Oil's New World Order It looks like high oil prices are here to stay. That changes the math for investors. Here's how to play a market in flux.
By Nicholas Varchaver

(FORTUNE Magazine) – What goes up must come down. That seemed to be the prevailing view last year when it came to oil. Throughout 2003, experts predicted that oil and gas prices would crater. Just wait until the war in Iraq is over, they vowed. Just wait until production rebounds. The months passed, and prices wavered but never came close to crashing. By year-end a hint of irritation had crept into the refrain. "We are perplexed by the stubborn strength in oil prices," wrote Prudential analyst Michael Mayer on Dec. 16.

That's putting it mildly. Benchmark West Texas Intermediate crude averaged about $30 a barrel last year--significantly higher than the $23 consensus prediction at the beginning of 2003--and held strong in early 2004. Natural gas also exceeded expectations. Analysts, meanwhile, continued to predict a fall but scurried to raise their estimates.

The markets seemed to grudgingly follow suit. For most of the year, oil shares lagged behind the rebounding S&P 500. Only in December did investors concede that there was value in the stocks. The result: a 20% rally into late January, when prices began to taper off.

It might seem like a formula for investor peril: a sector whose shares have just enjoyed a bump and whose product could swoon. Oh, yeah, and it's also a sector whose smaller companies were long seen as the embodiment of volatility, until tech and Internet stocks arrived to wrest that title away. For all those risks though, oil and gas stocks offer surprising potential.

For starters, a growing minority believe that a long-term realignment in oil prices is underway. Demand, stoked by China's torrid economy (see "Can China Keep the Lights On?") and a global economic rebound, is growing. Supply is stagnant. U.S. crude oil inventories are at record lows, and non-OPEC production in places such as the North Sea is waning. The result is renewed pricing power for OPEC, argues Leigh Goehring, who manages the Jennison Natural Resources fund. People can't accept today's oil prices, he says, because "we've been through a grinding 20-year bear market in oil. In real dollars, the price of oil has fallen tremendously since its peak in 1980." He adds, "People are convinced that around each corner lurks another debacle like 1998, when OPEC got into its last price war and oil went to $11. But there has been a fundamental shift in the global oil market."

And so, the thinking goes, we should no longer expect oil to drop to $20. There's little doubt that prices will slip from their current heights--but perhaps only to the middle to upper 20s. That's nowhere near as bad as it might seem for oil companies, because they base earnings projections on conservative price estimates. Most long-term revenue projections assume oil will drop more than $10 from its current price. If it doesn't, future earnings should outpace projections.

The present, meanwhile, has been flush for oil companies, which have been using cash to spruce up balance sheets. Still, says Stephen Leeb, an investment advisor and author of The Oil Factor, "the entire energy patch right now is trading as if oil prices are going to go back down." Even the biggest winners in the recent rally, so-called independent exploration and production companies such as Apache, now trade at a trailing price/earnings ratio of only 22.9, a slim discount to the S&P 500's 23.8 P/E.

That suggests there is still value in energy stocks. Moreover, with some companies oozing cash flow, it won't take a fundamental sector revaluation for them to pay off. With that in mind, we went looking for those that are not only generating cash but likely to deliver strong production growth--an absolute necessity in a business that depends on declining resources--while limiting their potential downside if prices fall.

Devon Energy (DVN, $54) has become the largest U.S.-based independent oil and gas producer with an astute series of acquisitions. Devon generated strong free cash flow of about $5 per share in 2003 and, despite the shopping spree, lowered its debt-to-capital ratio from 60% to 41%. Yet the stock trades at a forward P/E of just ten. Friedman Billings Ramsey analyst David Khani attributes the depressed valuation to concerns that Devon can grow only by acquisition. He argues, however, that Devon has begun to generate organic growth, most recently with new deep-water discoveries in the Gulf of Mexico.

Two other producers have also used acquisitions to great effect. But XTO Energy (XTO, $26) and Patina Oil & Gas (POG, $44) have done it differently from Devon: They've grown by acquiring gas and oil fields rather than entire companies. That means they don't take on corporate overhead or worry about management integration. Moreover, both have heavily hedged their production, reducing their susceptibility to price drops. Khani describes XTO as "predictable in an unpredictable business." It has had ten straight years of double-digit production growth, including 25% in 2003. XTO has brought its debt-to-capital ratio down to 45%, leaving it room to acquire, and analysts predict 15% annual production growth for the next few years. Despite that, the stock has a forward P/E of just 12.

The smaller Patina--with a market cap of $1.5 billion--is also enjoying a production spurt. "Patina really stands out," says Leeb, referring to the company's February announcement that it was increasing reserves by 38%. "In a world in which natural gas production is declining, this is a company that has the wherewithal to increase production at double-digit rates." Indeed, analysts expect 17% to 20% production growth for the next two years. And Patina is trading at 12 times future earnings.

To find a stock with the least risk in the event of a big drop in oil prices, look at the companies that gained least from the run-up: the majors. BP (BP, $47) has better prospects for production growth in the near-to mid-term than industry leader Exxon Mobil, argues John Segner, manager of Invesco's Energy fund, which has been buying BP shares. He expects 2% to 3% annual production increases from BP--not counting its $6.75 billion stake in a joint venture with a Russian oil company. (For more on oil, see "Billion-Dollar Bet on Russia.") If that pays off, Segner says, BP could boast 6% to 7% production growth. (By contrast, Exxon's output actually declined last year.) Segner argues that BP won't be dragged into a political quagmire in Russia. President Vladimir Putin, he points out, "was very involved with this deal at the time. So it has his blessings." At a forward P/E of 15, BP remains cheaper than Exxon (a P/E of 18), and its dividend yield alone--3.6% (compared with Exxon's 2.4%)--offsets most of the potential downside.