Five Energy Stocks to Buy Now

02/18/2011 11:45 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Major oil companies are struggling to obtain new reserves. I suggest looking at some oil producer and oil services stocks, which will benefit from their search.

On Jan. 28, I argued that the US economy is still in the early recovery stage of the business cycle and that you should overweight your portfolio toward the stocks that do best at this point in the cycle. "Sectors that do best are usually industrials, near the beginning of the stage; basic materials; and, near the end, energy," I wrote.

The next stage for the US economy is late recovery: "Sectors that have done well in this stage include energy, and, near the end of the stage, consumer staples and services."

From Jan. 28: Read “How to Invest in a Zigzag Economy

See any sector that those two stages have in common? Yes, energy. So why not overweight energy right now? Several readers asked me that, noting that by doing so, their portfolios could catch the sector's outperformance at the end of the early recovery stage as well as its outperformance in the first part of the late recovery stage.

That's an excellent idea—just be careful which energy stock you pick. The sector is a little tricky to navigate right now. Be highly selective on oil stocks. I think most of the international majors aren't all that attractive right now. Instead, I'd favor oil equipment and service companies, as well as small oil producers that are increasing production and that look like acquisition candidates.

The Problem with Big Oil

What's the matter with buying big oil now? After all, the sector “integrated oil and gas" has soundly beaten the Standard & Poor's 500 over the last six months. It gained 23.91% for the six months that ended Jan. 31, compared with the S&P's 17.93%. In the three months that ended Jan. 31, the sector gained 12.82% versus the S&P's 9.3%.

But big oil—and I do mean big, since ExxonMobil (NYSE: XOM) has a market capitalization of $416 billion these days and Royal Dutch Shell (NYSE: RDS-A) comes in at $217 billion—has recently shown signs of struggle. BP plc (NYSE: BP), for example, closed at $49.25 on Jan. 14, but closed at just $47.30 on Feb. 16. Royal Dutch Shell was at $73.35 on Feb. 1 and $69.75 on Feb. 16. Chevron (NYSE: CVX) was at $97.74 on Feb. 7 and $96.66 on Feb. 16. ExxonMobil closed at $83.91 on Feb. 1 and at $83.69 on Feb. 16.

The problem that's started to worry investors? Reserve replacement. And ExxonMobil's year-end report is a good place to start in understanding this problem.

In 2010, ExxonMobil said it increased its reserve base by 2.5 billion barrels to 24.8 billion oil equivalent barrels. The increase enabled ExxonMobil to replace 209% of the oil it produced. In other words, even after all the oil it produced in 2010, the company ended the year with more oil than it had started with.

The problem with ExxonMobil's reserve replacement report is that the 209% figure depends on the company's big acquisition of XTO Energy. The purchase of XTO's 2.8 billion barrels of reserves accounted for about 80% of the reserves that ExxonMobil added in 2010. Without the XTO purchase, ExxonMobil's reserve replacement ratio would have been just 45%, Barclays Capital calculates.

This isn't a problem just for ExxonMobil and it isn't a problem that's about to go away quickly. The national oil companies of countries such as Saudi Arabia, Mexico, Iran, Brazil, and Russia produced 52% of the world's oil in 2007, according to the US Energy Information Administration, but they controlled a whopping 88% of the world's proven oil reserves. To replace the oil the international majors are producing, international oil companies have had to look harder to find oil and spend more to produce it. Chevron's 2011 capital budget is an example of just how expensive this effort can be: For the coming year, Chevron will spend $22.6 billion on exploration and production. That's a big increase from the company's already substantial $17.3 billion 2010 exploration and production budget.

It takes time to turn capital spending into oil. Chevron has one of the industry's best pipelines of new projects, but the company added just 240 million barrels of oil equivalent reserves in 2010. That yielded a replacement ratio of just 24%. The delay in payoff for Chevron's investment is one of the reasons the company's stock sells for 10.2 times trailing 12-month earnings, while shares of ExxonMobil sell for a trailing price-to-earnings ratio of 13.4%.

The alternative strategy, one that ExxonMobil's purchase of XTO Energy exemplifies, is to acquire your way to new reserves. And this strategy doesn't come cheap, either. It cost ExxonMobil $41 billon in stock to acquire XTO Energy in 2010.

Think about the investing logic of this situation for a moment. Where does it tell you to put your money?

NEXT: My Five New Energy Stock Buys Revealed

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Five Energy Stocks to Consider

If the oil companies that are following the Chevron strategy by spending on exploration are adding big bucks to their capital spending budgets, you'd want to invest in the companies that are the beneficiaries of that money.

If the oil companies that are following the ExxonMobil strategy of spending to acquire reserves are willing to pay big bucks for smaller companies with promising reserves or exploration prospects, you'd want to invest in the companies they might acquire.

In the first group, I'd look to own companies such as global oil-service and exploration leaders Schlumberger (NYSE: SLB) and Weatherford International (NYSE: WFT). My third pick would be FMC Technologies (NYSE: FTI), a producer of deep-sea production and processing equipment. The company reminds me of the well-support team at John Wood Group that General Electric (NYSE: GE) just bought at 17 times EBITDA (earnings before interest, taxes, depreciation, and amortization). That's way above the 6.6 multiple for two deals in the sector in the last two years, Bloomberg calculates, so either GE overpaid or prices for deals in the sector are rising fast. How about a vote for both?

In the second group, I'd look to plays in the mode of XTO Energy. XTO not only had a lot of reserves, but it also sat in the safe and friendly United States.

I wouldn't just play a guessing game and hope that I hit on the next buyout stock, though. Instead, I'd make sure that I was looking at companies that can themselves increase production aggressively in the next few years. That way, even if they aren't bought, you'll profit from organic growth. One of my top two is Oasis Petroleum (NYSE: OAS), which has 39.8 million barrels of proven reserves and lots and lots of undeveloped acres under lease in the very promising Bakken oil shale formation. Proven reserves popped from just 13.3 million barrels at the end of 2009.

My other producer pick is EOG Resources (NYSE: EOG). Think of this company as a bigger Oasis with more exposure to natural gas. The company has sizable unconventional oil reserves and has been able to ride out the natural gas plunge by shifting production toward oil (67% of production by the end of 2011, the company projects) from natural gas (77% of production in 2007).

That's five energy stocks for the end of the early recovery stage and the beginning of the late recovery stage. Now if the economy will only cooperate by accelerating and not slowing down.

More from Jim Jubak:

At the time of publication, Jim Jubak did not own or control shares of any company mentioned in this column in his personal portfolio. The mutual fund he manages, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this post. The fund did own shares of Oasis Petroleum, Schlumberger, and Weatherford International as of the end of December. Find a full list of the stocks in the fund as of the end of December here. The January portfolio holdings will be posted later this week.

Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.

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