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TMFMmbop (34.36)

How I Invest in Energy (with an aside re: energy prices)

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December 19, 2006 – Comments (0)

I've always owned energy companies. And here's the reason: It's one of the only things I see that has a finite supply and nearly unlimited demand (water being another one, though I haven't found as many compelling opportunities here). And with the global economy growing rapidly and the population increasing exponentially, energy prices, while volatile, should outpace the rate of inflation.

For a while, my best energy pick was Valero. Its refineries were sorely undervalued by the marketplace. Yet, the refineries spent the last few years cranking at capacity as demand increased. Moreover, the spreads between what Valero could buy raw product at and what it could sell refined product at were amazing.

It was a great stock.

Now, however, I think Valero is closer to fairly valued. More investors have tuned into the midstream area.

So I've moved upstream. The companies I really like to look at our the service and parts providers. These are companie such as Natco, which makes (for lack of a better term) filters that separate product, water, and sediment as it all comes out of the ground together. As long as drillers keep drilling at a furious pace, the Natcos of the world will do well.

I also like companies such as Dawson Geophysical that help drillers find reserves. Moreover, I think it's still entirely possible (though not right now in the case of Dawson) to take advantage of inevitable energy industry volatility to snap up shares of these types of companies at great prices. Because here's the thing: As long as energy prices stay above a certain minimum level (and in the case of natural gas I've heard about $4 per mbtu), then companies like Dawson Geophysical will continue to se surging demand for their services.

Why?

Because as long as it's profitable for drillers to drill, they will keep drilling. They'd certainly like to have the highest margins possible, but the boom and bust history of the energy industry, has made most of these wildcatters greedy. They won't hold up production if they only stand to make 7% or 10%. They'll keep right on drilling in order to make profits while they can. So, while DWSN (and other energy service shares) will fluctuate along with energy prices, the demand for their services does not move in shades of gray. If natural gas is at $9 and then it is at $6, DWSN may drop. But, the demand for the company's services will not drop. That's because it's still incredibly profitablefor drillers to extract product at $6.

I don't think the market, for whatever reason, fully understands this dynamic.

That said, I also continue to like shares of WTI, a company that owns and operates extensive reserves in the Gulf of Mexico. In other words, it's a pure play on energy prices. I don't normally bother with these pure plays, so I'll explain why I did this.

First, like I said before, I think that the recent energy run has caused the market to catch on to the bargains in midstream and service companies. In other words, despite the volatility of energy prices in recent months, these stocks have not moved significantly. In fact, DWSN has done nothing but move up.

That said, smaller pure play companies such as WTI and larger ones such as CHK have moved down. And for good reason -- prices have dropped. But I don't think prices have dropped for long. We can have all the mild winters in the world, and I still think the combination of growing global economies and growing populations will cause energy prices to move up at a rate far greater than the rate of inflation in the coming years. Thus, these pure-play companies are undervalued today, in my opinion. And while they carry far more risk than my previous energy investing strategy, all of my math today shows very good reward.

And the reason I like WTI so much is the company boasts a historical drilling success rate of close to 90%. So if you'd like to value the company yourself, take the company's estimated reserves, multiply by the drilling success rate you think is appropriate, multiply by the natural gas price of your choosing, and discount those values back over the life of the wells. You'll get a very rough number, but I think that even if you choose conservative numbers (55% success rate, $4 gas, 12% discount), you'll see a promising investment.

Foolish best,

Tim

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