How to Pick an Oil Stock

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.