If money is near and dear to one's heart, Boston's buyside hasn't offered the most heartfelt of welcomes to the energy sector in recent years. Sure, a portfolio manager or analyst may have agreed to a meeting—but money flows point to most portfolio managers just checking they don't have to upgrade their energy holdings beyond an underweight or neutral weighting.

The beauty of Boston finance is the depth of its research. Energy as a sector may have lagged the broader equity market, but you don't have to walk far to find an analyst or expert with an informed opinion. If the commodities are range-bound—a widely-held opinion—where are the best opportunities to be found? If natural gas is capped short-term, how far out is the recovery? And is it possible that certain E&P valuations could even grow, as some think?

Ted Davis, portfolio manager of Fidelity Investments' Select Natural Gas fund, sees opportunity in distinguishing between E&Ps that are “the haves versus the have-nots,” as well as recognizing those basins with economics that have the potential to be re-rated by Wall Street. Davis has some 10 years of experience in energy, having covered the sector while on the buyside with AllianceBernstein, before joining Fidelity last summer.

Fidelity Investments, of course, is Boston's biggest asset manager, with mutual fund assets alone totaling $1.8 trillion. While Davis collaborates with other energy team members at Fidelity, his primary responsibility is managing the Select Natural Gas Portfolio. The fund's mandate offers greater scope than its name might suggest. Its top five holdings as of April 30, 2013, were Halliburton, Schlumberger, Anadarko Petroleum, EOG Resources and National Oilwell Varco.

What has been the buyside's general view of energy in recent years?

“It's a deeply out-of-favor sector,” says Davis. “Diversified portfolio managers are more underweight energy now than at any time over the last 10 years.” But with more than two years of underperformance, and valuations in energy compressed, “energy is an interesting value opportunity right now.”

Why so out of favor? A few factors cited by Davis include concerns of a slowdown in Chinese economic growth; decelerating emerging market economies that account for much of global energy demand growth; and the draw of better performing sectors tied to the US recovery. Also, he says, there is little expectation of an uplift in commodities.

“A diversified portfolio manager is going to be concerned about being underweight energy if there's a risk of a spike in commodity prices—which I don't think very many people really believe right now,” says Davis. “And we're not an outlier. I ascribe to the idea that oil prices are range-bound for some time. I don't think oil prices are going back up to $150; I don't think oil prices are going to crash, either. And I am more or less range-bound on natural gas prices, but probably with a little bit more volatility.”

So without the benefit of commodity tailwinds, what makes for a winning formula?

“You want to identify companies that have premier positions in the best basins, that are able to grow within current cash flow so that they're not leveraging up too much, and that are exploiting relatively low-cost resources—and, as a function of that, are capable of generating returns well in excess of their cost of capital,” says Davis.

In addition, “you want to play those stocks where you think you'll have a re-rating as the quality of the asset base is better disseminated,” he says. Typically, this occurs when “the quality of assets isn't reflected in the stock price yet, as people don't quite realize how attractive the economics of a given basin may be.”

In looking at various basins—and how well they may be understood—Davis describes the Bakken as “directionally becoming more ma-

ture” and likely to show “some diminished returns and slower growth eventually” as more step-out wells are drilled away from the current core. The Eagle Ford is viewed as less mature than the Bakken, with economics “continuing to improve on a steady basis as they fine-tune their completions and become more efficient with pad drilling.”

The Niobrara is a play that Davis finds “very interesting right now.” It is still “a little under the radar,” he says, “and I like things that are underappreciated and looking like they are getting better.” He cites the opportunity set of multiple Niobrara benches, as well as the Codell formation, and the expansion of the play to the north and east by Noble Energy and others. If the Eagle Ford was a focal point a year ago, “I think this year is the Niobrara's year.”

The Permian Basin is “also very interesting,” says Davis, describing it as developing probably a step behind the Niobrara. The attraction lies in the basin's multiple benches and its assortment of sub-plays. Davis acknowledges the leadership of Pioneer Natural Resources, among other companies, in advancing the area in the Midland Basin, and Cimarex Energy's lead in the Delaware Basin.

“There is a lot of evaluation going on right now,” observes Davis. “I'm spending a lot of time trying to find out who's got the right acreage and who's got the least appreciated acreage, and where the best economics are in all the sub-plays. Over the next two years there is going to be a kind of unveiling of a very mature basin that happens to have a whole lot more economic oil at current prices.”

On the natural gas side, Davis sees gas-directed drilling possibly coming back if prices move towards $5 per thousand cubic feet (Mcf)—and only if prices stay at that level for a while. With most of the Marcellus play economic at $4 per Mcf and lower—and in some parts at prices markedly lower—any increase in drilling would likely be directed to hybrid plays benefiting from liquids economics. Given the size of the resource base, prospects of a near-term price spike in natural gas are considered slim.

“There's a lot of gas that's economic north of $5 in this country, especially with service costs coming down right now,” says Davis. “And companies haven't even started to really drill out some of the low-cost Canadian resources, like the Montney.”

Best rocks

The prolific nature of the Marcellus play forms the backbone of the energy strategy drawn up by Dan Rice following his move to GRT Capital Partners early this year. For over 25 years, Rice was primarily responsible for managing the BlackRock Energy & Resources Fund (and its predecessor funds prior to Black-Rock's purchase of State Street Research & Management). Rice joined GRT Capital as lead portfolio manager of its energy strategy in January of 2013.

Rice runs two funds at GRT Capital. One is a long-only fund for institutional accounts with about $400 million in assets; the other is a hedge fund with a long bias that is expected to be capped at $100 million in assets. Portfolio composition is split roughly 75% E&P, 15% coal and 10% oilfield service. Of the E&P segment, about 80% is comprised of shale “manufacturing plays.”

Rice says the major theme of his portfolio is “best rocks.” In essence, as areas with best rocks move into a manufacturing phase—with acreage held, infrastructure in place and four or five wells drilled per pad—they will be capable of generating 30% to 50% free cash flow (operating cash flow less capex). And in turn, as producers recycle the cash flow back into the area, they will grow organically at 20% to 25% a year.

“I've never seen it before in the 30 or so years I've been covering energy,” observes Rice.

“Historically, with conventional plays, you had to put 90% to 95% of your cash flow back into the ground to maintain production. And when the industry recycled its 5% to 10% free cash flow, it would allow companies to grow just 2% to 3% a year, which is why the industry always traded at a discount to multiples accorded to the general market.

“But when you have 30% to 50% free cash, and you're able to grow organically at 20% to 25%—that's a different animal.”

Rice ranks his four best-rock areas as: the northeast Marcellus dry gas; southwest Marcellus wet gas; southwest Marcellus dry gas; and—although he cautions it is in the early stages of evaluation—the southern Utica play. Not surprisingly, given the above areas, his favored names are Range Resources, EQT Resources, Cabot Oil & Gas Corp., Gulfport Energy Corp. and Consol Energy Inc.

He argues that there will be a re-evaluation of best-rock plays over the next two years as a fuller understanding is gained of both the sustainability of growth—inventories of more than 10 years of drilling are not the exception—as well as the magnitude of margins possible in pure manufacturing mode. Coupled with no need of outside capital, this should over time allow best-rock E&Ps to trade at multiples well beyond their 8- to-10x historical ratio of enterprise value (EV) to EBITDA (earnings before interest, depreciation and amortization).

What kind of multiples could they attain?

Rice anticipates the best-rock names could trade up to an EV/EBITDA multiple as high as 15- to 18 times, driven by growth stock managers recognizing the group as one of the fastest-growing sectors of the economy, and the EV/EBITDA multiple expanding more in line with the rate of growth in production. And even without multiple expansion, the stocks should deliver at minimum 25% appreciation per year simply if the underlying volume growth continues at a 25% annual rate.

Although bullish on natural gas, Rice says his ranking of plays is based on revenue per day per well, without preference for commodity. He uses a flat commodity price deck going forward with natural gas held at $4 per Mcf and West Texas Intermediate (WTI) at $90 per barrel.

“I don't need a heroic gas price assumption to make the investment case,” says Rice. With production growth of 25% per year for the next two years, he sees 50% or more upside. “But if you do get a tailwind on the stocks from natural gas, then you've got 100% plus upside.”

And Rice does see much brighter days ahead for natural gas.

“We're in the bullish camp for natural gas, not necessarily near term, but out a couple of years, when we see prices between $5 and $6 per Mcf,” he says. “And if you give me three years, the confidence factor goes up dramatically, because then we're into the petrochemical plants coming onstream and then the liquefied natural gas (LNG) facilities.”

Part of Rice's optimism on gas prices stems from diminished competition from coal. Such has been the dramatic downsizing that Central Appalachian coal producers, for example, have lowered capacity to roughly 80 million tons from 180 million tons per year—a cut that can't easily be reversed. “In a $4.50-gas world, coal demand will be 180 million tons, but there's only 80 million tons available. When the market sees that, that's what gets gas prices to $6.”

As for stocks biased to oil, Rice leans towards a second-best group achieving volume growth of about 15% (versus 25% for best-rock names) that operate in the core areas of the Eagle Ford, Bakken and Niobrara. Here Rice says the 15% growth rate that the stock market currently rewards with an EV/EBITDA multiple of 7x is likely to rise to a 10x. In the Permian, Pioneer Natural Resources represents a quandary for Rice: “Is it a 15% internal grower or is it 25%?—I don't know the answer yet.”

Rice says longer times for wells to pay out in the latter areas—two to three years versus nine-month payouts in best-rock wells—account for the attractive, but somewhat slower internal growth rates and, in turn, more muted valuation uplift. “But versus anything historical, these are great numbers.”

Quality bias

Taking a longer-term view of an E&P's prospects is important for Kate Jackson, MFS Investment Management's energy equity research analyst, who assumed responsibility for the sector in the fall of 2010. Since then, energy has had consecutive years of underperformance versus the broader market, and it's necessarily been “a stock-picker's market”—a circumstance she sees continuing.

Jackson avows a “strong quality bias” in her research and says she tends to look for high-quality, long-duration stocks in the energy sector. She works primarily with mid- and small-cap funds that have both growth and value orientations. The funds tend to carry a market weighting in energy, with changes being aligned more with whether the energy stance is skewed to the offense or defense.

In the Marcellus, longstanding positions held by MFS have been Cabot Oil & Gas, EQT Resources and Range Resources. Jackson looks for E&Ps that have “large concentrated acreage positions in plays with great economics,” and those three holdings fit the bill. She estimates certain parts of the Marcellus can offer internal rates of return approaching 60% at $3 per Mcf, “and you have the potential to juice the returns further if gas climbs to $4 to $5.”

With the luxury of being able to look out to 2016 and 2017 in valuing companies, Jackson says the long-duration growth stocks in the Marcellus could well earn continued higher valuations versus their lower growth E&P peers.

“The market continues to give a premium for quality and duration of growth, and I would not be surprised to see that premium widen,” she says. “I'm still surprised when I hear companies being criticized for being so expensive on near-term multiples, when if you look out three or four years those companies that look expensive today are probably in line. And if you look out three or four years, they still have inventory left and they can sustain that high growth.”

On prospects for natural gas pricing, Jackson is encouraged by the negligible amount of rigs put back to work even as natural gas prices rose above $4 earlier in the year. In addition to gas production lagging the rig count by six to nine months, she notes that much depends on the location of the rigs and the productivity of wells in that area—for example, the prolific northeast Marcellus. “It's much more a question of where the rigs are versus what the absolute rig count is.”

In oil, Jackson describes as “compelling” the case for players in Wattenberg Field in the Niobrara. In addition to multiple stacked pays—Niobrara A, B and C, plus the Codell—Jackson sees upside from potentially increasing type curves, downspacing options, improved well engineering and better lateral placement. With four zones to test, some early Codell wells have come in better than the main Niobrara B targets. And with results pending from the Niobrara C and A zones, “you've got several call options there.”

In the Permian—a basin that Jackson says she wasn't excited about six months ago—similar work is under way to evaluate the economics of developing the stacked pays. “I think there might be some dark horses in the play,” says Jackson, preferring to avoid naming companies. “What strikes me about the Permian is you have stocks that have been under the radar for years, and then you realize that they have a big Permian position that we thought wasn't worth very much.”

Regarding the Bakken, she notes “well costs are coming down, the engineering is getting better, and infrastructure is in place so that basin differentials have improved. But a lot of the shareholder value got priced in early on, as the wells' estimated ultimate recoveries (EURs) were going up.

“I wouldn't call it a mature basin, but it's probably the basin that has relatively less to do in terms of incremental engineering and further optimization.”

Organic growth

Shaji John, vice president with Pioneer Investments in Boston, sees plenty of opportunity in energy—enough to give the sector a materially overweight position relative to his fund's benchmark. John is a co-manager of the Pioneer Select Mid Cap Growth Fund, which currently carries an energy position that is more than 50% overweight relative to the Russell Midcap Growth Index's energy weighting. John is responsible for the fund's energy, basic materials, industrials and utilities sectors. Portfolio holdings vary in market capitalization from $1 billion up to $20 billion.

John is attracted to energy because of its “tremendous organic growth capability” in the wake of the horizontal-drilling/hydraulic-fracturing revolution, which he describes as a “game-changer.” Like Rice, John foresees that certain E&Ps will have such strong cash-flow growth that they will start to generate free cash flow in coming years—in stark contrast to historical E&P patterns—and implement dividend policies and even stock-repurchase programs.

In terms of strategy, John has sought out producers with the most favorable combination of low costs and prolific rock. This approach led to ownership of Cabot Oil & Gas in the dry-gas Marcellus—the fund's largest position and one he has held for more than two years—and Range Resources in the wet Marcellus. The fund also owns Gulfport Energy Corp. in the Utica, Pioneer Natural Resources in the Permian and several players in the Niobrara: Noble Energy, PDC Energy, Bonanza Creek Energy and Bill Barrett Resources.

In addition, the fund owns non-E&P stocks that are plays on the broader US energy renaissance. For example, fund holdings include Westlake Chemical and LyondellBasell because of the benefits they can derive from the availability of markedly cheaper ethane and propane, used as feedstocks, in the US In the engineering and construction field, the fund owns CB&I, a play on the expansion of ethylene cracker and LNG capacity in North America using cheap ethane and natural gas.

John zeroes in on the fund's No. 1 position, Cabot, to illustrate his approach. With 200,000 net acres in the most prolific part of the Marcellus, Cabot already enjoys an advantage in that its operations are sustainable down to a $2 per Mcf gas price, he says. Moreover, management is not content merely with its ongoing efforts to improve EURs and operating efficiencies and to test for upside from denser downspacing options; it is vigilant in executing across the board, including solidifying take-away capacity well into the future.

John points to the Constitution pipeline as an example. The project is due to be in service towards the end of first-quarter 2015, allowing Cabot to move about 30% of its Marcellus volumes to higher-priced markets in the Northeast that typically command a premium to Nymex prices of about $1.

“This company is not satisfied with just having a great resource base,” says John. “They're looking ahead. They're saying, 'We need to execute beyond that.' The management team is as important a factor for me as having a company basking in a great resource base.”

On the oil side, John sees the potential for substantial upside beyond the conservative assumptions provided by Pioneer Natural Resources on its Midland Basin Wolf-camp play. Average EURs of 575,000 barrels of oil equivalent (BOE) and 500,000 BOE in the south and north areas of the play, respectively, are viewed as overly conservative, especially with recent northern well results suggesting EURs of 650,000 to 750,000 BOE or more. He also thinks spacing of one well every 140 acres is likely to get tighter.

Recovery factors are also trending higher in oil plays, as in Wattenberg Field, observes John. With 74 million BOE of original oil in place (OOIP) per section, development on 40-acre spacing assuming an EUR of 335,000 BOE per well translates into a 7% recovery factor—a metric Noble Energy expects to move higher. In the Midland Basin, by contrast, a recovery factor of 4%, assuming 140-acre spacing and even using an EUR of 650,000 BOE, was still “very low,” he says.

It is Johns' broader view of valuations in the industrial sector that supports his belief in the long-term appeal of certain E&Ps. While Cabot may now look “rather rich” versus its E&P peers, he says, forward valuations as compared to companies in the industrial sector are favorable, as Cabot generates growing amounts of free cash flow. Cabot's investor presentation shows a 2014 free-cash-flow estimate of $376 million, based on consensus estimates of Cabot cash flow and capex, and John says estimates of more than $1 billion of free cash flow in the 2014-2015 time frame are likely understated.

“This is not operating cash flow, this is free cash flow,” he says, suggesting that select E&Ps will be rewarded with higher valuations as their free cash flow grows and volatility versus the rest of the market, or beta, declines. “Cabot is starting to show less beta than in the past, because it happens to be the first company that is generating tremendous free cash flow,” says John. “As these companies start to get slightly more mature and you worry less about the funding gap, the valuations should improve.”

Price box for oil

Robin Wehbe heads up the global natural resources team for The Boston Co. and is lead portfolio manager/senior analyst for several resource-specific sector funds at the firm. The team has been an ardent advocate of an “energy revolution” in the US, authoring a white paper last year titled “The Death of Peak Oil” as a theory. Its wider research points to a “very constructive” view on the global economy, with growth in US gross domestic product (GDP) expected to recover to a 3% rate or higher.

Wehbe believes oil prices are range-bound—“we're in a price box for oil” is his expression—for several reasons, including the prospect of greater fuel economy.

“A lot of the new supply is unfortunately high cost, and so the downside is supported by high-cost oil supply from the US At the same time, upside is limited by the sheer volume of the US supply, which can now grow faster than demand growth in the Western world, given maturing demand from the US consumer,” says Wehbe. “We like to say that $80 to $100 per barrel for WTI is probably a good center of gravity for the commodity.”

One reason cited for maturing US oil demand is the expected impact of the Corporate Average Fuel Economy (CAFE) standards. With the average fuel efficiency to be raised to the equivalent of 35.5 miles per gallon by 2015, and then 54.5 miles per gallon by 2025, this would have the effect of lowering annual US oil demand by 500,00 barrels per day, assuming constant miles being driven, according to Wehbe.

While his team invests across several energy subsectors, including E&P and refiners, they have their biggest commitment in the oilfield-service and capital-equipment sector. Among E&Ps, there may be varying success depending on quantity and quality of acreage. “But for those guys to grow volumes, they have to go out and find it, drill it and produce it, and there is an energy service company for every piece of that value chain. As a team, we think the service companies look more interesting.”

He cites estimates that in 2013, the oilfield-service and capital-equipment sector is expected to benefit from some $670 billion in global upstream E&P spending, while spending in 2014 is likely to comfortably cross the $700-billion mark. Wehbe likes the sector for its repeatable sales of high-ticket consumable products. In particular, he favors the offshore market, where use of higher technology tends to result in higher barriers to entry and thus superior returns to those with that technology.

In the E&P sector, Wehbe favors companies with low cost structures that are not chasing growth for growth's sake. “We want to see companies that are focused on returns and cash flow, and hopefully their growth is a healthy byproduct of that. We need to know that the inventory of wells to drill is quality, which means it's a known resource and means it's a long runway.” And having infrastructure investments in place is key, he emphasizes.

“Infrastructure is absolutely mission critical.

You need to get your product to market, and you need to do it in a fashion that can keep up with pricing, because we're not riding a commodity wave.”

Wehbe is cautious about natural gas in the short term. “As long as we have this rapid growth of liquids production throwing off associated gas, we're going to be in for a difficult time with the gas market,” he says. “But if there is a manufacturing renaissance in North America, industry is going to keep buying the gas to fuel it. Even without a lift in gas prices, the guys sitting on good assets are going to be making plenty of money.”

Long-term perspective

Jeremy Javidi, CFA, is lead portfolio manager and responsible for energy for Columbia Management's Small Cap Value Fund I, a fund with $2.2 billion in assets that he has co-managed for 10 years. He looks for stocks with strong balance sheets, that can generate strong free cash flow, and that are trading at a discount to their intrinsic value. The value-oriented fund has a long-term perspective, with the weighted average holding period for its stock positions at about 3.5 years.

Relative to its benchmark, which is the Russell 2000 Value Index, the Columbia fund has about a 20% overweight position in energy, but Javidi explains this mainly reflects the breadth of the opportunity set that he finds arising in the sector.

“Our overall portfolio weightings are essentially the aggregate of the opportunity set that we are able to find in any one sector. Right now, we maintain an overweight in energy, and that is basically because we have been able to identify a significant number of opportunities at the individual stock level.”

Javidi points out internal rates of return earned in the E&P sector typically outpace those in industrial sector companies, for example. As the E&P sector moves to greater pad drilling and more of a manufacturing process, rates of return can range from 30% to approaching 100%. “But when I look at a lot of industrial companies, they are generally looking for a 10% to 15% rate of return on capex, which is only slightly greater than their cost of capital.”

Where does Javidi see opportunities from a value perspective?

He has found them in three different clusters of energy companies. In a subset offering “natural gas optionality,” holdings include E&Ps Bill Barrett, Forest Oil Corp. and Rex Energy, as well as driller Patterson-UTI Energy Inc. In offshore E&P, positions include Energy XXI, Stone Energy Corp. and Vaalco Energy Inc., plus offshore service provider Tidewater Inc. Stocks in the seismic service segment include Dawson Geophysical Co. and TGC Industries Inc.

Typically, these are stocks with less-well-appreciated facets to their businesses that are often overlooked by the market.

For example, in addition to offering a call on natural gas, Bill Barrett is leveraged to the Niobrara play through its 43,000-net-acre Northeast Wattenberg position, where it has announced several positive well results and plans a program of 65 gross/42 net operated wells this year. Rex Energy is levered to the Marcellus and Utica plays, in addition to potentially reinvigorating its oil assets in the Illinois Basin.

Patterson has a fleet of modern APEX rigs working under long-term contracts, predominantly drilling for oil, and pressure pumping operations centered in the Eagle Ford and Marcellus. In the event of a recovery in natural gas prices to $4.50 or higher, Patterson has spare capacity in mechanical rigs that could be deployed. The company has frequently implemented stock buybacks, and has $50 million still available under its current authorization. Based on a 2013 EV/EBITDA valuation of 4x, the company was trading at near a “private company valuation,” according to energy research firm Tudor Pickering Holt & Co.

In the offshore, valuations have been notoriously low. For example, valuations for Energy XXI and for Stone Energy have fallen below net asset values using a PV-10 (present value discounted at 10%) value of proved reserves only. Meanwhile, multiples have been among the lowest in the industry at about 3x EV/EBITDA, or lower, based on analyst estimates for 2013. Energy XXI has put in place a $250-million buyback. Both companies have adequate cash flow to implement robust exploration programs.

Javidi says his value investment style does not depend on having a near-term “kicker.” Because his expected investment horizon is three to five years, buying companies that can earn returns in excess of their cost of capital over the medium to long term in itself offers an investment profile that is “inherently catalyst-rich.” And with growth in global GDP translating into rising demand for oil, being overweight energy at attractive valuations makes sense. “Energy is just a cheap beta right now.”