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3 Ways to Play the Energy Stock Rally

Stocks in this article: DNR CLR APC GDP

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NEW YORK ( TheStreet) -- No stock can touch the 40% rally in Netflix (NFLX) to start 2012, but exploration and production stocks are no slouch when it comes to starting the new year in a big way.

Some have broken out more than others. Goodrich Petroleum (GDP) is up 25%, and Denbury Resources (DNR) has jumped 20%.

With crude oil rallying and fears it will reach historical highs given the tensions between Iran and the West, independent E&Ps levered to the price of crude have been an early favorite among stock pickers. The S&P 500 and Dow Jones Industrial Average have hit levels not seen since late July -- before the market tanked -- and that's helped some second-half of 2011 E&P laggards to rebound.

Is it too late to get into the E&P stock-picking game already, only six trading sessions into the year? Will the rally last, or should investors take gains, like Goodrich's 25% rally in a week, and head for the exits?

Last year, E&P stocks levered to the price of crude traded as high as 10 to 12 times forward EBITDA earnings before interest, taxes, depreciation and amortization and now are trading at 6 to 7 times, according to Raymond James analyst Andrew Coleman. "I think valuations are still a little discounted across the board, but they are reflecting a more cautious outlook," Coleman said.

Morningstar analyst Mark Hanson said there are undervalued stocks in the E&P sector -- EOG Resources (EOG) is one -- but EOG Resources wasn't even a big 2011 laggard. Hanson added, "I'm hesitant to infer too much from the short term with the backdrop of Iran and the oil price run up. That's the big driver I see, and oil prices are still very much of a wildcard."

The Morningstar analyst said macroeconomic concerns about China and Europe may counterbalance the Iran issue.

"I'm surprised by the volatility in this space. It used to be half a percent a day or a 1% move and now we are seeing 4% to 5% percent per day," Coleman remarked. Energy is an inflation hedge and a proxy for the global market, but with what has happened already in early January in these stocks, the analyst said that the question remains, how much risk tolerance is there?

There are sound reasons for the rally in E&P companies related to, but not limited to, the price of crude, which was over $102 on Tuesday.

There are three ways to think about playing the E&P rally on higher crude, and maybe more importantly, trying to figure out a way to buy a rally that is built to last, as opposed to an early year flash in the pan:

  • The E&P risk trade
  • The mid-cap E&P trade
  • The bigger E&P "safe" trade
  • Here's more on each of these approaches to E&P investing, analyst opinion on stocks that fit the strategy and have received recent attention, and what risks could keep the E&P rally from being extended.

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