ENERGY: ADDING VALUE BY PIONEERING IN THE OIL PATCH

Views on Oil and Gas

At the Nicholas Funds, we believe the oil and gas industry offers some attractive investment prospects.  Various drivers, both domestic and international, argue for a sustainable period of relatively high commodity prices.  Domestically, the outlook for natural gas is favorable; strong demand in tandem with decreasing supply has driven gas prices well above historical norms.  Healthy industrial, commercial, and residential demand for natural gas is combined with natural gas production in the lower 48 states that most likely peaked in 2001.  Internationally, geopolitical and economic factors are causing oil prices to be at levels not seen since the first Gulf War.  OPEC has shown an abnormal amount of discipline over the past few years, partially driven in our opinion by declining spare production capacity in most of the OPEC nations.  Mid-$30 oil prices should justify cheating, or at least expanding production quotas, yet the lack of significant production increases seems to point to an inability to do so!  This factor strengthens our bullish thesis on crude prices.

The following two charts illustrate the price patterns of crude oil and natural gas over the past several years.

Translating our Energy Views into a Value-Added Technique

However, at the Nicholas Funds, we can’t expect our bullishness on energy prices to single-handedly allow us to add value for our shareholders.  Commodity prices, while important, are only one piece of the puzzle in energy investing.  We feel that, too often, investing in energy stocks entails wild volatility. Many investors in the energy space treat the stocks as pure trading vehicles, using any oil or gas price blip, or the latest weekly inventory number, as an excuse to rapidly churn in and out of these stocks.  At Nicholas, our philosophy is to look for high-quality, solidly-managed growth companies that we can be comfortable holding for the long-term. On the surface, one might ask – given our philosophy, why would we participate in a sector that is dominated by high cyclicality and significant volatility?  In response to this, we believe that we can add value in this sector by playing the role of the contrarian – utilizing our in-depth fundamental analysis to gain an edge in a sector where in-depth fundamental analysis is often a rarity.

We believe that some of our best opportunities in the energy sector are in the smaller and/or undercovered companies that are neglected by most of Wall Street.  Our hands-on approach to research can pay off the most when no one else seems to be taking the time to dig around in the trenches.  In these cases, we believe we can counteract some of the cyclicality in the sector because many of these smaller companies will trade more in line with fundamental changes in their operations, rather than merely moving in lock-step with commodity prices.

As a result of this approach, we are often one of the initial institutional investors to begin acquiring these stocks, and at valuations we believe are quite attractive.

Pioneering in the Oil Patch – The Analysis in Practice

Here are some examples of the hands-on analysis we perform on these companies:

Harvest Natural Resources: Harvest Natural Resources is an oil and gas production company with the majority of its operations in Venezuela.  While we believe there is immense opportunity in that country, there are numerous risks present as well.  To get a better handle on these risks, we spent several days in Venezuela, meeting with government officials and leaders of industry, personally visiting all of Harvest’s oil and gas fields, and meeting with dozens of employees from the CEO, CFO and Chairman of the Board to the “roughnecks” in the field.  Our meeting with the Vice President of the Venezuelan Assembly (equivalent to the Speaker of the House in the United States) shed a lot of light on the government’s priority to encourage foreign investment into the Venezuelan oil industry.  Meeting with the President of Banco Mercantil, Venezuela’s largest bank, helped us to get a clearer picture of the financial and economic conditions in Venezuela.  Furthermore, interacting with Harvest’s employees gave us a much better understanding of the company itself, because in the oil and gas industry, a company really boils down to the quality, motivation, and talent of its employees.

Below is a chart detailing performance of Harvest’s stock since we started accumulating in September of 2002.

Denbury Resources:  Denbury Resources is a small-cap oil and gas production company that primarily produces oil in Mississippi, and focuses on a very unique strategy of carbon dioxide enhanced oil recovery.  Denbury owns the rights to an enormous underground dome (Jackson Dome) full of naturally occurring CO2 in Mississippi, and operates a pipeline system that transports the CO2 to a number of its oilfields in other parts of the state.  The injection of CO2 into the oilfields is a novel way to increase oil extraction out of mature fields.  Not only did we spend a couple of days meeting with Denbury’s management and touring their CO2 operations in Mississippi, but we also took things a step further by analyzing CO2 enhanced oil recovery as it pertained to other companies.  We visited Kinder Morgan’s giant SACROC oilfield in West Texas, a prime example of CO2 injection, and also have spent time with the management of NATCO Group, a company that provides membrane systems that are instrumental in the injection process.  Once we developed an understanding of the CO2 injection process (confirming from third parties what we heard from Denbury), we had the comfort level we needed to invest in Denbury Resources.

Below is a chart depicting the stock price performance of Denbury Resources, since Nicholas began accumulating shares in late October of 2003.

Contango Oil and Gas:  Contango Oil and Gas is a very unique little energy company that really exemplifies our approach to investing in energy stocks.  Contango is vastly under the radar screen of Wall Street, mainly due to its very small size.  However, we believe it has vast potential.  Not only does it produce gas and oil onshore in Texas, but also has low-risk exposure to dozens of high potential offshore wells in the deep shelf and deepwater of the Gulf of Mexico.  To cap things off, Contango also has a stake in an exciting liquefied natural gas (LNG) terminal proposed to be built in Freeport, Texas.  Given our view on the domestic natural gas situation, we see tremendous potential for LNG in the United States, and believe that Contango is well-positioned to capitalize on the opportunity.  We’ve spent the time to get to know management well, visiting their offices in Houston, and in fact have met with or spoken to every single one of Contango’s employees.

Following is a representation of Contango’s performance since we began accumulating shares in early September of 2003.

Conclusion

While we at the Nicholas Funds are currently constructive on the prospects for oil and gas prices, we do not put too much emphasis on predicting commodity prices.  Instead, we have structured an approach to energy investing that we feel will allow us to add value during any stage of the energy cycle.  We will continue our hands-on approach to fundamental analysis, and will keep digging in the trenches – there’s no better way to really figure out these companies than meeting one-on-one with management and getting our hands dirty with Venezuelan crude and our boots filled with West Texas dust.