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Patrick McKeough is one of Canada’s top safe-money advisors. The Wall Street Journal, Forbes and The Hulbert Financial Digest have all recognized his ability to find stocks with hidden value. He is editor and publisher of The Successful Investor, Stock Pickers Digest, Wall Street Stock Forecaster and Canadian Wealth Advisor; inventor of the Quick Profit/Value System and the ValuVesting System™. A best-selling Canadian author, he wrote Riding the Bull, the book that predicted the 1990s stock-market boom.

How to profit in volatile resources

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The Resources and Commodities sector of the economy has gone through a once-in-a-generation price boom in the past few years. Investors generally expect booming demand from India and China to keep prices high. However, this sector has always been highly volatile and subject to sudden downdrafts. We feel the best way to cut your resource risk is to stick with high-quality companies such as these three.

They all have a broad range of income streams, which helps them stay profitable, even if prices fall. Hidden or little appreciated assets should fuel their growth for decades. They also have the flexibility to adjust production in the face of lower prices, which conserves cash for dividends and stock repurchases.

CHEVRON CORP. $70 (New York symbol CVX; Conservative Growth Portfolio, Resources sector; Shares outstanding: 2.2 billion; Market cap: $154.0 billion; WSSF Rating: Above average) is the second-largest integrated oil company in the United States, after ExxonMobil Corp.

The company produces oil and natural gas in 35 countries, and refines oil into gasoline and petrochemical products. It also operates 26,500 gas stations. The U.S. accounts for 30% of Chevron’s total production.

In the three months ended December 31, 2006, Chevron’s earnings fell 6.5% to $1.74 a share (total $3.8 billion) from $1.86 a share ($4.1 billion) a year earlier. Revenue fell 11.3%, to $47.7 billion from $53.8 billion.

Although oil prices and production rose, natural gas prices in the U.S. fell 42% as production returned to normal levels following the disruption caused by Hurricane Katrina in 2005.

Chevron is doing a good job replacing its production with new reserves. The company spent $16.6 billion on capital expenditures and exploration in 2006, up 49.5% from $11.1 billion in 2005. Part of that stems from Chevron’s acquisition of Unocal in 2005.

Chevron will probably offset these costs by selling between $1 billion to $3 billion of older assets.

About 30% of Chevron’s new reserves come from its oil sands operation in Canada. The tar-like oil sands require much more energy to extract and refine than regular crude. But these fields are the second-largest oil deposits in the world after Saudi Arabia, and shouldlast for decades.

Chevron also owns half of the big Jack 2 offshore oilfield in the Gulf of Mexico. However, a lack of deep-water drilling rigs has slowed development.

The company’s strong balance sheet will help it fund these projects. It has $11.4 billion ($5.20 a share) in cash and $9.8 billion in debt (14% of stockholders’ equity).

Chevron spent $5 billion on share buybacks in 2006, but it may cut future repurchases as its exploration costs grow.

However, it will probably raise its $2.08 dividend, which yields 3.0%. The stock now trades at just 9.5 times its forecast 2007 profit of $7.36 a share, and at 6.4 times cash flow of $10.95 a share.

Chevron is a buy.

ENCANA CORP. $48 (New York symbol ECA; Conservative Growth Portfolio, Resources sector; Shares outstanding: 772.0 million; Market cap: $37.1 billion; WSSF Rating: Average) is a leading Canadian energy company. Natural gas accounts for 80% of its production, while oil supplies the remaining 20%.

In the three months ended December 31, 2006, lower gas prices cut EnCana’s profit 42.5%, to $0.84 a share from $1.46 a year earlier. These figures exclude unusual items such as gains on the sale of assets and hedging gains. Cash flow per share fell 24.3%, to $2.18 from $2.88, while revenue fell 37.3%, to $3.7 billion from $5.9 billion.

In the past few years, EnCana has sold its overseas assets to focus on unconventional properties in North America, such as early-stage gas fields and the oil sands in Alberta.

These assets cost more to develop, at least initially, but should last longer than regular properties. Focusing on North America also cuts EnCana’s political risk.

Extracting oil from the oil sands is much more costly than from regular oil wells. EnCana aims to increase its oil sands production 10-fold over the next decade. Two new joint ventures with ConocoPhillips — one in Canada and one in the United States — will help cut its costs. The Canadian operation will operate the oil sands, while the American venture will operate refineries in Illinois and Texas that will convert heavy oil into gasoline.

The two ventures will operate independently; the Canadian operation will sell its production at the highest price it can get, and the U.S. refineries will buy heavy oil as cheaply as possible.

Despite the cost savings from these ventures, shortages of materials and labor have hindered EnCana’s expansion plans.

Consequently, EnCana will cut capital spending in 2007 by 6.5%. It is using the savings to double its quarterly dividend to $0.20 a share. The new annual rate of $0.80 yields 1.7%.

The company should earn $4.30 a share in 2007, and it trades at just 11.2 times that figure. It’s also cheap at just 4.0 times its projected cash flow of $11.93 a share.

EnCana is a buy.

WEYERHAEUSER CO. $84 (New York symbol WY; Conservative Growth Portfolio, Resources sector; Shares outstanding: 236.5 million; Market cap: $19.9 billion; WSSF Rating: Average) is a leading forest products company, with 6.4 million acres of timberland in the United States, and 30 million acres of leased timberland in Canada. It makes a wide variety of wood products for the construction industry, as well as cardboard packaging.

In August 2006, Weyerhaeuser agreed to merge its fine-paper operations with Canadian forest products company Domtar Inc. Weyerhaeuser will own 55% of the new company, which will be North America’s largest producer of uncoated paper. Domtar will also pay Weyerhaeuser $1.35 billion.

Weyerhaeuser is giving its investors the choice of keeping their Weyerhaeuser shares, or exchanging them for stock in the new company.

Stockholders can tender all or part of their shares, subject to a limit of 11.1442 shares of Domtar per Weyerhaeuser share. Weyerhaeuser has designed the offer so that its investors will get to acquire Domtar stock at a 10% discount. The IRS will treat the swap as a tax-deferred exchange.

We feel the deal makes sense. Demand for fine paper is falling as more companies use the Internet to distribute annual reports, catalogs and other documents. The merger will give this new company the size it needs to compete with larger paper producers. Domtar is more risky than Weyerhaeuser, and does not pay a dividend, so we recommend only aggressive investors accept the offer.

Meanwhile, Weyerhaeuser earned $1.88 a share (total $450 million) in the fourth quarter of 2006, thanks to a $227 million after-tax refund of duties paid on lumber imported from Canada and a $43 million gain on the sale of an operation. It lost $0.86 a share ($211 million) a year earlier, mostly due to restructuring charges. Revenue slipped to $5.66 billion from $5.7 billion.

The stock has gained 30% since the Domtar announcement, and now trades at 25.8 times the $3.25 a share it will probably earn in 2007. That seems high, but Weyerhaeuser’s timberlands could be worth $50 per Weyerhaeuser share if it decides to spin them off. The $2.40 dividend yields 2.9%.

Weyerhaeuser is a buy.


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