Great Speculations?

Two weeks ago we held the monthly joint web chat for subscribers of The Energy Strategist (TES) and MLP Profits. The chat is conducted by Igor Greenwald, managing editor for TES and chief investment strategist for MLP Profits, and myself.

In the span of just over an hour we received some 90 questions and comments. While we addressed the majority during the chat — with a particular focus on portfolio holdings and recommendations — we still had a fair number of questions remaining at the end. In last week’s Energy Letter I answered what I thought was about half of the remaining questions, with the intent to answer the other half this week.

It turns out that last week’s “half” was really about a third. Answers related to portfolio holdings — past, present, and prospective — will be found in this week’s Energy Strategist. (For answers to some remaining MLP questions from the chat, see this week’s MLP Investing Insider.)

Q: What do you think about IOC? After announcing a partnership with Total they dropped by more than 30 percent in one day. Is that justified?

Q: If you follow IOC, any thoughts on its big deal recently announced and then the big sell off? Sounds like market maker ‘games’ as the deal seemly met expectation of values.

InterOil Corporation (NYSE: IOC) advertises itself as an integrated energy company operating in Papua New Guinea and the surrounding region. The company has four segments: upstream, midstream, downstream and corporate. The upstream segment explores, appraises and develops crude oil and natural gas structures in Papua New Guinea.

The knock on IOC is that it’s been a hype machine, more adept at issuing press releases and new shares than at finding and developing oil and gas. The company has nearly doubled the number of shares outstanding over the past five years, while operating income has been negative in three of the past four years. The share price has been volatile, rising 334 percent over the past five years but at times dropping steeply in a short period of time.

On Dec. 5, IOC issued an extensive press release trumpeting the sale to Total (NYSE: TOT) of an interest in its Papua New Guinea exploration. The IOC press release spun the sale as potentially worth billions to IOC, which has a current market cap of $2.6 billion. Indeed, that deal sounds like it could really make a huge impact on IOC, until you read the press release issued by Total. Total has indicated that its engineers will need to evaluate the prospects before any decision is made on payments. So the deal could be worth zero to IOC, and based on the company’s poor track record over the years in actually booking reserves many investors decided it was time to exit when it became clear that IOC’s spin on the deal was much different than Total’s. Shares fell 21 percent in pre-market trading on the day of the announcement, and are now down about 40 percent since the Total news hit.

IOC is not a company we have spent time covering, and is certainly not a candidate at this time for any of our portfolios due to its highly speculative nature. I view it as an inappropriate investment for all but the most aggressive speculators.    

Q: To follow up on your comments on E&P … with this drop, how does APC look to you? Would you agree with the assessment that APC is a core long-term holding? What is your best buy post drop?

The “drop” mentioned in this question referred to the correction in the prices of many domestic oil producer shares that I had warned was likely during our November web chat. But on Dec. 14, just two days after our latest chat, Anadarko Petroleum (NYSE: APC) suffered a far more worrisome drop. On that day a judge ruled that Anadarko is responsible for at least $5 billion and perhaps up to $14 billion of cleanup costs related to Tronox (NYSE: TROX), which was spun out of Kerr-McGee in 2005 and subsequently declared Chapter 11 bankruptcy in 2009.

Anadarko acquired Kerr-McGee in 2006 for $16.5 billion plus the assumption of $2.6 billion in debt. The bankruptcy judge ruled that Kerr-McGee had left Tronox insolvent and undercapitalized, which was tantamount to simply shirking responsibility for environmental liabilities.

Anadarko had corrected down along with the other E&Ps in November, but on the day of the judgment — which would rank among the largest environmental enforcement awards in US history — shares fell a further 12.5 percent before recovering some of the losses. Investors had factored in a potential $3 billion judgment against Anadarko, but they now have to be prepared for a hit three or four times as large.

Investors initially shaved about $5 billion off of Anadarko’s market cap, but about $2 billion of that was restored in subsequent trading sessions. Were it not for the environmental liability, Anadarko would be near the top of my list of E&Ps to own. But I have a tendency to avoid companies with large liabilities hanging over them. That’s why to this day I still won’t recommend BP (NYSE: BP), even though by many metrics it’s quite undervalued.

As far as the best buy post drop — it comes down to risk tolerance. If you believe oil prices are going to remain strong in 2014, and you are aggressively inclined, there are several solid names. One that may not be on a lot of people’s radars is Diamondback Energy (NASDAQ: FANG), a Permian Basin-focused producer which IPO’d in October of 2012 and has gained 140 percent year-to-date. It was off recently 20 percent from its highs of early November, but has once again been moving up over the past few sessions. If the stock experiences a sharp correction as a result of broader market weakness, this is one that aggressive investors should consider.     

Q: Do you cover UNT? Your thoughts after the Barron’s article?

We strive to cover the entire energy sector, and are constantly on the lookout for promising investments in the industry. More than once readers have called our attention to an undervalued company that ultimately made it onto our list of recommendations. So typically if the company is in the energy sector, it is something we will take a look at, even if it’s not one we have actually written about in the past.

Having said that, I can’t find anything in the article archives about Unit Corp. (NYSE: UNT). Unit describes itself as a diversified energy company engaged in the exploration for and production of oil and natural gas, the acquisition of producing oil and natural gas properties, the contract drilling of onshore oil and natural gas wells, and the gathering and processing of natural gas.

I haven’t seen a recent article in Barron’s discussing the company. I do see that Barron’s published an article in August in which Brean Capital upgraded UNT from a Hold to a Buy with a target of $59. At the time UNT was trading at $46.14. Today the share price is just over $50, although it has traded as high as $51.65 since that August article.

My opinion is that in this space Helmerich & Payne (NYSE: HP) looks better with respect to most metrics and pays a 3 percent dividend to boot. We recommended HP to subscribers in February, and it has returned more than 25 percent since. UNT hasn’t done too badly by comparison; it is up nearly 14 percent over the same time frame. But I would still favor HP today when I stack it up against UNT. HP’s debt is lower, its price/earnings ratio is lower, its volatility is lower, and its profit margin is higher than UNT’s.          

Q: What do you think is the fair value of LNG? Is it too late to buy?

Although it is the first of the first movers in this space, I think Cheniere Energy (NYSE: LNG) is fairly deep into speculative territory at this point. In 2012 Cheniere became the first to obtain approval from the Federal Energy Regulatory Commission (FERC) to export LNG to countries that lack a Free Trade Agreement (FTA) with the US. The non-FTA designation is important, because it covers many of the most lucrative LNG markets. Cheniere is the only company to have received the required approvals from both FERC and the US Department of Energy (DOE).  

In 2007 Cheniere created the Cheniere Energy Partners (NYSE: CQP) master limited partnership to own assets such as its Sabine Pass LNG export terminal under construction on the Louisiana/Texas border, as well as another LNG terminal in Corpus Christi. Cheniere has signed up a number of customers in Asia and in Europe.  

But the stock is surfing huge expectations that are already factored into the share price. While I believe there is money to be made in exporting natural gas, natural gas producers are lower-risk plays, followed by LNG tanker companies and gas infrastructure builders. LNG export backers are more aggressive and riskier options.

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