Going into the fall, energy investors were already skittish about commodity prices, a sputtering stock market and a slowing economy. Then came September 11. And everything came to a halt as they and the rest of the nation numbly watched the symbols of American capitalism disappear from the Manhattan skyline, enveloped by ghostly, gray, mushroom clouds of smoke. In the days that followed, as massive cranes moved like ants amid the ash-covered debris of what was once the World Trade Center, it was hard, if not impossible, for anyone to focus on the ticker trappings of Wall Street, which itself had come to an historic four-day halt. But during those days, as Americans watched New York's bravest, and its finest, pick through the still-smoking steel and concrete rubble of Ground Zero-continuing their search for life-a fresh and inspiring image of the heroic side of humanity emerged, as it did elsewhere around the city and country. It could be seen in the faces of the 33 missing policemen and firemen whose wreath-framed pictures were displayed in front of an adjoining fire station and police precinct on 51st Street and Lexington Avenue in midtown Manhattan. And it could be seen in the face of Michael Pascuma , a 92-yeard-old American Stock Exchange floor broker who lost his son in the collapse of the north tower of the World Trade Center. On the morning of October 1, he proudly rang the opening bell as the exchange reopened for trading, in its own home again, at 86 Trinity Place-only 100 yards from Ground Zero. The message of these images, and of those at the Pentagon and in western Pennsylvania, is simple: it is possible to rise above the ashes of yesterday-as this country has so many times before. And it is possible-in fact, certain-that a now-dampened U.S. economy, and the many industries that comprise it, will also rebound. This latter, long-term optimism was notably evident at a recent fall energy conference in Greenwich, Connecticut, held by <$iJohn S. Herold Inc. >, the Norwalk, Connecticut-based research and consulting firm. There, many Northeast buysiders gathered to hear the equity stories of top U.S. energy companies. "The true value investors were out in force this year, recognizing that the momentum of the energy sector is decidedly negative," says Arthur L. Smith, Herold's chairman and chief executive officer. "The smart money is now trying to identify when we'll hit bottom." He expects bottom to be found during the next two or three quarters. "At that point, energy stocks will become extremely attractive because the next recovery is going to be assisted by the fact that oil companies are now more capital-disciplined." He notes that <$iApache >, with an eye on the balance sheet, has announced that it may reign in capital spending next year in North America to $300 million, from about $900 million this year. The E&P stocks that will draw the most approving buyside nods? Producers like Apache, <$iAnadarko Petroleum >, <$iEOG Resources > and <$iXTO Energy >, says Smith. "They pull together the desired mix of good valuation, quality assets, strong growth potential, good balance sheets and managements fully aligned with investors, in terms of strong ownership of their companies' stock." Also, a premium will be placed on smaller producers like <$iSpinnaker Exploration > and <$iRio Alto Exploration > that have high value-added ratios, in terms of dollars invested versus the value of reserves developed, he adds. In the oilfield-service sector, investors will be drawn to the likes of <$iNabors Industries >, he expects. "Although its stock has fallen dramatically, from better than $60 per share to around $35, it has a better balance sheet and more assets than it ever did." Investors should start accumulating positions early in the energy sector rather than waiting for absolute evidence of a bottom, he advises. "By then, the market will have already begun discounting a recovery." Daniel R. Pickering, managing director, research, for <$iSimmons & Co. International > in Houston, says that while there has been slightly more market underweighting in energy stocks by the big U.S. institutions this year versus last, there's still a fairly consistent level of interest in the equities of that sector. (See chart.) While the energy weighting of the S&P 500 at the end of June was 7.7%-a modest uptick from a 6.1% weighting at midyear 2000-the comparative weightings for the top 30 institutions with energy equity holdings was an average 7.2% and 5.8%, he notes. As of June, the big institutions on average were underweight on major integrateds and overweight on oil-service, energy-convergence and E&P stocks. "In essence, they're putting less money to work, but making a more aggressive bet on the industry through their higher exposure to the more volatile subsectors," Pickering says. In 2002 he expects the buyside will own more, not less, energy equities, particularly if there is a pull-back in oil and gas stock prices. OppenheimerFunds One Northeast buysider fitting this profile is Nikolaos (Nikos) Monoyios, vice president and portfolio manager for <$iOppenheimerFunds Inc. >, which manages about $120 billion of assets. Up until September 11, he and 597 other employees worked in the firm's corporate headquarters at Two World Trade Center. Today his investment group, all of whom safely exited the fated tower, temporarily work out of East Brunswick, New Jersey. While the energy weighting of the firm's current $60-billion equity portfolio is just north of 5%, the Main Street mutual funds that Monoyios comanages are a bit more aggressive in the sector. The large-cap, $13.4-billion Main Street Growth and Income Fund-the firm's largest equity fund-currently has an 11.5%, or a $1.5-billion exposure to energy. The newer $530-million Main Street Small-Cap Fund and the $263-million, multicap Main Street Opportunity Fund have energy weightings of 5% and 7%, respectively. "In our largest fund, we went from a 3% energy exposure at year-end 1998-when commodity prices bottomed-to a peak exposure of 17% in December 2000," says Monoyios. During that time, the big recovery in oil prices-and especially natural gas prices-had a tremendous impact on the profitability of energy producers and service companies, and the stock performance of both groups. "Today, that fund is still overweighted in energy, but to a lesser extent. That's partly because many of our E&P holdings were bought out through mergers." Among Canadian E&P holdings scooped up were <$iAnderson Exploration >, which was taken out by <$iDevon Energy >; <$iBerkley Petroleum >, bought by Anadarko Petroleum; <$iRanger Oil >, folded into <$iCanadian Natural Resources >; <$iGene-sis Exploration >, acquired by <$iVintage Petro- leum >; <$iPetromet Resources >, bought by <$iTalisman Energy >; and <$iBeau Canada >, snared by <$iMurphy Oil >. Among U.S. upstream holdings, Vastar was acquired by <$iBP >, and <$iChieftain International >, by <$iHunt Oil >. Currently, the Main Street team's larger Canadian upstream holdings include <$iCanadian Natural Resources >, <$iTalisman >, <$iCanadian Hunter > [the recent takeover target of Burlington Resources] and <$iRio Alto Exploration >, then smaller producers like <$iParamount Resources > and <$iCana-dian 88 Energy >. In the U.S., its bigger E&P positions are in Murphy, EOG Resources and <$iBurlington Resources >, then in smaller operators like <$iTom Brown > and <$iWestern Gas Resources >. Says Monoyios, "All these stocks are a good play on the North American natural gas theme, are cheap relative to their underlying assets, and have managements that are very conscious about their rates of return and growing earnings, cash flow and reserves per share." Although the Main Street team reduced its exposure earlier this year to offshore and land drillers, due to high valuations and the less likelihood of takeover activity, it still holds <$iGlobal Marine >, <$iEnsco International > and <$iSanta Fe International >. "Again, we continue to believe in the fundamentals of the North American natural gas story," explains Monoyios. "Despite almost two years of record drilling, gas output hasn't increased to any significant degree because we've been fighting very steep production decline rates-and now, a drop-off in drilling. So it's inevitable that as soon as the economy recovers and higher energy demand resumes, we're going to have another natural gas crisis. The only question is when." JPMorgan Fleming Another Northeast buysider bullish on the North American natural gas theme is <$iJPMorgan Fleming Asset Management > on Manhattan's Fifth Avenue. From its midtown offices, one could still see billows of white smoke drifting skyward from Ground Zero days after September 11. "We've been building back our exposure to the energy sector since summer, when many producer and oilfield-service stocks, in particular, pulled back to attractive valuation levels," says Julie A. Hilt, vice president and U.S. energy equity analyst. "Much of that increased exposure is to gas-leveraged names because of the tight supply-demand outlook for that commodity." With more than $600 billion of total assets under management-$280 billion in U.S. and global equity portfolios-JPMorgan Fleming is currently 6% to 8% weighted in energy stocks. "The Lower 48 and Canada have very mature basins, and with rising gas demand during the last decade, we've gone from a 12-year to a seven- to eight-year gas-reserve life in the U.S. and from a 25-year to a 12-year gas-reserve life in Canada," says Hilt. "Thus, we can no longer turn on the gas faucet when we feel like it. We have to drill more, particularly in light of the fact that 64% of North American gas wells have decline curves in excess of 25% per year." Yet, despite the U.S. gas-rig count rising from 363 in April 1999 to a peak of 1,068 this summer, the industry has only been able to increase domestic gas deliverability by 5%. "So we've got a supply problem....And eventually, once gas storage is worked down this winter and the effects of a lowering rig count are felt, we're going to be in a tight supply situation again, even without any help from increased demand." This will mean better prices for gas and strong gas fundamentals 18 months to three years out, she expects. Given this outlook, Marian Pardo, managing director, U.S. equity, and a senior portfolio manager of small-cap stocks for JPMorgan Fleming, is inclined to bigger positions in small-cap gas stocks going to 2002. "Spinnaker Exploration is probably the largest position in our small-cap oil and gas portfolio, because of its underlying volume growth and leverage to gas. However, we're more focused on oilfield-service companies like Gulf Island Fabricators, Global Industries and FMC Technologies." Explains Hilt, "You get a bigger bang for your buck with a service name versus an E&P name because when dayrates start going up, a bigger part of that increase drops to the bottom line." Adds Pardo, "We're nearing a time of very low utilization levels in the North American oilfield-service sector and not too much has to happen to create a fairly dynamic earnings story." Dreyfus Funds Admittedly, not every buysider in the Northeast is close to being overweight in energy equities these days. Headquartered high up in the Met Life Building atop Grand Central Station in midtown Manhattan, The Dreyfus Funds, owned by <$iThe Dreyfus Corp. >, is one of them. Of its overall $50 billion of equities currently under management, about 5% to 6%, or $2.5- to $3 billion, is currently exposed to that sector. "Whereas we were significantly overweighted in the sector a year ago, we're probably down about 30% from that level today," says Anthony S. Socci, senior managing analyst. "For one thing, we're less bullish on oil and gas than a year ago. Near-term, we think commodity prices will trend down, just as they did after the Gulf War in 1991. Also, we're witnessing a longer downturn in the economy than we had originally expected, and the events of September 11 haven't helped matters any." This aside, Socci is much more sanguine about the longer-term fundamentals of the industry. He notes that the last recovery, which began in 1999, was first led by oil. But it was the price of gas that really continued the recovery. Going forward, he believes the same thing will happen-12 months into the next economic recovery, there will be equilibrium in gas demand and supply, with prices of $3.50 to $4.50. "And as an organization, we plan to be more aggressively invested in energy stocks-both prior to and during equilibrium." As balance resumes, the sector that will tend to fare best is oilfield services. "It has the most leverage to capital spending...The only problem is that it's tough to put a lot of dollars to work in this group because it's so small. In fact, back in 1985, Dreyfus as a corporation had enough cash to buy the stocks of the entire service industry." The analyst adds that, because of the volatility of service stocks, one also has to be careful about the timing of investments within the group. Currently, Socci is more focused on such E&P names as Anadarko Petroleum, XTO Energy and <$iOcean Energy >. "They represent value that Wall Street didn't even appreciate in the last cycle," he says. "Take Anadarko, for instance, which has a solid business plan and is good at finding new reserves. During the past 10 years, it has traded at an average multiple of nine times cash flow. But in this past cycle, it traded well below that." It even traded below a multiple that would be reasonably assigned with normalized pricing of $19 oil and $2 gas. What might make him shy away from an oil and gas story? "Presenters who are promotional or who wear $400 ties and pinky rings. You hate to stereotype, but 90% of the time when you see those things, it's a good decision to avoid the story and the stock." G.E. Asset Management Christopher W. (Kit) Smith, senior vice president and portfolio manager for <$iG.E. Asset Management > in Stamford, Connecticut, is also less than sanguine about the performance of oil and gas stocks in the coming three to six months. "The outlook for the economy now is rather uncertain," says the U.S. energy equities analyst. "If the economy continues to slow, then oil and gas usage will decline or at least be flat. That means commodity prices will then be weak, which will make it tough for the oil and gas group to outperform any time soon." Given this appraisal, Smith doesn't see G.E. Asset Management, which currently has about $104 billion of assets under management and a $47-billion exposure to U.S. equities, raising its 8% weighting in domestic energy stocks going into 2002. That, however, is his short-term investment thesis. What intrigues the analyst is the fact that while domestic drilling, mostly for gas, peaked this summer, there was at best only a 1% production response. "That means that during the next few years, it's going to be tough for the industry to meet the greater demand for gas as more gas-fired power-generation plants come online and as the economy grows stronger." As for the current gas-inventory glut, this has occurred not because the industry overproduced, but because gas demand, dampened by the price spike of last winter, has been far less than anyone expected, he says. "In the long term, stocks with a strong exposure to gas are a good place to be invested." Among E&P stocks with a strong gas bias, he cites Burlington Resources, Apache, Anadarko Petroleum, Devon Energy and EOG Resources; among service companies, he notes the best gas exposure lies with Nabors Industries and <$iBJ Services >, and such Gulf of Mexico drillers as <$iEnsco International >, Global Marine and <$iNoble Drilling >. "These companies possess the qualities we look for in an investment candidate," he says. "Their managements have the ability to adjust as things get better or worse in a cycle; they have balance-sheet strength and hence, the ability to drill more or produce more-and their earnings aren't solely dependent on the fluctuations in commodity prices." Nearer-term, Smith eyes the major integrated oils as the best performing energy stocks, and his firm's weighting in this sector reflects that confidence. "They can earn more steadily during the cycle because they're more diversified-across product lines and geographically-and they have higher-quality, more-profitable legacy fields, which in time will produce a higher return on invested capital." Wellington Management At the top of 2001, <$iWellington Management Co. > in Boston, with $280 billion in assets and dedicated energy-equity portfolios totaling some $3 billion-not including energy equities in its general holdings-wasn't as weighted to the oil and gas sector as it was last year. And with good reason. "Stock prices were a bit rich, so there was less value to be found buying oil and gas issues," says Karl E. Bandtel, a partner and portfolio manager who helps Wellington run the $1.3-billion, large-cap <$iVanguard Specialized Energy Fund > and the firm's $1.7-billion long-only energy institutional accounts and hedge funds. "But with the subsequent decline in commodity and energy-stock prices-and investor expectations for this sector-we've begun increasing our weightings again." The names that look attractive: those with an exposure to natural gas. In Canada, that includes producers like <$iRio Alto Exploration >. and <$iPenn West Petroleum, > and service companies like <$iTrican Well Service >. In the U.S., it includes operators like <$iPatina Oil & Gas >, XTO Energy and <$iEOG Resources >, as well as service companies like BJ Services, Ensco International and <$iVeritas DGC >. "The compelling feature about North American gas is you have a market in which annual demand-spurred by an improving economy-should rise 2% during the next couple of years, during which time the industry is going to be very challenged to increase supply in line with that growth in consumption," explains Bandtel. "Whereas a year ago, the price of gas was high enough to prompt supply increases and dampen demand, the current gas-price environment does just the opposite. And with gas drilling coming down since July, a now oversupplied gas market is going to become undersupplied within the next 12 months. That means gas prices will have to move higher-to above $3.50 by year-end 2002-for drilling to rebound and a balanced market to return." On the oil side, he sees just the opposite fundamentals at play in 2002. With the soft demand for oil during the past year continuing into next, plus the excess capacity that has built up within OPEC, oil pricing should be lower than in the past couple of years-between $18 and $22. But even in a $20-oil world, there are attractive stock opportunities. "Two of them, among our biggest holdings, are the <$iCanadian Oil Sands Trust > and <$iWestern Oil Sands >," says Bandtel. "These companies have about a 40-year reserve life versus the average eight-year reserve life for most conventional oil producers, plus they have a favorable cost structure. In short, they have a unique asset-something we look for in an investment candidate. A similar example on the gas side is <$iWestern Gas Resources >, with its coalbed-methane position in the Powder River Basin." He also has plaudits for <$iAlberta Energy Co. >, which bolstered its oily position during the last downturn with the purchase of two crude-leveraged Canadian producers-Amber Energy and Pacalta Resources. "We like managements with a contrarian style, that buy wisely during depressed periods of the oil and gas cycle and are cautious in their spending during the more exuberant points of the cycle." Wellington's management has employed that same contrarian philosophy in its energy investments, and it has paid off. For the three years ending September 30, the Vanguard Specialized Energy Fund's total annualized return was 10.6%; the firm's long-only energy portfolio, 18.8%; and its energy hedge funds, 29.4%. During the same period, the S&P 500 was up 2%. State Street Research Unlike many buysiders, Dan Rice, senior vice president and portfolio manager at <$iState Street Research & Management Co. > in Boston, doesn't necessarily view the much-touted gas story as the Holy Grail for energy investors over the long haul. "The long-term gas theme has been called into question with the amount of coal-fired electricity-generation capacity that has been coming onstream," he says. "This year, the coal burn rate is up about 4%, and a similar gain could occur in 2002. That's taking the marginal electricity-generation market away from gas." It's only when gas falls below $2.25 per thousand cubic feet that it's cheaper than spot coal purchases or the current long-term contracts for coal, he says. "So one shouldn't use the number of electricity-generation plants coming online as a barometer of gas demand growth in the power-generation market. Just because a plant is available to burn gas doesn't mean it will fully utilize that fuel source." Managing the firm's $700-million small-cap, energy-only equity portfolios-which is separate from the $1 billion of energy stock holdings within State Street Research's core $20-billion equity portfolio-Rice is more focused these days on valuation. "Last spring, amid sagging gas prices, we took our energy weightings down significantly. But since then, E&P and service stocks have plummeted to the lower end of their historical trading ranges-coming down 30% to 40% since May. So we've been buyers recently, raising our earlier underweighting to a more neutral position." In the analyst's view, most of the damage to the sector has been done and, based on estimates of $2.25 to $3 gas and $22 to $24 oil for 2002, energy stocks should perform halfway decently going forward. Currently, the market is discounting $2.25 gas and $18 to $19 oil. On the gas side, he looks for supply to drop by 2 billion cubic feet per day in 2002 while demand rises by a like amount. "In October, we had about 950 rigs drilling for gas; with $2.50 gas, the rig count will likely drop to 750 by year-end. That'll exacerbate normal production-decline rates, leading to balanced gas markets." On the oil side, he believes OPEC has the will and wherewithal to hold prices within its stated band-even if the world's economies slip into a recession. "Non-OPEC oil production, while growing marginally, won't be enough to pressure the cartel from its price objectives." Of all energy stocks, those of E&P companies should perform best next year-not because of any spike in commodity prices but because there will be continued M&A activity, he predicts. "If producer stocks are discounting $2.25 gas, and the longer-term price now being used by acquisitors is north of $3, these stocks have the ability to go up anywhere from 30% to 60% from recent levels. An example of such a stock last year would have been <$iHS Resources >-one of our larger holdings. Examples this year would be Western Gas Resources-our largest small-cap holding-and Patina Oil & Gas." In screening E&P stocks, Rice, whose small-cap portfolio through the end of September achieved a three-year rate of return of 14.1% versus 2% for the S&P 500, looks for discernible growth-not just exploration drillbit growth, but low-risk, development drillbit growth-that's not yet reflected in a producer's stock price. Companies fitting that profile are Ocean Energy and <$iPlains Resources >, he says. What turns him off? "Most presentations spend way too much time on the past and very little time on explaining future bread-and-butter growth. I have to be very comfortable with that before I can even consider a company's exploration portfolio." Fleet Investment Advisers With an overall 10% weighting in energy equities, Boston-based Fleet Investment Advisers-the institutional money-management arm of <$iFleet Boston Financial Corp. >-is relatively bullish on the sector. Even more so is Gene Takach, a Fleet senior funds manager. Up through this past spring, the more than $1 billion worth of growth, income and global funds and trust accounts he manages had an equity exposure to small- and midcap oil and gas stocks as high as 24%. Today, however, that weighting is a slightly less aggressive 14%. "With gas prices going crazy, we just rode the market through 2000 and first-quarter 2001," he says. "But ultimately, the exposure became too much within the portfolio, so we just took some money off the table-before commodity prices began to nosedive." The E&P stocks in which the funds manager has built positions since 1999 include the likes of St. Mary Land & Exploration, <$iRemington Oil & Gas >, <$iPetroQuest Energy >, Ocean Energy, <$iSpinnaker Exploration > and <$iUltra Petroleum >. On the service side, he owns the likes of <$iSchlumberger > and <$iNoble Drilling >. "However, with 300 or more rigs expected to be idled going into next spring, we're not heavy in this sector because earnings are going to lag." While Takach believes oil prices may test $18 before rebounding to $22 next year, and gas prices might skid to below $2 before bouncing back to an average $3 in 2002, he nonetheless is upbeat about upstream stocks, particularly those of Ocean, Remington, St. Mary, Spinnaker and PetroQuest. "For one thing, you have the likelihood of more takeovers in the upstream and hence, a premium that might be paid for such stocks," he says. "But that's not the reason we're buying them. All have a good track record of finding oil or gas, increasing production volumes and generating revenues well in excess of expenses. Also, these stocks are relatively cheap, trading at depressed multiples of earnings and cash flow-which again makes them good candidates to be taken out by larger companies." So far, Takach's sense of timing in the energy sector has contributed mightily to some remarkable funds performance for investors. Case in point: for the three years ended September 30, Fleet's Galaxy Growth Fund II Fund, which he oversees, was up 53.26%. "About 75% of any energy investment decision has to do with management," he says. "We look for people who have come from large energy organizations, who have participated in their growth, and who know how to build smaller companies into larger ones." And in the weeks and months ahead, New Yorkers will also be looking for people with soaring vision, who can build from the rubble of Ground Zero an even more imposing silhouette than graced the skyline of lower Manhattan before September 11.