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How to Pick an Oil Stock

Chuck Marvin

Updated from 6:30 a.m. EDT

With oil prices still hovering around the $70-a-barrel level, it's no surprise that investors are throwing loads of money at oil companies.

Most of the time that means banking on the integrated oil group, the enormous multinationals like Exxon Mobil (XOM - Cramer's Take - Stockpickr), Chevron (CVX - Cramer's Take - Stockpickr) and BP (BP - Cramer's Take - Stockpickr). They are involved in all aspects of the oil and gas business, from the wellhead all the way to the gas pump.

Realizing that there is growth potential in energy is easy. The difficult part is choosing which firms are good investments and which ones should be avoided. Since integrated oil companies share similar business models, it can be tough to choose the stock in the group that offers the best value.

However, analysts say there are some clues that can help investors make the best decision. Some are easy to grasp, others require a little more homework, but all will serve to educate.

Crude Isn't Everything

To start, don't focus only on commodity price movements. Integrated oil companies have diversified cash flows from different businesses. Not only do they make money by pumping fossil fuels out of the ground, they also profit from refining those fuels into chemicals and petroleum products and then selling those goods in the retail market.

	What metrics do you focus on when picking an oil stock? Answer Here

Their drilling projects tend to have longer life-spans than those of smaller E&P companies, and they often reduce the volatility of their cash flows by hedging thoroughly.

Thus, it isn't necessary to buy and sell integrated oil stocks as commodity prices move, says Sheraz Mian, an analyst at Zacks Investment Research. These companies can make money regardless of what prices are doing.

Don't misunderstand -- commodity prices do matter. But rather than trading on the direction that oil is moving, investors should monitor the relationship between the existing oil price and a theoretical price of oil that the overall market deems to be normalized, says Bruce Lanni, an analyst at A.G. Edwards.

Energy research analysts often divulge what they think is the consensus normalized oil price in their research reports. Lanni believes that the normalized price is around $55 a barrel. At roughly $70 a barrel, crude is trading at a 27% premium to the normalized price.

Historically, a 30% premium between the spot price of oil and the normalized price sends stocks through the roof. This has happened to energy stocks recently, but Lanni thinks that stocks are still undervalued relative to the current price of oil.

OPEC's oil ministers also frequently discuss what they think the market's fair price should be. OPEC President Mohammed al-Hamli said earlier this month that he thinks the normalized oil price is somewhere near $50 a barrel.

Straightforward Analysis

There's no need to make financial analysis too complicated. Often, a price-to-earnings ratio works just fine. According to Mian, a simple comparison of P/E ratios is a great first step toward choosing which stock to buy.

But don't just look at P/Es at one time. Instead, watch what they do over a range. Also, European companies tend to follow U.S. accounting procedures, so there's no need to analyze American and European firms separately.

Below is a list of five major integrated oil companies and their corresponding P/E ratios.

If you want to dig deeper into a company's finances, profitability ratios aren't a bad way to go. By their very nature, these measures are excellent for comparing how companies utilize their assets to generate income. Mian endorses using the return on average capital employed, or ROACE.

To calculate ROACE, divide earnings before interest and taxes, or EBIT, by average total assets minus average current liabilities. Here's the same list of companies and their corresponding ROACE percentages.

Watch Out for Cyclical Red Flags

Two major themes have popped up in the last few years that are dictating terms in the energy industry. One is refining margins, which wax and wane as demand for gasoline and heating oil changes with the seasons. The second is the weather, which can be a major determinant of profitability for companies with large exploration and production businesses.

Paying attention to these issues and adjusting investment positions accordingly can go a long way toward your success as an energy investor.

Integrated oil companies, by their very nature, have operations in the upstream (exploration and production) and downstream (refining, selling and distribution) businesses. However, their resource allocation among these businesses can vary significantly.

Recently, high gasoline demand has kept refining margins abnormally elevated. To see how this plays out among companies with different resource allocations, look at the recent histories of Marathon Oil (MRO - Cramer's Take - Stockpickr) and BP. At Marathon, 58% of its income comes from its downstream refining business, whereas 14.5% of BP's business comes from its downstream operations.

Marathon's stock has climbed about 10% in the last 12 months, while BP's shares have fallen 6% during the same time period.

Want more? Check out TheStreet.com TV video. Chuck Marvin gives tips on picking oil stocks.

Aside from the national integrated oil companies like Mexico's Pemex, most firms in the group refine more oil than they produce themselves. Those that rely more heavily on refinery operations will generally be more sensitive to refining margins than crude prices, says Jim Williams, an economist at WTRG Economics.

Monitor Geopolitical Risks

Recent events around the globe show just how risky it can be for companies to pursue large E&P projects in hot spots. Royal Dutch Shell (RDS.A - Cramer's Take - Stockpickr) has heavy exposure to geopolitical strife in Nigeria, where rebel groups have forced the company to shut in a 380,000-barrel-a-day field since February 2006.

Alternatively, BP has its own risks in Russia, and recently took a hit when state-run oil giant Gazprom assumed control of its stake in the Kovykta gas field.

Elsewhere, ConocoPhillips(COP - Cramer's Take - Stockpickr) and Exxon recently watched their large investments in Venezuela's Orinoco river region go up in smoke after the Chavez government decided to nationalize production activities there.

According to Morningstar analyst Elizabeth Collins, all integrated oil companies are subject to some level of geopolitical risk, considering how much crude is found in volatile areas like the Middle East and the regions mentioned above. The key for the companies is to keep those risks diversified, and also that they be compensated for the chances that they choose to take.

As a corollary, compare strategic positioning and asset quality. As spare capacity of fossil fuels declines around the globe, any edge in assets one company has over its competitors becomes key.

Mark Gilman, an analyst at Benchmark Company, recommends that investors pay attention to companies' positions in up-and-coming areas like liquefied natural gas and oil sands. He also says that the quality of a company's assets is important, especially in the downstream business. For instance, how up-to-date are a company's refineries? What kind of utilization rates is a company clearing? Or have a company's assets recently seen significant downtime due to unscheduled maintenance?

Who's the Boss?

Finally, take note of a company's management team. Given the ever-increasing demand for energy sources around the globe, the growth outlook for integrated oil companies as a group looks peachy. But to be comfortable with an investment, Mian suggests finding a company with a management team you have confidence in.

A solid team of executives will be able to navigate the complex geopolitical chessboard of energy and leave you better off than where you started.

Gilman takes the idea of management strength further, saying that investors should get into their heads and understand how executives think about their business and strategy, whether that's mergers, share buybacks, capital expenditures or commodity price hedging.

If management doesn't discuss these issues in their financial reports and conference calls, they're probably still looking for the right answers. And that's a sign you should stay clear.

Oil prices were losing ground in Tuesday's market, and so were the stocks. Exxon Mobil was recently falling $1.10 to $84.02, Chevron was losing $1.40 to $85.60, and BP was down $1.34 to $65.37. ConocoPhillips was down $1.18 to $79.80, Marathon Oil was losing $1.58 to $51.27, and Royal Dutch Shell was slipping $1.04 to $74.22.

Interested in more oil plays? Check out this portfolio from Cramer on Stockpickr. And there's this portfolio from oil tycoon T. Boone Pickens, who's made waves with his "Peak Oil" theory.