portfolio is weak on Canada and weak on oil sands. That’s exactly what is going on in the strategic discussions of the large companies: They are trying to figure out where they are going to reinvest their cash flows. Norsk Hydro is being acquired by Statoil [STO] and that makes a lot of sense. Norsk then announced a $700 million write-down of reserves related to its acquisition of Spinnaker Exploration a few years ago.

We see very few reports where companies have met their production targets, kept their costs down and have projects coming up on time. Instead, everything is delayed, costs more and produces less, which is why we’re more in the camp that believes the market is extremely tight and the real challenge is putting the reinvestment dollars to work.

Last year you recommended writing covered calls on energy stocks. Do you still recommend it?

It is a brilliant strategy right now. The option premiums are very attractive and the yields are similar. ConocoPhillips [COP] is just as cheap as it was a year ago.

We don’t think ExxonMobil [XOM] is the great value it was a year ago. It has had a huge run and a lot of things have gone right, and I don’t see it getting a lot better. Royal Dutch Shell now looks like one of the big ones offering a lot better value.

Any other themes emerging?

There is a re-emergence of the master limited partnership for upstream companies. Linn Energy [LINE] and EV Energy Partners [EVEP] are two. There has been a tremendous amount of market interest in the midstream companies, companies with pipelines and transportation like Kinder Morgan Energy Partners [KMP], Enterprise Products Partners [EPD] and Plains All American Pipeline [PAA] — I’m on the board of Plains All American.

The whole sector is very attractive because it distributes a very healthy portion of cash flow and yet continues to reinvest at good rates and grow. They distribute 50% of their cash flow, and they use the other 50% to drill enough wells to keep production and reserves even. They get a great tax advantage because of the cost depletion on your investment.

Will we see what happened in Canada with the income trusts happen here?

In Canada, the train stopped when government realized that everything was going to become an income trust. In the case of the U.S., it will take several years of conversion to MLPs before it will become evident to the Government Accountability Office.

The premise of many of these companies is that most of the production in the U.S. is old, tired, depleted fields that decline very slowly and companies should in effect distribute the income to the shareholders and not try and replenish reserves by drilling wildcat wells or in 20,000 feet of water.

Thanks, Art.