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Energy Investment Ideas for Growth, Inflation and Deflation
Presentation by Kurt H. WulffThe 41st Contrary Opinion ForumBasin Harbor, VermontOctober 2, 2003
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Summary and Recommendation
Invest in Energy for Real Return with Inflation Protection, Deflation Resistance and Tax EfficiencyOil is Underpriced and Natural Gas is CleanValue Stocks for Energy Resources on Unlevered BasisBuy Canadian Oil Sands Trust (COSWF), Anadarko (APC) and Marathon Oil (MRO)Sell Kinder Morgan (KMI, KMR, KMP)
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Outline
Investment StrategyIndustry OutlookValuation MethodBuy IdeasSell Ideas
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Investment Strategy
Real Return Bond BenchmarksReal Rates Trend Lower
Inflation ProtectionInflation Expectations Trend HigherFree Money Spawns InflationTwin Deficits Are Back to Spawn Inflation
Deflation ResistanceChronic Deflation Concerns WaneAccidental Deflation Possible Any Time
Tax Efficiency
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Bond Benchmarks
4.84.0Nominal BondReturn (%/yr)
3.22.0Implied Inflation (%/yr)
1.62.0Real Bond Return (%/yr)
20th Century Actual
(Dimson, Marsh & Staunton)
Current Ten-Year Expectation
U.S. Treasury Securities
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Real Interest Rate May Drop More
1.50
2.00
2.50
3.00
3.50
4.00
10/1
1/20
01
12/1
1/20
01
2/11
/200
2
4/11
/200
2
6/11
/200
2
8/11
/200
2
10/1
1/20
02
12/1
1/20
02
2/11
/200
3
4/11
/200
3
6/11
/200
3
8/11
/200
3Rea
l Yie
ld (P
erce
nt P
er Y
ear)
U.S. 10 Yr Inflation Indexed Note 200 Day Average
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Inflation Expectations Trend Up
1.00
1.20
1.40
1.60
1.80
2.00
2.20
2.40
10/1
1/20
01
12/1
1/20
01
2/11
/200
2
4/11
/200
2
6/11
/200
2
8/11
/200
2
10/1
1/20
02
12/1
1/20
02
2/11
/200
3
4/11
/200
3
6/11
/200
3
8/11
/200
3
Perc
ent P
er Y
ear
U.S. Ten Year 200 Day Average
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Free Money Spawns Inflation
?2002- ?
Annual InflationPeriods of T-Bill Rate below Inflation
8%1970-1980
4%1933-1951
10%1914-1918
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Twin Deficits are Back to Spawn Inflation
Trade deficit on the order of a half trillion dollars may signal weaker dollar and higher priced importsDollar exchange rate decline limited by inflation in other currenciesFederal budget deficit also on the order of a half trillion dollars
Military spendingSocial spending
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Resistance to Chronic Deflation Builds
3.00
3.50
4.00
4.50
5.00
5.50
6.00
10/1
1/20
01
12/1
1/20
01
2/11
/200
2
4/11
/200
2
6/11
/200
2
8/11
/200
2
10/1
1/20
02
12/1
1/20
02
2/11
/200
3
4/11
/200
3
6/11
/200
3
8/11
/200
3
Yiel
d (P
erce
nt P
er Y
ear)
U.S. Ten Year Note 200 Day Average
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Deflation Accidents Possible Any Time
High debt carries high riskMortgage market?Derivatives abuse?Securities fraud?Hedge fund speculation?Country defaults?Utility deregulation?
Be wary of high-leverage entities
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New Tax-Efficiency Favors Equity
Investors taxed at half or less the rate on stocks compared to bondsReducing tax on dividends and capital gains reduces tax on inflation which logically should not be taxedImprovement in relative appeal of equity helps overly leveraged companies to substitute equity for debt
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Industry Outlook – Natural Gas and Oil Most Valuable Energy Resources
OilDemand, Supply and PricePrice Cycle Turning Up2006 Oil Rising 10% Per YearSix-Year and One-Year Futures for Price Forecast
Natural GasReliable and CleanConvenient and EconomicDiscount to oil historical pricesPremium to oil in futures prices
Refining/MarketingPower
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Oil is Cheap
Demand linked to economic growthDemand artificially suppressed
Fuel taxesRationingAcceptance of dirtier fuels
Spare production capacity minimalMiddle East Religion and PoliticsFutures prices low
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Oil Price Cycle Turning UpLight Sweet Crude Oil, 1969-2003
0.0010.0020.0030.0040.0050.0060.0070.0080.00
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
Dol
lars
Per
Bar
rel
Inflation Adusted Current
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2006 Oil Rising 10% Per YearLight Sweet Crude Oil Futures
17.00
18.00
19.00
20.00
21.00
22.00
23.00
24.00
25.00
26.00
2/18
/200
0
4/18
/200
0
6/18
/200
0
8/18
/200
0
10/1
8/20
00
12/1
8/20
00
2/18
/200
1
4/18
/200
1
6/18
/200
1
8/18
/200
1
10/1
8/20
01
12/1
8/20
01
2/18
/200
2
4/18
/200
2
6/18
/200
2
8/18
/200
2
10/1
8/20
02
12/1
8/20
02
2/18
/200
3
4/18
/200
3
6/18
/200
3
8/18
/200
3
Dolla
rs P
er B
arre
l
December 2006 40 Week Average
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Rolling Six-Year and One-Year Futures Input to Fundamental Analysis
2.002.503.003.504.004.505.005.506.006.50
12/28
/2001
1/25/2
0022/2
2/2002
3/22/2
0024/1
8/2002
5/16/2
0026/1
3/200
27/1
1/200
28/8
/2002
9/5/200
210
/3/20
02
10/31
/2002
11/27
/2002
12/26
/2002
1/22/2
0032/1
9/200
33/1
9/200
34/1
6/200
35/1
4/200
36/1
1/2003
7/9/200
38/6
/2003
9/3/200
3
Dol
lars
Per
Mill
ion
BTU
12.0015.0018.0021.0024.0027.0030.0033.0036.0039.00
Dol
lars
Per
Bar
rel
72 Month Natural Gas 12 Month Natural Gas 72 Month Oil 12 Month Oil
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Natural Gas Reliable and Clean
No blackouts because of primitive transmission along wires strung on unsightly polesNo discharge of excessive waste heat into rivers and waterways, especially during hot monthsNo windless days or bird kills from whirring turbine blades on polesNo particulates or sulfur dioxide and far less carbon dioxide than from coalNo flooding of human or wildlife habitat behind dams
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Natural Gas Convenient and Economic
Turbine driven with waste heat recovery (combined cycle) most efficient generation of electricity from heatDistributable underground to point of use
Coal and nuclear like obsolescing mainframe computersNatural gas like personal computers
Highly refined oil most competitive alternative turbine and heating fuelStrong demand drives up natural gas priceOil a backup for natural gas
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Natural Gas Historical Discount to Oil
Natural Gas Price Discount, 1969-2003
0.00
0.20
0.40
0.60
0.80
1.00
1.20
196919711973197519771979198119831985198719891991199319951997199920012003
Nat
ural
Gas
/Oil
(6:1
= 1
.0)
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Natural Gas Futures PremiumNatural Gas/Oil Futures
0.70
0.80
0.90
1.00
1.10
1.20
1.30
1.40
1.50
12/2
8/20
01
1/28
/200
2
2/28
/200
2
3/28
/200
2
4/28
/200
2
5/28
/200
2
6/28
/200
2
7/28
/200
2
8/28
/200
2
9/28
/200
2
10/2
8/20
02
11/2
8/20
02
12/2
8/20
02
1/28
/200
3
2/28
/200
3
3/28
/200
3
4/28
/200
3
5/28
/200
3
6/28
/200
3
7/28
/200
3
8/28
/200
3
Nat
ural
Gas
/Oil
(6:1
=1.0
) Six-Year One-Year
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Refining Margin Improving
Refining Crack One-Year Futures and 40 Week Average
4.00
4.50
5.00
5.50
6.00
6.50
7.00
12/2
8/20
01
1/28
/200
2
2/28
/200
23/
28/2
002
4/28
/200
25/
28/2
002
6/28
/200
27/
28/2
002
8/28
/200
2
9/28
/200
210
/28/
2002
11/2
8/20
02
12/2
8/20
02
1/28
/200
3
2/28
/200
33/
28/2
003
4/28
/200
3
5/28
/200
3
6/28
/200
37/
28/2
003
8/28
/200
3
Dol
lars
Per
Bar
rel
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Power Underpriced – Dirt for DollarsElectricity vs. Natural Gas
-60-50-40-30-20-10
010203040
6/24
/200
2
7/24
/200
2
8/24
/200
2
9/24
/200
2
10/2
4/20
02
11/2
4/20
02
12/2
4/20
02
1/24
/200
3
2/24
/200
3
3/24
/200
3
4/24
/200
3
5/24
/200
3
6/24
/200
3
7/24
/200
3
8/24
/200
3
9/24
/200
3
Spar
k Sp
read
(Dol
lars
/Meg
awat
t Hou
r) East West
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McDep Ratio measures unlevered value
Market Cap and Debt to Present ValueUnlevered – counters the distortion of debtPresent value depends on interest rates, inflation, commodity prices, reserve life, investment requirements, operating costs
Weekly calculations for natural gas royalty trustsPeriodic reconciliation of cash flow multiple assessments with reserve life
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Weight Portfolio Positions onUnlevered Basis - Example
CNOOC Limited Kinder Morgan, Inc.Symbol CEO KMIRating Buy SellPrice Change 2003 31% 27%Debt/Present Value - 0.80 Portfolio Weight (Equal Unlevered PV) 83% 17%Weighted Gain 26% -5%
Portfolio Gain = 21%
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Buy energy producers
Mega Cap – CVX, RDDividends above TIPS real returnDividends likely to adjust for inflationLow debt offers deflation resistanceNew lower tax rate makes dividends more valuable
Producer/Refiners – COP, MRO, PTRNorth Am Natural Gas – ECA, BR, APC, XTO, SJTOil – CEO, EAC, COSWF
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Mega Cap Energy ProducersDominant Market Cap, Attractive Value
Price($/sh) Market Debt/
Symbol/ 24-Sep Cap Present McDepRating 2003 ($mm) Value Ratio
Exxon Mobil CorpoXOM 36.90 247,000 0.10 1.05 Total S.A. TOT 76.84 98,000 0.19 0.92 BP plc BP 42.65 158,000 0.15 0.87 Royal Dutch/Shell RD B 45.00 156,000 0.18 0.85 ChevronTexaco CorCVX B 72.33 77,000 0.22 0.82
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Energy Producer/RefinersPotential to Outperform Mega Caps
Price($/sh) Market Debt/
Symbol/ 24-Sep Cap Present McDepRating 2003 ($mm) Value Ratio
Murphy Oil Corporation MUR 59.83 5,530 0.26 1.34 Imperial Oil Limited (30%) IMO 37.81 4,290 0.12 1.04 Petro-Canada PCZ 40.35 10,690 0.19 0.92 Norsk Hydro ASA (49%) NHY 52.74 6,670 0.27 0.91 OAO Lukoil LUKOY 77.60 16,000 0.12 0.88 ConocoPhillips COP B 55.75 38,000 0.38 0.87 Marathon Oil Corporation MRO B 28.35 8,790 0.31 0.80 Suncor Energy SU 18.66 8,880 0.14 0.78 PetroChina Company Ltd (10%) PTR B 32.85 5,780 0.11 0.70
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Opportunity in Marathon Oil (MRO) About Every Ten Years
Double oil production from Yates Field in Texas free from price controls – DLJ Action Recommendation, October 1973Leading candidate for financial restructuring –DLJ Action Recommendation, April 1, 1981Vote for Spinoff – McDep Action Recommendation, March 19, 1990Set It Free from U.S. Steel– McDep Stock Idea, April 16, 2001
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Opportunity in Marathon (MRO) Today
Acquirable, efficient producer/refinerLow multiple of cash flow – EV/Ebitda = 5.4Value split approximately
45% oil and overseas natural gas35% U.S. Midwest refining/marketing20% North American natural gas
Competent managementStock should trade like peers and offer additional possible upside surprise
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Independent Nat Gas and Oil Producers Concentrated on Higher Potential
Price($/sh) Market Debt/
Symbol/ 24-Sep Cap Present McDepRating 2003 ($mm) Value Ratio
Occidental Petroleum Corp. OXY 35.11 13,500 0.38 1.00 Apache Corporation APA 69.09 11,000 0.20 0.99 Encana Corporation ECA B 37.01 17,500 0.20 0.94 XTO Energy Inc. XTO B 21.27 3,910 0.25 0.91 Unocal Corporation UCL 31.69 8,100 0.35 0.87 Burlington Resources BR B 48.48 9,800 0.27 0.86 Devon Energy DVN 49.14 8,000 0.42 0.86 CNOOC Limited (19%) CEO B 34.15 2,670 - 0.86 Anadarko Petroleum Corp. APC B 44.16 11,100 0.32 0.82
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Anadarko (APC) – Acquirable Producer
Management ready to sellDisenchanted ownersStrategic complement to LNG
56% North American natural gasPremier Rockies acres (Union Pacific land grant)
Cost savings in overhead and hedgingMarketable reservesOpportune time in energy commodity cycle
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Income Buys
Price($/sh) Market Annual
Symbol/ 24-Sep Cap Income McDepRating 2003 ($mm) (%) Ratio
San Juan Basin Royalty Trust SJT B 17.88 830 10.6 1.03 CNOOC Limited (19%) CEO B 34.15 2,670 4.7 0.86 Royal Dutch/Shell RD B 45.00 156,000 4.4 0.85 ChevronTexaco Corporation CVX B 72.33 77,000 4.0 0.82 Marathon Oil Corporation MRO B 28.35 8,790 3.5 0.80 Canadian Oil Sands Trust (US$) COSWF B 28.95 2,500 5.0 0.71 PetroChina Company Ltd (10%) PTR B 32.85 5,780 6.2 0.70
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Canadian Oil Sands Trust (COSWF)Premium Characteristics
Sole asset 35% Syncrude Oil Sands PlantEqual economic partner Exxon et alLow fee, efficient, administrationVolume growth – 260mbd, 350mbd, plusReserves last practically foreverEnvironmentally desirable productDividend double by 2006, triple by 2007Dividend qualifies for 15% U.S. rate
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Canadian Oil Sands Trust (COSWF)Potential Ten-Bagger (10x in 10 years)
Ten-bagger growth rate: 26%/yearCanadian Oil Sands Trust Multipliers
Volume: 2xEV/Ebitda: 2xOil Price: 2x, 3x, 4x Dividend/Ebitda: 3x,4x
Downside: Cash Breakeven at US$13/barrel
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Sell pipeline partnerships– EEP, EEQ, EPN, KMI, KMR, KMPReal growth valued two to three times buy recommendationsMost inflation protection usurped by general partnerLimited deflation resistance because of high leverageAccounting misrepresents debt and high compensation to general partnerTax change expands competitive income opportunities
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Pipeline PartnershipsUnattractive Valuation
Price($/sh) Market Debt/
Symbol/ 24-Sep Cap Present McDepRating 2003 ($mm) Value Ratio
Kinder Morgan Energy Partners, L.P. KMP S 42.09 5,790 0.47 2.07 Kinder Morgan Management, LLC KMR S 37.20 1,710 0.47 1.88 Kinder Morgan, Inc. KMI S 53.63 6,600 0.80 1.56 Enbridge Energy Partners, L.P. EEP S 48.99 1,910 0.57 1.68 Gulfterra Energy Partners GTM S 40.38 2,220 0.56 1.68 Enbridge Energy Management, L.L.C EEQ S 44.39 420 0.57 1.58
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KMP/COS Side by Side
Arizona Pipe Failure
Notoriety
5.0%6.2%DistributionYield
.311.61Distribution/Equity Ebitda
.19.47Debt/PV
718EV/Ebitda
Canadian Oil Sands Trust
Kinder Morgan Energy Partners
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Moral Hazard in Pipeline Partnerships
General Partner takes up to 50% of cash flow for no capital outlay exploiting moral hazard
Partnerships skimp on debt servicePartnerships skimp on maintenance and safety
Failure of 48-year old Arizona pipeline triggered gasoline shortages in August 2003
Rating agencies allow outlawed debt pyramidsSEC exempts partnerships from Sarbanes OxleyNYSE facilitates excessive GP compensationFERC allows asset stripping at public expense
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What is Contrary Opinion in Energy?
Oil price likely be to higher than in the futures market, possibly by a lot in a surprise inflationary environmentNatural gas premium to oil likely to be higher than in the futures market as environmental advantages become more valuable as the politics sort outUnlevered present value of cash flow the most useful tool of energy valuationThe stocks that pay the least amount of fees to managers and financiers may be the among the best opportunitiesThe SEC, the NYSE, the Federal Energy Regulatory Administration, and the debt raters do not appear to protect thepublic interest in pipeline partnerships
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Wrapup
Invest in Energy for real return, inflation protection, deflation resistance, tax efficiencyOil is cheap, natural gas is cleanOwn stocks on basis of unlevered holdings of energy resources and businessesBuy Marathon, Anadarko, Canadian Oil Sands Trust and other energy producersSell Kinder Morgan and other pipeline partnerships
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Disclaimer and Disclosure
Independent energy investment analysis by Kurt Wulff doing business as McDep Associates is posted at www.mcdep.com. Mr. Wulff is not paid by covered companies. Neither he nor his spouse act contrary to a buy or sell rating. Analyses are prepared from sources and data believed to be reliable, but no representation is made as to their accuracy or completeness.