Buy-recommended Occidental Petroleum (OXY) offers unlevered appreciation potential of 12% to a McDep Ratio of 1.0 where stock price would equal Net Present Value (NPV) of $95 a share. The increase in NPV from $87 is justified by a strong trend in cash flow generation and a long reserve life index of 11.2 years. Third quarter results released October 22 disclosed unlevered cash flow (Ebitda) above our expectations of three months ago, helped by actual oil price 12% better than earlier indications.

A new discovery in California, announced with second quarter results, is already contributing 26 thousand barrels equivalent daily, about 4%, to the company’s worldwide oil and gas volume in the latest quarter. The new production comes from conventional zones in an area near Oxy’s Elk Hills field (see map).

After visits with technologists at an explorer and three trusts in Calgary, we have confidence in our assessment of attractive investment potential signaled by McDep Ratios of 0.87 for Birchcliff Energy Ltd. (BIR), 0.91 for Freehold Royalty Trust (FRHLF.PK), 0.95 for Peyto Energy Trust (PEYUF.PK) and 0.95 for Penn West Energy Trust (PWE).

BIR is for investors looking for high growth subject to higher risk. The remaining three income stocks have strong resource value at the same time they expect Canadian taxation changes in 2011. All are applying newly developing techniques of multifrac horizontal drilling (HZ) to unlock oil and gas accumulations more profitably. Neither fracturing nor horizontal drilling is new, but the combination of multiple fracture treatments with horizontal drilling is sweeping Canada after having been advanced in the Barnett Shale natural gas drilling in Texas. In its Analyst Day presentation, PWE illustrated in a deliberate oversimplification how 8 single frac vertical wells costing $8 million might be replaced by one multifrac horizontal well for $2 million (see slide below). We think HZ is promising for individual companies without depressing industry pricing from too much long-term supply. We’ll have more to say about each of the four stocks in future analyzes.

Stocks of the European Oil group, made up of five buy-recommendations, Total (TOT), StatoilHydro (STO), Royal Dutch Shell (RDS), BP plc (BP) and BG Group (BRGXF.PK), have low McDep Ratios that fall within the tightest range (0.75-0.87) of the six industry groups in our coverage. McDep Ratios for the European stocks have reversed a three-year slump (see chart below). In the context that lower McDep Ratio stocks should return more than higher McDep stocks, BP has underperformed modestly over three years.

Otherwise, occasional extremes appear to get reduced in a pattern of reversion to the mean. Among the three majors, BP and TOT have the traditional oil concentration near 60%, while RD has a traditionally greater concentration on downstream and natural gas. STO has the highest concentration on natural gas production. BG profits from a dominant natural gas trading position and is the largest partner of Petrobras (PZE) in deep offshore Brazil oil discoveries. Fundamental trends for the five stocks are favorable with futures prices for oil and natural gas for the next six years trading above 40-week averages. The five stocks are also bargains at median cash flow multiple (EV/Ebitda) of 5.9 and pay high dividends at the median rate of 5.3% a year.

Canadian Income Trusts are in a good position to make money for investors after adjusting to the Halloween Betrayal of 2006, the Alberta royalty overreach of 2007 and the global financial follies of 2008. Each of the six stocks in our coverage is in an upward fundamental volume trend per unit adjusted for debt reduction and high income distributions (see chart Volume per Unit, below). The adjustment casts the trusts in a better light when reported volume is divided by adjusted units that have been declining for most of the trusts (see chart Units Outstanding, Adjusted, below). Bumps in the trend prior to the market peak last year reflect acquisitions.

The three largest conventional trusts acted as consolidators of smaller trusts in the face of changing trust taxation in 2011. Now those trusts are focused on reinvesting more cash flow. Considering our latest comparative analysis, Enerplus Resources Fund (ERF) retains a low McDep Ratio of 0.79 after we reduce estimated Net Present Value (NPV) to US$32 from US$36 a unit.
The largest income stock, Canadian Oil Sands Trust (COSWF.PK), has our buy rating, while the other five also offer attractive appreciation potential indicated by low McDep Ratios.

Stocks of the U.S. Integrated Oil group, made up of four buy-recommendations, ConocoPhillips (COP), Marathon Oil (MRO), Chevron (CVX) and ExxonMobil (XOM), have the lowest median McDep Ratio (0.75) among the six industry groups in our coverage (range 0.75-0.94). McDep Ratios for the lagging group have begun to pull out of a three-year slump (see chart below).

In the context that lower McDep Ratio stocks should return more than higher McDep stocks, CVX has outperformed XOM over three years and MRO has underperformed during the same period. In contrast, COP has retained its lowest McDep Ratio position throughout the period. MRO and COP declined much more than XOM and CVX during last year’s weak market and thus may have extra potential with market values advancing again. CVX’s stronger relative performance has been helped by its highest concentration on oil (70%).

Buy-recommended Canadian Oil Sands Trust (COSWF.PK) offers unlevered appreciation potential of 55% to a McDep Ratio of 1.0 where stock price would equal Net Present Value (NPV) of US$42 a share. When the next quarterly distribution is declared on October 28, we believe the outlook supports C$0.50 a unit, twice the C$0.25 most recent payment. The increase we envision can be carried by our projection of fourth quarter Ebitda minus Interest of C$0.75 a unit, about the same as an estimated C$0.74 in the third quarter and a more normal level than C$0.14 in the second quarter.

Third quarter volume recovered from the depressed second quarter and management’s guidance calls for operations at 99% of 350 thousand barrels daily (bd) capacity for the fourth quarter. At the same time, a distribution more in line with cash flow may help stock price and thereby raise the initial offer of a potential acquirer who would try to buy at a price as far below NPV as possible. While the distribution increase is our opinion today, the COSWF board will have another month of history before deciding and/or may have different intentions. In any case, we believe that COSWF is a choice long-term pure oil growth investment at an attractive price.

Sporting a McDep Ratio at the low end of the range, buy-recommended Suncor (SU) offers 42% unlevered appreciation potential to a McDep Ratio of 1.0. Management is saying less than usual to investors in recent weeks while it is focused on the future for resources acquired in the Petro-Canada merger. Combining the previous outlooks we had for each company, we update our Suncor model to include operations from acquired properties beginning August 1.

A primary purpose of the merger was to make Suncor strong enough to be able to withstand the financial market conditions that forced last year’s interruption of Suncor’s oil sands expansion. Oil sands in Canada account for most of the new company’s 85% concentration on oil, leaving oil and gas properties outside Canada potentially available for sale. Some natural gas properties may be sold. Petro-Canada’s refineries are likely “keepers” as Suncor often looked at prospective downstream acquisitions.

Buy-recommended Cimarex Energy (XEC) has built up its best backlog of drilling projects while maintaining low debt, minimal hedging and generating cash at the highest rate of any stock in our income and small cap coverage. Shale gas in western Oklahoma, a 3-D seismic natural gas play in southeast Texas, and horizontal oil in west Texas, all appear to be working well. The prospects are reassuring because reinvestment effectiveness is especially important for companies generating high levels of cash.

At the same time, Cimarex’s low-debt policy helped the company to gain ground on high-debt competitors during the turmoil of the past year. Nonetheless, management felt it necessary to take out some price insurance in the form of hedging to assure minimal operations to keep the organization on top of its game, among other considerations. XEC stock has appreciation potential of 9% to a McDep Ratio of 1.0 where stock price would equal Net Present Value (NPV) of $46 a share. NPV could be higher considering a somewhat low unlevered multiple of Present Value to Ebitda compared to the ratio of Adjusted Reserves to production. We may also be entering the phase of the cycle where natural gas price moves up while drilling costs lag, the most favorable conditions for Cimarex’s active drilling strategy.

Highlighted by meetings with executives of buy-recommendations Gazprom (OGZPY.PK) and Lukoil (LUKOY.PK), I had a memorable first visit to Russia last week (see pictures below). I also glimpsed first-hand the cultural legacy of the country while touring its current and former capital cities, Moscow and St. Petersburg. I traveled alone while trusting two excellent local guides, one in each city, both provided by an American travel agent with long experience in Russia. It was an adventure to explore new places safely and it was rewarding to meet warm and friendly people who work hard for a better life. Adventure may also describe investment in Russian stocks as demonstrated by last year’s stock price volatility. My thesis for including Russian investments in a diversified portfolio is a motivated government will seek long-term growth in a global economy that enriches Russia and by necessity must also reward international investors. Success will be measured by higher stock prices. Stock prices will be higher only if investors see appropriate reward.

Russian Pride
Like people everywhere, Russians take pride in their achievements. Despite communism’s antipathy to the monarchy, the government directed support to restoring historic palaces. After communism, cathedrals were restored. The accumulation of wealth in the form of gold, precious stones, and fine craftsmanship in glorious structures is startling.
There are many smart and talented Russians, of course. One of my favorites is the 19th century chemist, Dmitri Mendeleev, the inventor of the Periodic Table of Elements. Another is a current national hero, Irina Rodnina, the all-time great pairs figure skater.
The Kremlin, a symbol of a controlling government, also showcases history. I once pictured the Kremlin as a building that looked like what turns out to be Lubyanka, the former KGB headquarters. Instead the Kremlin, or ancient fortress, surrounds cathedrals and museums along with an office building for President Medvedev. The Assumption Cathedral in which all the tsars were crowned is practically gold clad, it seems to have so much of the precious metal. The Armory Museum does have ancient armor that Russians used to repel the Mongols who dominated the country in its early history. Otherwise the Armory is better known for its collection of Faberge eggs. The tsar’s coaches are also on display looking just as I envisioned in fairy tales.
Steeped in the knowledge that Communism was atheist, I was surprised to see churches and cathedrals seemingly everywhere. The government supports the Russian Orthodox religion again and likely controls it. Apparently there are also choices for those seeking solace away from the government religion.

Mesa Royalty Trust (MTR) offers pure natural gas income with no debt and no hedging, but limited trading liquidity. The practical alternatives for most investors are buy-recommended San Juan Basin Royalty Trust (SJT) and buy-recommended Hugoton Royalty Trust (HGT). Persisting lower regional natural gas price discounts contribute to higher estimated distribution yield for the next twelve months for each trust of 8.4% for MTR, 6.9% for SJT and 5.9% for HGT. Offsetting the higher distribution expectation for MTR, we reduce estimated Net Present Value (NPV) to $48 a unit from $56 following the September 19 disclosure of reserves and operating results for the year 2008. Despite that change, MTR has the lowest McDep Ratio among natural gas producers.

Trading in the stock is limited because the trust is less than a tenth the size of SJT and HGT. MTR now has the shortest reserve life index when previously it had the longest. To analyze MTR we also look closely at our outlook for SJT and HGT because the three share concentration on natural gas in traditional long-life large fields. Underlying volume normally declines gently though there are opportunities to hold it stable with more reinvestment not considered here. Distributions declared monthly through the third quarter 2009 follow a similar pattern. Up-to-date distributions help in projecting cash flow while we await operating results for 2009 quarters.

On the strength of favorable exploration results and in the context of a rising stock market, buy-recommended Anadarko Petroleum (APC) has appreciated beyond a McDep Ratio of 1.0 where stock price matched Net Present Value (NPV) of $59 a share. The potential for increasing NPV and the momentum of the market justify continued buy interest, in our opinion. Yet, investors overweight in APC might rebalance toward lower McDep Ratio recommendations.

Today the company announced that the Venus well drilled offshore Sierra Leone is an oil discovery. Though it is too soon to declare commerciality, Anadarko technologists are excited about the value of the information obtained. The well confirms the promise of the Liberian Basin where Anadarko has 6 large acreage blocks (see slide from management presentation below). Referring to the general area as a Cretaceous Fan Play last month, APC now refines its disclosures to map a separate Liberian Basin and Ivorian Basin. The latter has the billion barrel Jubilee field under development by APC and partners. In the two basins the company has about a 40% share in some 30 leads to potential discoveries.

Buy-recommendations Gazprom (OGZPY.PK) and Lukoil (LUKOY.PK) have long-run appreciation potential from a gradual relaxation of natural gas price controls in the case of Gazprom and the oil export tax in the case of Lukoil. Many of the same issues of energy economics and politics being debated in Russia today parallel the arguments we recall vividly that came to a boil in the U.S. during the 1970s.

Having visited the two leading Russian companies in their Moscow headquarters on September 21, we will have more to say on each. McDep Ratios below a half for the two companies point to the opportunity subject to the usual risks. Market multiples, Enterprise Value to Ebitda, convey a similar message. Last, the industry backdrop looks positive with an upward oil price trend.

Buy-recommended Canadian Oil Sands Trust (COSWF.PK) stands out at a low McDep Ratio of 0.67 despite a steady uptrend in stock price from the bottom on January 23. Opportunities for optimists, or concerns for pessimists, might include operating reliability, distribution rate and environmental issues. We remain hopeful that the trust can meet management guidance with operations near capacity of 350,000 barrels daily (bd) to the end of the year despite a surprise upset in August that reduced monthly volume to 284,000 bd.

We see ample capacity to double the distribution rate on October 28 to C$0.50 a unit compared to estimated Ebitda minus Interest of C$0.79 a unit for the quarter ended December 31.

Buy-recommended Petrobras (PBR) offers unlevered appreciation potential of 37% to a McDep Ratio of 1.0 where stock price would equal Net Present Value (NPV) of $58 a share. The President of Brazil, Mr. Lula da Silva, has proposed an equity injection into Petrobras as part of a new model to regulate areas currently unleased in the offshore Pre-Salt trend. The federal government would pay for its one-third in oil while other shareholders would pay cash. A new government company, Petrosal, would own the government’s share of new leases while Petrobras would be the operator and have a minimum interest of 30%.

The details to assure fair treatment to all parties remain to be determined and the proposal is subject to legislative approval or rejection, apparently within 90 days. The multi-billion dollar stock offering would be in the first half of 2010. Petrobras is unlikely to be treated negatively in the new regulatory regime as the president’s chief of staff and candidate to succeed him in an upcoming election, Ms. Dilma Rousseff, is Chair of Petrobras.

Buy-recommended Encana (ECA)’s revived plan to split into an integrated oil sands producer, Synovus Energy, and a more concentrated natural gas producer, which keeps the Encana name, may ultimately generate more value. Investor interest in the split, originally proposed a year ago, was reignited on September 10, when the company announced it would go forward. The original plan was suspended when equity and debt markets became too tumultuous. It has been reinstated now that markets are moving up again.

Applying McDep analysis to the financial and operating disclosures, we see Net Present Value (NPV) of $62 a share divided into $26 for Synovus and $36 for the 94% pure play North American natural gas producer. With Synovus, our Canadian coverage will expand again after losing Petro-Canada to takeover. Therein lies a tale as any number of global oil buyers, from China especially, may be interested in acquiring Synovus, or other bite-size producers, judging from recent actions.

Income and Small Cap stocks, including buy recommendations San Juan Basin Royalty Trust (SJT), Dorchester Minerals, L.P. (DMLP), Hugoton Royalty Trust (HGT) and Cimarex Energy (XEC), offer some of the purest opportunities to buy natural gas at the lowest commodity price in seven years. The low may have been set on September 4 when October futures touched $2.409 a million btu and the national average cash price dipped below $2.00 to $1.97 as reported by Platt’s Gas Daily. Stock prices seemed to anticipate short duration for extreme natural gas price conditions with only SJT among 19 stocks in this weekly coverage still trading below its 200-day average, a widely watched trend indicator.

The main contributors to low fuel price are the convergence of the seasonal cycle and the economic cycle along with lag time between the drilling cycle and the production cycle. The low demand period in the fall when weather is pleasant is occurring at the same time that economic activity is at a recessionary low, which follows a few years of expansion. Surely, fall will turn to winter and the economy will grow again. While producers began sharp curtailment of drilling new wells a year ago, it took months for volume to slow and then to decline. Surely, it will take time for supply to grow again after producers resume drilling. The cyclical signs are clear. Though the price lows can always be lower, the upside is beckoning beyond the next few weeks into October.

We recommend current purchase of the units of natural gas income stock San Juan Basin Royalty Trust (SJT) for unlevered appreciation potential of 38% to a McDep Ratio of 1.0 where stock price would equal Net Present Value (NPV) of $21 a share. Investors looking for a stock that has not participated much in the market recovery need look no further than SJT, which trades at the lowest ratio, 0.85, to its 200-day average of any stock in our coverage. The overwhelming factor influencing the stock price of SJT is the price of natural gas, which is under acute short-term pressure ahead of the winter heating season that begins on November 1. Record short interest seems to anticipate a price decline climax in the next several weeks. We think it is time to “jump the gun” because if the climax occurs, the price recovery could be sharp. The main risk is that depressed conditions take longer to be alleviated.

SJT Almost Always Offers Attractive Income
Our current estimates anticipate a distribution of $1.08 a unit for the next twelve months ended September 30, 2010. That implies a distribution yield of 7% a year. Buyers can usually figure that the distribution yield will be in the high single digits because the stock price tends to adjust for distribution expectations. In that case, the risk becomes the prospect for changes in expectations, which in turn depend mostly on the outlook for natural gas price. Alternatively, if an investor has a view on natural gas price, then SJT is a pure play vehicle to invest in that view.

Buy-recommended Lukoil (LUKOY.PK) offers unlevered appreciation potential of 140% to a McDep Ratio of 1.0 where stock price would equal Net Present Value (NPV) of $135 a share. Second quarter results released on August 28 exceeded our estimate from four months ago for unlevered cash flow (Ebitda) and earnings. Ebitda margin for exploration and production continued at 25% rather than at the lower level of the past several years.

The volatility of the exchange value of the U.S. dollar contributed to a wider spread between oil price in dollars and costs in local currency. At the same time, the Russian government seems more willing to lower the high rate of tax on oil production to encourage new investment. After latest disclosures, we see oil production making up about two-thirds of NPV. Oil volume up 5% a year in the second quarter may continue to grow through 2013 including large potential increments from the Caspian Sea.

Buy-recommended PetroChina (PTR) offers unlevered appreciation potential of 30% to a McDep Ratio of 1.0 where stock price would equal Net Present Value (NPV) of $150 a share. First half results released on August 28 exceeded our estimate from a month ago for unlevered cash flow (Ebitda) and earnings on the highest cash flow in the industry for downstream operations. Relaxation of price controls on refined products drove a dramatic gain compared to a dramatic loss last year.

On the production side, natural gas volume was up 14% over the second quarter of 2008 and 46% a year in the eight years we have been covering the stock. Latest results justify a boost in the relative contribution to NPV from downstream to 15% and from natural gas production to 15%. Oil is the remaining 70% of NPV where the outlook is for growth outside China.

Buy-recommended ExxonMobil (XOM) stock is the only one of twenty-four large cap buy recommendations not trading above its 200-day stock price average and its McDep Ratio of 0.80 is at a desirable buy level. Though trading below the 200-day indicates a downtrend, it also indicates a lagging stock price that may have catch up potential. Similarly the attractiveness of the 0.8 McDep Ratio takes on greater significance considering that most of the many years we have been analyzing XOM stock or its predecessor it has had near the highest McDep valuation. For example, seven years ago at another low point in the stock market cycle, XOM had a 0.98 McDep Ratio, at the top of its peers.

We know of no reason why XOM stock price should be lagging. Some investors may be concerned about higher future taxes, but that would affect most companies and most investors. Some owners of XOM stock may be concerned about future growth for a company that is already large. When we look at growth per share adjusted for debt and distributions, we see that XOM continues to perform well. Finally, increasing natural gas exposure is also a plus for growth once we get past the next few weeks before winter weather starts alleviating the current supply/demand imbalance for the clean fuel. Forbes astutely picked up on the natural gas thrust in its August 24 feature, “Green Company of the Year: Exxon”.