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Three Under-the-Radar Oil Plays

  • One way to play the oil patch is through commodity-related ETFs. There are several that track, one way or the other, the price of oil.
  • Another way to invest in an overinvested sector is to narrow your focus on companies with very specific areas of expertise in those sectors.
  • Oftentimes, peripheral companies that supply the actual sector leaders are a further way to take advantage of an area without directly investing in it.
  • It seems like you can't get away from the oil story these days. CNBC has been in "oil crisis" mode for weeks. And you certainly can't get away from the story by filling up the tank. Well, if you can't beat 'em, join 'em, they say. So, I went looking to see whether there are any energy-related companies that still have room to run. As an investor with a contrarian bent, nothing makes me more nervous than something that keeps going up. My natural inclination is to start looking for what will go wrong. However, in the case of oil and energy stocks, the more I look, the harder it is to find a compelling reason to avoid the names. Other than short-term technical reversals, I think this bull has legs. For one, demand for oil keeps rising fairly steadily. The chart below shows U.S. demand for petroleum products over the last 17 years, as measured by the U.S. Energy Information Administration. While demand can slow during a recession, the upward trend has been slow and steady.

    Now that the rest of the world's demand is catching up to our own, it is getting harder for supply to keep up. I'm not making some catastrophic "peak oil" argument, but simply stating that it takes a long time to find new reserves, build the rigs to tap them, and get the product to market. In the meantime, demand will continue to rise slowly -- making a moving target. Diversification Of course, with the economy and stock markets acting the way they have been, it is nice to have a bull market in something in which to invest. One of the basic tenets of investing is diversification. Diversification works best when the investments in question tend to move in different directions. Oil is certainly moving opposite to the economy these days. In the latest employment report, healthcare and oil were the only two industries adding significant numbers of jobs. Historically, oil and other commodities have also offered good diversification to stock and bond portfolios. Know What Risks You are Willing to Accept There are lots of ways for investors to gain exposure to the bull market in energy. One way is through commodity-linked ETFs, such as U.S. Oil Fund (USO). If it's just exposure to oil prices you want, this may be the way to go. You won't get a perfect match because the fund invests in oil futures rather than spot oil, and the changes in value between spot and futures aren't always equal. Furthermore, the fund expenses will eat into the return. However, the general direction should be right. Then, of course, there is big oil. Many people gravitate toward the Exxon Mobils (XOM) of the world as a way to play oil. However, these companies do everything from exploration to transportation, refining and marketing. While higher oil prices can be good for the exploration part of the business, they can hurt refining margins. And of course, all this talk of "windfall profit taxes" adds an element of political risk. I don't mind taking risks as long as they are compensated for by higher returns. The problem with the big integrated oil companies is that you get a whole bunch of risks all bundled together, making it hard to tell which risks are being rewarded. I'd rather break the investment up in to smaller portions, accepting each risk only when the rewards for doing so are high. Finding the Oil When oil prices are rising, one of the smartest plays is to go straight to the source. The more a company is involved in exploration and drilling, the better. And that is a big reason why I like W&T Offshore (WTI). W&T is an independent oil and natural gas producer, active in the acquisition, exploitation, exploration and development of oil and natural gas properties in the Gulf of Mexico. They have begun extending their traditional expertise in the continental shelf (less than 500 ft of depth) to exploring deepwater and deep-shelf sites up to 15,000 feet deep. Since becoming a public company in 2005, its revenues have more than doubled, driven by both rising prices and increased sales volume. The company has had a successful exploration streak of late. In 2007, they drilled seven exploratory wells and two development wells. Both development wells and six of the exploratory wells were successful. The company has announced they are six for six in 2008. They are also growing through acquisitions of small projects from larger oil producers who want to focus on more capital-intensive projects. Analysts have certainly started to take notice. In the last 90 days, the consensus earnings estimate for 2008 has risen from $2.56 to $3.62. For 2009, estimates have gone from $2.92 to $4.05. While volatility in both price and production levels can cause wild quarterly valuations, the trend has been in WTI's favor of late. The company's last four earnings reports have beaten estimates by an average of 30%. On a valuation basis, WTI is trading at about 3.5 times book value, which is slightly above the industry average. However, the company's growth and return on equity are also above average, according to Zacks Research Wizard. I think the valuation can hold, meaning the 15%-20% annual earnings growth expected over the next several years should result in similar growth in share value. Selling the Shovels Popular legend has it that the only people to get rich in the California gold rush were those who sold shovels. The modern-day equivalent in the oil industry would be the oil-services industry. In this group, I particularly like Seacor Holdings (CKH). Seacor operates a fleet of offshore support vessels and helicopters servicing oil- and gas-exploration, development and production facilities worldwide and a fleet of U.S.-flagged product tankers that transport petroleum, chemicals and crude products primarily in the U.S. domestic trade. It also operates a fleet of inland river barges transporting grain and other bulk commodities on the U.S. inland waterway and offers environmental consulting services to companies that store, transport, produce or handle petroleum products and environmentally hazardous materials. Despite having a market capitalization of nearly $2 billion, and its exposure to the agriculture/energy/infrastructure boom, Seacor has Wall Street coverage from just two analysts. This surprising neglect makes Seacor an enticing wallflower, in my opinion. Of course, because of the leverage inherent in the business, and the potential for short-term hang-ups outside the company's control (think weather in the Gulf of Mexico), investors interested in Seacor should prepare themselves for a potentially bumpy ride. Since there are only two analysts publishing estimates, there is little consensus about the prospects, and overshooting or undershooting the consensus estimate should be considered the norm rather than the exception. Over the last 12 months, Seacor has generated about $325 million in free cash flow, which equates to a very juicy 16% free-cash-flow yield. This wasn't just a fluke number, either. Over the last three years, free cash flow has averaged $295 million per year. The company is using most of that cash flow to buy back its stock and convertible bonds. Over the last three years debt, has been reduced by $177 million and $336 million has been used to repurchase stock. The diluted shares outstanding fell by more than one million (4% of total shares outstanding) in 2007. At 1.2 times book value, Seacor is trading well below the industry average (according to Zacks Research Wizard) of 2.5 times. Based on its return on equity, I estimate a sustainable growth rate in the high single digits. Adding in a potential valuation expansion to the industry average, total return could range from 20% to 30% per year, with the main variable being the estimated time for Seacor's price/book to converge to the industry average. To me, it's worth the wait. The Diversifier As I noted earlier, high oil prices could hurt refining margins. But I also said that diversification is a key reason to invest in oil. If you want to diversify a long position in oil or oil services, refineries may be a way to do so. My favorite refining play is Frontier Oil (FTO). Trading at 55% off its 52-week high, Frontier clearly has not been a beneficiary of oil's run-up. However, things may be ready to change. For one thing, the latest PPI report is showing that refiners have gained some pricing power.

    Although analysts have cut their earnings estimates lately, Frontier is currently trading at less than 10 times the reduced numbers. Taking a small position to hedge a larger bullish bet on oil might be a prudent idea.

  • One way to play the oil patch is through commodity-related ETFs. There are several that track, one way or the other, the price of oil.
  • Another way to invest in an overinvested sector is to narrow your focus on companies with very specific areas of expertise in those sectors.
  • Oftentimes, peripheral companies that supply the actual sector leaders are a further way to take advantage of an area without directly investing in it.
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