Throughout the heartland of America, institutional investors are sensing the winds of change now blowing across the global energy landscape. With North American supply/demand fundamentals for natural gas tightening and OPEC asserting more discipline in output, the traditional notion of normalized $2 to $3 pricing for gas and $18 to $22 for oil may become as archaic as the horsedrawn carriage, the kerosene lantern and 32-cent gasoline with complementary glassware and full-service island. One Chicago buysider observes that some Wall Street analysts are still valuing oil companies as though crude prices were going to decline to $20 within two years. "With demand rising faster than supply, I don't see that happening-rather an OPEC-determined $30 median oil price with average natural gas prices one-sixth of that." Echoes a St. Louis-based portfolio manager, "We don't see crude prices dropping below the mid-$20s any time soon. Similarly, we look for natural gas prices to remain strong, around $5." Since there's a credible consensus that the market is on the cusp of witnessing a new threshold for "normalized" oil and gas prices, even a slight pullback in recent commodity prices-an event widely expected later this spring-could set the stage for another energy-share buying spree such as occurred in second-half 2003. After all, with the valuation ground floor for energy shares being redefined by market fundamentals and OPEC's desire to maintain maximum profitability without encouraging alternative supply, investors may reasonably conclude that higher normalized commodity prices ultimately translate into higher earnings, cash flow and share prices. Amid these winds of industry change, Midwest-based buysiders are pondering more than ever which energy stocks are value plays, which are growth vehicles and which are a mixture of both. The larger institutional investors, more often than not, will play the safer, bigger names in the industry, the buysiders say. Meanwhile, those with smaller portfolios will seek out the emerging, frequently overlooked names in the sector or-in contrarian fashion-increase their weighting to a whole sector out of favor with The Street. Big names, big bucks Headquartered just off of LaSalle Street in Chicago's downtown financial district, Harris Trust and Savings Bank-with $30 billion in assets-is definitely in "The Loop" when it comes to energy investing. Through its Harris Private Bank arm, the firm, wholly owned by the BMO Financial Group, has a market weighting in the energy sector-currently 6% relative to the S&P 500. This adds up to hundreds of millions of dollars in equity exposure on behalf of foundations, trusts, high-net-worth individuals and mutual-fund investors. "We have more of a buy-and-hold investment strategy versus a trading-type mentality," says Thomas C. Lewis, vice president and senior equity analyst, fundamental research, for Harris Trust and Savings Bank. "As a result, our equity investments within the energy sector have been mostly in the larger-cap, integrated oils." These are companies with established track records, high-quality management, a record of consistent dividend payments and the prospect of good earnings growth-the kind of names that can be kept in a portfolio for 24 to 36 months, he says. An anchor for its energy-equity portfolio has been-and continues to be-ExxonMobil. "The stock represents nearly 45% of the S&P 500 Energy Index, so if you're not in it, you're making a big bet against the index and the stock itself. I'm not desirous of making that kind of bet." Quite the contrary, Lewis views ExxonMobil as the gold standard within the energy arena. During the past several years, it has had the best returns of any of the major oils-with an average annual return on equity in the high teens-high dividend growth with a five-year historical growth rate of about 4%, a net debt/total capitalization of around 2% and some $10 billion-plus of cash on its books, he says. "In addition, it has the best people and the best opportunities, particularly in the E&P business," he adds. ConocoPhillips is another of the firm's core holdings. The attraction: the recent merger combines Conoco's strong E&P assets and downstream European operations with Phillips' Tosco refining operations in the U.S.-a potentially higher-return business-and the Alaskan upstream assets it acquired from Arco. "All of these are catalysts for growth." Despite such emphasis on integrateds, the portfolio also includes some select E&P names-the likes of XTO Energy and Apache. "These are names you buy when commodity prices are trending up," says Lewis. "In such an environment, you're calculating crude oil or natural gas production times price, less cost." In the case of XTO, whose management the analyst has known since the days it ran the old Southland Royalty Co., it's focused on acquiring and exploiting reserves in areas where it has established expertise and where it can achieve economies of scale as it folds those properties into its existing asset base, he says. Apache, once viewed as a one-trick pony because all it had was a successful acquisition-and-exploitation strategy, has since blended in a lucrative exploration program. "Now it has all three legs of the stool-acquisitions, exploitation and exploration-to fuel growth," Lewis says. Long term, he is sanguine about the fundamentals of the U.S. oil and gas industry. "A lot of the low-hanging domestic hydrocarbon fruit has already been picked from the tree-and the remaining fruit is going to take a bit more time and money to get, particularly in the case of natural gas," he says. "That argues for a tighter supply/demand environment than we've seen in the past and more positive future pricing for gas, much like we now have for crude." In search of value Across the street from Milwaukee's historic City Hall, William J. Nasgovitz, president of Heartland Advisors, oversees about $3.3 billion of 95% equity-focused funds in a modern, glass-framed office that resembles the control deck of Captain Kirk's Enterprise. But the one-time Dean Witter broker has his feet firmly planted on terra firma. Following the principals of Benjamin Graham, the noted value-investing seer, Nasgovitz founded Heartland in 1982 with a down-to-earth focus on undervalued small-cap stocks largely ignored by Wall Street analysts. The largest of Heartland's three mutual funds, the Value Fund-with $2.2 billion of equities under management as of year-end 2003-has enjoyed an average annual 16% net return since inception 19 years ago, a recent three-year average annual return of 25% and a 70% gain in value last year. Notably, that fund is around 9% weighted to energy-more than double its benchmark, the Russell 2000, energy weighting of 4%. "We like to buy small-cap energy stocks-from $1.5 billion down to $100 million in market cap-based on fundamental research," says Nasgovitz. "We look at such key metrics as price/cash flow, price/earnings, price/net asset value (NAV) and price/replacement value in the case of service stocks. In short, we like to buy energy stocks cheap, relative to assets." While Heartland may gravitate toward out-of-favor stocks selling at a discount to NAV, it doesn't do so with abandon. It screens for companies with low financial risk and plenty of free cash flow. It also looks for insider stock-buying by the people who operate a company-particularly when share prices are distressed. Within the energy sector, Heartland is mainly an E&P investor and is applying these criteria to the likes of Forest Oil Corp. "We started buying this stock late last summer at around $20 per share," says Nasgovitz. "What caught our eye at the time was that there was significant insider buying, the stock was out of favor with The Street and it was selling at a significant discount to our estimated break-up value of $30 per share-all of this in the face of rising oil and gas prices." Even though this stock has been beaten down because of recent downward reserve revisions, the company has manageable debt, excess cash flow, a president with a good track record and its shares are selling at only 3.5 times estimated 2004 cash flow, says the contrarian investor. "It fits well with our value style of investing." Heartland has also applied this style of investing to Nuevo Energy, which recently entered into an agreement to be bought by Plains Exploration & Production Co., as well as to Spinnaker Exploration and Harvest Natural Resources. "Three years ago, when Jim Payne took over as head of a then highly leveraged and troubled Nuevo, he took all his compensation in unrestricted stock," says Nasgovitz. "We liked that commitment, on top of his history of success, and accumulated the stock as low as $11 to $12 per share." Recently, the stock has traded above $30 per share. In the case of Spinnaker, Heartland began buying the stock in 2002 at under $20 per share after the debt-free gas producer had fallen out of favor because its drilling results didn't meet market expectations. Says the Heartland head, "It moved from a growth stock to a value stock, trading below NAV with a price/cash flow multiple of less than four versus 15 for the S&P. We recently sold part of our position in the company around $35." Over the long haul, the value maven is upbeat in his sector outlook, primarily because of increasing energy demand and supply shortfalls worldwide. He points out that in China alone, daily oil consumption during the past 12 years has more than doubled, from 2.4 million barrels to nearly 5.4 million. "It's running short of domestic reserves and has become a net importer of oil." In Nasgovitz' view, producers with U.S. reserves should command a premium valuation like Evergreen Resources whose stock trades at 14.9 times cash flow. "There's a potential shortage looming in terms of secure domestic energy supply-whether that's gas, coal or oil-and it's a situation likely to be with us for the foreseeable future." LNG pressure Operating in 20 countries worldwide, UBS Global Asset Management has about $463 billion of assets under management, overseeing $173 billion of equity investments globally. Currently in the U.S., the firm has a neutral market weighting in energy equities-around 5%-up from 3% at the start of 2003. "Ours is a bottom-up, fundamental, long-term valuation approach," says William J. De Allaume, Chicago-based executive director and senior investment analyst for UBS Global Asset Management (Americas) Inc. Instead of just looking at a company's forward-year multiple of earnings or cash flow, it goes out five years in its modeling to estimate mid-cycle free cash generation for a given company. "This normal cash flow level, together with estimates for long-term growth and profitability, allow us to calculate a net present value for each company we follow," he explains. "We then compare this value to the company's current market price to determine if we want to own its stock. "The advantage of this approach is that it helps us look beyond some of the short-term ripples in the market and make investment decisions from a longer-term perspective." The buysider used this long-rifle approach to look past the prevailing conventional market wisdom last year that there wouldn't be much deepwater exploration and development drilling in 2004. While deepwater-drilling stocks like Transocean, Diamond Offshore and GlobalSantaFe took a pounding in the wake of this market miscalculation, UBS did some opportunistic buying in the sector-believing that higher-end rigs would find work in rebounding markets like West Africa. More conservative than other buysiders, the company anticipates during the next five years normalized oil prices in the low $20s and natural gas prices in the $3.50 to $4 range. Says De Allaume, "What's best for Saudi Arabia, which has the ability to enforce discipline within the cartel, is a lower oil price that encourages demand growth, thwarts the development of non-OPEC supply and optimizes the present value of its resource base over its life." While this outlook for crude prices would suggest commensurately low $4 natural gas prices, the analyst sees further pricing pressure on gas. "Right now, there's a lot of high-cost North American gas production that can still be justified because of high commodity prices," he allows. "But longer-term, what the market may be underestimating is the impact of incremental imports of LNG-the costs of which are coming down-and the globalization of the natural gas market." At some point, when enough terminals are built in the U.S. and LNG becomes a bigger component of this country's gas supply, there could be a further drop in gas prices because the marginal cost of supplying these terminals will be lower compared with drilling in existing North American basins, he adds. "If you're a high-cost gas producer in North America, you're either going to have to change your asset portfolio such that you're moving down the domestic cost curve like many operators in the Rockies or you're going to have to diversify internationally," he says. Clearly, the big beneficiaries of the analyst's macro outlook will be the major integrateds. "They have the capital, the relationships with host governments and the logistical skill sets to bring LNG into the U.S." He cites BP in Trinidad, Shell in Nigeria and ExxonMobil in Qatar. "Right now, the natural gas market is disjointed and regional, but LNG has the potential to turn that market into a global one-where the majors have a competitive edge over smaller, independent producers." The service sector From its Menomonee Falls, Wisconsin, campus on the outskirts of Milwaukee, Strong Capital Management Inc. oversees about $39 billion of assets in mutual funds and institutional accounts. Some 40% of those managed assets are equity-focused. "In my group, which has the largest equity component-$7.5 billion-we have a 10% to 14% weighting to energy stocks, depending on the account, primarily in small- to midcap names in the E&P and oil-service sectors," says Richard T. Weiss, portfolio manager and vice chairman for Strong Capital. This aggressive market stance is due to the fact that in the past few years, commodity prices have done better than most forecasters anticipated, not because of the Iraq situation but because energy demand is exceeding supply. "Very simply, we're not finding enough energy to meet the needs of an improving U.S. economy," he says. "And as this improved economic activity spreads around the world, the market is going to conclude that energy prices have to be higher than in the past to induce the level of drilling needed to bring on sufficient supplies of energy." Last year, Strong Capital believed the best way to play energy stocks was through investments in the E&P sector. It felt that producers had enforced upon themselves a much more disciplined approach to capital allocation, that their returns on capital would rise and that the oil-service sector wouldn't enjoy the pricing leverage it had in the past. Strong was largely proved right, as the 2003 market performance of such holdings as XTO Energy, Quicksilver Resources, Apache and Houston Exploration bore out. However, it isn't clear that such a strategy is appropriate in 2004. Because E&P stocks did so well last year, a lot of the underpricing in that sector has disappeared. In contrast, oil-service stocks were up only 12% in 2003 while the S&P registered a 40% gain. Within its energy portfolio, Strong this year is increasing its exposure to service-sector equities, to 40% to 45% from 33% in 2003. "Land drillers like Nabors Industries seem a pretty safe place to be in first-half 2004, then as a previously weak Gulf of Mexico market picks up in the second half of the year, offshore drillers like GlobalSantaFe, Ensco and Noble would be advantaged," says Joe Grabowski, associate portfolio manager at Strong. "Also, these offshore drillers all have international activity in regions like West Africa and the North Sea-markets that should improve as well by second-half 2004." The analyst similarly expects equipment suppliers to exhibit growth. He cites BJ Services, which provides well-completion technologies for drillers; Smith International, which manufactures drillbits; and Weatherford International, which provides underbalanced drilling services. Says Grabowski, "If the overall market is up 15% to 20% this year, we would expect service-sector stocks to be up perhaps 25%." This sector emphasis aside, Strong will still be 55% to 60% focused on E&P stocks in its energy portfolio. Among its bigger holdings is Burlington Resources. "This well-managed company, which we show selling at below net worth, has a low-cost position, a focus on return on capital employed and plenty of free cash flow that can be reinvested in acquisitions, drilling or stock buybacks," says Weiss. Among smaller E&P stocks, the company still sees plenty of upside in Houston Exploration. While the stock of this successful Gulf of Mexico operator moved up 30% to 40% last year, it's still cheap versus its peers, in terms of price/cash flow, price/private value and price/reserve value, says Weiss. "The reason for this discount is that the company is owned by a utility. We expect that issue to be resolved, however, and the stock to trade closer to its peer group." The Rockies In the shadow of the Gateway Arch in St. Louis, Kennedy Capital Management oversees about $3 billion of equity investments, mainly for pension funds. It has a small-cap focus-stocks with market caps ranging from $1.5 billion to $50 million-with the Russell 2000 as its benchmark. Currently, the money manager has a 4% weighting to the energy sector. "Starting in the spring of 1999, we began to feel there was a supply/demand imbalance or tightness emerging in the natural gas market, so we began buying North American service companies and gassy upstream stocks," says Terry Raterman, portfolio manager and energy analyst at Kennedy. "Since then, our strategy hasn't changed all that much, except that we added mostly E&P names last year." The analyst explains that the major oils today don't have a great interest in North America because the size of discoveries and unit costs simply aren't very attractive on a rate-of-return basis. "Because small-cap drilling and service companies have an inherent North American focus, that leaves them with overcapacity and weak pricing power, thus we've tended to move away from that group, for the most part," Raterman says. In the upstream, Kennedy is focused on natural gas producers that have large acreage positions, longer-lived reserves, limited exploration risk and good cost control. Not surprisingly, those criteria have caused Raterman to focus considerable attention on Rockies operators. "Evergreen Resources is the kind of E&P stock we're seeking for our core holdings," the analyst says. He notes the company has predictable growth from its manufacturing-type coalbed-methane gas production in the long-lived-reserve Raton Basin. "It doesn't have to go out and make a discovery with every well. Also, it has done a good job of cost-control, which inherently flows from that type of operation, and has a large acreage position there." Another current holding is Patina Oil & Gas. "This gas producer has a lot of drillsites in Colorado's Denver-Julesburg Basin, has done a lot of reentries and refracs of old wells there, knows what its costs are and how to control them, and is generating predictable rates of production and reserve growth year after year." The St. Louis-based money manager also owns shares of St. Mary Land & Exploration. Raterman notes the company recently announced record 2003 production of 76.9 billion cubic feet equivalent-a 40% increase over 2002. He also likes the operator's financially disciplined management, its growth prospects over the long term and its balance sheet. "The company has only about $100 million in debt and roughly $400 million in equity." Another upstream holding: Tom Brown. "The company has spent a lot of years building a solid acreage position in the Rockies and East Texas and has several plays-both development and exploration-that it can work simultaneously to achieve long-term growth," Raterman adds. Gas plays Based in Chicago, Columbia Wanger Asset Management LP manages some $17 billion of assets within the five-fund global family of Columbia Acorn mutual funds. At year-end 2003, about $1.1 billion of that $17 billion was invested in energy stocks. "Even though the rig count rose in 2002, the shortage of natural gas didn't go away," says Jason B. Selch, global energy analyst for Columbia Wanger Asset Management. "At that point, we became convinced that the U.S. was a declining gas basin, that demand would continue to grow faster than supply and that going forward, gas would be priced at scarcity. The producers we've invested in own gas-growth opportunity sets not fully priced into their stocks." Growth would certainly characterize the recent performance of the mainly E&P stocks that Selch has shepherded into the Acorn family fold. Last year, the shares of Ultra Petroleum soared nearly 149% in value; those of Southwestern Energy, nearly 109%; Talisman Energy, 56.5%; XTO Energy, nearly 53%; and Evergreen Resources, 45%. "The companies we've invested in don't have decline curves; rather, they have incline curves," says Selch. "That's because, with the exception of Talisman, they're involved in either tight-sands gas or coalbed-methane (CBM) plays-manufacturing-type projects where their reserves and production volumes grow predictably every year in line with the number of wells they drill on acreage they already own." Such opportunity sets are frequently overlooked by Wall Street analysts because they often make the mistake of valuing E&P companies on the basis of which ones have the lowest price/cash flow multiple, he says. "If I see a company that's growing reserves and volumes at a predictable 15% per year and it's trading at a higher-than-average multiple of cash flow, I'm willing to pay that premium multiple to own that opportunity set." In the Acorn family, there are other upstream holdings with growth opportunities that have yet to be priced into their shares, says Selch. These include Western Gas Resources, Quicksilver Resources and McMoRan Exploration. He notes that Western Gas has strong gas-reserve and volume-growth potential because it operates with Ultra Petroleum in the Pinedale Anticline in Wyoming's Greater Green River Basin and because of its large CBM program in the state's Powder River Basin. "While getting well permits in the Powder River has held the company back, in terms of meeting its production targets, we expect this permit logjam will soon end. When it does, that will be the catalyst for this stock to revalue to what it's really worth." Although a first mover with a 450,000-net-acre position in the large Canadian CBM play on the Palliser Block near Calgary, Quicksilver is trading at a price that greatly underestimates the value of it being the first mover in the region and its huge acreage position, Selch contends. Yet another Rodney Dangerfield in the upstream that's getting little or no respect is McMoRan Exploration. Currently focused on deep-shelf drilling in the Gulf of Mexico, the Jim Bob Moffett-run company has made two major gas discoveries at JB Mountain and Mound Point that are currently producing about 100 million cubic feet from four wells. "These are hundred-plus-billion-cubic-foot wells and the gas reserves in this area are in the trillions of cubic feet." He concludes, "I like to invest in undervalued stars where the incremental value isn't being recognized by the market, and right now there's a number of overlooked opportunities in the E&P sector where the valuations are still very attractive." SHAPE OF THINGS TO COME While recent stratospheric $37 oil and $5 to $6 natural gas prices have sent energy-stock valuations soaring, Midwest buysiders are stressing that high-flying commodity prices are likely to correct in the near term, affording investors another chance to load up on energy shares that are ultimately headed for yet higher market plateaus. They also point out whatever the near-term retrenchment in commodity prices may be, it won't be to historical norms but to levels that will draw more attention to values within the overall sector. Also, they contend industry fundamentals are likely to change the way oil-service shares trade. Their comments following: Thomas C. Lewis, Harris Trust and Savings Bank, Chicago Coming out of this winter, there's an estimated 1.4 trillion cubic feet of gas in storage in the U.S.-about 400 billion cubic feet more than this time last year-and hence spot gas prices this spring will likely back off to around $4.50. Meanwhile, many Wall Street analysts believe that recent high crude prices may be due for a pullback to a more normalized $24 to $26. As we see such a retreat in commodity prices, that hopefully will translate into a pullback in oil and gas stock prices and present yet another buying opportunity for investors. And as those investors begin to accept today's higher level of normalized commodity prices, they'll likely reward energy share prices with commensurately higher valuations. William J. Nasgovitz, Heartland Advisors, Milwaukee Investor sentiment is running high about the sector-almost to the extreme. That's a bit unsettling. My gut feeling is that we're going to see a sell-off in commodity prices this spring, possibly to below $4 for natural gas and $27 for oil. The upside to such an event, however, is that the attendant retrenchment in energy shares might allow us to buy back into stocks like Spinnaker. William J. De Allaume, UBS Global Asset Management, Chicago Compared with the tech sector, which seems a little ahead of itself and very sensitive to overall market movements, we'd rather have more client money in the energy sector today because it's a better relative value and has defensive qualities. Richard T. Weiss, Strong Capital Management, Menomonee Falls, Wisconsin While service stocks may never see the boom times they did in the past, it's clear that we need a very high level of exploration and drilling today just to sustain current production rates-and that service companies should be able to grow at above-average rates for a long time. This doesn't mean the market is going to witness wild dayrate peaks in the sector, but rather sustained high dayrates over a longer time horizon than before. As that happens, investors will begin to value service stocks on a more normal basis, and the cyclical peaks and valleys in the sector will smooth out in tandem with steady growth. Terry Raterman, Kennedy Capital Management, St. Louis Given OPEC's discipline and a strong worldwide demand for crude, we don't see oil prices dropping below the mid-$20s anytime soon. Similarly, we look for natural gas prices to remain strong, around $5, based on tight supply/demand fundamentals. One cautionary note amid this commodity-price optimism, however: The industry has to be wary of high natural gas prices. We don't want to see $7 gas. A lot of demand could get lost if that happens. Jason B. Selch, Columbia Wanger Asset Management, Chicago One of the reasons why E&P valuations are still attractive is because sellside analysts use mid-cycle or normalized commodity-price forecasts, with every oil company being valued as though crude prices were going to decline to $20 within two years. With demand rising faster than supply, I don't see that happening-rather an OPEC-determined $30 median price for oil with average gas prices one-sixth of that.