Investors, pay attention: Stock prices for many energy firms today remain surprisingly attractive. By James K. Glassman, Contributing Columnist August 31, 2006 In 2001, a gallon of unleaded regular gasoline cost less than a buck and a half, and the barrel of crude oil from which it was refined was a mere $22. Today, crude is about $75, and Goldman Sachs analysts believe $100 is a real possibility. The companies that produce that oil -- extracting it from the deserts of Arabia or the depths of the Gulf of Mexico -- are making record profits.The good news is that even as Americans pay $3 a gallon at the pump, many are investors who are sharing in the spoils. Do you own a fund that tracks Standard Poor's 500-stock index? The 30 energy stocks that are part of that index had year-to-date gains averaging 16% at the beginning of the second half of 2006, lessening the blow of the index's small loss of 1%. Stocks look cheap Investors, pay attention: Despite the boom, stock prices for many energy firms today remain surprisingly attractive. Look first at the big-name integrated oil companies -- the ones that explore for oil and gas, refine it, and market it to businesses and consumers. ExxonMobil, with the largest market capitalization in the SP 500, trades at a trailing price-earnings ratio of just 11; both Chevron and Royal Dutch Shell, at a P/E of 9; and ConocoPhillips, 7. Compare those valuations with the SP as a whole, at 17, or the Dow Jones industrial average, at 20. Remarks Marshall Adkins, director of energy research for Raymond James Financial: "Oil has gone up, but the multiples have crashed." It's a strange situation. In the late 1990s, Chevron and Exxon carried P/Es in the 20s. Now, nasty and unstable governments rule oil-producing countries such as Iran, Nigeria and Venezuela. Demand for energy is rising in fast-growing nations such as China and India. Refining capacity is pinched, and the U.S. government makes matters worse by restricting drilling on federal lands. With all this going on, the stocks of the majors are downright cheap. Despite the run-up in prices and profits, their shares are up roughly 50% in five years -- a pittance. Advertisement Typically, when a sector becomes highly profitable, businesses expand and earnings level off or decline. But that's not happening with energy. Analysts at Friedman Billings Ramsey in Arlington, Va., recently raised earnings estimates on the integrated oil companies by 7% for 2006 and 17% for 2007. ConocoPhillips (symbol COP) is considered a top pick; FBR estimates its earnings for next year at $12 a share. On July 14, the stock finished the day at $67 (for a forward P/E of just over 7) and carried a dividend yield of 2.1%. Dow Theory Forecasts, a cautious newsletter I admire, recently listed 12 buy-rated stocks with below-average risk. Among them: ExxonMobil (XOM) and Chevron (CVX). The majors are certainly attractive -- especially with stocks such as Total and BP yielding 3.2% -- but Adkins and his colleagues believe that smaller energy companies that focus on natural gas are an even better deal. I agree. Unless you think the world is headed for a serious recession, it's hard to ignore a company like Chesapeake Energy (CHK), with holdings in 18 states, from Montana to Maryland. Chesapeake Energy currently trades at a P/E of 8, despite the fact that analysts estimate earnings will rise 33% this year over 2005 levels. Natural gas is the clean energy of choice for industry and utilities, and throughout U.S. history we've "grown our own" or piped it in from Canada. But as demand has increased and supply has leveled off, concerns have risen that a severe squeeze will send prices soaring. The problem is that, unlike crude oil or refined gasoline, natural gas can't be easily imported. The gas has to be cooled to -260 degrees Fahrenheit to be converted into a liquid, loaded on tankers, then brought to special ports called LNG (liquefied natural gas) terminals and turned into a gas again. Few Americans want LNG terminals in their backyards, so we have only five operating today and none on the West Coast. Advertisement Premature prophecy Speaking in June 2003, Alan Greenspan, then the chairman of the Federal Reserve, warned Congress in uncharacteristically blunt terms of an impending natural-gas crisis. He noted that the spot market was pricing natural gas at $6.31 per million Btu's, up from just $2.55 three years earlier. "The perceived tightening of long-term demand-supply balances is beginning to price some industrial demand out of the market," he said. Big chemical plants, for example, were moving abroad, where gas is much cheaper. But more than three years later, after a spike following hurricanes Katrina and Rita, the domestic natural-gas price is actually lower than when Greenspan gave his speech: $5.78 for the August 2006 futures contract. Adkins thinks that this fall, natural gas could drop to $4 or $5. Why? "There are record amounts of gas in storage," he says. According to the U.S. Department of Energy, there's about 30% more than average for this time of year. The reason is the "bizarre winter" of 2005-06. Global warming, or plain luck, helped us dodge a very large bullet. A cold winter could have pushed U.S. natural-gas prices into the stratosphere. Kevin Book, a senior analyst for FBR, told me, "With LNG hopes diminished by state-government action, we see few structural offsets to the imbalance in natural-gas supply and demand -- another source of comfort for bulls with time on their side." In other words, Greenspan's prophecy may turn out to be right. Advertisement After a seasonal dip in the fall, Adkins sees prices going far higher -- and by the way, so does the futures market. In early July, the February 2007 natural-gas contract was fetching $11.17. But again the stock market is ignoring the prospect of more-expensive gas. "There is huge negative sentiment," says Adkins. In other words, he says, prices of natural-gas stocks are too low. Shares of Chesapeake have dropped by about one-fourth from their October 2005 high. Shares of Ultra Petroleum (UPL), which has core gas assets in Wyoming, are down by about $15 from their peak. Wayne Andrews, Pavel Molchanov and John Freeman, three energy analysts at Raymond James, have been pounding the table for Ultra: "It has what every exploration-and-production company dreams of: a massive asset base with a developmental upside and a vast inventory of low-risk, high-rate-of-return prospects. We believe that the best is yet to come and remain very bullish on the company's prospects. We reiterate our Strong Buy rating." This is strong stuff coming from an investment firm well known for its conservatism. Chesapeake and Ultra, both exploration-and-production companies, own or lease domestic and international properties with gas reserves. But Raymond James's Adkins likes the firms that service these companies even better because the leverage is greater. When prices plummet, business for the service firms dries up. No one wants to drill for gas if it's cheap. But when prices rise, as Adkins expects they will, the demand for scarce drilling resources skyrockets. At such times, the service companies have enormous financial leverage and money gets made quickly. Advertisement Consider Patterson-UTI Energy (PTEN), an on-shore contract driller. Its shares have fallen from a high of $38 earlier this year to just $25 as of mid July. Based on earnings of the past 12 months, its shares trade at a P/E of 9 and, according to Yahoo Finance, an almost unbelievable PEG ratio of just 0.13 -- in fact, the lowest number I have ever seen and an excellent example of economic leverage. The PEG ratio is derived by dividing a company's P/E by its expected annual growth rate over the next five years. A PEG ratio of 1.0 or lower is generally considered a bargain. Another driller that Adkins recommends, BJ Services (BJS), trades at a PEG ratio of 0.69. Protected profits Although the low prices and high dividend yields of the major oil companies are enticing, I find a lot to like among the domestic natural-gas producers and service businesses. First, they are not as likely to face political punishment -- either from foreign governments or our own -- for making too much money. Second, they operate in a self-contained market, largely immune to the vagaries of OPEC and other oil titans. Third, the supply-and-demand fundamentals point to higher and higher prices -- unless, of course, politicians get smart and allow more drilling and more LNG terminals. At this point, I'll lay my bets on the pols staying dumb.