7 ways to invest in the oil boom

Oil prices have been on the rise, but many energy stocks haven't kept pace. Fortune's Jon Birger looks at some surprisingly undervalued companies in a still-hot industry.

By Jon Birger, Fortune senior writer

(Fortune Magazine) -- Since January, the price of oil has risen from $50 to $65 a barrel. Didn't notice? For casual investors that's understandable. After all, the last time this happened - back in the summer of 2005 - soaring energy costs were front-page news.

Unhappy consumers were accusing gas stations of price gouging. Oil company CEOs were pointing fingers at hedge funds. Economists predicted that $3 gasoline would tip the U.S. economy into recession. And most notable for our purposes, oil company shares went absolutely crazy: The S&P energy index rose 24 percent in four months.

The Cajun Express, a Transocean rig, at work in the Gulf of Mexico

By comparison, this latest run in oil prices has been a ho-hummer. "When gasoline first hit $3, we all complained and said consumers can't afford it," says David Ginther, manager of the Waddell & Reed Advisors Dividend Income fund. "Well, now gas is back to $3, and suddenly it's no longer on CNBC. The fact there's no pushback from consumers tells me prices will continue to go higher."

While Ginther is betting on rising prices - he has 20 percent of his fund in energy stocks - he seems to be in the minority. Yes, oil stocks have rallied from their January lows, but big-name stocks like ConocoPhillips (Charts, Fortune 500) and Exxon Mobil (Charts, Fortune 500) still trail the S&P 500 in year-to-date performance.

Overall, the S&P Energy index's price/earnings ratio is 12, well below its ten-year average of 19, reflecting a belief that oil will soon head lower. How else do you explain the P/E of a stock like Transocean? The deep-water driller is projected to boost earnings 157 percent this year (on the heels of 90 percent in 2006), yet its stock trades at a mere 12 times 2007 earnings, according to Baseline.

In fact, a return to $70 oil seems a better bet than a fallback to $50. That's especially true near-term as we head into summer driving and the hurricane season soon thereafter.

The supply-and-demand picture points higher too. Global oil demand is forecast to increase by 1.43 million barrels a day in 2007, according to Barclays Capital, even as supply increases only 1.18 million barrels. That's a recipe for higher prices. Indeed, the latest trading on the NYMEX has September oil futures trading at $66 a barrel and May 2008 futures at $70.

So what's the best way for investors to play oil right now? We'd start with the stocks that appear the most glaringly undervalued - offshore drillers like the aforementioned Transocean, Diamond Offshore, GlobalSantaFe, Noble and Rowan Cos.

Those companies own and operate offshore-drilling rigs and lease them to the likes of Chevron and Exxon Mobil for rates that, for deep-water rigs, can exceed $500,000 a day. As a group, drillers boast the stock market's best combination of low valuation and high earnings growth. Their average PEG ratio - P/E divided by projected growth rate - is 0.4, vs. an average of 2.0 for the S&P.

We made a similar case for drillers last December in Fortune's 2007 Investor's Guide. Our favorite driller then was Diamond Offshore (Charts), based in part on expectations of a gaudy special dividend (which turned out to be $4 a share, paid in March).

All in all, Diamond has produced a 15 percent total return in the five months since we recommended it. We still love it, but if you're an investor who favors price appreciation over dividends, a good alternative is Transocean (Charts). While Diamond is pouring its windfall profits into dividends, Transocean is buying back stock - $3.4 billion worth since October 2005.

In any event, both companies benefit from their deep-water focus. There's been a rig-building boom of late, which could potentially threaten driller profits. However, according to Michael Hoover, portfolio manager of the Excelsior Energy and Natural Resources fund, a disproportionate amount of the new rigs are "jack-ups," which operate in 200 or 300 feet of water, not in thousands. "The deep-water rigs are much more expensive and difficult to duplicate," says Hoover.

For fund investors there's now an exchange-traded fund, Oil Services HOLDRS (Charts) (OIH, $161), that owns all the major drillers. It also has heavy exposure to oil-services companies, which is another oil niche where the growth rates and valuations are compelling.

The leading oil-services company is Schlumberger (Charts), which provides well testing, reservoir imaging and seismic surveying, among other essentials. Especially dominant in the oil-rich Middle East, Schlumberger is a favorite of many of the energy stock investors we talked to, including Hoover, Ginther, T. Rowe Price energy analyst Tim Parker and Robb Parlanti, an energy analyst at Turner Investment Partners.

Schlumberger is oil services' safest choice, but investors willing to swing for the fences might consider Cameron International (Charts). Cameron produces an array of subsea valves, wellheads and blowout protectors that are in high demand right now. The company raised earnings estimates in April, and analysts now expect Cameron's profits to climb 39 percent this year - excellent for a stock that trades at 17 times 2007 earnings. To top it all off, Parlanti thinks it's a takeover candidate.

Another stock we like is refining giant Valero (Charts, Fortune 500). The dearth of new refining capacity used to be mainly a U.S. story, with commentators pointing out that there hasn't been a new refinery built here since 1976. The upshot seemed to be that more gasoline would have to be imported from countries where local opposition and construction costs were less of an impediment to refinery construction. Well, refining is fast becoming a global bottleneck, not just an American one. Kuwait, for example, recently canceled plans for a new 615,000-barrel-a-day refinery when construction bids came in at $15 billion - $9 billion more than expected.

Needless to say, the lack of new refining capacity bodes very well for refiners' profit margins, says Valero fan Bob Doll, chief investment officer for equities with BlackRock Funds. He calls Valero "the largest, purest, and most leveraged play on the refinery business."

Our final pick - XTO Energy (Charts, Fortune 500) - amounts to a straight bet on natural gas. Historically, gas markets have been tied to seasonal demand for heating and cooling. Prices rose in winter and summer and fell in the spring and fall. This spring, however, gas prices have held up unexpectedly well, with prices staying near $7.50 per million BTUs. A key driver has been commercial and industrial demand, up 8 percent in January and February, according to the Energy Information Administration.

One surprising explanation is the ethanol boom. Most of the new ethanol plants dotting the Midwest are gas-fired. In addition, corn growers are using much more fertilizer, which is produced using natural gas. "That's why we're seeing $7-plus natural gas now," says Parlanti. XTO, an independent gas producer, has a P/E of 12 and is projected to increase profits 11 percent this year.  Top of page