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As the world's thirst for new energy supplies to fuel rapidly growing economies continues drive commodity prices higher, many stocks in the sector remain attractively valued, and thus it makes sense for investors to have some energy exposure within their portfolios. One way to identify the potential winners in this sector is to take a look back at previous energy cycles and try to determine the characteristics that drove out-performance within the sector.

While clearly the correlation between the commodity price and stock performance was the strongest and most obvious determinant of out-performance, investors could also outperform the sector returns by choosing the best energy companies. Over 1, 3, 5, and 10 year time periods the energy stocks whose stock prices led the sector to a large degree shared the following traits:

1. Production growth – during periods of rising prices, the energy companies who have opportunity to realize growth tend to perform the best.

2. Asset efficiency or reserve replacement efficiency – The ability of an energy company to replace its reserves economically. Effectively, energy companies whose assets are “self-sustaining” and long-lived, tend to be rewarded with higher multiples.

3. The ability to “grow organically or “through the drill-bit” Particularly during times when it becomes more expensive to acquire new reserves (such as now!), those companies that have opportunities to grow from within will generate stronger and more consistent returns.

4. Improving trends in return on capital and conservative management. When energy companies are managed by individuals that appreciate economic returns and effectively balance risk and return, their stocks tend to outperform.

These four fundamental attributes of prolific energy companies may lead investors to Newfield Energy (NYSE:NFX), a Houston based E&P.

Historically, NFX has been awarded a lower valuation than its peers because of its heavy exposure to short-lived and riskier Gulf of Mexico wells. However, investors may not be giving NFX credit for its recent efforts to re-distribute its sources of production growth. Over the next 3 years significant production growth is expected to come from more attractive sources such as continental U.S. (which tend to be very low-cost, long-lived type assets), China, and the North Sea. The company that once generated 80% of its production from the Gulf of Mexico will now only have 40% of its asset base there. This will effectively reduce the risk of NFX’s production growth and also improve its overall asset efficiency and return on capital (and should therefore improve its multiple).

The company will not completely abandon the Gulf as it embraces a “portfolio management” approach using these Gulf wells as a source of cash for other more speculative growth opportunities. Importantly, as the major integrated and the “acquire and exploit” E&P’s abandon the GOM fields, the returns are becoming more attractive. As their development program becomes more diversified over the next two years investors should expect these metrics to improve sharply, leading to higher valuation.

Perhaps more importantly, NFX has peer-leading production growth opportunity. While 2006 production growth has been sluggish resulting from hurricane related shutdowns, 2007 production is expected to exceed 22%. Much of this growth is expected to come from a gas play in Oklahoma known as the Woodford Shale. The Woodford Shale often draws comparisons to the highly prolific Barnett Shale, in Texas, which has driven the strong results seen from companies such as EOG. Importantly, the higher silica content of the Woodford Shale, makes the gas easier to “frack”. Because these rock structures are less porous, the wells have been more successful than the exploratory Barnett wells. The Woodford test wells are averaging 2.75mmcfe per day, compared to 2.00mmcfe for similar test wells in the Barnett Shale. The 110K acreage position and significant first mover advantage of NFX makes them well positioned to fully exploit this asset. The opportunities are not fully priced into the stock either. While NFX effectively trades at net asset value equal to its current reserve base of 2Tcfe, investors are not properly valuing the potential incremental 2Tcfe-4Tcfe opportunity in the Woodford. (estimate based on historical cash costs and long term gas price of $6.00, discounted at 10%). This is 100-300% reserve growth potential, and a catalyst to drive the stock higher.

Lastly, this company is well managed by a team of return-focused energy executives. Although NFX uses the less desirable “successful efforts” accounting methodology that capitalizes exploratory costs, its historical results show a disciplined, and conservative energy development program.

In summary, Newfield Exploration is a company trading at a significant discount to peers (4x cash flow) and has an evolving portfolio of assets that investors are not fully appreciating. This repositioning is like to drive significant improvement in the production growth, asset efficiency, profitability, and risk profile of NFX, and likely drive significant improvement in its stock price as well.

Source: The Long Case for Newfield Energy