How to Make Money Off Oil, Gas Pains

BOSTON (TheStreet) -- Bullish commodities analysts see oil hitting $150 by next spring. Such a spike, while a detriment to economic growth, would bring outsized gains to energy stocks.

Chevron ( CVX) and larger rival Exxon Mobil ( XOM) delivered record profits in 2008, following crude's meteoric rise to $147 a barrel. We may be in the midst of another energy bull market as oil has retained a foothold above $90 and is enjoying support amid improving global demand fundamentals.

Chevron is scheduled to report second-quarter results Tuesday. The company's stock has advanced 15% in 2011 and 50% in the past 12 months as the commodities boom widened the company's profit margins, bolstering net income. Chevron's first-quarter pre-tax margin, at nearly 20%, ranked in the 73rd industry percentile. Return on equity, the critical measure of profitability for stockholders, was outstanding, at 20%. One critical investment metric, which renders Chevron more attractive than key rival Exxon, is its balance sheet. Chevron held $1.7 billion of net cash (cash minus debt) at the quarter's end, so it has flexibility to pursue acquisitions, amplify financial leverage or increase the quarterly dividend.

Exxon's debt load overshadowed liquidity by about $2.6 billion. Both firms remain compelling energy investments, given their scale, geographic diversification and management quality. Cornerstone Analytics, a closely-followed forecaster, has projected a $170 plateau for black gold. The supply picture remains tenuous, which is one reason that bulls may have the upper hand, going forward. Turmoil in the Middle East has crimped output in that region, as global demand continues to increase. So-called strategic reserves in oil-consuming countries are meager. The International Energy Agency released 60 million reserve barrels in late June.

While this catalyzed the most recent correction in the market, its magnitude is overstated. In fact, 60 million barrels a day is only two thirds of the world's daily oil consumption. Total emergency stocks amounts to just 18 days of supply, according to Barron's. In sum, upside demand risk is prevalent. Peak oil, the point at which global extraction hits is apex is fast approaching and, in fact, may have already passed. Optimists estimate that 2020 is the year that the production curve will begin its descent. Unless we have steadily weaned ourselves from fossil-fuel reliant technology by then, oil prices will continue to rocket due to scarcity. In our current political and economic environment, this is the most plausible scenario.

According to Standard & Poor's, energy is supposed to be the second best-performing sector this earnings season, based on year-over-year profit growth. S&P 500 energy components will grow earnings by 38% in the second quarter, a solid expansion. Materials, expected to lead, will grow the aggregate bottom-line by 61%. Other sectors aren't predicted to grow profit, at all. For example, telecom services will suffer a modest year-over-year decrease. Utilities, despite solid stock performance as of late, are next worst, forecasted to raise profits just 2.3%. Typically, earnings are backward looking. In other words, energy's outperformance should already baked into share prices. But, should margins or profits expand farther than anticipated, the stocks would likely rally. The sector is still popular with investors.

Chevron is the favored blue-chip play. Its stock receives "buy, "overweight" or "outperform" ratings from 77% of researchers. The remaining 23% recommend holding shares. Barclays has the highest price target on Wall Street, expecting Chevron to advance 25% to $132. Analysts predict, on average, $3.56 of earnings in the second quarter, for a year-over-year rise of 32%. They project sales rose 29% to $63 billion. In the past 12 months, oil and gas S&P 500 components have achieved the best sales growth, out of 10 sectors, boosting the top line 22%, on average. They also have earnings momentum.

However, these comparatively large companies have been dividend laggards. They have increased their payouts the slowest of any sector in the past 12 months. This trend is due for a reversal as shareholders will demand a higher proportion of profits returned to owners, at some point. In the near term, however, they appear pleased that earnings are being reinvested internally. After all, with oil in a sweet spot, these companies can generate more dollars of profit per barrel extracted, and growth is the most critical stock price determinant. S&P 500 oil and gas stocks command an average forward P/E of just 12, so despite outstanding metrics and touted momentum, they are cheaper than the broader index, which sells for more than 14-times forward 12-month earnings.

It's difficult to pull the trigger on what appears to be a crowded trade. Still, oil and gas companies are inexpensive and poised for ongoing earnings growth amid rapid emerging markets expansion and peak oil extraction. This late-cycle sector is due for greater gains.

-- Written by Jake Lynch in Boston.

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Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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