There's still zip in energy stocks
Even with oil prices near record highs, there are some companies with lots of room to run.
By Abrahm Lustgarten, FORTUNE reporter

(FORTUNE Magazine) - The last time we recommended a group of energy stocks - 17 months ago - the price of crude had fallen to $42 a barrel from a recent peak of $55 (see "Three Ways to Make Money in Energy Stocks").

We said buy anyway, and we're saying it again now: It's not too late to invest in energy. Even though you can't count on crude remaining at its recent highs indefinitely, the fundamental market forces that set prices climbing are still at work.

Brace yourself
Plenty of gas left in the tank
These energy companies are well positioned for profits even if the price of oil falls.
Company (ticker)  P/E ratio  Market cap (billions)  Yield 
Apache (APA)  8.0  $21.3  0.6% 
ConocoPhillips (COP)  6.4  $104.7  2.3% 
Energy Conversion Devices (ENER)  N.A.  $1.6  None 
Fuel Cell Energy (FCEL)  N.A.  $0.5  None 
Marathon Oil (MRO)  7.7  $27.5  2.1% 
Suncor (SU)  22.4  $36.9  0.4% 
Valero Energy (VLO)  8.7  $37.8  0.5% 
 Notes: N. A. Not applicable. Data as of May 25, 2006. Price/earnings ratios are based on past 12 months' earnings.
 Source: Bloomberg

Anyone getting into energy stocks now has to take a long-term view and brace for volatility. The price of oil has been holding in the $70-a-barrel area for the past few weeks. If rising interest rates lead to an economic slowdown, demand for crude will dip and prices will drop.

That's why, according to Oppenheimer analyst Fadel Gheit, the question investors should ask isn't "How high can oil go?" but rather "How low?" Gheit says oil will always be subject to sharp swings, but the cyclical low points for crude have trended higher over time - a fact not reflected in the average oil stock.

ConocoPhillips, for example, trades at a price/earnings ratio of six, Apache at eight. Gheit says these valuations assume oil will return to an average of about $40 a barrel, something he considers highly unlikely.

"Oil could go to $55," he says. "But you are not going to get a 40 percent drop. Stock prices just don't reflect this understanding."

Gheit has a point. For one thing, demand isn't going to fade anytime soon. Americans have barely touched the brakes at the sight of $3 gas, and when you consider the surging economic growth in China and India, it's no wonder that the world consumed 84 million barrels of oil a day in 2005, up from 80 million two years before.

And while energy thirst may be endless, the supply of oil is not. Surplus production capacity, or the industry's ability to get more oil in a crunch, is down more than 80 percent since 2002.

"The economists say that production will increase with higher prices," says Tim Guinness of Guinness Atkinson Funds. "I think they are underestimating the challenge of that."

Weather and politics

And then there is weather and political risk. Meteorologists say the Gulf of Mexico is in the early stages of a 25-year cycle of increased storm intensity, meaning disasters like Hurricane Katrina - which locked up refining and inflicted heavy damage on the gulf's 950 offshore drilling rigs - could be a regular event. Meanwhile bad news from Nigeria, Iraq, Iran, or Venezuela can send jittery traders scrambling and jack up crude prices.

In light of those factors, we think oil stocks can still be good investments. The mini-portfolio we recommended in December 2004, which included two renewable-energy companies, has posted an average total return of 51 percent against the Morgan Stanley oil and gas index's 36 percent gain.

We think four of the seven companies we picked then are still worth buying today, and we've added three new ones to consider.

Good bets

ConocoPhillips (Research) has posted a total return of 50 percent since we recommended it. That figure might have been even higher, but investors have been dubious about Conoco's December 2005 acquisition of Burlington Resources, a big natural-gas company.

That, says Gheit, is reason to buy, not sell. Gas prices should rise again next year, and Conoco is already a steal. "Barrel to barrel, you are buying Conoco reserves at a 20 percent discount to Exxon, Shell, or BP," he says.

Apache (Research) has returned 28 percent since December 2004. In 2005 reserves grew 9 percent and earnings per share, 53 percent. Apache has a consistent record of finding oil where others have quit and gone home.

In April it bought BP's shallow-water oil and gas reserves in the Gulf of Mexico for $1.3 billion - staking a claim to a vast new field and adding 2.5 percent to its own proven reserves. What else makes Apache attractive? Its board recently authorized a buyback of 15 million shares.

Canada's oil sands remain alluring as a future source of crude. Suncor (Research), the pioneer of Alberta's booming industry, remains our favorite oil sands play. Suncor has returned 142 percent since we recommended it, despite a slow 2005 following a major fire at its big processing plant. But by expanding operations at its Millennium mine and Firebag facility, Suncor is expected to increase production of crude by 15 percent annually for the next six years.

Suncor pipes its output south, where only a limited number of refiners can handle the heavy crude that comes from tar sands. One company gearing up to handle heavy crude is Marathon Oil (Research), a stock we didn't name in our December 2004 story. The Houston-based company gets about half its income from production and most of the rest from refining. Many of its refineries are located in the central states, which positions them perfectly to handle both oil sands and ethanol.

"It's my favorite by far," says J.P. Morgan analyst Jen Rowland. "They are extremely well positioned right now."

Rowland also likes Valero Energy (Research), the largest U.S. refiner. Valero already specializes in low-quality heavy crude processing and boasts some of the highest profit margins of any refiner.

"They have the best management around and deserve an Exxon-like premium," says Rowland.

To diversify your energy portfolio you may want to include companies that steer away from hydrocarbons altogether. But be warned: When you move into alternative fuels, you're often dealing with small, unprofitable companies and risky stocks.

Case in point: Fuel Cell Energy (Research). The company makes industrial-sized fuel cells for such customers as Starwood Hotels. The stock is up $1 since we recommended it, but as recently as April 25, it traded at $15.

Ardour Capital Partners managing director Walter Nasdeo says the 33 percent drop - sparked by a decline in first-quarter sales - presents a buying opportunity. New CEO Daniel Brdar has cut production costs (the key to eventual profitability) by almost 25 percent for two years straight.

"Their business proposition is making more sense the longer the energy markets stay unsettled," says Nasdeo.

Another company to consider is Energy Conversion Devices (Research). The company boasts an experienced management team and a basket of different technologies, including solar cells and nickel metal hydride batteries (made in partnership with Chevron (Research)) used in hybrid vehicles. Saturn recently signed a contract with Energy Conversion for batteries to use in its new VUE Green Line cars.

"The stock value does not reflect this hybrid business at all," says Brion Tanous, an analyst at Merriman Curhan Ford. "They win as long as the hybrid market expands."

Tanous believes Energy Conversion will turn profitable within a year, by which time the stock could hit $70.

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