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BARRON'S COVER

| SATURDAY, AUGUST 4, 2012

By ANDREW BARY

Energy stocks have been dragged down with the price of oil, creating opportunities for investors. Strong dividends add allure. The case for ExxonMobil, Chevron, and Royal Dutch Shell. Plus: a 7% yield on HollyFrontier.
Energy stocks have stalled this year as the supply of oil has grown faster than demand. The price of crude is down about 10%, to $90 for West Texas Intermediate and $108 for Brent, a key international benchmark. The bull case on the sector has long been that demand from emerging markets would outstrip supply. Softness in the global economy has now put that on hold. U.S. natural-gas prices, meanwhile, are about flat in 2012, just under $3 per million BTUs, although up from a low of $2 in the spring, due in part to searing summer heat in much of the country. Current natural gas prices, however, are half where they stood in 2009, leaving little or no profit for domestic producers. The energy stocks in the Standard & Poor's 500 index are up only 1%, compared with a 10% gain for the index overall. Nor are there any signs that things are getting better. Second quarter profits were down about 15%. The industry remains very profitable, however, and many stocks across a range of subsectors look appealing. These include Chevron (ticker: CVX), ExxonMobil (XOM), Royal Dutch Shell (RDS/A), and Total (TOT), among the major integrated companies. Their shares trade for seven to 11 times estimated 2012 profit and carry dividend yields of 2.7% to 5%. Exploration and production companies like Apache (APA), Anadarko Petroleum (APC), and Hess (HES) appear to be undervalued, based on their reserves and their growth outlook, as do the depressed Canadian producers Suncor (SU) and Canadian Natural Resources (CNQ). The appeal of the E&P sector was highlighted recently with the $15 billion acquisition of Nexen (NXY), a Canadian producer, by CNOOC (CEO), the Chinese energy company, at a 60% premium. Evan Calio, an energy analyst at Morgan Stanley, wrote recently that many stocks trade "near liquidation value," and the group as a whole is valued at "trough" levels, based on such measures as price to cash flow and reserves relative to enterprise value,

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which is stock-market value plus debt. He likes stocks that can do well "without commodity support," which is to say rising prices. His favorites include Chevron, Anadarko, and Hess. JPMorgan strategist Thomas Lee is likewise bullish on energy, noting that the price ratio of energy stocks
Enlarge Image Nicholas Eveleigh for Barron's

relative to the S&P 500 is near lows reached at the 2009 market bottom and during the 2010-'11 low. After those troughs, energy rallied more than 25%. Not everything in the group looks attractive. Natural-

Many stocks in the energy sector now trade at trough valuation levels.

gas-oriented stocks have moved up in recent months, and many look richly priced, including Chesapeake Energy (CHK), Encana (ECA), Southwestern Energy (SWN), and QEP Resources (QEP). They seem to be discounting sharply higher gas prices. OIL-SERVICE STOCKS like Halliburton (HAL) and Schlumberger (SLB) have perked up as well, but remain unusually inexpensive relative to the stock market. There could be additional upside potential in the hot group of U.S. oil refiners, including Phillips 66 (PSX), Valero Energy (VLO), and Marathon Petroleum (MRO), as currently ample refining margins look sustainable. The companies are boosting dividends and may weigh further value-enhancing strategies like putting some of their refineries into master limited partnerships. There are plenty of exchange-traded funds tied to the oil and gas sector, led by the $7 billion SPDR Energy Select Sector (XLE), which owns the energy stocks in the S&P 500, led by ExxonMobil, Chevron, and Schlumberger. Other ETFs include the Market Vectors Oil Services ETF (OIH), whose largest holdings are Schlumberger, Halliburton, and National Oilwell Varco (NOV), and SPDR S&P Oil and Gas Exploration and Production ETF (XOP), which holds a broad portfolio of energy producers. One encouraging sign is that the major energy companies are heeding investors' call for higher dividends. Chevron has boosted its dividend twice in the past 12 months, capping a 25-year period of annual increases. It yields 3.3% at its recent share price of $109. Long-stingy ExxonMobil is relenting and paying a more generous dividend, as it recognizes that its yield has been well below that of peers. Exxon's dividend rate is hardly robust at 2.7% based on its current stock price of $86, but the world's largest investor-owned energy company did boost its quarterly dividend by 21% in April, above its usual annual increases of around 6%. Another sizable

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increase looks likely in 2013, given that the company's dividend-payout ratio is below 30%. It's even possible that Exxon may opt for a second dividend boost in one year. Stock buybacks remain important but not paramount at Exxon.

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ConocoPhillips (COP) spun off its refining business in May as Phillips 66 and then maintained its prior 66-cent quarterly dividend. It now yields 4.7%, based on its stock price of $56. The major European energy companies have long returned cash almost entirely through these payouts, reflecting a strong preference among European investors. Royal Dutch Shell yields 4.2% (after withholding taxes); Total's yield is around 5%. AMONG THE MAJOR OILS, Chevron could be the best bet because it has the combination of an attractive valuation, at nine times its estimated 2012 profit, a nice dividend and the prospect of a bump in its energy production from 2014 to 2017 as major gas fields off the coast of Australia come on stream. Chevron is favored by Calio and Deutsche Bank analyst Paul Sankey. "Chevron's major investment programs should start delivering results in 2014," Calio says. He sees 20% production growth over a three- to four-year period. Chevron aims to lift production to 3.3 million barrels a day by 2017 from the recent 2.6 million. (Following industry practice, this production figure converts natural gas to barrels of oil on an energy-equivalent basis.) Chevron also has the best industry balance sheet, with $11 billion of net cash. One of the biggest challenges faced by the major energy companies is expanding output. Most have struggled to produce any annual gains amid depletion of existing fields and the difficulty of finding large new sources of energy. This has reduced P/E multiples on the stocks. Chevron is sinking $60 billion into two giant gas fields off the coast of Australia and facilities that will liquefy that gas for export to Japan and the rest of Asia. International contracts for LNG generally are pegged to crude prices, which translates into much higher prices than for U.S. natural gas. Calio says Chevron's stock may rise next year in anticipation of the production growth in 2014. He has a price target of $120. ExxonMobil remains the industry leader; it has maintained a higher valuation than its "super-Major" peers, at 11 times its estimated 2012 profit, versus seven to nine for rivals. It has lost some of its luster in recent years as production has flattened and its output
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has shifted more toward inexpensive North American gas. Speaking in June about the domestic gas market,

CEO Rex Tillerson said: "What I can tell you is the cost to supply is not $2.50" per thousand cubic feet. "We are all losing our shirts today." Exxon made a big bet on gas with its ill-timed $40 billion purchase of XTO Energy in 2010. That occurred when gas prices were nearly double current levels, and the XTO deal has helped boost gas to almost half of Exxon's energy output, versus around 30% for Chevron. Exxon's profit per barrel of oil equivalent now trails Chevron's. Exxon, however, remains a powerhouse with huge LNG production in Qatar, oil-sands operations in Canada through majority-owned Imperial Oil (IMO), offshore African oil fields, and large chemical and refining businesses. Production trends often drive energy stocks, and Royal Dutch Shell has risen in investor esteem as its output has grown -- output is up 2% in the second quarter.

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Shares of Total, the big French oil company, have been crunched this year, falling 11% to $46, hurt by a leak in a North Sea gas field, the election of a Socialist president in France, and concerns about whether its 5% dividend will be sustainable amid high capital spending. Total looks inexpensive, trading for seven times projected earnings and for just a small premium to book value. Two of the largest Canadian energy companies, Suncor and Canadian Natural Resources, have fallen from favor in the past year, hurt by the drop in crude prices, concerns over delays in additional pipeline capacity into the U.S, and wider discounts of Western Canadian crude relative to U.S. oil. They have given up most of the premium they once maintained over midsize U.S. energy producers. Suncor, at $30, trades for 10 times projected 2012 earnings. Canadian Natural Resources, at $27, trades for 14 times earnings. SUNCOR IS ONE OF THE LARGEST producers in the Alberta oil sands, with more than half its daily output coming from the region. Suncor's status as the leading oil-sands play used to be the source of its high valuation because of a multidecade reserve life. A 2009 merger with Petro-Canada initially displeased investors because it diluted Suncor's oil-sands exposure. The deal, however, looks smart now because Petro-Canada brought significant refining capacity, which is very profitable and balanced the oil-sands operations. Deutsche Bank's Sankey is bullish, saying Suncor represents one of the "most attractive refining plays" in North America. Canadian Natural Resources lacks the refining operations of Suncor and has trailed it in the stock market. But Canadian Natural has significant exposure to oil, given its long-lived oil-sands operations, which it plans to expand in the coming years. This makes it a
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good play on higher crude prices. It is also viewed as a takeover target.

U.S. exploration-and-production companies have lost some of their appeal because many are heavily weighted to natural gas, and others with sizable exposure to natural-gas liquids have been stung by sharp price declines for fluids like ethane in recent months. Most don't produce a lot of free cash flow thanks to heavy capital spending. Dividends are sparse. Anadarko, Apache, and Hess look appealing. Anadarko, the subject of a recent bullish article in Barron's ("To Mozambique and Beyond," July 9), may have the best set of international exploration prospects among its peers, thanks to finds like a huge natural-gas field off the Mozambique coast. Its shares, now about $68, could approach $90. Catalysts could include a partial sale of its Mozambique field, or a victory or favorable settlement in its legal battle involving the bankruptcy of Tronox, whose former parent, Kerr McGee, was bought by Anadarko in 2006. Barclays analyst Tom Driscoll is partial to Apache, whose shares trade cheaply relative to its peers. The stock now fetches $83, or eight times its projected 2012 profit. Driscoll argues that investors are overly penalizing the company for its exposure to politically unstable Egypt, where it gets 20% of its energy. Hess has been a poor performer, falling 28% to $47 in the past year amid investor disappointment over production trends, heavy capital spending and doubts about management, led by CEO John Hess. The company has a 2012 funding gap of $1 billion to $2 billion. Its shares trade cheaply based

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on its earnings with a P/E of just eight, and its price/book ratio of 0.8 is the lowest in the group. Calio wrote recently that Hess's second-quarter results suggest that it is "making the right moves" by better aligning cash flow with capital expenditures and narrowing its exploration focus. It could attract an activist investor or even a takeover offer. Driscoll is wary of gas stocks. "Many investors looking for contrary bets have been willing to buy them despite extraordinary multiples," he says. Encana, at $21, trades for 26 times the projected 2012 profit, while Southwestern, at $32, also fetches 26 times estimates. "Southwestern is a dry-gas company. It has some of the best dry-gas assets out there. But being the best of a challenged lot isn't a great place to be." Dry gas wells produce natural gas with little oil or gas liquids. Chesapeake Energy has attracted value investors and activists like Carl Icahn, but its shares look rich at around $18. The company is seeking to plug a funding gap in its $7 billion annual exploration budget, and its complex agreements with outside partners that have funded some of its gas projects don't give it much latitude to cut production. It also engages in aggressive financial maneuvers like capitalizing rather than expensing nearly all of the interest on its $13 billion of debt. The company says the interest capitalization fully complies with accounting rules for energy producers. An aggressive company, with a controversial CEO in Aubrey McClendon, may not be the best place to be a tough gas market. THE OIL-SERVICE SECTOR has been stung by weakening prices for pressure pumping services used in hydraulic fracturing, or fracking, amid increased pumping supplies and weak domestic gas prices. Baker Hughes' better-than-expected profit report for the second quarter lifted its stock and sentiment. "The stocks are trading far below historical norms," says Judd Bailey, the oil services analyst at ISI Group. His favorite is industry leader Schlumberger, whose shares, around $71, trade at a premium to the group at 16 times estimated 2012 earnings and 14 times projected 2013 net. "Schlumberger has the largest global footprint and the most leverage to deep-water exploration, the best technology and diversification," he says. Refiners have led the sector this year, with Marathon Petroleum up 44% to $48 and HollyFrontier (HFC) up 59% to $37. Still-wide differentials between U.S. and international crude prices have given U.S. refiners an edge, particularly those, like Holly and Marathon, that are exposed to the boom in oil output in the middle of the country. Even with the run-up, the stocks still trade for an average of just six times projected 2012 profits, and free-cash flow yields generally top 10%. HollyFrontier is leading the group with a 7% dividend yield, including a special dividend that it has paid for four straight quarters and which its CEO, Mike Jennings, considers "sustainable" in light of the company's geographic advantage and a cash-rich balance sheet that gives it the ability to maintain the current payout for two years even if profits collapse. Calio, a bull on the group, sees higher dividends throughout the sector amid strong earnings and reduced capital expenditures. His view: Valero Energy, which recently boosted its dividend, likely will continue to increase it in the next year. Refiners could get a boost from the recent IPO of Northern Tier Energy (NTI), which was structured as a master limited partnership. Northern Tier, whose main asset is a Minnesota refiner, came to market at a premium to other refiners, thanks to its tax-advantaged structure. It has a high

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expected initial yield of 17%. The deal could prompt refiners to consider putting some of their assets into MLPs and boost their share prices. While the energy sector has trailed this year amid a drop in oil prices, the world is going to be heavily dependent on oil and gas for decades. That should provide plenty of profits for a range of companies in a still-growing industry.

E-mail: editors@barrons.com
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