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10 ways to play the domestic energy boom

Domestic energy production is soaring, and some investors say the boom is just starting.

  • By Daren Fonda,
  • Fidelity Interactive Content Services
  • – 11/29/2012
  • Energy Sector
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Domestic energy production is soaring, and some investors say the boom is just starting.

Say goodbye to imported oil – and hello to homegrown energy. According to a recent report by the International Energy Agency, the United States is on track to become the world's largest oil producer by about 2020 and could start exporting oil a decade later.

That's creating a long-term opportunity in energy stocks, according to some investing pros. Indeed, the energy sector now trades at a discount to the broader market, with the S&P 500 Energy Index trading at 10.5 times estimated 2013 earnings, roughly 13% below the S&P 500's (.SPX) P/E ratio of 12.

"We think we're getting in on an industry that has a lot of growth ahead," says Kent Croft, co-manager of the Croft Value Fund (CLVFX), which owns shares in several domestic natural gas and oil producers.

Energy stocks still could get knocked down for any number of reasons. The sector has lagged the broader market this year due to concerns about slowing economic growth and weak prices for oil and gas. Wall Street has set the bar low for earnings, forecasting 5.7% growth in industry operating profits next year compared to 10.5% growth for the S&P 500, according to S&P. Furthermore, there's a glut of natural gas on the market, depressing the commodity's price as well as profits for gas producers.

Yet stock valuations may already reflect these pressures, according to John Dowd, manager of the Fidelity Select Energy Portfolio (FSENX). Energy stocks are generally inexpensive compared to the market, he says, judging by how much cash energy businesses are generating.

The industry is fundamentally healthy, meanwhile, with production growing steadily thanks to new horizontal drilling and hydraulic fracturing, or "fracking," techniques that are opening up vast deposits of oil and gas from Texas to North Dakota.

The advent of horizontal drilling and fracking "gave the industry new life," says Dowd, whose fund owns shares in domestic oil-and-gas producers such as Occidental Petroleum (OXY) and EOG Resources (EOG).

Indeed, U.S oil production is expected to reach 6.8 million barrels a day next year, the highest level since 1993, according to the U.S. Energy Information Administration. Analysts predict additional growth as the industry continues to extract oil from more unconventional resources such as shale deposits, tar sands in Canada and deep-water wells in the Gulf of Mexico.

The global supply and demand picture also looks compelling. World oil production declines about 5% annually as reserves are depleted, notes Mike Breard, an energy analyst with Hodges Capital, an asset manager in Dallas. That means companies need to pump more crude oil each year just to keep total oil supply from falling. Demand is gradually increasing, meanwhile, as China, India and other emerging markets consume more oil to fuel their growing economies. Even in a slowing global growth environment, the IEA forecasts that world oil demand will increase by 800,000 barrels a day next year.

Ways to invest

For investors who want broad exposure to the U.S. production industry, an exchange-traded fund may fit the bill. The iShares Dow Jones U.S. Oil & Gas Exploration & Production Index Fund (IEO), for instance, holds 62 domestic energy stocks, including big producers such as Occidental Petroleum and Anadarko Petroleum (APC). The fund yields 0.57% and costs 0.47% in annual expenses.

While the ETF is well-diversified, it's still a volatile investment. It has very little exposure to "midstream" energy companies such as pipelines and refineries, which can help smooth out revenues, notes Morningstar analyst Abraham Bailin. Indeed, when the price of the commodity falls, production companies often see profit margins plunge because they have high fixed costs and can't quickly cut production.

Individual oil-and-gas producers could be better bets, according to some investing pros, though it's important to keep some caveats in mind.

Stocks are generally riskier than more diversified funds, and energy stocks, in particular can bounce around quite a bit because they're sensitive to swings in commodity prices. So an energy producer's stock may fall even if its underlying oil production is growing.

Over time, if a company is profitably growing production and staying disciplined about financing, its earnings and share price are likely to rise. If you're going to invest, though, it's a good idea to build a position gradually over a period of weeks or months. That can lower your average cost should the markets or commodity prices take a tumble.

One natural gas producer that looks attractively priced is Southwestern Energy (SWN), says Croft of the Croft Value Fund (CLVFX).

While natural gas prices are low now due to excess production, Croft says that could change as electric utilities and some manufacturers continue to switch from coal and oil to lower-cost gas, which could benefit producers like Southwestern.

Several liquefied-natural-gas (LNG) terminals are now being permitted for construction and could increase exports once they're operating. And if prices stay flat or decline, gas production may level out as drillers with high operating costs cut back on projects that are losing money at current prices.

Why Southwestern Energy? For one thing, it's a low-cost producer that's able to preserve revenues and earnings better than peers, even with prices at depressed levels, says Croft.

Southwestern also has one of the highest production and reserve growth rates in the industry, notes Oppenheimer analyst Fadel Gheit. And it's been quite profitable, leading the industry in returns on capital over the last decade.

Bear in mind, the stock trades at a 37% premium to the industry based on its P/E ratio and other metrics, according to Gheit, and it doesn't pay a dividend. Still, the stock has been a winner: It was the best-performing natural gas producer over the last 10 years, notes Gheit. And it beat the S&P 500 in the last 5 years, returning 39.7% compared to a 4.4% loss for the market.

Sticking to the oil patch

Oasis Petroleum (OAS) is more of a domestic oil play with 88% of its production coming from crude oil, according to the firm. Its high production growth and profitable operations make it an attractive stock, says Breard at Hodges Capital.

The company has 333,000 acres in the Bakken/Three Forks region of North Dakota and Montana and has grown daily production 109% since 2011. Earnings are on track to reach $1.65 a share this year, up 92% from 2011, according to Thomson Reuters.

And unlike many producers, Oasis's production is rising while costs are coming down, notes Stephen Berman, an energy analyst with brokerage firm Canaccord Genuity. That's "a powerful one-two combination," he wrote in a recent note, estimating the stock is worth $40 a share, up from $31 recently.

Domestic oil producer Continental Resources (CLR) could also fare well, according to Rudolf Hokanson, an energy analyst with Barrington Research.

Continental is the largest landholder and producer in the Bakken region with 1.1 million acres. In 2010, the company set a goal of tripling production and reserves by the end of 2014. It's on track to achieve that goal 18 months early, and now aims to triple reserves and production again by 2018.

Continental's third-quarter results beat Wall Street estimates with the company earning 87 cents a share, up 28% from a year earlier. Analysts forecast earnings hitting $4.63 a share in 2013 and $6.30 in 2014. Yet the stock trades at a P/E of 11.2 times 2014 earnings, well below its growth rate.

Continental's production growth is slowing from about 59% this year to an estimated 36% in 2013. But that's still an exceptionally high growth rate coming off a large production base, says Hokanson. The company also runs a tight financial ship, keeping its debt levels reasonable. Plus, it's an efficient producer with cutting-edge drilling technology and a "carefully-managed environmental footprint," he says, helping to lower operating costs.

"They're a focused organization that runs like a Swiss watch," he says, estimating the stock is worth $137 a share, up from around $70 recently.

Energy services and offshore drilling stocks

Big energy producers tend to see profits rise and fall with commodity prices but companies that provide drilling rigs and other oil-field services are usually a bit more stable. While they aren't immune from commodity price swings, their long-term contracts can provide steadier revenues than big oil producers.

The SPDR S&P Oil & Gas Equipment & Services ETF (XES) offers a low-cost way to invest. The ETF holds 47 stocks and is well-diversified with no stock accounting for more than 3% of its assets. Big names in the ETF include Schlumberger (SLB), Helmerich & Payne (HP) and Halliburton (HAL), offering broad exposure to a growing industry.

Another option: Invest in individual offshore oil drillers. These companies rent out rigs for production and exploration in deep-water projects, and the business is now strengthening, according to energy analyst Breard.

Oil exploration companies made a record 39 deep-water discoveries in 12 countries in the first nine months of 2012, he notes. The new areas opened up much more prospective acreage for drilling, and more rigs will be needed to extract oil from these regions. Drilling companies are now building deep-water rigs that will boost future earnings, he says, and they're earning high day rates on deep-water rigs in service due to a shortage of available rigs, which could persist into 2017.

Offshore drillers such as Atwood Oceanics (ATW), Ensco (ESV), Noble (NE), Rowan Companies (RDC) and Transocean (RIG) all look attractive, says Breard. Their P/E ratios are between 6 to 7.4 times consensus estimates for 2014 earnings. At the peak of an industry earnings cycle, P/E ratios typically reach 10 to 15, he says, leaving plenty of upside in the stocks. His bottom line: "We're only in the second inning of a long upward cycle."

Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services.

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Content for this page, unless otherwise indicated with a Fidelity pyramid logo, is published or selected by Fidelity Interactive Content Services LLC ("FICS"), a Fidelity company with main offices in New York, New York. All Web pages that are published by FICS will contain this legend. FICS was established to present users with objective news, information, data and guidance on personal finance topics drawn from a diverse collection of sources including affiliated and non-affiliated financial services publications and FICS-created content. Content selected and published by FICS drawn from affiliated Fidelity companies is labeled as such. FICS selected content is not intended to provide tax, legal, insurance or investment advice and should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security by any Fidelity entity or any third-party. Quotes are delayed unless otherwise noted. FICS is owned by FMR LLC and is an affiliate of Fidelity Brokerage Services LLC. Terms of use for Third-Party Content and Research.
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