December 27, 2004:  Kurt Wulff Interviewed by Sandra Ward in Barron's


Drilling for Value

The analyst oil barons consult on where to make money at today's high energy prices


An Interview With Kurt Wulff -- In an industry populated by mavericks, it makes sense that one of the best analysts covering the oil and gas sector is equally as innovative. Providing independent research through his Needham, Mass.-based McDep Associates, the firm Wulff founded in 1988 after a long career on Wall Street, his work is sought after by investment banks as well as individuals. The McDep ratio -- market cap and debt to present value of energy -- was devised by Wulff in the 1980s as a way to better appraise a company's value. It was that kind of creativity that distinguished his work during the 16 years he covered the sector for Donaldson Lufkin & Jenrette through the oil boom of the 'Seventies and the bust of the 'Eighties. Oil barons and financiers such as Gordon Getty, Carl Icahn and T. Boone Pickens relied on his advice during the takeover battles of the mid-'Eighties. Now through his Website,, his insights are more widely available. For his views on where the price of oil is headed and how to profit from it, please read on.

Barron's: Where do you stand in the great debate on oil reserves?
Wulff: There are reserve issues with every company and there are differences in reporting, and a lot of work is trying to judge those differences, but the big story on reserves is in Saudi Arabia and Russia. Imagine Saudi Arabia and Russia observing the same standards as Royal Dutch Shell. We have a test in Russia with ConocoPhillips buying Lukoil: ConocoPhillips took Lukoil's reserves, which had a life of roughly 22-23 years, and cut them to less than half that, or about nine to 10 years to conform to SEC [Securities and Exchange Commission] standards. Lukoil's oil is still there but it is not developed, and you have got to spend some money to get it. In Lukoil's case, some of the revisions apparently involve whether Lukoil will continue to hold a license to produce in a particular area. We know from the Yukos affair that anybody's right to do business in Russia is at the pleasure of the government. I liken Russia to the U.S. whose oil production peaked in 1970. There has been a lot of oil developed in the U.S. since 1970, and there is a lot of oil to be developed in Russia. But the U.S. never went above its peak production in one year, and Russia won't produce more than it did in its peak year around 1985 either, though Russia's production has rebounded after dropping off very fast in the 1990s.

Kurt Wulff

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 five-year period.

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 gas worldwide.
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 gas.

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 of 11.4.

Q: What's the average cash-flow multiple for the group?
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 with Marathon and Amerada 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 independents?
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 Burlington?
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.

Wulff's Picks…

    Recent Net Present Debt/
Company Symbol Price Value (share) Value Ratio*
ChevronTexaco CVX $53 $62.50 0.13 0.86
ConocoPhillips COP 88 110.00 0.25 0.85
Burlington Resources BR 44 58.00 0.14 0.79
Encore Acquisition EAC 33 47.00 0.22 0.77
Canadian Oil Sands COSWF 51 72.00 0.18 0.77
…And Pans
Kinder Morgan Eng P KMP 45 15.00 0.52 1.97
Kinder Morgan Inc. KMI 73 20.00 0.74 1.69
Kinder Morgan Mgt KMR 41 15.00 0.52 1.83

* McDep ratio: market cap and debt to present value of oil and gas and other businesses

Q: What about the small-cap independents?
Encore 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 and Not.]

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.