Morningstar Advisor - Spring 2007 - 57

Sector Rap Oil and Gas Gushing with Values It’s brutally cyclical out there, but explorers and producers look like bargains. by Sonya Morris A number of midsize oil and gas producers are in 4- and 5-star territory. As a result, the handful of ETFs that focus on this area look attractively valued. I sat down with Morningstar energy analysts Eric Chenoweth, Cathy Milostan, and Justin Perucki to get their take on this segment of the energy sector. Sonya Morris: Oil and gas producers operate in a brutally cyclical business. What does it take to succeed in this environment? Cathy Milostan: The best companies are those that can continue to create value or at least maintain value during cyclical troughs. There are a number of ways to do this. For example, firms can scale back production when commodity prices decline or when costs go up. The best management teams maintain capital discipline and use the downturns to make acquisitions at attractive prices. They can also build a portfolio of assets with very long reserve lives to help them weather cyclical downturns. Justin Perucki: They can also build a diversified portfolio that gives them the flexibility to divert capital to the most promising areas and away from the least attractive. Managing an oil and gas producer is similar to investing. The best managers constantly evaluate their portfolio of projects and reallocate their assets to those projects with the potential to generate higher returns. EOG Resources EOG is an example of a firm with a disciplined management team that has done a good job with that. They have assembled a portfolio that allows them to replace reserves at low costs. Milostan: Apache APA is a good example of a firm that has taken advantage of down cycles to acquire other firms’ assets at attractive prices. Eric Chenoweth: The same could be said for XTO Energy XTO. It has been dialing down the pace and size of its acquisitions for the past year. Morris: EOG, Apache, and XTO, by the way, are among the top holdings in iShares Dow Jones U.S. Oil & Gas E&P Index IEO, my latest recommendation for an opportunistic play. It’s hard to build a competitive edge in an industry that is so exposed to the vagaries of commodity prices. What attributes must a producer possess to build a moat? Chenoweth: One way a firm can build a moat is to assemble a unique set of assets. Ultra Petroleum UPL is an example of a firm that owns a very unique natural gas asset in Wyoming that allows it to produce gas at a low cost. Milostan: Producers can gain competitive advantages by being disciplined about the projects they acquire. The best firms buy assets that have potential even when prices are low. Morris: Can you explain in broad terms how you go about valuing an oil and gas producer? Chenoweth: We use a discounted cash-flow model. To forecast cash flows, we must estimate a firm’s production outlook and the cost of that production, and we must also forecast commodity prices. We also have to make some assumptions about the sustainability of a company’s projects and the returns it can earn on those projects to assess future reinvestment risk. MorningstarAdvisor.com 57

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Morningstar Advisor - Spring 2007

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