What's Cooking in Energy Stocks

S&P analyst Craig Shere says in the area of utilities and energy merchants his top picks are AES and Constellation Energy

The prices for both natural gas and oil should moderate over the next year, according to a forecast reported by Craig Shere, Standard & Poor's analyst covering natural gas utilities, energy merchants, and pipelines. Specifically, the forecast calls for the average fourth-quarter gas price to fall from $6.08 per million Btu in 2004 to $4.84 in 2005, and for oil to average around $35 per barrel next year. And he notes that S&P still recommends that investors overweight energy in their portfolios.

Among the stocks he covers, Shere has buy rankings on two energy merchants. The first is Constellation Energy (CEG ), which has managed to maintain an investment-grade credit rating and shows above-average growth in earnings per share but trades at a discount to its peers. The other is AES (AES ), "another energy merchant that has made the leap from a vicious deteriorating credit cycle to a more positive cycle of debt reduction, improved cash flows, asset sales, and debt refinancing."

On the issue of whether such companies are still suffering an "Enron hangover," Shere says it's "more like the afternoon after, rather than the morning after," with few companies in near-term financial distress and the likelihood that wholesale power margins will eventually recover.

These were among the points Shere made in an investing chat presented Aug. 24 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff. Edited excerpts follow. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Note: Craig Shere is a Standard & Poor's Equity Analyst. He has no ownership interest in or affiliation with any of the companies under discussion in this chat. All of the views expressed in this chat accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this chat. For required disclosure information and price charts for all S&P STARS-ranked companies, go to spsecurities.com and click on "Investment Research," then click on "Required Disclosures & Standard & Poor's STARS vs. Closing Prices Charts."

Q: Craig, what's the latest on energy prices? And where are crude-oil prices going for the rest of 2004?

A:

We expect natural gas prices to average $5.42 [per million Btu] in 2005, which is down from $5.88 in 2004. We're looking for oil in 2005 to average around the $35 range, as the premium for concerns about Yukos, Iraq, and Venezuelan politics finally add up.

Q: Are oil shares dropping because they're already fully valued for the future?

A:

There has been a substantial run-up in prices in the oil sector, followed by some downside correction in the last couple of weeks. We still recommend an overweight allocation to the energy group.... But your observation that the shares are not necessarily cheap may be reasonable.

Q: What effect will the high energy prices have on the fuel-cell industry?

A:

This certainly increases public and private interest in fuel cells, which are still much more expensive than combustion engines. But increasing natural gas and gasoline prices certainly make large users begin to add up the potential economics of fuel cells over the long term.

In addition, the global political environment would argue for more public support of fuel-cell development. If you recall, President Bush made specific comments about the need to advance fuel-cell research in his State of the Union address. Despite these positive factors, fuel cells don't have an infrastructure in place for mass consumption and are simply more expensive than existing alternatives.

I've little doubt that our grandchildren will use lots of them. But the big question is whether we or our children will make any money off it. Fuel-cell companies are very risky and comparable to the biotechs of the energy world.

Q: Opinion on AmeriGas Partners (APU ) and Enbridge Energy Partners (EEP )?

A:

We have hold rankings on both of these master limited partnerships.

Q: Are XTO Energy (XTO ) and Anadarko Petroleum (APC ) good gas stocks for the future?

A:

We have hold rankings on both of those companies as well.... Keep in mind that I am primarily a utilities and energy merchant analyst, covering regulated utilities, as well as more volatile companies like Calpine (CPN ), Williams (WMB ), El Paso (EP ), and diversified utilities in between, such as Duke (DUK ), Dominion Resources (D ), and Constellation Energy (CEG ).

Q: So in the areas of your specific coverage, what are your best picks, Craig?

A:

I have a buy rating on Constellation Energy and on AES (AES ). CEG is one of the few multi-utilities with a majority of earnings from energy merchant operations that has managed to maintain an investment-grade credit rating. Despite what we see as above-average EPS growth, near 10%, the stock trades at a hefty discount to slower-growth utility peers.

AES is an example of another energy merchant that has made the leap from a vicious deteriorating credit cycle to a more positive cycle of debt reduction, improved cash flows, asset sales, and debt refinancing.

Q: What do you think about the outlook for Dominion Resources?

A:

I have a hold ranking on Dominion. The company's p-e ratios are in line with its multi-utility peer group, and its EPS growth projections are not much above the group. Our 12-month target price is $66.

Q: Comment on Dynegy (DYN )?

A:

I have a hold ranking on Dynegy. I like Dynegy's new management but believe they have their plate full. The company has little room for investing discretionary free cash flow for growth and is likely to issue diluted equity as soon as margins improve and the stock price improves.

We're reluctant to guess as to when the stars will align for Dynegy's margins and see a practical ceiling to the shares because of the likely equity offering. However, in our opinion, Dynegy has largely turned the corner from the point where it was once a potential imminent bankruptcy risk.

Q: You mentioned this name -- what is your opinion on Calpine?

A:

I have a hold opinion on Calpine. I believe they have sufficient liquidity to service their significant debt burden until power margins recover over the next two to five years. However, cash flow in the first half of 2004 has been especially disappointing. This summer's mild weather is not helping. And the company has $1 billion in preferreds coming due for remarketing between November and August next year.

We're concerned that Calpine will use at least one-third common equity to retire these preferred interests -- that would translate into an additional 100 million shares. Our concerns may be conservative. Trading at about one-third of book value, we believe Calpine fairly discounts the risk of near-term dilution and longer-term potential bankruptcy if power margins never recover. This is a highly speculative name.

Q: You gave us some natural gas prices near the start of the chat, but what's ahead for this winter?

A:

We expect December prices to be at the highest levels of the fourth quarter, averaging around $6.50.

Q: Your opinion on Consol Energy (CNX ), please?

A:

We have an avoid ranking on Consol Energy. We downgraded them from hold on July 28. The downgrade was based primarily on valuation, as CNX was trading at a meaningful premium to its peer group. Our 12-month target price remains $32.

Q: If you were a market timer, is now a good time to put money to work in your group?

A:

We upgraded the utility-sector recommendation to marketweight because of the recent moderating interest rates and weakness in other sectors. For example, over the 13 weeks ended Aug. 20, the utilities sector was up 9.1%, nearly double the total year's performance, as interest rates on the 10-year Treasury fell from 4.76% to 4.23%.

We don't believe, however, that this is a secular trend, and our chief economist still looks for much higher interest rates by the end of 2005. If your time frame is measured in weeks or not many months, then the broader regulated utility group would be an appropriate allocation for total-return investors. Longer-term, we're more positive about multi-utilities and energy merchants with unregulated operations.

Q: Are the energy merchants still suffering from what might be called an Enron hangover?

A:

I think this is more like the afternoon after, rather than the morning after. Most energy merchants that haven't gone bankrupt have refinanced short-term debt maturities, sold assets, and replaced prior management. As a result, few companies are in near-term financial distress. Many regulatory liabilities have been settled and resolved.

In our opinion, by the end of 2005, the final settlements for the 2000-01 Western energy crisis will have been resolved.... At some point, we're confident that wholesale power margins will recover.

Q: Is there any concern among your companies over regulatory changes should Kerry win?

A:

The primary issue that would come to my mind would be the treatment of near-term environmental emission issues. The Bush Administration has arguably had a mixed stance on near-term emission restrictions, despite maintaining long-term goals that are much more favorable to the environment. If nitrogen oxide, sulfur oxide, and mercury emission restrictions became much tighter in the shorter term, the cost of running coal-fired power plants could rise substantially.

We already see the most efficient baseload natural-gas-fired plants cost-competitive against smaller inefficient coal plants during the peak summer months that entail extra ozone emission restrictions. Beneficiaries from changes in wholesale power prices may change, depending on the relative costs of coal-fired plants vs. gas.

Edited by Jack Dierdorff

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