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Energy Stocks with Room to Run

With oil prices up nearly 85% from a year ago, are there any good sector plays left? Yes, especially among production and oilfield service outfits

The surge in energy prices has been so rapid and relentless—particularly since the beginning of this year —that investors may think it's too late to grab a piece of the action. Of course, they may have thought that when oil was at $80, or $100, or $125 a barrel. But now many forecasters think that oil prices could be headed higher than the low $130s reached in the past week—maybe toward $200 a barrel over the next year. On May 16, Goldman Sachs (GS) raised its average price estimate for the benchmark West Texas Intermediate grade of crude for the second half of 2008 to $141 from $107 per barrel.

There are dissenters, however, such as a Bloomberg analyst composite forecast of $97 per barrel for WTI crude. Some economists think the prices aren't sustainable, as they are being driven more by speculation among traders than a worsening supply-and-demand outlook. Mark Gilman, an analyst at the Benchmark Co. in New York, attributes the price runup to money flows from big institutional investors who have suddenly decided that commodities are a valid asset class.

One thing everyone on Wall Street can agree on: The gains in prices of energy-sector stocks have lagged far behind the underlying commodities, due to prevailing skepticism in the market that the energy price hikes can be sustained. Valuations in the energy sector are considerably below historic medians, says Rob Mackenzie, an oilfield service analyst at Friedman Billings Ramsey (FBR) in Arlington, Va.

Goldman Sachs Raising Forecasts

That's good news for investors who think fuel prices will continue to push higher and are eager to participate in those gains.

In a May 5 research note, Goldman Sachs analyst Arjun Murti raised his earnings forecasts for the integrated oil producers—the big outfits that have soup-to-nuts operations in oil exploration, production, and refining—and trimmed his estimates for refiners, although he said he'd continue to buy industry players Valero Energy (VLO) and Frontier Oil (FTO) at their current prices.

Tim Guinness, chairman and chief investment officer of Guinness Asset Management in London, pointed out that energy equities, as represented by the MSCI World Energy Index, are up just 25% since the end of June, 2007, while the WTI crude price has jumped 84%, from $70 to $130, over that same period.

Gauging the Impact of a Correction

Based on the supply-and-demand evidence, Dan Rice, who co-manages the $1.47 billion BlackRock Global Resources Fund (SSGRX), believes $100 oil is defensible but says there isn't enough information yet about demand at higher prices for him to gauge whether or not they can be sustained.

If there was a substantial decline in oil prices, integrated oil stocks would certainly get hit, probably harder than the oil price correction might warrant, given the oversized reaction in equities to significant downward moves in corresponding commodity prices in recent months, says Clay Hoes, subadviser of the $145 million AmEx Global equities Energy Fund.

But since it takes a few months for oil price hikes to flow through to earnings, integrated oil producers will certainly revise their earnings higher, which "could make for another leg of investable opportunity if prices go up," says Minneapolis-based Hoes. Any pullback in oil stocks would also scare out the momentum players—those whose invest based on price moves—giving longer-term investors the chance to buy on the dip, especially if they expect a positive earnings surprise, he says.

Refining Profit Margins Have been Hurt

The stock prices of Marathon Oil (MRO), Exxon Mobil (XOM), and ConocoPhillips (COP) haven't appreciated as much some of their smaller rivals because of their large refining and marketing businesses. Refining profit margins have suffered as oil prices have risen, says Hoes. Meanwhile, Hess (HES), Occidental Petroleum (OXY), and Brazil's Petrobras (PZE) have benefited more, as investors have recognized their production growth capabilities with new oil discoveries.

A pullback in oil prices would cause a bounce in independent refining stocks such as Valero, Frontier, and Tesoro (TSO) because it would take some pressure off refining margins and help gasoline prices ease, encouraging more road travel by American families, Hoes says.

Rice believes integrated oil stocks could move 30% to 40% higher over the next year or so, while North American land drillers such as Nabors Industries (NBR) and Patterson-UTI Energy (PTEN), which provide rigs that drill mostly for natural gas, could climb another 20% to 30%.

Schlumberger Has Room to Run

Oilfield service stocks are generally strong bets, since their revenues will continue to rise as producers put additional rigs to work in an anxious attempt to replace rapidly depleting reserves, says Rice. He thinks Schlumberger (SLB), Halliburton (HAL), Baker Hughes (BHI), Weatherford International (WFT), and Smith International (SII) are best poised to benefit from that trend, but he considers them names to hold, not necessarily to buy, at current valuations.

FBR's Mackenzie thinks that Schlumberger has much more room to run. "Supply is not going to end this cycle any time soon," he says. "There's not enough incremental supply coming in over the next two years to soften up [oil prices]."

Even greater opportunities may lie elsewhere in the broader energy sector, as the legislative focus on curbing the effects of global warming sharpens over the next few years.

Climate Security Act Would Change the Game

The prospects for stronger natural gas demand—and hence prices—look positive, especially if the game-changing Climate Security Act gets passed into law. The bill, sponsored by Senator Joseph Lieberman (D-Conn.) and Senator John Warner (D-Va.), has scant chance of even getting voted on June 2, if Republicans fail to show up to provide the required quorum of 60 Senate members. But it would stand a better chance of passing sometime next year under a Democratic President and Congress, says Hoes,

Besides helping to subsidize energy costs for those who can't afford them, the bill would establish a carbon cap-and-trade system that is expected to drive up coal prices by forcing coal-burning electric utilities and coal producers to cover the costs of reducing greenhouse gas emissions.

A spike in coal prices would spur electric utilities to turn to natural gas as an "interim solution," which would benefit not only oil and gas producers but those oilfield service companies that support them, particularly land drillers, says Hoes.

No Bubble Seen in Oil-Drilling Stocks

Mackenzie expects at least another 100 land rigs to be drilling for natural gas in North America by the end of 2008. Pressure-pumping margins won't recover to prior levels because of the continuing addition of new drilling capacity, which will hurt companies such as BJ Services (BJS). But drillers that are building fit-for-purpose rigs—more efficient and designed for horizontal drilling in shale deposits—such as Helmerich & Payne (HP) and Nabors—will continue to do well, he predicts.

Nabors is trading at just 12.5 times projected earnings over the next four quarters, vs. its historic median of a 19.5 times multiple, which suggests it's undervalued, says Mackenzie.

"There's no bubble in these stocks like there was in technology stocks 10 years ago," he says. "They're going to keep running until oil demand falls," either once a broadly viable alternative energy infrastructure is in place or, more likely, when there's a global economic contraction.

Keeping an Eye on Oil Futures

Stocks of exploration and production companies probably have the least chance for significant appreciation, with perhaps another 20% on the upside, says Rice. Of those weighted toward oil production, he likes Plains Exploration & Production (PXP) and Canada's Galleon Energy (GOa.TO) and PetroLifera Petrol (PDP.TO), while on the gas side, he favors Penn Virginia (PVA) and Southwestern Energy (SWN), based on the type of gas they're extracting and their current valuations.

While it's hard to forecast when institutional investors might start to shift their interest away from oil and into other asset classes, Gilman at the Benchmark Co. has seen a subtle movement in the pricing of oil futures in the past two weeks that could drive a change.

There's been a switch to later-dated futures contracts (i.e., for delivery several months out) being priced higher than nearby-dated (current or next-month) contracts, which means the fund managers who want to keep their positions open are paying up to roll over into the next contract month instead of rolling into cheaper contracts. So far, there's only a 14¢ spread between the July and August contracts on the New York Mercantile Exchange—pocket change compared with $130 per barrel. But if the differential widens to $3 to $5 per barrel, that will make it much more expensive to roll into the next-month contract and could prompt fund managers to close their positions, driving oil futures prices lower, says Gilman.

But lower, of course, is relative when you're looking at an 85% price surge in such a short time. Investors still appear to have a good chance to profit from the super-spike.

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