Analyst Spotlight: Les Childress, Senior Analyst, Energy

Based in Seattle near the oil-rich Western Canadian provinces, cutting his teeth in energy research in the heart of Texas, Dutton & Associates senior analyst Les Childress certainly has positioned himself in the right places with regard to energy. Childress, who holds a B.S. degree from the University of Oregon and an M.B.A. from the Cox School of Business, Southern Methodist University, combines a deep macro understanding of the industry with an incisiveness and appreciation for getting inside difficult stories and special situations, qualities that underscore his stature as one of the leading energy analysts in the country.

How did you get involved in energy research?

When I first started in the securities industry as a junior analyst many years ago, I learned the energy industry by listening carefully to senior energy analyst Bob Phaneuf of what was then Kidder Peabody and to Allan Edgar, research director at Schneider, Bernet & Hickman in Dallas. The firm's research specialty was the independent oil and gas companies based principally in Texas and Oklahoma.

From the sell-side at Schneider, Bernet, I went to the buy-side at Composite Research and Management, a mutual fund group in Seattle, where among other groups I had coverage of the energy sector, with particular emphasis on the exploration and production companies in the S&P 500 and some of the internationals like Shell. In the mid-80s, while I was research director at Harper McLean, I began to focus on the Canadian oil and gas companies as well as smaller-cap energies in the U.S. Seattle's proximity to the Western Canadian provinces of British Columbia and Alberta allowed me to be very close, geographically, to many of the independent Canadian oil and gas companies based in Edmonton, Calgary and Vancouver.

Was there much coverage of Canadian companies?

No. Not in the U.S. at least. This was at a time when there was concern about excess energy supply and falling demand in the U.S. Prices in the 1980s were at historic lows. Canadian natural gas supply was an afterthought, even though Canadian gas was piped to the U.S. I decided to make a research visit to Calgary and Edmonton to look at the Canadian natural gas producers for the first time and concluded that Canadian energy companies were under-followed and would be a very interesting area of research coverage if and when demand recovered. In the event of a natural catastrophe or disruption of foreign supplies - i.e., OPEC - my theory was that Canada would be the swing energy supplier, so to speak, and that has been borne out, I believe, over time. However, I believed back then Canadian natural gas producers could actually become a permanent or long-term source of energy supply for the U.S. There's an enormous amount of energy in very large reservoirs of conventional oil and gas, shale, oil sands, tarsands and CBM in Canada, and U.S. policy makers as well as analysts have probably underestimated how much energy is actually there. It will require sustained higher prices ($4-5 per mcf) and even more technology to properly exploit it. Conventional and unconventional natural gas reserves in Alberta, B.C., and Saskatchewan are enormous

What companies did you cover there and in the U.S.?

Some have been acquired and others renamed. But Nexen, formerly Canadian Oxy, was a company I followed for many years. Renaissance Energy, Ranger Oil, Shell Canada and Gulf Canada were others I followed. Alberta Energy (now EnCana) is a company I've liked for a long time. Another company I liked for four or five years was West Coast Energy, a Vancouver pipeline company that was acquired by Duke Energy.

In the U.S. I don't follow many large energy companies, as they have plenty of sell side coverage, or at least they did. That has probably changed under the new research paradigm. But basically I follow the smaller oil and gas producers, the independents in the U.S. and Canada. I find them to be much more interesting than the large caps. The decline in research coverage in small-cap and mid-cap energies is still an issue and is going to present some real opportunities, I think, going forward.

Such as?

Mexco Energy (BB: MEXC) is a very small market-cap energy company I like a lot. And I'm very optimistic about their short and intermediate term prospects. They have a very unique way of adding to their reserve base. Essentially, it's a re-entry play to exploit producing zones that were never intended to be developed. They acquire existing prospects after they have had a chance to evaluate the engineering. These prospects, which have been on production for many years, are located in legacy basins and are in the last stages of their decline curve, but they are actually showing significant hydrocarbons further up the hole, but these prospects have never really been successfully exploited. Although they've been successfully tested, simply not developed. I look at Mexco as more of a special situation company inside the energy patch.

What do you mean by special situation?

Ask five analysts that question and you get five different answers. The company has an approach of adding to their reserve base that one doesn't see that much anymore because it requires a flexible, small-team approach to decisions and a focus on low-risk opportunities. A lot of the smaller oil and gas companies are really wildcat driven -- their primary focus is drilling wells in unproven areas. Mexco's special situation aspect is that they increase their reserve base by leveraging their industry contacts and looking at smaller prospects nobody else wants or knows about -- as opposed to, say, wildcat drilling. They add to their land base by being smart buyers. It is a small company with conservative management and a discipline in what they do--they farm in and out, joint venture--whatever it takes. It's a good business model. Investors should really spend some time to get to know the company beyond the financials.

Do special situations tend to be the common theme in the many areas you cover?

Yes. I think my eclectic research approach fits pretty well with what is required of a special situations analyst. Special situations, in a very broad way, include companies with emerging technology, turnarounds of companies, turnarounds of out of favor companies, companies with novel solutions or applications to address a specific market. Usually, some catalyst for change is necessary. Sometimes it's management or a product or an industry revolution. Safeco is a good example of one where a management change there made it a special situation. Sometimes special situations don't easily fit a particular sector. Examples might be Trendwest Resorts, which was a vacation time-share company that was recently acquired by Cendant, or Orphan Medical, a company that addresses small market serious illnesses. I think a special situation sometimes is a company that's a fallen angel with a lot of cash and low or no debt that's somehow dropped off radar screens of most of the investment community, particularly the sell-side research community. It could even mean an announced merger that is not fully understood or even a company with accounting issues.

My approach to research is very eclectic. I don't eliminate a company because it doesn't fit a ÏstyleÓ or have 10 years of increasing earnings. I look at growth situations, and I look at value situations with equal interest. So I go into each assignment with absolutely no bias about the company. The challenge in a special situation, no matter the market cap, is being able to determine the issues and the story. I have to make valuation judgments about a stock separate from equity market conditions because special situations often need time to fully develop. Sometimes there is no story; it's just out of favor and cheap based on traditional measures of value. But whatever it is, I somehow must properly and concisely communicate the story and put together a believable valuation case.

What other companies do you cover that you'd like to mention?

A small company like Teton Petroleum (AMEX: TPE) is drilling and producing oil in Russia, which is dominated by big oil. They're the only publicly traded U.S.-based pure play on Russian oil. Another is Amcol International (NYSE: ACO), a new company in our universe that I like a lot. It's still undervalued in my opinion. It, too, is a special situation company that doesn't fit easily into a specific industry sector. It probably fits the specialty mineral category more closely than anything else. The company exploits its bentonite reserves as well as employs technology to develop high-value products across a whole array of businesses.

Another might be Gastar Exploration (TO: YGA). It's another special situation E&P company with vast coal-bed methane reserves in the U.S. and Australia.

One company I don't cover but that fits a special situation of importance is Cheniere Energy (AMEX: LNG). It is capitalzing on the gap between short-term supply and demand. It's in an industry sub-segment -- liquidied natural gas -- that was speciifcally mentioned by Alan Greenspan in two separate days of testimony on Capital Hill regarding national energy policy. In the short term, Mr. Greenspan feels the U.S. has few options to fill that gap beside liquified natural gas.

What do you do to get to know a company and to value it?

How I value a company obviously varies. Again, I tend to be eclectic. A high P/E company, for example, doesn't bother me if it has the growth to support the price earnings multiple. I'm looking for smart and ethical management able to execute. I'm always interested in a company that's got a revolutionary product, an end market to support it typically with a very sound balance sheet and profitability. Market cap doesn't matter. I like Starbucks, a very large market-cap company, but a one-of-a-kind company, very unique. I followed it for many years. A lot of people probably wouldn't waste their time recommending such a high P/E company, and the bear case is predicated on market saturation, but I think there's plenty of growth left on a worldwide basis.

One thing I do that other analysts don't do is get too close to management. That may sound odd, but my reasoning is I don't want to be spoon-fed. I want to do my own work. I want to develop my own model and my own opinion about the company's prospects. Frankly, for far too long I think both sides of Wall Street have been spoon-fed, and willingly so, because they were or are primarily concerned with the investment banking or want a position in the next financing.

You wrote an industry report in January that was quite accurate in its bullish forecasts. What is your current view?

Nothing has fundamentally changed since then. Through mid-year the XNG is up 36%, and I'm happy for our covered companies, but it's not over. We still see higher equilibrium price levels for natural gas for the next few years due to supply constraints. Inventories of storage gas are still low, and there is no chance, in my opinion, of replenishment in time for the heating reason of 2003-2004. Canadian supply is challenged due to sharper decline curves in some of their fields. It may be that toward the end of this year we'll see the best performance of the stocks the year, but I think this year is going to be good and I think the same scenario will play out in 2004. I think demand will increase whether there is an economic recovery any time soon or not. I'm not as concerned about what oil prices do or not. I'm looking potentially down the road for oil prices and natural gas prices to decouple from one another. It's always been the theory that whatever oil prices do, so will natural gas prices, but I think going forward it will be a very different picture. There are deliverability and capacity issues in natural gas that don't affect oil. I can't think of one major energy facility in the State of California, for example, that won't be fired by natural gas. Looking further out, we have substantial gas reverses in the U.S., if you include Alaska, and in Canada. It's just that much of it is unconventional like coal-bed methane or tightsands gas and much of that supply needs better pipeline access, too, so I don't think the supply of the resource is an issue in the very long term. Prices will remain above $4.30/mcf on an average basis because the decline curve in many conventional basins is still increasing. But some of the smaller energy companies, in particular, are well positioned in unconventional gas.

How so?

These smaller companies' reserve additions don't have to come from discovery of the next 3 trillion cubic feet field. That's frankly what the very large, international companies have to do -- they have to find enormous quantities of reserves to add to their base. Which means they have to drill for oil and gas all over the globe and make major discoveries, and that gets harder and harder to do as we go through time. It requires greater technology or the willingness to invest substantial sums in Russia, for instance. Alternatively they can buy the barrels or mcf of gas on Wall Street, which has been the case recently or through the drill bit.

Large domestic companies were pushing for an energy policy that will allow them to drill in ANWR (Artic National Wildlife Refuge), but that's not going to happen, I don't believe. But I believe one thing: For the smaller oil and gas companies, it won't matter to them whether ANWR is opened up for oil and gas drilling or not. Small exploration and production companies leveraged to natural gas in an unconventional way are going to do just fine, because there are enough undeveloped domestic reserves in small and existing large fields in the lower 48 states and in Canada to keep them very busy for many years to come.