Top 5 Energy Stocks

When I was working on the trading floor a few years ago, oil had just started trading electronically. It was a big deal in the world of trading because oil had always been closely guarded, accessible only through a very tight network of insiders at the exchanges. But now, in the blink of an eye, almost anyone with a computer and a few thousand bucks could get behind the wheel.

We of course were very eager, and it didn’t take us long to figure out that this was a place to get some serious action.

There was a long list of headlines that could instantly send prices shooting higher.

1.) Political Conflict-there’s nothing like a good political conflict in the Middle East to put the bid in oil. That was on display this week, with prices jumping the most in 15 months on brewing political uncertainty in North Africa.

That’s because of OPEC (Organization of Petroleum Exporting Countries), the 14-country cartel that controls more than 40% of global production. Even though most of these countries are pretty stable, they are friends with and reside in a very unstable part of the world. So if Iran starts acting up or the Nigerian rebels decide to blow up a few pipelines, you can bet that prices will be quick to respond as the market worries about production.

2.) Surging Demand-This is an emerging markets story. Demand for energy resources from the developed economies of the world like the United States and Japan is relatively stable and predictable. But the emerging markets like China and Brazil are seeing big gains in annual consumption. That has been pressuring the already tight relationship between supply and demand.

3.) Limited Supply-In a lot of markets, if you need more product, you just flip a switch and push the accelerator to 10. But that’s not how it works with oil. Not only is it becoming more difficult to find and extract, refining and production capacities remained constrained due to the capital intensive and high-risk nature of such projects.

4.) Inflation-Investors all over the world continue to be worried about currency devaluation. Basically another way of saying inflation. That has put a premium into hard assets, particularly oil, where many investors are looking for a way to avoid being diluted.

5.) Hurricanes-This is just an added bonus to anyone investing in energy. Ya, a natural disaster is nothing to celebrate, but that doesn’t mean you have to feel guilty about making a good investment. When a hurricane cuts through the Gulf of Mexico you are talking about major production disruption, with the rigs and transports closing shop. It can also knock out an existing installation off line for repairs. When a market suffering from tight supply/demand dynamics loses production, prices have one way to go.

Fortunately, I made it off the trading floor in one piece, but these trends are alive and well in today’s market. That’s why having a few good energy investments is an absolutely essential part of a growth portfolio.

Let’s go ahead and take a look at our top picks in the category.

Top 5 Energy Stocks

Transocean Ltd (RIG)

This is basically the world’s biggest off-shore drilling services company, providing deep-see drilling rigs to off-shore explorers with a market cap of $28 billion. Off-shore drilling continues to be a popular destination for energy companies looking for new wells. And if you think about the geography of the world, 2/3 water, that makes a lot of sense.

That has pushed demand for Transocean’s deep-sea drilling rigs to a multi-year high. And keep in mind, it’s not easy to bring new capacities on line, these rigs can cost up to $3 billion and take 2 years to build. That makes this a well insulated business. Also, as an oil-services company, RIG won’t be as sensitive to the underlying price of crude. On the valuation front, RIG is trading at 11.5X forward earnings, a discount to the S&P500 and its peer group.

Cimarex Corp. (XEC)

Cimarex is a domestic explorer of oil and natural gas with a market cap of $8.5 billion. This is a straight play on crude and natural gas, with crude accounting for 65% of the company’s revenue. Categorically, Cimarex is an “E&P”, which means Exploration and Production. This is a company that buys big chunks of land, looks for oil, and then extracts. That’s why its share price has such a strong correlation to underlying crude prices.

Here’s another reason I like this stock. It has good political stability, focusing exclusively on domestic exploration. That means if things get crazy in the Middle East, Cimarex stands to benefit with uninterrupted production. We also have a good valuation, something we look for in all our stocks, with shares trading at 15X forward earnings, a nice discount to its peers 21X.

Apache Corp. (APA)

This is an extremely large and global exploration and production energy company, with operations in a number of different regions of the world and a market cap of $42 billion. The company’s share price recently took a little hit on the riots in North Africa and Egypt because of key installations in the area. Long-term production will most likely return to normal levels so it could be a chance to buy ahead of summer as shares trade $10 below the recent 52-week high.

Diamond Offshore Drilling, Inc. (DO)

Diamond reminds me of Transocean Junior, slanted toward domestic markets with a market cap of $10 billion. If we see more consolidation in the energy services space, this is a company that could become a target because of its smaller size. The valuation picture also looks great, with a forward P/E of just 11X, a slight discount to Transocean and below its peer average.

Chesapeake Energy (CHK)

Chesapeake  is a straight play on natural gas, one of the few companies that offers such an opportunity. Natural gas is definitely a strange market. Unlike crude, we have tons of it, with production capacities and inventories at record levels. But there is no path to consumption, because the civil infrastructure doesn’t exist to support it yet. How many natural gas pumps do you see at your local gas station? I’m guessing not many. But in the long-run, if the infrastructure adjusts to support natural gas, we could see a structural shift in the relationship between supply and demand that would produce strong earnings for a company like CHK. That’s a story to keep your eye on.

Updates:

McDonalds (MCD)

We saw pretty solid fourth-quarter results from McDonald’s this week, with both sales and earnings coming in ahead of expectations. Its biggest gains came from its Asia Pacific/Africa/Middle East region, with same-store sales up 5.5%. Its biggest region, the U.S., saw sales increase 4.4% from last year. The good quarter was driven by the company’s value menu, which continues to sell well in the shaky consumer environment. Its McCafe initiative also looks strong, enabling McDonalds to expand its presence in a new market.

On the cautionary side of the tracks, McDonalds warned of higher food costs squeezing its margins while ongoing economic uncertainty in the Euro Zone could present head winds. Taking a look forward, the company announced an aggressive strategy for 2011, saying it will invest $2.5 billion to open 1,100 new restaurants and upgrade existing locations.

Here’s an added bonus; MCD still has value, trading with a historically low forward P/E of 14.5X. The last time shares were this cheap was March of 2009, the bottom of the brutal sell off, and before that it was in June of 2003, just before the stock market posted big end-of-year gains.

Buckeye Partners (BPL)

Buckeye was also in the news, issuing 4.5 million units (shares) at $64.48, which is about where shares finished trading on the day. The reason we saw the slight decline is because the new issue is dilutive to existing shareholders. Technically that’s not a good thing, but here is the upside.

The company just raised some more equity capital that it can use to fund growth or beef up its balance sheet. Buckeye already has a very strong financial profile, with tons of operating cash flow to fund short-term liabilities. That’s why the market doesn’t seem to be too worried about the new issue.

That’s all for this week. The Vodicka Group is going on vacation next week, so we’ll be back with our next update in two weeks. In the meantime, here is an article about the weirdness of the natural gas market that we talked about above and another about some recent regulatory changes related to 401K disclosures.

Radical things like sharing information about costs and fees with investors.

Enjoy!

Natural Gas: The Ugly Duckling

Changes Coming to 401K

Your Investment Partner,

Mike

ABOUT THE AUTHOR

Michael Vodicka

Michael Vodicka is the president and founder of the Vodicka Group Inc., a licensed investment advisor (Series 65) and a financial journalist.