Deals Flower in the Oil Patch

Fears of slower growth have pulled energy stocks down. But Andarko's $21 billion acquisition bid and other deals show fundamentals are strong

It's been a sure-fire investment strategy ever since the giant bull market in energy stocks started in 2003: Buy shares on any major pullback and ride them higher. But a lot of new negative analysis has dragged these stocks much lower in recent weeks, with some issues down 20% to 30% from their recent highs. Is buy-the-dip still a winning formula? Probably so.

Sure, there are plenty of reasons to wring your hands. Sky-high crude prices have taken a bite out of worldwide demand growth. The industry's push to bring on new capacity is starting to work, producing more raw materials and products. Inventories are high, which can drive prices down suddenly—just look at the plunge in natural gas prices. The industry is facing cost pressure for everything from drilling rigs to engineers. Plus, the Federal Reserve may overshoot with its the interest-rate hikes and throw the U.S. economy into a downturn, which would curtail buying in the No. 1 consuming country.


  Still, the glass looks half full for many energy stocks. Profits this year and next have so much momentum and liquidity is so great that even a large downturn in oil prices won't put extreme financial pressure on most parts of the industry. For most big companies, that means dividends are secure and large stock buybacks will likely continue to cushion any downside risk. Stocks of smaller outfits have another safety net: If they fall very far they become candidates for buyouts or takeovers by their rivals.

Just today (June 23) Anadarko Petroleum (APC) announced plans to acquire both Kerr-McGee (KMG) and Western Gas Resources (WGR) in deals totaling more than $20 billion. Energy Partners Ltd. (EPL) agreed to buy another Louisiana-based exploration and production company, Stone Energy (SGY), for $800 million. Stone had been a target of Plains Exploration & Production (PXP).

Smart money was already been pouring into the sector. Just look at what some of the very smart money is doing. Rich Kinder, the savvy founder and chief executive of Kinder Morgan (KMI), is leading a group of management and institutions to take the pipeline company private for $13.4 billion, or $100 per share—an 18% premium over its pre-offer price. Tenaris SA (TS), a unit of Tehint Argentina, agreed to pay a 42% premium for another maker of seamless oil and gas pipe, U.S.-based Maverick Tube (MVK). And hedge fund JANA Partners wants to acquire the 90% of Houston Exploration (THX) it doesn't already own, for about $1.8 billion. Overall, according to Thomson Financial, announced energy deals are up about 32% through June 20 compared to the same period in 2005. “We expect M&A to remain robust,” says senior research analyst Richard Peterson.

Kurt Hallead, RBC Capital Markets oil service analyst, believes the big sell-off is caused by macro-economic concerns—specifically that the Fed will raise interest rates too much and there will be an economic downturn three to six months down the road. “I can't identify anything in oil services that has changed to negative or even flattened out. Investors seem to be making a call about the economy and it doesn't seem to matter what the industry fundamentals are now,” he says. Hallead concedes he doesn't know whether the economy will turn down, but he notes that the market predicts more recessions than there actually are.


  Given the current environment,what are the best plays? Energy sector mutual funds—the kind offered by Fidelity Investments, the Vanguard Group, and others—make a lot of sense. That way, if one company suffers interruptions or other setbacks, the diversification from holding other companies' shares saves the day. In addition, most analysts believe the majors, including Chevron (CVX), ConocoPhillips (COP), and ExxonMobil (XOM) are reasonably priced after recent pullbacks, and large enough to withstand the energy market's perpetual turbulence.

Interested in taking a little more risk for a chance at greater upside? Check out the services and equipment companies. Ed Yardeni, co-manager of Oak Fund, calls this sector “the best way to play high, though not necessarily rising oil prices,” according to his June 20 market briefing. He expects the price of oil to retreat to the $55- to $60-per-barrel range because the current $10 to $20 geopolitical premium is not justified when there is so much supply sloshing around. Analysts at Standard & Poor's have recently recommended several stocks in this sector, including Baker Hughes (BHI), Nabors Industries (NBR), and BJ Services (BJS).


  Hallead thinks there are a few stocks that provide more of a safety cushion within the often-volatile services and equipment sector. He points out that Transocean (RIG) and Noble Corp. (NE), two drilling companies, have strong books of business stretching out for several years. “Both companies have a number of different contracts that run from 2007 through 2009 at good terms,” he says. Transocean announced June 22 that Norsk Hydro (NHY) awarded it two long-term contracts for $950 million. One contract, running through 2013, is for building and operating a drill ship capable of working offshore at depths up to 12,000 feet and drilling as deep as 40,000 feet. Hallead also likes Oceaneering International (OLL), which provides deep-sea services such as sending divers into oceans to lay pipes and perform safety checks. That specialization makes Oceaneering less reliant than other players on U.S. natural gas exploration—a market segment that could be especially vulnerable to any economic weakness. With so much riding on continued economic growth in the U.S., big natural gas producers and companies that specialize in downstream refining and marketing businesses are seen as riskier bets.

Of course, there are no sure bets in the always-volatile energy sector. A sudden interruption of global economic growth could knock the stocks much further down. Yet the long-term trends of rising demand (especially in China, India, and other developing countries) and limited gains in supply seem likely to keep driving energy demand higher. Right now investors seem to be focusing too much on the dire possibilities and not enough on the industry's solid fundamentals and swelling bottom line. That's just the kind of distortion that creates buying opportunities.

Before it's here, it's on the Bloomberg Terminal.