A Guide to Energy Bargains

After a spectacular run, the price of oil has come off the boil, and with it share prices of virtually the entire energy sector. This gives oil-consuming economies a chance to catch their breath, but it's not the end of the story. Fundamentals argue for high energy prices in the medium and long term. So if you invest on that same long-term basis, consider this a buying opportunity.

From a high of $147 a barrel in July, oil tumbled to $115 in mid August. In the short term, the price of oil may go lower, perhaps breaking $100. But there are two reasons, with prices down sharply, you should be a buyer and not a seller of energy stocks now. The first is that a lot of money can be made in the energy sector under the umbrella of $100-a-barrel oil. You just have to choose your shots carefully. The second reason is grounded in basic economics: a tight market induced by robust global demand and rather anemic supply.

The demand story is pretty well known. As emerging markets, such as China, India and Brazil, industrialize and urbanize, hundreds of millions of their citizens are rapidly becoming consumers of gasoline and diesel fuel. The International Energy Agency projects that global demand for oil will grow 1.6% a year for the next five years, to 94 million barrels a day in 2013 (versus 87 million barrels today), and that 90% of this new demand will come from developing nations.

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The supply picture is not as well documented, but it's troubling. The world is straining to boost oil output. For many years we've consumed more oil than we've found, and now the well-depletion rate is accelerating in many large oil fields, including those in Mexico and the North Sea. The industry needs to find 3.5 million new barrels of oil a day just to maintain output, and that's without taking new demand into consideration.

High prices produce two results: They dampen demand and encourage production. The former is already happening in the U.S. and other well-off countries. Getting more oil out of the ground will take several years and will involve projects that are costly (tapping the oil sands of Alberta, Canada) or controversial (offshore drilling).

As a consumer, you can fight back by investing in energy production. Natural-resource stocks, such as the companies below, provide some protection against inflation, a particularly valuable hedge if the dollar descends over the long term. The recent pullback in oil prices could provide you with a good entry point. Unless noted otherwise, results are to August 11.

Integrated giants

The group: These goliaths do almost everything, from exploring for oil and gas to refining and selling the finished petroleum products.

Dynamics: Many of the big oil companies straddle the globe. So while their U.S. refining business may be ailing this year, they benefit from surging demand for diesel and liquefied natural gas in Asia.

The record: On average, the stocks are up an annualized 19% for the past five years, but they're down 13% in 2008. Several, such as ExxonMobil, have had trouble increasing energy production. BP is fighting its Russian partner.

The outlook: Many of the integrateds appear undervalued, selling at less than ten times forecast 2008 earnings and paying out rich and rising dividends. Energy-fund managers tend to look for companies that deploy capital wisely and that can raise oil-and-gas production.

Best bets: Independent oil analyst and consultant Kurt Wulff assumes a long-term oil price of $100 a barrel and values each of the companies based on reserves and such financial measures as debt and cash flow. He concludes that ConocoPhillips (symbol COP) and Royal Dutch Shell (RDS-A) are the most undervalued. Conoco's controversial acquisition of Burlington Resources is starting to look smarter as natural-gas prices rise. Century-old Shell yields nearly 5% and has some large liquefied-natural-gas (LNG) projects ramping up in the next couple of years.

ExxonMobil (XOM) is by several measures the world's largest corporation. Exxon has enormous financial strength and a reputation for allocating capital skillfully for the benefit of shareholders. Charles Ober, manager of T. Rowe Price New Era Fund, likes the stock, in part because he thinks LNG projects in the Middle East coming on stream over the next year will get volumes growing again.

Producers

The group: Exploration and production (E&P) companies search for and develop fields, then pump crude oil and natural gas to refiners and distributors.

Dynamics: Because working oil fields are being steadily depleted, E&P outfits must strive to maintain level production. It doesn't help that many of the most promising energy deposits in the world are controlled by hostile or nationalistic governments and are off limits to E&P players. But surging oil prices have boosted the rewards for finding and bringing in oil fields. Even expensive, previously marginal projects are now economical.

The record: Great. Stock prices for this group (which includes natural-gas producers) are up an annualized 29% over the past five years, though down 6% in 2008.

The outlook: Jay Singhania, an oil analyst with Westwood funds, estimates that E&P stocks still reflect $80-a-barrel oil, rather than the higher prices being paid. That's why so many fund managers remain bullish on the E&P sector. They look for companies that can boost production and that enjoy reinvestment opportunities.

Best bets: One that fits the bill, according to Singhania, is Occidental Petroleum (OXY). Oxy exited the refining business years ago and has lucrative oil assets in Texas, California, Libya, South America and elsewhere. It generates robust free cash flow and continues to raise oil output.

A smaller and totally different outfit is Denbury Resources (DNR). Denbury controls the largest reservoirs of natural carbon dioxide east of the Mississippi. It injects the gas into older fields to coax out more oil. MacKenzie Davis, of RS Global Natural Resources fund, says the CO2 reserves provide Denbury with a competitive advantage that allows it to earn a solid return on capital at even $40-a-barrel oil prices.

The Alberta tar sands are high-cost and a bit of an ecological nightmare. But they're a known resource controlled by a friendly neighbor and viable at today's oil prices. Bill Gerlach, co-manager of Aberdeen Natural Resources fund, likes Suncor Energy (SU). As one of the oldest oil-sands producers, Suncor built its facilities before an enormous run-up in capital costs in the industry.

Refiners

The group: Crude oil isn't worth much until it's made into usable products, such as gasoline, diesel, heating oil and jet fuel.

Dynamics: Refiners make their money by carving out margins between the price of crude and refined products. In the U.S., profits tend to be driven by the spread between the cost of oil and the price of gasoline.

The record: Terrific until 2008. Stocks were up 18% annualized for the past five years but fell an average of 50% in 2008. Refiners have been able to pass on only a fraction of the increase in petroleum prices. Demand for gasoline weakened when prices neared $4 a gallon at the pump, and refiners' profit margins collapsed.

The outlook: To make matters worse, global refining capacity has increased in Canada, India and Kuwait. At home, government-mandated ethanol refineries have sprouted up across the Midwest. So oil refiners are squeezed.

Best bets: This is probably one sector to avoid. If you think oil prices will continue to weaken, then consider Valero Energy (VLO), the leading independent refiner.

Servicers

The group: The huge energy business depends on services, such as seismic surveying and drilling. Even oil-and-gas giants, such as ExxonMobil, need to purchase such services, as well as technology and hardware, such as pipelines and oil rigs.

Dynamics: The services-and-equipment sector is one of the hottest links in the energy food chain. Resource nationalism hurts the international oil companies. But Saudi Arabia, Iran, Venezuela and Russia do require first-rate oil-and-gas services, technology and equipment.

The record: Really good. The group is up an annualized 28%, on average, for the past five years, but down 2% in 2008. At present prices, oil-and-gas producers are spending freely.

The outlook: Bright, given high petroleum prices, cash-rich producers and tight supplies. Saudi Arabia is investing $60 billion to expand its oil industry. And new drilling tends to be in deep seas and other hard-to-reach locales, which stimulates demand for expensive, state-of-the-art services.

Best bets: Not surprisingly, the boom in offshore drilling benefits the world's largest offshore driller, Transocean (RIG). Evan Smith, co-manager of US Global Investors Global Resources fund, says that the cost of a Transocean deep-water drilling rig has rocketed from $150,000 to $650,000 a day in the past four years. Transocean has an order backlog of $34 billion. Cameron International (CAM), which manufactures equipment for drillers, is particularly strong in engineering and services for subsea production. Schlumberger (SLB) is considered the technological leader in services, such as well stimulation and seismic surveys. The company sells its knowledge-intensive services to just about anyone.

Gas players

The group: Once considered a nuisance that came out of the ground with oil, natural gas is now in great demand by power generators around the globe.

Dynamics: Natural gas, which burns cleaner than coal or oil, continues to expand in volume in the U.S. even as demand for oil stagnates. Europe and Asia are importing rapidly growing streams of the stuff in the form of pricey LNG. The U.S. imports only 20% of its natural gas, mostly from Canada. Natural-gas prices in the U.S. were among the lowest in the world, but that's starting to change as gas becomes a more globally traded and priced commodity.

The record: Unlike oil, the natural-gas industry has managed to increase production and reserves in recent years. Demand for LNG is extremely strong from Spain to China, and prices are rising worldwide. This year, U.S. gas producers have been rewarded with high prices and profits.

The outlook: David Ginther, of Ivy Energy fund, thinks demand for gas will stay buoyant in the U.S. because most new power plants will be gas-fed.

Best bets: One of his picks is Devon Energy (DVN), one of the largest independent producers of gas. Devon is the leading producer in the Barnett Shale project in Texas, which is proving to be a prolific new source of supply. The managers of XTO Energy (XTO) have a history of buying reserves cheaply and boosting gas production (XTO, like Devon, is boosting production by more than 10% a year). Fund managers, including Davis of RS Global, consider XTO to be one of the energy industry's most skilled investors of capital, with a knack for high-return projects.

Finally, a different way to play gas is through Russia's giant Gazprom (OGZPY.PK). Russia has by far the world's largest proven reserves of natural gas, which are a near-monopoly of state-controlled, publicly traded Gazprom. The Russian company pipes gas to the European Union and the Commonwealth of Independent States. Quips analyst Wulff: "We're on the same side as Putin with Gazprom." Still, consider Gazprom highly speculative.

Coal diggers

The group: The cheapest and dirtiest of the fossil fuels, coal is divided into two main types: thermal (for power generation) and coking (used in steel making). The U.S. generates nearly half of its electricity from coal.

Dynamics: Coal prices have tripled in the past year, partly due to escalating hydrocarbon prices but also as a result of coal's supply-demand dynamic.

On the demand side, as is the case for so many natural resources, the big story is China, the world's largest consumer of coal. In the past year, China has swung from exporting coal to becoming a net importer.

On the supply side, the industry has gained from something like a perfect storm the past year -- bad weather and an earthquake in China, blackouts in South Africa, and congestion in Australian ports. U.S. exports, particularly of Appalachian coal, have surged to strong-currency Europe. With the world's largest reserves of coal, the U.S. stands to benefit from strong global demand. As with natural gas, coal prices are being bid up in international markets.

The record: Stock prices rose an average of 84% in 2007, then fell 8% this year.

The outlook: Dan Rice, co-manager of BlackRock All-Cap Global Resources fund, says coal miners have far more operating leverage than oil and natural-gas producers. He calculates, for example, that when coal prices rise from $80 to $110 a ton (a 38% increase), coal profits more than double. He thinks demand will remain strong because global electricity demand (mostly powered by coal) grows by the energy equivalent of three million barrels of oil a day, ten times the annual growth rate of gasoline demand.

Best bets: Two of Rice's largest holdings are big Appalachian coal miners, Massey Energy (MEE) and Consol Energy (CNX), the leading coal producer east of the Mississippi. The cheap dollar has suddenly turned the companies into large exporters. Rice calculates that Massey's share price seems to be based on $80-a-ton coal while it's writing contracts up to $150 per ton.

The king of coal is Peabody Energy (BTU), the largest producer in the U.S. Peabody mines the coal, largely in the Powder River Basin area of Wyoming, that generates 10% of all the electricity in this country. It also ships coal to the Far East from its Australian mines.

NEXT: The Pipelines -- Another Way to Play Energy Prices