Safe Energy Investments for 2011: Analysts

NEW YORK (TheStreet) -- Oil prices may be falling, but the industry is gearing up for longer-term growth, offering investors a potentially prime opportunity to profit from the energy sector.

A study of capital budget expectations of more than 400 oil and gas companies published by the Barclays Capital commodities research team showed that global exploration and production spending in the industry will surpass a half a trillion dollars in 2011. Spending should rise 16% to $529 billion this year compared with $458 billion last year. This is a positive sign for oil prices.

The report attributes the robust year-over-year increase to large spending increases in both North America, up 16.2%, and outside North America, up 15.5%. In December, Barclays forecast a smaller increase of 11% globally, 7% in North America and 12% outside North America.

The bigger budgets alongside higher oil prices and the expectation of rising oil prices are consistent with historical trends, the authors of the report said. "The correlation between exploration and production spending and inflation-adjusted oil prices is significant and we expect a high oil price environment to persist over the next several years driven by ... continued difficulty finding and developing large reserves, increased demand especially in emerging markets and tight spare capacity."

"This is setting the stage for further growth in spending in 2012 and beyond, and 2011 is likely to mark the first year of the restarting of multi-year, double-digit growth in global exploration and production spending."

Oil and gas companies collectively are basing their 2011 capital spending budgets on an average price of $87 a barrel of West Texas Intermediate (WTI) oil. In early December, their average oil price expectation was $77 a barrel. The Barclays commodities team meanwhile predicts that WTI oil prices will average $106 a barrel for the year, $137 for 2015 and $185 for 2020. Its Brent forecast is $112 for the year, $135 for 2015 and $184 for 2020. Roughly 23% of the companies Barclays spoke with suggest that if oil prices were to average $90 to $100 a barrel this year, they would increase spending, while only 3% said they would decrease spending. About 74% of the respondents said they would not adjust their spending plans for 2011. The vast majority of those surveyed say they expect to increase spending in 2012, with nearly half forecasting expenditure increases of 10% or more, the Barclays analysts said.

Kate Warne, U.S. investment strategist with Edward Jones, recommends a 12% portfolio weighting in energy stocks -- neither underweight or overweight, which is roughly in line with the S&P 500 index's energy sector weighting. Warne likes the diversification the energy sector offers. "It trades with oil and natural gas prices rather than the rest of the market," she explains.

Within the energy sector, investment advisers are generally recommending oil-weighted stocks over gas-weighted stocks, given that they have a bullish outlook for oil and bearish outlook for North American natural gas. Typically, the U.S.-traded, natural gas pure plays are overwhelmingly exposed to the U.S., rather than international natural gas markets, which receive a much more bullish outlook from analysts. "Right now, we definitely have a weighting towards the oil. We like the fundamentals better," says Standard & Poor's analyst Michael Kay. Plus, "You never know what's going to happen politically out there."

That said, a tolerance for volatility may be required of oil investors, whether in the commodity itself or the equities. Oil prices, of course, have a tendency to be volatile -- in 2008, oil prices hit a peak of $147 a barrel before retreating to the mid-$30 range that year; then it popped back up over $100 this year. "There is going to be volatility in this industry. There's no way around it," says Argus Research Group's senior energy analyst Philip Weiss. "It's a cyclical industry."

"You have to be selective with energy," adds Raymond James & Associates analyst Stacey Hudson. While the alternative energy industry tends to benefit from higher oil prices as they render alternative energy fuels more economical, the correlated companies carry a lot of execution risk. "Many of these companies are still in the process of scaling up their technology and working towards commercialization," Hudson cautions.

In oil, the least volatile stocks are the large, integrated companies, which both produce oil and have refining businesses. "In general, the integrateds are going to be the safest," says Weiss. "They have a more diversified revenue stream, so even if prices fall, they're still going to profitable." Typically, these oil majors derive a much bigger portion of their earnings from upstream, or exploration and production operations, than downstream, or refining and product marketing operations.

That said, the problem with the integrated companies is they're less able to take advantage of higher oil prices than oil services companies, such as the drilling contractors and pressure-pumping outfits. "With an integrated oil company, it doesn't control the price of oil. It is whatever the market says it will be," says Weiss.

When oil prices rise, the refining side of the integrated companies can be a bit of a drag due to higher feed stock costs. And even though the integrated companies have the incentive to ramp up their production and exploration operations as oil prices rise, doing so also means taking on higher services costs. "You can't just say, oil prices are higher. I'm going to produce more oil. It doesn't quite work that way," Weiss points out.

Services companies, on the other hand, are less diversified and therefore riskier than integrated oil companies. However, they also have a greater ability to benefit from higher oil prices. "Increased demand leads to greater pricing because there's only so much service to go around," says Weiss. "The law of supply and demand basically says that as oil prices rise, generally services companies generate better profits." Services companies, who don't own any oil, are better able to control their revenue stream and pricing in times of higher oil prices, says Weiss. Their customers range from the major, integrated oil companies to national oil companies.

That said, safe investments in services companies are possible, says Weiss. With its 5% dividend yield at current prices, Transocean ( RIG), the world's largest offshore contract drilling company is one of them. "I just upgraded the stock to buy. Based on the strength of the company's balance sheet and cash flow, that dividend seems safe to me. Even if I'm wrong about when the stock will appreciate, you'll get paid to wait with the dividends."

Read on for more leaders in the energy sector ...

Chevron ( CVX)

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Chevron is unanimously liked by the Raymond James, Standard & Poor's and Argus Research equity teams due to its superior ability to explore for and produce oil at a time when analysts are expecting rising oil prices.

The research groups have outperform, strong buy and buy recommendations, respectively, for the stock.

"Among the big integrated oil companies, Chevron is one of my favorites," Weiss of Argus Research tells TheStreet. He reiterates his buy recommendation and $120 target price on Chevron as the company's cash flow benefits from production in several major projects that began over the last two years -- leaving it well-positioned to fund the next stage of these projects.

The Raymond James team says Chevron stands out in three, positive ways: through its above-average focus on oil compared with other energy peers -- over the last five plus years, Chevron has demonstrated the ability to outdo its peers in terms of finding oil and gas resources; and the company has a relatively small refining segment, within which there's significant exposure to the rapidly developing Asian economy.

Chevron, which has an attractive dividend yield of about 3%, is a low-risk stock, according to Standard & Poor's. S&P maintains that the company has a diversified and strong business profile in volatile, cyclical and capital-intensive segments of the energy industry; and sound, corporate governance practices and stable earnings.

ConocoPhillips ( COP)

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Major integrated energy company ConocoPhillips is another one of Weiss' favorite integrated stocks thanks to its ambitious plans to return cash flow to shareholders.

"The company's restructuring program continues to move forward," Argus Research analysts say in a report. ConocoPhillips wants to return 40% of its cash flow to shareholders every year and has gone through a multi-year restructuring program as part of its efforts to reach this goal.

Last year, ConocoPhillips sold assets worth $7 billion and shares in Russian oil giant Lukoil worth $8 billion, reduced debt by $5 billion, and according to Weiss, improved the profitability of its upstream business on a per barrel basis. In first quarter 2011, ConocoPhillips completely exited its Lukoil position and has plans to dump another $5 billion to $10 billion in assets in 2011 and 2012. "As with its previous transactions, management is targeting those assets that have relatively higher associated costs, which should benefit margins, cash flow and net income per barrel," the Argus equity research team said. Weiss has a buy view and $95 target on the stock.

Exxon ( XOM)

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Standard & Poor's has a strong buy recommendation and $103 twelve-month price target on Exxon explaining that the company has enjoyed "superior earnings and dividend growth and stability."

Exxon has launched 11 major projects through 2013 in Qatar, the U.S., the U.K., Canada, Australia, Russia, Angola and Nigeria, and this is expected to boost production by 600,000 boe (barrel of oil equivalent) a day.

In the first quarter, Exxon's oil-equivalent production rose 10% year-over-year, driven by its assets in Qatar and growing unconventional gas production.

Exxon returned over $7 billion to shareholders in the first quarter through dividends and share buybacks. The stock is considered by S&P to be low-risk.

BP ( BP)

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Raymond James' equity research team says oil giant BP is a "good deal for retail investors" because it offers an attractive 4% dividend yield and is "very cheap" compared with its peers.

"BP, out of all the integrated companies, is the most undervalued," Hudson of Raymond James tells TheStreet. "We think as time goes on, OPEC (Organization of the Petroleum Exporting Countries) spare capacity will shrink and push oil up, she adds, helping to boost BP's profits.

BP, of course, remains under scrutiny in the aftermath of the Gulf of Mexico oil spill -- the legal overhang is part of why the stock is so cheap. The latest in a series of independent reports on the oil spill -- the marine board report from the Coast Guard -- will be released on July 27. Much like the Presidential Commission's oil spill report from January, this will not be a judicial document, though its conclusions could certainly have an impact on BP's legal road ahead, Raymond James' research analysts in a report.

But "we concur with the company's view that this report will echo the January report's central conclusion that the spill had multiple causes and multiple responsible parties," they noted in their client note. "Thus, this report should further bolster the company's defense against any potential attempt by the Justice Department to pursue gross negligence charges."

UK-based BP is one the world's largest private-sector integrated oil and gas companies. It's been rated outperform with a $62 price target by Raymond James.

Transocean, Noble ( NE) and Halliburton ( HAL)

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The Argus Research team likes a number of oil services companies with reasons varying from high dividend yields and attractive valuations, to robust North American growth.

Argus recently upgraded Transocean, the world's largest offshore contract drilling company to buy from hold with an $85 target price, with the explanation that the stock is undervalued and offers a very attractive 5% dividend yield.

Furthermore, much of the uncertainty about when deepwater drilling activity in the Gulf will return levels prior to that of the massive oil spill has already been priced into Transocean shares, the analysts say. According to Weiss, deepwater drilling activity has started picking up in the Gulf of Mexico, Brazil, West Africa and some areas of Asia since the five-month, post Gulf oil spill moratorium on deep water drilling moratorium in the region was lifted last October.

"Provided that Transocean is not found to be at fault or that it is indemnified for damages by BP, the primary costs related to the incident are likely to be liability for personal injury or death, the loss of the income associated with the rig being out of service, and any additional legal and insurance-related expenditures," the analysts say. Transocean was contracted by oil giant BP to provide the Deepwater Horizon drilling rig that in April 2010 suffered explosions that triggered a massive offshore oil spill in the Gulf of Mexico.

Weiss notes that Noble Corp ( NE), for which he has a buy recommendation and $50 price target, has a similar investment story to Transocean, but better margins. Highly levered to the offshore drilling operating environment, Noble has a diverse fleet that enables it to drill in harsh weather and up to 10,000 feet deep.

Still, of all the services companies in Weiss' universe, his favorite is Halliburton ( HAL), thanks in part to the company's strong North American performance.

"We expect a continuation of the current trend in which rigs drilling for natural gas are switching to liquids-based activity, which remains a key driver of robust North American results, his team says in a client note.

Argus equity analysts recently reiterated their buy rating and $56 target price on Halliburton and are raising their 2011 earnings per share (EPS) forecast for the company to $2.95 from $2.80 and 2012 estimate to $3.60 from $3.50.

They expect the company will focus on maintaining and growing share in North America, increasing international margins and expanding its presence in both deepwater and underserved international markets. The analyst says that furthermore, Halliburton's management believes it can lower costs to boost profitability. "For example, it plans to spend roughly $200 million this year building out its technology center in Houston and expanding its manufacturing capabilities, particularly in Asia."

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-- Written by Andrea Tse in New York.

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