Q: What about Saudi Arabia?
A: Saudi Arabia more or less managed to market its oil around the
$25-a-barrel level for as long as it could. The big event of 2004 is that the
oil market called Saudi Arabia's bluff. They couldn't deliver the spare capacity
they said they had. It turns out they have spare capacity, but it is in heavy
oil, not light oil, which is easy to refine and doesn't have much sulphur in it.
It's also known as "light sweet" crude, and it produces more gasoline
and more heating oil. So 2004 was the year in which the world production of
light oil peaked. There are no big fields of light oil producing now that can
produce more. Saudi Arabia has heavy oil to sell, but they have to discount it
much more. If Saudi Arabia could have produced more light oil, they would have.
Q: The price of oil is off its highs. What's a fair
price for oil?
A: I'm glad to see it falling back because it gained about 60%-70% from
the previous year. The five times in the last 30 years we had economic problems
it was associated with a spike in the price of oil. We can make a nice case for
oil stocks with oil priced at less than $55 a barrel. The two bear-market
bottoms -- 1974 and 2002 -- were preceded by a 10-year period of stable oil
prices. That gives us an historical cycle running from 1964 to 1991. Just by
replaying the last oil cycle, starting in 1976, we could have a
three-to-fivefold gain in the oil price in the next five to 13 years. I'd just
as soon see threefold in 13 years, that's a reasonable percentage per year.
Fivefold in five years is too much. In the futures markets, where prices are
quoted out six years, we can see some nice consistent trends toward higher
prices. We don't know if the trends are going to continue. We don't know how far
they are going. But the prices are well above the 40-week average, which is
equivalent to the 200-day moving average. That doesn't tell you anything except
that the price trend is up. Of course, the day it goes below the 200-day moving
average, the trend will be down. But those trends tend to persist, which is why
people look at them. On a chart basis, oil looks good. Recently, crude was
pretty flat with the futures at 43 or 44 on the near month, but the six-year
number was at 37 and the average for six years is 39. The stocks only reflect
about $31 oil on a long-term basis. As long as the price of oil is higher than
31, the stocks look good.
Q: What's your outlook for the stocks?
A: Presumably, at the minimum we are going to make a normal return. If it
is anything like the 1970s, the big stocks may double and redouble again in a
Q: Do you think this is a time like the 'Seventies?
A: Yes. In the 'Seventies, the trigger was the U.S.
reaching its capacity. Now, the world has reached the limit of its light-oil
capacity. Reaching capacity limits causes prices to respond very strongly.
Q: Which areas of energy are you most focused on?
A: Five areas: Mega-caps, producer refiners, large-cap independents,
small-cap independents and income trusts.
Q: Do you cover the liquefied-natural- gas market?
A: LNG is pretty important. The North American natural-gas market is the
premium market for heating fuel, and we are not going to get more production in
a single year in North American natural gas, but we are going to get a lot more
production. That opens up the opportunity for LNG. LNG is the alternative for
North American natural gas. If we want clean fuel, we could import huge amounts
of LNG. It could be similar to nuclear power in the 'Seventies, when we went up
from nothing to 10% or 20% eventually. But we are far from peaking on natural
There is plenty of natural-gas supply. In fact, Russia's potential is more in
natural gas than it is in oil. All it takes to get it to us is money and steel.
LNG is very capital intensive. It requires big liquefaction plants that cool the
gas hundreds of degrees below zero and big tankers that are several times as
expensive as a conventional tanker. The biggest supplies of natural gas are in
the Middle East. That's a long way from market, so you need a lot of tankers.
Now the price of steel is going up. By the time these plants are built, LNG is
going to be a lot more expensive. LNG is a great opportunity for
capital-equipment and services companies. My LNG plan is conventional natural
Q: How is that?
A: If you own natural gas in the U.S., you will get the whole value
increase as LNG comes in more expensively than people think it will. The typical
mega-cap company is investing in LNG. I would argue that maybe you could buy Burlington
Resources and hedge your LNG investment with conventional gas. Don't spend
all your money on these LNG plants.
Q: What are your favorite stocks in the different
areas you cover?
A: I'm recommending all the mega caps, but one I'll focus on is ChevronTexaco.
The McDep ratio on ChevronTexaco is 0.86, compared with 1.02 for ExxonMobil.
Another way of putting it is that ChevronTexaco has the lowest cash-flow
multiple in the group, about 4.8 times cash flow, and the highest reserve life
Q: What's the average cash-flow multiple for the
A: About six times, which is cheap.
Q: Why is ChevronTexaco discounted here?
A: They have always been somewhat discounted. They don't have quite as
good a long-term record as Exxon. They are a little smaller. They have hardly
any debt. It is a $53 stock, and my present value of about 63 assumes $35 oil.
They're going to expand five big projects they have in Angola, Nigeria,
Kazakstan, Australia and the deep Gulf of Mexico. Their refining market has got
a little extra concentration in Asia. That's a quick rundown of where their
excitement is. For the most part, it is very solid, diversified and low-risk, as
are all of the mega-caps. They have a 3% dividend yield, which is likely to go
up more than inflation. TIPS [Treasury inflation-protected securities], by
comparison, are yielding 1˝%.
Q: What do you like among the producer-refiners?
A: There are two reasons to invest in the producer-refiners. One is for
dollar diversification, because they include some non-U.S. companies -- and the
non-U.S. companies are a little cheaper than the mega-caps. Some of the non-U.S.
companies are very cheap. If I wanted to pick a single name out of that group it
would be ConocoPhillips. There only are three big U.S. energy stocks:
ExxonMobil, ChevronTexaco and ConocoPhillips. ConocoPhillips has a pretty
distinctive record in recent years, but at one time they were an also-ran along
Hess and Unocal.
Now they've become a top performer. You have to give Jim Mulva, the CEO of
ConocoPhillips, credit for bold and creative leadership. They are buying a 20%
stake in Lukoil and may hold 10% of Lukoil by year end. Conoco has a low
cash-flow multiple of 4.8 times and a long reserve life of 11.9 years. Debt in
terms of value is a little higher than Chevron, around 0.25, but it is still
less than the market as a whole. It's an $88 stock that could go to $110 on $35
oil. Future excitement around the stock is centered in the Arctic North Slope
and Russia. They are in the Canadian Oil Sands and in Venezuela. They are the
largest U.S. refiner. And they are doing some LNG projects.
Q: What's your pick among the large-cap
A: My favorite from a pure asset point of view has been Burlington.
They've underperformed in terms of management and shareholder return, but they
still have great assets and they've been doing better in recent years.
Burlington has got two good properties: the San Juan Basin and the Deep Basin.
These are assets that will always produce gas. In the case of Burlington, their
stock at $44 only reflects about $29 a barrel and 63% of its business is in
North American gas. At $35 oil, Burlington should be valued at about $58 a
share. At $50 oil, Burlington would be about an $86 stock. I also think
Burlington Resources is a possible royalty-trust candidate.
Q: How is that?
A: One of my favorite income stocks over the years has been the San
Juan Basin Royalty Trust, although I have a hold on it for now. It is a
slice of the same properties that Burlington Resources has in the San Juan
Basin. The royalty trust has been a much better stock on a total-return basis
over the years than Burlington has been because income investors are willing to
pay a significant premium for it because there aren't very many income
investments they can have a lot of confidence in. If we treated Burlington
Resources as a royalty trust, there would be a 50% gain in valuation. Now, if
you think about the oil cycle I mentioned earlier and oil is poised to go up
several fold, then it might be too early for Burlington Resources to make this
change. In the 'Seventies, most of the royalty trusts were created at the end of
the period. It is a potential idea for Burlington, and it points out the
undervaluation in the company. It could be applied to Anadarko
Petroleum, as well. Burlington has also always been my favorite for
acquisition, but it has never happened.
Q: Who would be a likely candidate to take over
A: ConocoPhillips is a $60 billion-market- cap company that could buy
Burlington Resources and Marathon. I've had that fantasy over the years. For
now, ConocoPhillips is concentrating on Lukoil, but they won't ever be able to
buy all of Lukoil. But its stock is cheap, and so using the stock to buy the
other two isn't compelling. Presumably they could do it for debt, but
ConocoPhillips actually has a fair amount of debt. Other possible buyers would
be ChevronTexaco, which might want to boost its market cap. Total
doesn't have any North American natural gas and it might want to diversify in
that direction. Royal Dutch is desperate for something after this tough year and
they have made bids for natural-gas companies from time to time in the past.
That would be a good hedge for their LNG assets, too.
Q: What about the small-cap independents?
Acquisition is my focus. Encore has a reserve life of about 12 years, and
their multiple is 5.4 times. One of their biggest distinctions is their main
asset: a long-life oil field in North Dakota they bought from Shell. Encore's
reserves are stated as though this field had a recovery factor of 19%. But they
think they can get the number up to 31%. They think they can make the oil flow
better by horizontal drilling and water-flooding technologies. But the real
distinctiveness of the company is the founder, Jon Brumley. He is a serial value
creator. He headed up Southland Royalty in the 'Seventies, which was a great
performer. He formed the San Juan Basin Royalty Trust and the Permian Basin
Royalty Trust in the 1980s. Then he formed the Cross Timbers Royalty Trust in
1991. Another company he started was Cross Timbers Oil, which is now known as XTO
Energy. XTO is the greatest performer among the independents in recent
years. It has been a 10-bagger: 10-fold in 10 years. Encore is his sixth
company, and we are hoping for unusually good returns. So far so good. The stock
came out at 14 about four years ago and is now at 33.
Q: That leaves us with the royalty trusts.
A: If you like income stocks, royalty trusts are a great prospect for you
to make money in oil and gas and get income at the same time. I personally would
rather own stocks and sell a few shares when I need income. The royalty trusts
are priced for $40 oil, a premium to most oil and gas producers. They are priced
about 50% higher than the operating companies based on adjusted reserve life.
But royalty trusts keep coming up with more cash and issuing more stock and
buying more properties, and it is pretty well accepted that a royalty trust is a
superior way of holding a mature property. [For more on royalty trusts, see Hot
Q: What are you recommending there?
A: Canadian Oil Sands Trust. Its shares are priced at $51, a big discount
to my present value estimate of $72. Their strength is related to the life of
their reserves. They've got billions of barrels of reserves. The oil sands is
not a conventional oil field. The oil is mined on the surface. It is like
chocolate fudge and spongy to walk on. Hot water separates the oil from the
sand. The oil is very, very heavy and has sulphur in it, so it requires
intensive refining and more than the normal amount of refining. The biggest
refiner of the oil sands is Syncrude Canada, which is 35% owned by the Canadian
Oil Sands Trust. ExxonMobil owns 70% of Imperial which, in turn, owns 25% of
Syncrude. The trust then piggybacks on Exxon, and trust holders basically get
Exxon's operating expertise free. The trust has been expanding the refinery's
capacity and in a year or two should see a 50% increase in capacity. To pay for
the plant expansion, the trust hedged production to make sure they had the cash
to pay for it and kept the dividend payout steady at about 3% of the current
stock price. Otherwise, they could have a 10% dividend yield. The hedges are off
Jan. 1, and presumably they could pay out four times as much as they are paying
now. With 50% volume gains down the road, the trust could end up paying six
times as much as the current dividend.
Q: What's the risk here?
A: By far the greatest risk is the price of oil.
Q: What would you recommend people sell?
A: I'm recommending the sale of Kinder
Morgan Inc., Kinder Morgan Energy Partners and Kinder
Morgan Management. Kinder Morgan is an illusion that would make Houdini
jealous. In the last few months they've transferred a pipeline asset from Kinder
Morgan Inc., the general partner, to Kinder Morgan Energy Partners. The
partnership presumably pays full value, maybe more than full value, because it
is not an arms-length transaction. The general partner gets the full price of
the asset. The general partner also gets 42% of the cash flow from all the
assets of the partnership without making any capital contributions. They get
100% capital value of the assets and continue to get 42% of the cash flow of the
partnership. When the pipeline was part of the general partner, the earnings on
it were modest. Some years it made money, other years it didn't. It is not even
a reliable asset. As part of the partnership, however, income from the asset is
distributed and the general partners get a share and report the whole
distribution as earnings. They have been very successful stocks, but I would
argue they have underperformed, particularly when you allow for the risk. The
partnership is selling not for five times [the] cash flow multiple like Chevron
and ConocoPhillips, but for 15 times cash flow. It has 50% debt leverage and the
general partner has got 75% debt.
Q: Thanks so much, Kurt.