BARRON'S ONLINE: Bullish and
Interview with Kurt Wulff, Founder, McDep Associates
By SANDRA WARD
IT MAY NOT SPORT the catchiest name, but Needham, Mass.-based McDep Associates and its founder, Wulff, have built a big following among investment banks and individuals for in-depth, independent research on the energy industry. That's partly because he makes his research available on the World Wide Web, at www.mcdep.com. But partly, too, because he is an enormously insightful and creative thinker. McDep is named for a ratio Wulff devised in the 1980s, while he was a top-ranked oil analyst at the former Donaldson Lufkin & Jenrette, to better appraise the value of energy companies: McDep = market cap and debt (McDe) to present value of energy (p). Last year in these pages ("Drilling for Value," December 2004), Wulff forecast a value of Burlington Resources stock of $86 a share on $50 oil, and fantasized about a ConocoPhillips takeover of Burlington. Now he makes the case that natural gas isn't expensive at current levels, and that it one day could be worth more than oil.
Barron's: Have the prospects for energy changed since we spoke a year ago?
Wulff: It has been a great year for the stocks, so automatically you have to be a little cautious about anticipating another great year. But the long-term outlook is still pretty powerful. Demand is strong, and higher energy demand means more economic activity. The supply picture, obviously, has changed. Last year we learned Saudi Arabia could no longer produce additional light oil. That hasn't changed. We were happy when oil prices dropped back to $55 a barrel because they had gone up a little too much too soon, but they are in an upward trend. We think $60 a barrel is close to the 40-week moving average. Maybe the higher limit for now might be $80 a barrel rather than $60. We don't ever know what is going to happen in the future, but the momentum is good: Oil prices are above the 200-day moving average, the gas price is above the 200-day moving average, refining margins are above the 200-day moving average and the underlying long-term expectation is that oil could still be a lot higher. So it is better to bet on it going higher than not going higher. My vision for oil is $150 a barrel by 2010. We've only gone up threefold so far this decade and we went up 10 times in the 'Seventies, so who knows what's ahead for us? The upside is still pretty powerful.
What of the relationship between stock prices and the price of the commodity in the futures market?
The McDep ratio I use to calculate present value includes a denominator that is the value of the company's oil and gas resources depending on some oil price and gas price. Last December we were using $35 a barrel as our long-term expectation. In January I raised my long-term number to $40 a barrel and in August I went to $50 a barrel. That didn't take a lot of imagination because the six-year price of crude oil was going up at the same time. So today my values for companies are tied to $50 oil. The futures market is at $61 a barrel for six-year oil. The market is at about $60, I'm at $50 and stocks are at $40 and will probably go a lot higher yet.
ConocoPhillips buying Burlington Resources was on your wish list a year ago. What do you think of this deal?
Burlington Resources [ticker: BR] has been one of my favorite stocks for a long time, and my present value on Burlington is $86 on $50 oil. The current stock price is right at my present value. I've been looking for this deal for a long time, and so I'm delighted that ConocoPhillips [COP] bid for Burlington Resources. It obviously demonstrates confidence in natural gas on the part of ConocoPhillips because Burlington Resources is about 70% natural gas. While I quote the price for Burlington in oil terms, it is really a natural-gas value. Burlington Resources is the largest gas producer in the San Juan Basin, and Phillips was about the third-largest producer. The two together will now be the largest producer in the San Juan Basin, which is the largest gas field in the U.S. It has been a wonderful long-term property, and it just gets better and better.
What now? Should investors continue to hold these stocks?
I continue to recommend both. The deal does change the picture a little. Obviously, if you have a lot of Burlington and you want to cash in, this is the time to do it. You will get cash for half of your Burlington. Part of the rationale would be to take the cash and recycle it in something else. The rationale for holding Burlington would be to get ConocoPhillips, which was a cheap stock before the deal and is a cheap stock after the deal. If you are a taxable investor, you don't pay taxes on the ConocoPhillips part of the transaction, so you may as well buy Burlington. But, of course, Burlington isn't the best buy out there, while ConocoPhillips could be one of the best buys. You could rationalize you are buying ConocoPhillips at a slight discount if you buy Burlington Resources, because of the arbitrage discount. ConocoPhillips is my favorite among the megacaps.
What is your favorite part of the energy market?
From a commodity point of view, natural gas has to be a favorite. It has always been my favorite.
But is natural gas too high at $15?
Most people think it is, but I don't. The one-year natural-gas-price for the next 12 months is $12 per million BTU [British thermal unit]. For oil it is $63. The conversion rate of oil to gas is 5 to 1, roughly the price of heating oil. At $15 you are paying a little bit of a wintertime premium. But for the full year, at $12, you are not paying any more for natural gas than for heating oil, and natural gas is a cleaner fuel than heating oil.
What's changing is that in former years, natural gas would compete with heavy fuel oil and the high-polluting fuels. But increasingly, with the new electrical-generation capacity that runs on gas, gas competes with jet fuel or heating oil, which can also run those turbines. So, the competitive interface is heating oil. If natural gas goes to $12, or $13 or $14 or $15, that means all of it is being used as competitively as possible. In the U.K. the gas price has been around $18 per million BTU, which is really quite amazing.
But there are big shortages in the U.K.
It's a classic case. The U.K. converted to natural gas in the last 30 years and it has been wonderful for the country. But they have been relying on the North Sea fields, which are now running down, and the substitutes of LNG [liquefied natural gas] are not coming in fast enough. The LNG market is making a point on natural gas very well, because now we have Spain and the U.K. and the U.S. and Japan all bidding against each other for the incremental LNG supplies. There aren't very many available. A tanker might set out for one of these places and change direction midstream.
The competitive equivalent for LNG, again, is oil, not coal. At $18 a million BTU, natural gas is at a premium, but there are some places where you can't burn oil as a substitute for gas. Eventually, gas will be worth more than oil.
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