After two years of strong gains, are energy stocks running out of gas? Not at all, says Standard & Poor's (MHP ) oil analyst Tina J. Vital. "The year ahead could be a repeat of 2005," when they rose 34%, she says. New investors "won't be late to the party," agrees Evan Smith, co-manager of the $780 million U.S. Global Investors' Global Resources Fund (PSPFX ).
Why the optimism, when the chief executives of BP PLC (BP ) and Shell Oil (RD ) are fretting that oil and gas prices are inflated and bound to fall? Simply because with supplies remaining tight in the face of growing demand around the world, profits are again expected to rise sharply. In fact, Smith expects a much longer and stronger up-cycle than usual because so many oil and gas producers underinvested in their business for the past two decades and have years of catching up to do to develop new supplies.
All the same, expect a wild ride on the way to higher valuations. Energy stocks tend to overreact to short-term fluctuations in prices of oil and gas, which zig and zag according to weather reports, global politics, and economic shocks.
With that in mind, major integrated oil companies may be the safest plays. Most have single-digit price-earnings ratios and rock-solid balance sheets, and they pay nice dividends. S&P's Vital points to Chevron Corp. (CVX ), which she expects to make its numbers more reliably as it further digests the August Unocal Corp. (CVX ) acquisition. It announced a $5 billion stock buyback on Dec. 8. She also likes Exxon Mobil Corp. (XOM ), which has virtually no debt and rewards investors with ever-fatter dividends. Money manager Smith prefers Petro-Canada (PCZ ) and Brazil's Petrobrás (PBR ). Both are aggressively adding to their reserves while rivals are struggling just to replace what they produce each year.
One smart bet, some experts suggest, would be companies heavily tilted toward natural gas. A.G. Edwards & Sons Inc. (AGE ) analyst Thomas E. Covington likes mid-size players such as XTO Energy Inc. (XTO ) and EOG Resources Inc. (EOG ). They are positioned to make more than two-thirds of their revenues from natural gas and add to them faster than rivals even if gas prices moderate.
Other parts of the oil patch may offer even more upside -- with a lot more risk: companies that drill wells and supply equipment or services, for instance. They are racing to keep up with their customers, the major and independent exploration and production outfits, which are poised to boost capital spending by double-digit percentages, after hefty increases in 2005. Kurt Hallead, an analyst at RBC Capital Markets (RY ), recommends service companies Baker Hughes and Smith International (SII ) as well as drillers Rowan (RDC ) and GlobalSantaFe (GSF ) -- expecting all of them to beat current Street earnings estimates by 5% to 10% in 2006.
Global resources' Smith likes TODCO, which has recently put back to work seven drilling rigs that had been mothballed for several years. The Houston-based contract driller, which specializes in shallow-water rigs concentrated in the Gulf of Mexico, is a good example of the industry's rejuvenated earning power. Its profits jumped to $38 million as revenues climbed 35%, to $383 million, in the first nine months of 2005, up from a $32 million loss a year earlier.
TODCO's former parent, Transocean Inc. (RIG ), is another good pick. Some of its deepwater rigs are fetching $400,000 per day, double the rate of two years ago. And it is locking in long-term leases. Some analysts estimate earnings could almost triple in 2006. Still, Transocean stock sells at a rich 45 times trailing earnings after jumping 80% in the past 12 months, so investors should try to buy it on weakness.
Investors should also keep in mind that even if the next couple of years are robust, energy is a cyclical industry. Companies are investing billions in new projects that may not pay off for five or even 10 years. That calls for resilience, patience, and some diversification among the different types of energy players.
By Mark Morrison