BARRON'S ONLINE: Hot as Ever
By RHONDA BRAMMER
DESPITE RUMBLES FROM WASHINGTON, mounting skepticism among the pundits on Wall Street and assurances from the oleaginous spokesmen for OPEC, energy prices occasionally bend but refuse to break.
Sure, the price of crude, which briefly spiked above $70 a barrel in the wake of Hurricane Katrina, has slipped to about $58 these days. But that's still a fair piece north of the $43 or so where it started the year.
And natural gas, after falling briefly to around $9 per million British thermal units in November, bolted sharply higher again this month, soaring to well above $15 per million BTU, before slipping to $11 and change on Friday -- still a far cry from around $6 a year ago.
Indeed, natural gas, especially reserves of the stuff right here in the good old U.S. of A., is becoming a very hot commodity. As prices have risen, giants of the oil patch, like ExxonMobil, Royal Dutch Shell and BP, which long ignored the continental U.S. as they set their sights on finding huge deposits of crude abroad, have suddenly been taking a keen interest in domestic natural gas and beefed up their spending accordingly. In the fullness of time, this turn homeward will translate into more gas.
But not tomorrow. And, meanwhile, the stocks of energy producers continue to rise, as merger activity heats up. Just two weeks ago, in the largest oil-and-gas deal in years, ConocoPhillips agreed to fork over a cool $35 billion for Burlington Resources. About 80% of Burlington's reserves are North American natural gas, for which ConocoPhillips has agreed to pay just under $3 per thousand cubic feet.
The comparatively rich price underscores a conviction among the big-buck buyers that high energy prices are here to stay. Indeed, by one analyst's reckoning, for Conoco to earn a 10% return on its Burlington purchase, the long-term price of natural gas would need to average at least $8 per million BTU.
As the accompanying chart shows, shares of exploration and production outfits have gone through the roof this year, soaring almost 70% and far outdistancing small-caps (the S&P SmallCap 600 is ahead 8%) and large-caps alike (the S&P 500 is up 5%).
Is the buying spree overdone?
Probably yes, at least in the short run. Come some warm weather and once damage by Katrina to Gulf Coast pipelines is repaired, natural gas prices are likely to moderate. But, contrary to the skeptics and the fervent prayers of consumers, energy prices aren't destined to collapse. Even an energy analyst like Jon Wolff at Credit Suisse First Boston, who sees the E&P group in general as "overbought" near term, is forecasting crude of $62.50 a barrel, on average, for next year, and gas of $7.75 per thousand cubic feet, or mcf.
The Burlington deal is ample proof that big oil outfits, with dough piling up on their balance sheets, are more than happy to write hefty checks, a trend not apt to stop anytime soon. Among small-caps that might prove attractive to an energy-hungry acquisitor Wolff mentions enhanced oil recovery outfits like Whiting Petroleum (ticker: WLL) and Denbury Resources (DNR). He's also keen on Range Resources (RRC), an onshore gas producer that he believes can dramatically increase its long-life reserves from a vast drilling inventory of low-risk prospects in Appalachia.
The Conoco-Burlington deal was priced at 5.6 times enterprise value (market cap plus net debt) to Ebitda (earnings before interest, taxes, depreciation and amortization). That price tag was hardly a wake-up call that the industry was wildly undervalued, Wolff argues, since his universe of 50-plus E&P stocks was already selling at more than that -- at an average of six times enterprise value to Ebitda.
Some E&P companies, obviously, fetch woefully less than that lofty average of six times. And among them is one selling at a mere 3.8 times estimated 2006 Ebitda: Cimarex Energy, a company, readers may recall, we mentioned positively in February, at $34 and change. The stock is now $41, up about 17%. Compared with the 60% gain of the average E&P stock this year, that move is darn anemic. (For more on Cimarex and natural gas, see this week's interview.)
Cimarex (XEC) lost much of its allure as a take-out target by becoming the acquirer itself, buying Magnum Hunter in a deal valued at some $2 billion, which closed in June. Paying $2.33 an mcf for proved reserves, Cimarex doubled production and tripled reserves, but slightly diluted this year's earnings.
As part of the deal, moreover, Cimarex not only took on some debt, but it also booked undeveloped reserves, which before it had staunchly refused to do, and, more dismaying, because Magnum Hunter had sold some of its production forward, nearly a fifth of total 2005 production was hedged. A painful prospect in a year of soaring energy prices.
What attracted us to Cimarex in the first place was its conservative way of booking reserves; its big holdings of natural gas in the Lower 48 (it's still about 70% gas); its robust balance sheet; its enviable record of boosting production and replacing reserves, all via the drill bit; its veteran management, headed by F.H. "Mick" Merelli, former president of Apache, and -- last but not least -- its dogged refusal to sell forward or hedge its production.
Mick Merelli, however, when we chatted with him back in February, insisted it would be only a matter of time until the hedges were rolled off, the debt was paid down and the undeveloped reserves drilled.
What's more, while $2.33 an mcf for proven reserves might look dear -- it appears far less so in the wake of the Burlington buyout at $2.77 an mcf -- Merelli argued at the time that Magnum's properties in the midcontinent fit snugly with Cimarex's own, that intriguing prospects in the Gulf didn't cost Cimarex all that much and, best of all, Magnum's sizable footprint in the Permian basin, including huge blocks of territory that Merelli knew well, offered a myriad of high-return prospects where Cimarex could sharply accelerate its drilling.
True to his word, Merelli has already paid off a chunk of debt, the hedges (which clobbered earnings in the third quarter) are being rolled off (they'll disappear entirely by year end 2006) and Cimarex's drilling program is going gangbusters.
The bottom line: For all of this year, even with damage from the hurricanes, if one-time charges are excluded, Cimarex should earn about $5 a share.
Next year's earnings manifestly depend on the price of oil and gas. But even if one is bearish on energy prices and assumes that oil averages only $45 a barrel and gas, $6.70 an mcf -- way below what Cimarex netted this year -- the company would still earn some $3.45 a share and, if priced at 5.5 times Ebitda (still below the industry average of six), would fetch $48.
So calculates hedge-fund manager Tim Curro of Manhattan-based Value Holdings; the fifth largest position in his $250 million hedge fund is Cimarex.
Should oil average $62.50 next year and gas, $7.75 (as Credit Suisse's Jon Wolff forecasts), Cimarex would earn about $5 a share and, at 5.5 times Ebitda, would sell at $63. With $9 gas and $60 crude, Cimarex would earn over $6 and, at 5.5 times Ebitda, the shares would top $70.
In other words, it's still a cheap stock.
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