My latest post is up at RealMoney.

I think there is still quite a bit of run left in the energy bull market. That belief has led me to some good picks, such as Patterson Uti (PTEN) and Flowserve (FLS) , as well as one bad one, Frontier Oil (FTO) . My models recently brought W&T Offshore (WTI) into focus, and I’m thinking it is more likely one of the former than the latter.

The stock shows up very well in the Stock Market Beat models:

• Earnings momentum score: 1 (Positive)
• Earnings quality score: 5% (Positive)
• Price momentum score: 37% (Positive)
• Free cash flow yield: 10.6% (Positive)
• Return potential: 16.8% (Positive)

Capital expenditures are ramping up, which will hurt free cash flow in the near time. If the expenditures are as successful as those of the past, however, the cash should start flowing again after a year or two.

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Disclosure: Author is long UNITED STS OIL FD LP UNITS (USO) at time of publication.

My latest column is up at RealMoney. Here is a summary:

Government economic reports can do more than just indicate the state of the economy. Since many of the reports include industry-level data, digging deeper in the reports can help investors find specific industries to consider more closely. For example, the Bureau of Labor Statistics, which prepares the PPI report, provides detailed information on an industry basis.

Since I wrote about the PPI data in September, the pricing power has shifted to some different industries. Therefore, I thought an update would be in order.

Some of the industries that look interesting are petroleum refineries, industrial gases, computers, computer storage devices, and line-haul railroads.

Disclosure: At time of publication, William Trent has no financial position in the companies mentioned.

photo credit: Gastev

This article is a reprint of my February 19, 2008 RealMoney column

After peaking above $49 per share last year, refiner Frontier Oil (FTO) sunk to intraday lows in the $20’s last month before starting a rally on the news of Valero’s (VLO) positive outlook on the latest conference call. My biggest surprise, looking over the data for Frontier and the industry, is why it hasn’t rallied even more.

First of all, Valero indicated that “Current industry conditions are setting the stage for rebounding gasoline margins.” If true, that would be equally positive for Frontier and others. Not that I don’t believe Valero, but I thought a check of the PPI industry statistics could provide an unbiased second opinion.

Petroleum Refineries PPI, 12-Months Percent Change

Source: Bureau of Labor Statistics

Lo and behold, year/year price increases for petroleum refineries have suddenly shot straight up. If that doesn’t set the stage for rebounding margins, what will?

Hardly a week later, there was actually speculation that Valero would buy Frontier. However, according to the Reuters article, Fadel Gheit, an oil analyst with Oppenheimer & Co, also questioned the rationale behind Valero buying Frontier, especially since Valero has already sold one refinery and has said it would sell two and maybe three others.

Sold a refinery, you say? That sounds like a ripe opportunity for a comparables analysis to see how Frontier’s valuation stacks up against an arms-length transaction between industry experts. And at first glance, Frontier doesn’t come out looking so hot.

Valero’s Lima, Ohio refinery was sold last year to Canada’s Husky Energy (HSE.TO) for $2.1 billion. Lima’s 165,000 barrel per day stated capacity being quite close to Frontier’s total capacity of 162,000 barrels per day, the comparison initially looks valid. And with Frontier’s enterprise value at $3.6 billion, the implications could be that Valero’s management got ripped off, Frontier is overvalued, or the assets aren’t really comparable.

Valero is a good company, and I don’t believe its experienced managers got ripped off. The other two theses can be tested by comparing the assets. According to Husky’s road show slides, it seems Lima was something of a fixer-upper. Running well below the stated throughput, its sales and profitability were not close to those of Frontier. Taking the 2006 performance as an example, I was able to compare the valuation relative to various fundamental metrics.

Sources: Company filings, compiled by William A. Trent

Although Frontier looks more expensive on the basis of throughput or sales, its full-throttle capacity utilization has resulted in a far more efficient operation. As a result, Frontier is cheaper based on EBIT or EBITDA, which are the valuation measures most frequently used in the industry.

Of course, running at full capacity also means there is little room for further improvement other than through the commodity prices themselves. Even considering a fair valuation, that could mean there is significantly more downside risk than potential upside.

I also looked at Frontier on the basis of my favored valuation tool, its free cash flow yield. In this regard, Frontier’s yield on trailing free cash flow is about 6.2%, which is sufficiently above the yield on five-year Treasuries that I don’t need significant growth to justify a purchase. The potential rebounding margins, in other words, is a bonus.

Disclosures: None

Disclosure: Author is long UNITED STS OIL FD LP UNITS (USO) at time of publication.

The following is a reprint of my January 17, 2008 RealMoney column.

For the last several months, as most of us were complaining about the price of oil at the pump, oil drillers like Patterson-UTI (PTEN), Helmerich & Payne (HP), Grey Wolf (GW - Annual Report) and Unit Corp. (UNT) have been seeing customers push back on the rates they charge for operating rigs. Morgan Keegan analyst J. Michael Drickamer described the fourth quarter as “choppy.”

The latest PPI report backs up that assessment. Despite the rising oil price, price increases for drilling equipment have been quite constrained – in the mid single digits compared to a year ago.

Year/Year Price Change for Oil and Gas Equipment

Source: Bureau of Labor Statistics

Helmerich & Payne has survived the choppiness relatively unscathed, as its FlexRig design is more efficient than traditional rigs and is allowing for higher dayrates. Patterson has been the dog of the group, shedding nearly half its value over the last two years.

From a perfunctory look at valuation using traditional measures such as P/E or Price/Book, Helmerich & Payne and Unit look like the cheapest stocks, while Grey Wolf has the best growth potential. The momentum is clearly with HP, and I wouldn’t blame anyone for wanting to let that winner ride.

Source: Yahoo! Finance, William A. Trent

But Helmerich’s success has come at a significant cost, with capital expenditures exceeding the cash flow provided by operating activities over at least the last four years (free cash flow has been negative). It has made up this gap by piling on half a billion in new debt. Unit has been in similar straits. Thus, my preferred valuation metric of free cash flow yield (free cash flow divided by enterprise value) is rendered meaningless for these companies.  Suddenly, the lower P/E multiples start to make sense.

There are several reasons I like looking at the free cash flow yield. For one thing, doing so avoids some of the most common earnings management ploys. For another, cash represents the real money the company has available for growth, acquisitions, dividends and share repurchases.

And Patterson has been doing plenty of share repurchases. During the three months ended September 30, 2007, the company purchased 2,275,000 shares of its common stock and the Board has authorized approximately $200 million more for repurchases. These buybacks have reduced the share count from 170 million in the first nine months of 2006 to 156 million in the same period of 2007. That is a 10% gain in earnings per share for any given level of net income.

Unfortunately, the net income has been declining due to the lower rig utilization. This is not expected to reverse soon, as analysts are currently expecting revenue to decline a further 5% in 2008. That’s an improvement from the 17.6% decline in 2007, though, so value investors may want to start looking for the bottom around here. The big fear, of course, is the economy. If demand for oil slows, will prices collapse?

I don’t think so. For one thing, most commodity cycles are driven by supply rather than demand. While a reduction in economic activity may have a short term impact and keep a lid on prices, the longer-term outlook is still driven by long-term economic growth and the growth in supply. If $100 oil doesn’t bring new rigs on line, eventually the demand will catch back up to supply and the price of oil will go higher.

The latest inventory data notwithstanding, oil inventories are at a historically low level relative to sales. A downturn would allow inventories to be rebuilt to something in line with the historical average, but in the long term supply - not demand - will dictate price.

Oil Stocks: Days Sales in Inventory (Including SPR)

Source: Energy Information Administration, compiled by William A. Trent

A recent Howard Simons article on what really moves energy stocks showed that Patterson is one of the most sensitive names to crude oil prices, natural gas prices, and even the crack spread. Little of that has applied in the last two years, of course. But it might be well worth speculating that in the long term, Patterson again benefits from the higher energy prices.

Disclosure: Author is long UNITED STS OIL FD LP UNITS (USO) at time of publication.

With oil reaching new highs on the back of the oil inventory drawdown, I decided it was time to update my chart on the topic.

People who know more about energy investing than I have objected to my naive supply/demand analysis, so for now I make no attempts to draw conclusions. I’m still not convinced, but will keep my trap shut unless I can back it up with more substantial data.

Disclosure: Author is long UNITED STS OIL FD LP UNITS (USO) at time of publication.

I have frequently heard that oil inventories aren’t very important because refining capacity is the gating factor for most products. According to a recent MSNBC article:

There hasn’t been a new refinery built in the U.S. since 1976, the result of extremely tight environmental restrictions, not-in-my-back-yard community opposition, and the high cost of new construction. Used refineries currently sell for about 30 to 50 percent of the cost of building a new one, so it’s cheaper to buy an old refinery and upgrade it. Or squeeze a little more gasoline out of the refineries you already own.

Expansion of refining capacity is also made more difficult because oil refineries are a lot more complicated to build and operate than your average widget factory. For starters the raw material — crude oil — has many different properties, from thickness to sulfur content, so not all refineries can blend just any barrel of crude.

You would think that in this type of environment the refineries would be able to charge whatever they like. But recent PPI data suggests otherwise.

After a prolonged period of significant price gains, the year/year change in refinery pricing power dipped into negative territory early in the year and has been relatively flat since. Are the glory days over or is this a temporary lull? For help answering this question I turned to the recent conference calls from three of the larger companies that get most of their business from refining and marketing: Sunoco (SUN), Valero (VLO) and Holly (HOC).

First, speaking to refining margins, as we did last quarter, if you look at slides 6 to 9, we have included some detail of the realized refining margin versus our reported market benchmark for each of our geographic refining regions. Rather than walk through each slide in too much detail, let me make a few summary comments.

In the Northeast, our realized gross margin for the quarter was $12.32 a barrel, which was up about $0.75 a barrel from last year’s very strong second quarter, and was also about $0.73 a barrel better than our standard 6321 benchmark. On the input side, realized crude costs in the second quarter were $1.66 a barrel higher than our Dated Brent plus $1.25 a barrel benchmark. So still reflective of a very expensive market for light sweet crude in the Atlantic basin, but improved from the first quarter of this year….

If I can turn now to the MidContinent region, where industry downtime had a more significant market impact, our realized gross margin in the second quarter was $22.14 a barrel, up over $7 a barrel from the second quarter of last year but about $6 a barrel lower than our standard WTI based 321 benchmark. Again, on the crude side, actual crude costs were $2.17 a barrel above the WTI plus $0.75 a barrel marker, as WTI continued to be a weak relative benchmark.

Additionally, the price of Canadian syncrude, which accounts for about half of our crude slate at Toledo, traded at an increased premium to WTI during the quarter, due largely to upgrade or maintenance and other downtime among Canadian producers.

On the product side in the MidContinent, our realization was almost $4 a barrel below the benchmark. This correlation, also seen in last year’s second quarter, is fairly typical of periods when gasoline crack spreads are very strong. This is primarily because the 321 marker we use implicitly assumes that two-thirds of our MidContinent refinery production is gasoline when it actually averages more like about a half.

So let me say in summary, putting all those numbers and relationships aside, clearly second quarter refining margins were very strong by any historical measure.

(Excerpt from full SUN conference call transcript)

Paul Sankey - Deutsche Bank

Hi everyone. I think we’ve just about hit all my questions, actually, but one that’s outstanding is the way the curves have shifted. Is there any meaningful impact for you from the moves that we’ve seen to backwardation in crude markets? As a follow up, any observations you could make about the fact that crude inventories, ostensibly, are quite high in the U.S., but we’ve seen obviously very high prices. At the same time, gasoline inventory is not super loose by any means, but a cratering of the price there - any observations you can make on those would be great.

Unidentified Company Representative

Well, I’ll speak to gasoline. Gasoline pries are very low. They’re very low on a historical basis. So the decline that we’ve seen in the margins there isn’t necessarily fundamentally driven. We’re entering the season where we will start blending butanes back in, and so we know that will have an effect on the inventories. Nonetheless, we go into that period with inventories at very attractive levels relative to previous years.

On the crude, the change in the market structure just means that we’re not paid to carry it right, so what we’ll do, what we always do, is we aggressively manage the inventory to the market structure, as we’ve done on the product side.

Paul Sankey - Deutsche Bank

Right, so I’d expect to see inventories continuing to fall, but maybe the price, nevertheless, staying high.

(Excerpt from full VLO conference call transcript)

Historically high industry-wide margins, our location advantage product prices, and record production levels at our facilities fueled the best quarter in Holly’s history.

The pure gasoline and diesel prices in our markets, due to the tight supply/demand balance in our Rocky Mountain and Southwest markets, combined with lower raw material costs to create historical quarterly average gas and diesel cracks at both plants.

Higher runs at lower cost black wax crudes at Woods Cross and a widening of the discounts for sour crudes run at Navajo, compared to compressed WTI prices versus similar worldwide crudes, helped drive down our raw material costs.

Our folks ran both plants at 99%-plus utilization rate, realizing the full benefit of the 2006 midyear expansion of the Artesia refinery and enabling a virtual full capture of the great margin environment experienced during the second quarter….

Although, as in other markets, our margins have reduced substantially in July and August from the lofty levels experienced during the second quarter, we remain extremely bullish on the refining industry fundamentals.

(Excerpt from full HOC conference call transcript)

Now I’m no energy expert, but it sounds to me like there is very little wrong with refining industry fundamentals. If anyone out there can enlighten me, please do so.

Disclosure: Author is long UNITED STS OIL FD LP UNITS (USO) at time of publication.

According to its recent 10Q:

Sun Cal Energy, Inc. (the “Company”), was incorporated in the State of Nevada on July 20, 2004 under the name Host Ventures, Inc. On November 6, 2006, the Company changed its name to Sun Cal Energy, Inc. The Company is currently in the exploratory stage as defined in FASB Statement 7 with its principal activity being the exploration of mining properties for future commercial development and production.

Effective March 12, 2007, the Company acquired all of the outstanding shares of Sun Cal Energy Corporation (”SCEC”) in exchange for issuing 26,925,000 of its common stock. SCEC was incorporated in the state of Nevada on June 2, 2006, For financial reporting purposes, the acquisition was treated as a reverse acquisition whereby SCEC’s operations continue to be reported as if it had actually been the acquirer.

The company has no revenue, and just enough cash on the balance sheet to last for another nine months at the current burn rate. According to the 10Q:

Even if we are successful in obtaining equity financing to fund our exploration program, there is no assurance that we will obtain the funding necessary to pursue any advanced exploration of our properties. If we do not continue to obtain additional financing, we will be forced to abandon our properties and our plan of operations.

Still, this hasn’t stopped someone identified as Pinnacle Energy Investments from paying a whopping $900,000 to NatCon Publishing to blast mail a glowing report on the company touting its investment prospects.

The report’s author, who claims he is “becoming the greatest oil & gas stock-picker of all time” (move over, Boone Pickens and Richard Rainwater!) says the shares, now trading at $3.26, could be on their way to $55 because they have “75 million barrels of potential oil reserves x $60 per barrel of oil = $4.5 billion, or $55 per share.” Yet even ExxonMobil trades at a valuation far below its proven (let alone potential) oil reserves. And Exxon has financed its exploration program and actualy getting oil out of the ground and to market.

Anyway, if I were confident my $3.26 stock was headed to $55, I would be using my $900,000 to buy up all the shares I could, not to pay somebody to write a newsletter about it.

Disclosure: Author is long UNITED STS OIL FD LP UNITS (USO) at time of publication.

With the end of the first quarter approaching, it is time to adjust the names in my Watch Lists. I will price all the new lists as of the close on Friday, June 29.

Today I present my planned updates to the Small Cap Watch List. There was a fairly high level of turnover to the list. 12 of the 24 names from the previous run made it to the current list, which was also 24 names. Performance-wise, the list created in March has returned an unweighted average return of 2.6% through June 28, with 80% of the stocks in positive territory. All of the money-losers from the previous list fell out of consideration.
So without further ado, the names on the chopping block from the previous list are: PW Eagle (PWEI), Insteel Industries (IIIN), Allied Defense (ADG - Annual Report), Hartmarx (HMX), Parlux (PARL), Hansen Natural (HANS), FirstFed Financial (FED), Young Innovations (YDNT), ITT Educational (ESI), Rent-a-Center (RCII), Valassis (VCI), and Travelzoo (TZOO). The castaways include four of the five money losers from the previous portfolio (HMX, PARL, YDNT and TZOO) as well as the biggest gainer (ESI).
The new list is:

I will continue to track both lists on StockPickr.

Producer prices up 0.9 pct in May - Yahoo! News

Overall producer prices, which are a measure of prices before they reach the consumer, rose 4.1 percent from a year ago, the biggest year-over-year increase since June 2006. However, core producer prices were up just 1.6 percent from a year ago, and that moderate gain will likely add some relief to Federal Reserve policy-makers as they balance the risks of inflation against economic growth.

As is often the case, I am more interested in whether the data will give me specific investment ideas. Therefore, I like to look into the industry PPI data for a sense of which industries may be gaining or losing pricing power relative to market perceptions.

For example, the housing slowdown means sawmills are gathering dust. Pricing power is plummeting.

Yet the stock price for industry leader Weyerhaeuser (WY) is fairly strong.

Yes, I know that institutional investors are clamoring for timberlands.  So perhaps private equity would make a play for WY. But then again, perhaps they wouldn’t - and with all the buying that’s been going on lately I wonder who is left to buy.

Think gasoline prices are high? Actually, refinery pricing has been far lower than normal the last year. The bad news (for drivers) is that it seems to be rebounding.

A chart of Valero (VLO)  suggests the PPI may have some explanatory power. Note the stock dip late last year when PPI plunged, and the subsequent rally as pricing recovered.

I’m sticking with these two for today, as I’ve written about many of the other opportunities in prior months.

Producer prices rose 0.7 percent in April - Yahoo! News

Elevated energy costs pushed producer prices up a slightly more-than-expected 0.7 percent in April, but excluding volatile food and energy costs, prices paid at the factory gate were unchanged, a Labor Department report released on Friday showed.

As the headline (and core) numbers get widely reported, I like to dig a little deeper into the PPI report to find industries that appear to have more (or less) pricing power than normal. If the pricing power has not yet been recognized widely it can occasionally lead to some good stock picks. (All pricing power charts are from the Bureau of Labor Statistics.)
The pricing power in fruit and vegetable canning appears to be helping Del Monte gain some momentum.

Refinery margins hurt Large Cap Watch List (Track at Marketocracy) member Frontier’s (FTO) earnings. Is a turnaround in sight?

One place the pricing power theory definitely didn’t work is in industrial gas. The stocks never weakened, and now pricing power seems to be making a comeback.

Consolidation and pricing power? What’s not to like about Mid Cap Watch List (Track at Marketocracy) and Large Cap Watch List (Track at Marketocracy) member Steel Dynamics’ (STLD - Annual Report) prospects?

Pricing power for industrial valves helped me call the recent earnings pop for Curtiss Wright (CW - Annual Report).

Would you looky what’s happening to semiconductor pricing? Who would have expected that?

Well, that seems like enough for now. Back again next month.

Disclosure: William Trent has a long position in SMH.