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Energy's Pullback Could Be Opportunity

With crude and natural gas prices finally pulling back, many energy stocks have tumbled 10% or more over the last four days. That has spooked energy investors.

The scare is fair. Since oil has been the go-to sector for most of the year, maybe investors became complacent. Fast money, opportunistic investors and stupid money all found their way into the sector in the third quarter -- and it's probably no coincidence that the tumble began right after the quarter ended.

There's nothing like a 15% pullback to cause a gut-check among investors and move the fast money back to the sidelines. However, while there may be a lot of volatility in the coming days, there may also be a lot of opportunity.

What Hasn't Changed

Commodity prices are likely to moderate, and that creates some challenges for the stocks. However, as I wrote earlier in the week, there are plenty of opportunities in a $50 oil environment.

In the last week, all that has really changed are stock prices. The fundamental arguments remain the same. Consider the following:

  • In North America, the number of rigs drilling for natural gas has doubled over the last year, yet natural gas production has remained stagnant, a result of a quickening decline in production from existing wells. In Saudi Arabia, the number of rigs drilling for oil has also grown, with little production response.
  • Hurricanes Katrina and Rita will affect supply for months, not days or weeks. As we enter winter, natural gas supplies will be tight.
  • The hurricanes have damaged at least a dozen offshore rigs that are needed to keep production growing in the Gulf of Mexico.
  • All of these factors point to continued strength in drilling and exploration activity. They also suggest that prices for commodities aren't likely to drop precipitously anytime soon. Sure, $50 oil and $8-$9 natural gas are possible, but that still provides for plenty profit opportunities for energy companies.

    To take advantage of this pullback, start by looking at quality names. Nabors (NBR - Get Report) will continue to see rig day-rates increase, and that should put earnings above $4 this year and potentially around $6 next year.

    National Oilwell Varco (NOV - Get Report) will benefit from rig reconstruction and new builds in the coming year -- the pullback in its shares is excessive.

    On the exploration front, look for opportunities to buy quality as well. Companies such as Chesapeake (CHK - Get Report) react to the market in the short term but have lots of earnings power over the longer term. You can argue that Chesapeake is overpaying for the Appalachian natural gas assets it agreed to buy Monday, but the company has shown over time that it can gain efficiencies that others can't in the exploration game. As long as commodity prices remain firm, it's a moneymaker.

    The pullback has been unsettling, but it also has created opportunities. Know your investing style and tolerance for short-term volatility, and then set your goals. The selloff this week seems overdone to me, and over time, the earnings power of oil and gas companies will support prices.

    Have a great day.

    Christopher S. Edmonds is partner and managing director of research at Pritchard Capital Partners, a New Orleans energy investment firm. He is based in Atlanta. At time of publication, neither Edmonds nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.

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