3 Ways to Play the Energy Stock Rally

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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.

    The high risk, crude levered trade: Goodrich Petroleum

    Goodrich Petroleum was one of the dogs of the E&P universe in 2011. Goodrich shares traded above $23 in March 2011, and even after the 25% rally to start the year, are at $17.32 as of the close on Tuesday. The valuation discount argument has helped to buoy shares. Another reason for the rise in shares of Goodrich is its recently provided 2012 annual guidance implying more oil production on lower costs.

    Dan Guffy, energy analyst at Stifel Nicolaus, said the big negative on Goodrich is its highly levered nature. That's a tailwind when the risk-on trade is happening and crude oil prices are strong, but it can reverse quickly. Guffy, though, doesn't think the cash needs of Goodrich will stretch the company too thin in 2012, or force it to pursue any dilutive market capital action like a secondary offering. If oil drops to $90 and gas prices remain at $3, the Stifel analyst argues that the company will only outspend its cash by $50 million. Goodrich has a $175 million credit revolver that can be tapped to meet any short-term cash needs.

    Vanessa Howell, energy analyst at Raymond James, said the recent outlook from Goodrich showed that the company is having success in moving up the E&P ladder from early stage to sustainable production growth.

    "We've seen this before as companies implement new technology and become more comfortable in their plays Eagle Ford for Goodrich. They can complete wells at a quicker pace and lower cost. There have been hiccups along the way but now they know where the sweet spots are and are seeing steadily improving results," Howell said.

    "We are confident in their Eagle Ford program steadily outperforming what the Street is expecting," Howell said.

    The Raymond James analyst added that Goodrich could ultimately make a good takeout candidate. The company has talked about monetizing assets in some of its plays like the Haynesville. If it is able to sell off some assets it may make for a good comparison to Brigham Exploration ( BEXP), which came up the learning curve in the Bakken shale of North Dakota, using similar drilling technologies as Goodrich is using in the Eagle Ford, and Brigham ended up being taken out by Statoil at a 20% premium last year.

    The Brigham deal did not represent the peak of the independent E&P takeout trend -- Petrohawk was taken out by BHP Billiton ( BHP) at a 60% premium earlier in 2011, but the Brigham deal was a signal that independent E&Ps that are highly levered may be willing to cut deals sooner rather than later.

    If Goodrich has to trim assets before becoming a takeout candidate, though, it could be a problem given that the Haynesville is the most uneconomic play among major resource basins in the U.S., with natural gas prices so low. "There aren't many buyers in the Haynesville right now, which is why they haven't sold or can't sell," said Guffy.

    Coleman at Raymond James said Goodrich has some assets in the Tuscaloosa Marine shale play which is near the region included in the five-play joint venture that Devon Energy recently signed with a major Chinese petroleum player. That may be a under-the-headlines reason for optimism about its shares.

    In any event, it's the production growth story to which the company's stock fortunes are levered more so than a potential takeout.

    "This is a small company trying to jump up to the next level and production growth is very important. They are still in the early days in the Eagle Ford, delineating and refining completion processes, and as they continue to do that they become more return focused," Stifel's Guffy said.

    For TheStreet Ratings take on Goodrich, click here.

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    The mid-cap E&P trade

    Denbury Resources was one of the dogs of the E&P universe in 2011. It hit a 52-week high of $26 last March, and even after its 20% rally to start 2011, closed at $18.09 on Tuesday. The valuation discount argument supports the recent rally and suggests that it could continue, and the fact that Denbury was cited on Tuesday as a potential takeover target by Susquehanna Financial helps.

    Denbury is far from alone among E&P stocks rallying in the early days of 2012. The list includes Continental Resources ( CLR), Concho Resources ( CXO), Whiting Petroleum ( WLL), Oasis Petroleum ( OAS) and Pioneer Natural Resources ( PXD). In fact, Susquehanna in its Denbury call suggested investors swap out of Whiting and into Denbury.

    The above stocks have one thing in common: They are all in the mid-cap E&P universe, and that's a group that stock investors like relative to other energy niches.

    A survey released on Monday from the International Strategy & Research Group (ISI) asked investors what energy stocks they most prefer to own in 2012, and the winner was mid-cap oil.

    Approximately 52% of investors said mid-cap oil stocks were the best bet in 2012.

    This was followed by large-cap oil -- 28%; Marcellus gas -- 12%; and large-cap gas -- 7%.

    Is Denbury the best bet among this surging mid-cap E&P niche?

    Anish Patel, analyst at ISI, said Denbury isn't unique among mid-cap E&P stocks in rebounding from 2011 losses, but it's a starting point for more bullishness. "You look for value in names that can snap back from losses last year."

    The ISI analyst is more interested in Denbury as a "perfect way to play long dated oil assets," as opposed to being completely levered to a short-term high crude price.

    Denbury has a somewhat unique approach among mid-cap E&Ps, using an enhanced oil recovery carbon dioxide injection technology to extract oil. It's built the only CO2 pipeline east of the Mississippi for this purpose, and it's an approach which, if successful, is designed to allow Denbury to develop assets with more longevity and to respond to fluctuations in the price of oil without as much volatility as other E&Ps.

    Coleman said that while Denbury has some exposure to the Bakken -- a straight crude oil price levered trade -- it doesn't work as well as other stocks based on that trigger. But the offset is that if crude pricing is more stable or softens a little then the fact that its wells ramp more slowly than other shale plays means it will still be ramping in a crude environment that forced other E&Ps to pull back on production. That makes Denbury a more defensive stock, though if crude prices tank, its fortunes are the same as the larger E&P peer group.

    However, the CO2 approach has not been without its hiccups. Michael Scialla, Stifel analyst, said Denbury is among the commodity-related stocks that were oversold last year and were due for a bounce, and for some of these mid-cap stocks the bounce began in late 2011, though not for Denbury. "Assuming the global macro economic picture holds together, oil weighted E&P names should continue to do well this year."

    Denbury also has some assets in the Tuscaloosa Marine shale play where Devon Energy recently signed the joint venture with China's Sinopec.

    Scialla said Denbury's CO2 approach has been a double-edged sword: "They have had all kinds of execution problems with their CO2 project, but assuming they can fix those, this stock still looks cheap."

    Coleman said, "I have $22 target on Denbury. Shares got into the upper $20s last year and in 2008 shares were in the mid $30s. I don't tend to be super aggressive in stocks, but just think with execution it can keep ratcheting production along and oil prices will be favorable and it's already weathered a storm of execution problems."

    Patel said there will be continued buying among the E&P stocks because stock values had been discounting $85 crude and investors are now taking the view that E&P stock values can move closer to the actual price of crude. Though reading between the lines of the ISI survey results may present a good contrarian stock picking strategy, too.

    If some of these stocks were laggards in the latter part of 2011, the sentiment may have changed too quickly. As ISI analyst Anish Patel said, "These mid-cap oil names may be over-bought."

    For TheStreet Ratings take on Denbury, click here.

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    The "safe" trade

    If an investor is wary of the highly levered E&Ps like Goodrich, and the more "experimental" plays like Denbury, accepting a little less production growth potential can still lead to finding undervalued names in the E&P space.

    Morningstar's Hanson said the production growth potential is typically going to be greater in the smaller companies, including the mid-cap high flyers of early 2011, but 7% to 10% growth from a Devon Energy ( DVN) or Apache ( APA) is still going to be rewarded.

    Patel said his focus is more value oriented, higher quality and lower beta E&Ps, less reliant on crude oil price-triggered rallies. "At this point, I wouldn't be buying high beta names, but I am still comfortable owning a Pioneer or Noble ( NBL).

    "These are not bets on commodity prices but on asset growth." The ISI analyst said Anadarko and Apache are similar plays, though Pioneer and Noble remain his top picks.

    Amir Arif, a Stifel analyst, agrees with Patel in thesis, launching coverage on both Apache and Noble this week, but he thinks Noble is already at fair value and has a more bullish view of Apache as the undervalued "safe" E&P play. It's hard to call Apache safe after the last year, in which it was punished by investors for its exposure to Egypt -- the only U.S. E&P reliant on Egypt -- as well as for its exposure to the stalled deepwater Gulf of Mexico drilling region.

    Arif's buy on Apache and $115 price target assumes that an Egypt discount remains in shares. "If the Egyptian concerns settle down, we see potential upside to $130/share," Arif wrote on Tuesday. "We believe that this current valuation overly discounts risks related to Egyptian production and GOM issues, and both of these concerns should ease over time." Apache shares closed at $98.09 on Tuesday.

    A clean balance sheet and 8% production growth place Apache in the camp of E&Ps that won't shoot the lights out, but won't hurt you and turn on a dime if the crude oil price-rally fades. "We estimate APA to remain free cash flow positive and generate mid to high single-digit growth over the next five years," Arif wrote.

    The bottom line for the Stifel analyst is that given big returns many energy stocks have already seen in 2012, Apache's performance provides a "good entry point in a stock with a good history of creating value for shareholders."

    For TheStreet Ratings take on Apache, click here.

    -- Written by Eric Rosenbaum from New York.

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    >To contact the writer of this article, click here: Eric Rosenbaum.

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