Energy Stocks: The Top Prospects

The disconnect between depressed—even declining—natural gas prices in North America and robust oil prices is growing. Some energy analysts are convinced that oil prices are grossly inflated, fueled more by speculative money than actual demand, despite the modest economic recovery taking place.

The April futures contract on the New York Mercantile Exchange (NYMEX) for West Texas Intermediate crude oil, after topping $83.00 on Mar. 17, settled $1.57 lower, at $80.63 a barrel, on Mar. 19. Some analysts think the price should be closer to $50 to $55 a barrel. The U.S. benchmark price of natural gas, known as Henry Hub, dropped to $4.02 per million British thermal units (Btu) on Mar. 19, compared with $4.75 less than three weeks earlier. Analysts don't believe domestic natural gas prices will return to an equilibrium range of $5 to $7 for at least two years due to a supply glut.

Not everyone thinks oil prices are ahead of themselves. Tim Parker, an energy analyst at T. Rowe Price (TROW), concedes that speculation has a role in oil prices but says speculation is more about the speed at which prices move than their actual levels: It causes prices to move faster in the direction they were already going, both on the upside and the downside. Parker predicts oil prices will be comfortably above $100 a barrel for more than a day at a time sometime in 2011, once the world realizes there's not as much spare production capacity as it now believes.

The Push for Energy Efficiency

Rehan Rashid, head of energy and natural resources research at FBR Capital Markets (FBCM), says he's comfortable with the current 12-month futures price range on NYMEX of $75 to $80 a barrel. But even Rashid thinks the economic recovery, to the extent that it fulfills people's expectations, will be much less energy-intensive than prior ones. Construction and manufacturing, two industries that consume a lot of energy, won't drive this recovery in the U.S., since both are suffering from overcapacity, Rashid says. Growth in energy demand will also be hampered by the push by governments and private industry for greater energy efficiency, he adds.

It's true that annual oil consumption in the developed nations began to decline in 2005 as countries became more serious about conservation, says Parker at T. Rowe Price. But roughly half of global oil consumption is by emerging countries such as China, India, and Brazil, where demand will continue to grow, he says. Although global oil demand won't climb as fast as it did from the mid-1970s to 2005, there still isn't enough supply available to prevent oil prices from rising from 2011 to 2013, a period with few new projects in the queue, he says. Large projects, such as ones in Brazil, are slated to begin production in the latter half of this decade.

Clearly, investors hunting for companies with more earnings growth potential are better off buying shares of oil-oriented producers than ones that produce more natural gas. Integrated producers such as Exxon Mobil (XOM) and Chevron (CVX) fit the bill, but you have to be careful of those with too much exposure to refining and marketing. The economics of the so-called downstream side of the business "are just horrendous," according to Pavel Molchanov, an analyst at Raymond James (RJF) who covers integrated oil and gas producers. Refining margins have shrunk to 15-year lows on depressed demand for industrial and transport fuels and excess refining capacity worldwide. Molchanov expects oil to average $80 a barrel in 2010 and $95 a barrel in 2011.

Getting Rid of Refineries

Integrated companies are trying to invest more in exploration and development, the "upstream" side of the business, while reducing their presence on the downstream side by closing or trying to sell refineries and service stations, often at steep discounts. Valero Energy (VLO) and Royal Dutch Shell (RDS/A:US) are each in the process of shutting down one plant, while Chevron is trying to sell its Pembroke, U.K., refinery. (Raymond James has received noninvestment banking securities-related compensation from Valero within the past 12 months.)

Molchanov's top picks right now are Chevron and Hess (HES), both of which have little refining exposure. One metric he finds instructive is a company's ratio of proved reserves to refining capacity. "The higher the number, the better," he says. "Chevron is at 5.2%, and Hess is at 4.5%. To put that in perspective, Marathon Oil [MRO], which is very refining oriented, is at 1.4%." (Molchanov and/or a research associate own shares of Chevron.)

Another useful metric is the portion of a company's total proved reserves that comes from its North American natural gas reserves, which tells you which companies have the least exposure to gas. Domestic natural gas currently accounts for about 4% of Chevron's and Hess's total proved reserves worldwide. At the other extreme is ConocoPhillips (COP), with 21% of its proved reserves made up of North American natural gas. The excessive debt that Conoco took on in buying Burlington Resources in 2006 also makes that stock a bad bet, in Molchanov's view.

Oily Exploration

As for independent exploration and production companies, Nicholas Pope, an analyst at Dahlman Rose, upgraded Denbury Resources (DNR) to buy from hold in a Mar. 9 research note, citing greater clarity on the beneficial impact of the company's $3.25 billion purchase of Encore Acquisition—which develops oil and gas fields in the Rockies, Texas, and Oklahoma—, a deal scheduled to close in early April, and improved production growth from the combined company. With 76% of its production in oil, the combined company will be one of the "oiliest" domestic exploration and production companies, the note said.

Among independent oil-oriented producers in the U.S., Parker prefers Concho Resources (CXO) to Denbury, citing Concho's "repeatable" production growth profile. While Denbury can flood its fields with CO2 to squeeze out the last drop of oil, its properties tend to provide uneven growth over the long term. Investors also need to be mindful of potential integration issues after completion of the Encore acquisition, he warns.

"I prefer Concho today because I can see 20%-plus [production] growth for at least the next few years," he says. "And they're savvy asset buyers in the Permian Basin," an oil-rich area that spans western Texas and southeastern New Mexico.

Oilfield Service Plays

Parker regards Hess and Nexen (NXY) as deeper value plays. Neither company increases its production much each year, and each can be bought at a fairly low valuation, which will look more attractive as oil prices rise.

Natural gas plays should be left to experts who can to identify companies with the lowest cost, most efficient production methods, says Parker. Those are the ones best positioned to do well in the long-term, low-price environment.

Big oilfield service companies such as Schlumberger (SLB), Halliburton (HAL), and Baker Hughes (BHI) make sense now that exploration is rebounding from "disaster" levels in late 2008 and early 2009, says Parker. A raft of new projects by the end of 2010 will also create opportunities for McDermott International (MDR), which builds offshore production platforms, since deposits at depths of 10,000 feet or more continue to be the best sources of oil. Deepwater discoveries will also benefit FMC Technologies (FTI) and Cameron International (CAM), makers of subsea hardware that makes bringing oil to the ocean surface more efficient, he says.

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