Morningstar Advisor - Spring 2007 - 58

Sector Rap Morris: What factors do you consider in forecasting commodity prices? Perucki: For our long-term forecast for the price of oil, we develop an estimate for the longterm cost of oil and then add a premium to account for OPEC’s impact on petroleum prices. Right now, we assume the long-term price per barrel to be in the mid-$40s. (At this writing, the price of crude oil stood at $60.) Milostan: Obviously, oil prices have been quite volatile recently. For the past couple of years, the excess oil supply wasn’t nearly enough to handle some of the shocks we experienced from geopolitical and weather-related factors. But during that time, OPEC ramped up production. A Saudi oil minister estimates Saudi spare oil production capacity may be as much as 3 million barrels per day. This would be an appropriate excess supply cushion to handle shocks. So I’m hoping that oil prices will now be more reflective of long-term fundamentals going forward. Perucki: Natural gas prices are usually more volatile than oil, because gas is a stranded resource. Limited infrastructure is currently in place to import gas from overseas, so we have to rely on production on our own continent for our supply. However, the expansion of liquefied natural gas (LNG) will allow natural gas to be Energy Exploration and Production ETFs Fund Inception Expense Ratio (%) YTD Return (%) Worst 3 Mo. Return (%) % In Top 10 Holdings Avg. Mkt. Cap ($mil) iShares DJ US Oil & Gas IEO PowerShares Dyn Energy PXE SPDR S&P Oil & Gas Expl & Prod XOP 05-01-06 10-26-05 06-22-06 — 0.66 0.36 8.67 7.81 6.78 –9.06 –6.55 –8.98 60.03 46.35 26.35 10,374 8,236 6,461 Watchlist of Oil & Gas Producers Company Morningstar Rating Business Risk Fair Value ($) Consider Buying ($) Consider Selling ($) Apache APA EOG Resources EOG Ultra Petroleum UPL XTO Energy XTO Data as of March 31, 2007 QQQQ QQQ QQQQ QQQ Avg Avg +Avg Avg 86.00 77.00 64.00 53.00 66.30 59.40 40.80 40.90 107.70 96.50 77.20 66.40 more of a globally traded commodity. This should help smooth the volatility, but it will be some time before it can significantly affect supply—perhaps as far out as 2012 to 2015. Milostan: But even then, we estimate that LNG imports will only account for about 10% of the domestic supply by 2015. Perucki: Based on these factors, our long-term forecast for the price of natural gas is around $6 per mcf (thousand cubic feet). (At this writing, the price of natural gas stood at $7.25 per mcf.) Morris: Oil and gas stocks are extremely volatile. Do the star ratings get whipsawed by this volatility? Chenoweth: Absolutely. Shortly after the 2005 hurricanes in the Gulf of Mexico, stock prices spiked, sending many E&P stocks into 1- and 2-star range. But by April and May 2006, when commodity prices came back to earth, E&P stocks were trading back in 4and 5-star territory. Then they gradually rallied into 2- and 3-star range until fall, when forecasts of a warmer-than-normal winter sent them back down into 3- and 4-star territory late in 2006. Morris: What are the implications of this for the long-term investor? Chenoweth: Investors who bought and sold on our signals—that is, bought at 4 and 5 stars, and sold at 1 and 2 stars—would have done quite well. But this implies a shorter time horizon. Milostan: It’s encouraging that many of the current 5-star stocks are ones we like for their long-term projects and which have the potential to deliver attractive returns for several years. It goes back to our conversation about moats—the firms that have the potential to increase production, regardless of commodity prices, will have sustainable, long-term, competitive advantages. K How To… Generate Energy Ideas You can track high-quality, undervalued energy stocks in Advisor Workstation and Principia Stocks. Start your search with: Sector Energy Average Below Average ) 4 AND ( Business Risk OR Business Risk AND Morningstar Overall Rating Sonya Morris is a fund analyst with Morningstar and editor of Morningstar ETFInvestor. This article appeared in the March issue of Morningstar ETFInvestor, a monthly newsletter that covers 150 ETFs. Subscribe at: http://www.morningstar.com/goto/Adv37. 58 Morningstar Advisor Spring 2007

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Morningstar Advisor - Spring 2007

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