The View From the Summit

By Robert Rapier • April 29, 2014 • Energy Strategist Weekly

The Investing Daily Summit

This week I will speak about energy investing at Investing Daily’s annual Investing Summit in Alexandria, Virginia. Last year’s presentation in Scottsdale, Arizona was my first since joining Investing Daily, and I laid out my personal philosophies for creating long-term wealth. They are:

  • Spend less than I earn and invest the rest

  • Minimize personal debt

  • Invest in businesses I understand

  • Understand the risk level

  • Avoid investments that are dependent on government subsidies and/or mandates

  • Identify long-term trends and invest accordingly

  • Have an exit strategy

I will cover a number of long-term trends in the energy business. One is that oil will continue to be hard to replace, and even though new supplies are coming online, voracious demand from developing countries and the higher costs of developing unconventional reserves will keep prices high. Another is that coal and nuclear power both face a lot of headwinds, and investors have to be extremely picky if they choose to invest in these sectors. On the other hand, solar power’s prospects look bright, and solar will in the long run become perhaps our most important source of energy.

Natural Gas Powers Ahead

But the story of the year for me is the developing picture with natural gas. In my presentation last year, I had a slide that simply said “Natural gas is cheap.” I went on to explain why I felt like natural gas was undervalued, and I made the case for investing in natural gas producers on the basis of several long-term bullish drivers.

What has happened since then?

Natural gas prices are up about 20 percent since I wrote that, and natural gas producers — undervalued for so long in my opinion — have begun to surge. Over the course of the year we added a number of natural gas producers to the various Energy Strategist portfolios, and by my count now hold 10 of the country’s top 20 as shown in the table below:

140428mlpiitopgasproducers

Top 20 natural gas producers in 2013. Source: Natural Gas Supply Association

For example, we added Chesapeake Energy (NYSE: CHK) — the country’s second-largest natural gas producer — to our Aggressive Portfolio on May 13 and have gained 42 percent since. (Check the latest Energy Strategist for our current advice on Chesapeake and the other natural gas producers.)

Devon Finally Bounces

But Chesapeake isn’t an exception to the rule. All of our natural gas producers in the portfolios — 100 percent — are sitting on gains. I personally bought the nation’s fourth-largest natural gas producer — Devon Energy (NYSE: DVN) — last September because I felt the market was discounting both the potential for higher gas prices and Devon’s moves toward even more lucrative liquids production. Devon’s shares were pretty flat from the time I bought them until early February. I was in no hurry, because remember, I am targeting long-term trends and positioning accordingly.

But the very cold winter meant I didn’t have to wait for investors to recognize the long-term bullish factors that I believe will support a natural gas price rise. The short-term factors lined up as well, as natural gas inventories depleted at a record pace this winter. Since Feb. 1, Devon shares have surged by more than 20 percent, and are regularly breaking through new 52-week highs:

140428mlpiiDVN
Devon Energy’s share price, Feb. 3 through April 25

A similar picture has emerged for other natural gas stocks. They have all begun to move higher over the past few months. Since most natural gas producers also have substantial liquids production, oil prices that are stubbornly clinging to $100 a barrel have helped.

Cabot’s Production Surges

As I have been saying for months, most of these producers will report better year-over-year results versus last year. Last week Cabot Oil & Gas (NYSE: COG) — with most of its focus in Pennsylvania’s gas-rich Marcellus Shale and the Eagle Ford crude oil shale of Texas — reported first-quarter results. Some highlights for the quarter were:

  • Natural gas and liquids production of 119.9 billion cubic feet equivalent (Bcfe), an increase of 34 percent over last year’s comparable quarter

  • Discretionary cash flow of $319.5 million, an increase of 36 percent over last year’s comparable quarter

  • Net income excluding selected items of $109.7 million, an increase of 102 percent over last year’s comparable quarter

  • Total unit costs of $2.66 per thousand cubic feet equivalent (Mcfe), a 19 percent improvement over last year’s comparable quarter

Despite what was shaping up to be a good quarter, shares had recently sold off after Cabot announced production would be flat during the first half of the year as a result of a transition to the more efficient pad drilling. Several brokerage houses even downgraded the company on the basis of this short-term outlook, but shares have surged since last week’s earnings report, and are now up 17 percent in the last 10 trading days.

Conclusions

Based on my forecast for natural gas prices this year, I expect this to be a great year for the shares of most major natural gas producers. Some have already made strong advances, but many are still undervalued. For the long-term investor especially, it’s certainly not too late to buy in.

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)

Portfolio Update

Drilling Into Earnings

Energy stocks came into this earnings season riding strong momentum, so it’s not especially surprising that a couple of our big-time winners stumbled last week after falling short of quarterly expectations. But none said anything to undermine our faith in those stocks or our bullish stance on the energy sector in general.

Top-ranked Best Buy Chicago Bridge & Iron (NYSE: CBI) has so many irons in the fire that it is liable to get burned now and then by short-term business fluctuations. That was the case in the most recent quarter as CBI’s pipe-making plants lost time waiting for engineering blueprints from customers. Accounting rules also required the company to absorb a disproportionately large stock compensation expense during the period.

But the plants have already begun catching up, and are not expected to jeopardize CBI’s annual guidance for revenue growth of some 15 percent this year. Meanwhile, the company remains in the sweet spot of the rush to build liquefied natural gas facilities, refineries, nuclear power plants and petrochemical complexes around the globe, as borne out by its $30 billion and growing contract backlog.

Since the report, the stock has pulled back 8 percent from the vicinity of record highs back to the lower end of its recent trading range. We’re not deterred. Buy CBI below $94.

Core Laboratories (NYSE: CLB) also missed estimates, as bad weather and deepwater project delays capped the reservoir specialist’s revenue growth below 1 percent year-over-year and some 7 percent shy of the consensus estimate. Nevertheless, the operating margin actually improved to an industry-leading 33 percent, and Core expects the shortfall to be made up during the balance of the year, issuing annual guidance in line with its prior forecast and analysts’ expectations.

This is a leading technology supplier profiting as never before from its expertise in maximizing crude flows from shale fields and deep offshore wells. Free cash flow is expected to increase at least 14 percent to $300 million or more this year, and will be dutifully returned to shareholders via share repurchases and dividends.    

At the current price that would represent a modest cash flow yield of 3.5 percent, backed by moderate revenue growth of 8 to 9 percent. The stock squandered its recent breakout to all-time highs following the disappointing earnings news, retreating to the prior six-month trading range. But the advanced technology, fantastic margins and a disciplined, shareholder-friendly management leave plenty of long-term upside. CLB remains a Hold.

Robert noted Cabot’s strong results above; the rally on the news also celebrated an incrementally strong second-quarter production forecast, which is now expected to show a 5 percent sequential boost, leaving Cabot on pace to increase its annual production by the promised 35 percent in 2014. The company also laid out an early forecast for growth of 20 to 30 percent in 2015, using conservative assumptions that suggest there will in fact be little let up from the current growth pace for years. Discounts on the Pennsylvania gas Cabot produces relative to quoted futures prices remain a problem, but one that should improve by next year as new transmission infrastructure comes online, pushing Marcellus gas into New England, where it should fetch a premium. And in the meantime returns are lucrative enough to cover all of Cabot’s foreseeable investment needs, including the newly announced third rig for its Eagle Ford acreage, and leave plenty left over for share repurchases, on which Cabot has bided its time so far this year. This remains one of our strongest-conviction picks. Buy COG below $42.50.

Finally, oilfield services giant Schlumberger (NYSE: SLB)  extended its long record of operational and financial excellence in results reported on April 17, beating earnings expectations by a penny per share as relentlessly rising margins and a pickup on land and offshore in North America offset weather delays and a slowdown in Brazil. The company announced that rising cash flow has led it to accelerate the $10 billion buyback initiated in July, now to be completed over two-and-a-half years instead of five. The stock is trading at a six-year high. Buy SLB below the newly increased maximum of $110.        

— Igor Greenwald

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