October 2, 2000

Oil, gas firms stuck in valuation rut Investors snub sector despite higher commodity prices

Claudia Cattaneo, Calgary Bureau Chief Financial Post All dressed up and nowhere to go. That about sums up the predicament of Canadian oil and gas companies over the past year. The group is stuck in a valuation rut, despite a rally inspired by higher commodity prices that put it in the Canadian market lead for year-to-date stock market performance.

On average, stocks are still trading at 3.3 times forward 2001 cash flow, to the dismay of many chief executives, who are stumped over what to do. The historical normal, says analyst Jeffrey Fiell, of Canaccord Capital Corp., is about five times cash flow on average, with superior performers trading at as much as 15 times forward cash flow.

The market's aversion is clearly illustrated by the poor inflow of investment capital. According to figures compiled by the Financial Post Data Group, oil and gas companies collectively raised $1.3-billion in new equity year-to-date, compared with $3.4-billion in 1997, when conditions were similarly buoyant before crude oil prices collapsed.

Here are the most often cited reasons behind the investor snub, which bodes poorly for valuations in the future, even if profits continue to climb:

- Oil and natural gas prices are too high. Some investors don't think oil prices will stay above US$30, or that natural gas prices will stay in the current range of more than $7 per thousand cubic feet for winter gas. They are waiting for prices to stabilize closer to a historic average before jumping in. While popular, this thinking is contradicted almost daily in the stock market. When oil prices fall, investors still aren't buying, and the group slumps. Oddly enough, with more than a reasonable chance that these commodity prices are here to stay, investors in this group may have even more reason not to get in.

- The Never Cry Wolf excuse. This one has legs among those who've been burned too many times by predictions of imminent disaster, which were proven wrong consistently by warmer-than-expected winter weather, slowing energy demand growth, or some such saving grace that in the end demonstrated supplies were ample to deal with consumer needs. "So many times in the past 15 years investors in the U.S. have gotten all excited about the natural gas story, they bought the stocks, and the market collapsed beneath them. And so, rightfully so, they are very leery to buy the story," said one U.S. analyst for a large institutional investor. This time around, while a crisis is indeed the most likely it's ever been if this winter is cold, investors aren't listening. Apathy toward the sector is so entrenched it'll take none other than an energy shock to awaken investor attention, the analyst said. "People are scared. They've lost money before. They want to make sure it's real."

- The technology excuse. Under this school of thought, the high-tech sector is draining other sectors of the economy of investment capital and attention, which wasn't the case in the past. At an energy conference two weeks ago organized by Peters & Co. and Goldman Sachs & Co., for example, 150 institutional investors turned up to hear presentations from Canadian oil and gas companies. A high-tech conference running concurrently organized by Donaldson, Lufkin and Jenrette Securities Corp. attracted 3,000.

"The experience of our conference is an indication that the mindset of the investment public at large is still highly motivated to seeking investments in companies where supernova rates of return are potentially achievable," said Wilf Gobert, research director at Peters.

Said the U.S. analyst, "In the past 15 years, it didn't matter if you were in the Exploration and Production stocks or not. If you were in technology, you still outperformed."

- The trust issue. Yet more investors are staying away because they no longer trust the sector, especially junior companies. They point to fiascos like Big Bear Exploration Ltd., Merit Energy Ltd. and Canadian 88 Energy Corp., to name a few. Regulators such as the Alberta Securities Commission aren't helping. An investigation launched about 18 months ago into whether Blue Range Resource Corp. was inflating its reserves, resulting in the collapse of Big Bear after it took over the company, has yet to yield a conclusion, while shareholders lost hundreds of millions. There is so much investor uneasiness with the sector's junior ranks there's a dearth of upstarts. And this is the stage of the cycle when one would expect investors to start searching for the next Canadian Natural Resources Ltd.

Larger companies have also changed, by becoming more profit-oriented, less speculative, and bigger, in response to investors' views that bigger oil is better and more trustworthy than smaller oil.

"The oil and gas market is paying for different things," Mr. Fiell said. "Two years, ago, it was paying for the prospect of discovery. Today it is paying for certainty of growth. The market doesn't want to get burned."

What has emerged, though, is a double standard.

"Investors pushed the oil-and-gas industry to be more profit-oriented, more stable, less speculative, all those things that they are chasing in high-tech," Mr. Gobert said. "The fact is that these valuation problems are everywhere, and the market is pursuing the very kind of company that they criticized the energy industry for having been."

The irony is that energy prices are so high energy companies don't need the market at this point. In fact, most companies are having difficulties spending their cash flows.

But they're not planning for growth, either. The cash windfall is used to pay down debt, buy back shares and pay taxes -- not to look for new reserves. In fact, exploration has become the exception, rather than the rule.

All of this adds up to an unfavourable outcome for consumers looking for energy price relief.

Will investor sentiment change?

While the industry continues to hope for a valuation boost, particularly if the high-tech bubble continues to deflate, some analysts concede this could be a multi-year phenomenon.

So the reasons cited above that are are causing investors to look the other way have nothing to do with profitability, cash flow, general corporate health, which oil and gas companies are now well-positioned to deliver in the future.

http://www.nationalpost.com/home/story.html?f=/stories/20001002/415920.html

Unless there's an outright crisis, this industry may have to look for new ways to inspire investor attention, or risk being taken out piece by piece to become a source of easy cash for sectors that do.

-- Martin Thompson (mthom1927@aol.com), October 04, 2000