These Stocks Could Be The Best Bets in the Energy Sector

U.S. crude oil prices have plunged by more than half since June and, as I write, are trading near a six-year low of $45 a barrel.

The S&P 500 is up 4% over this period, but the S&P 500 Energy Index, comprising the largest companies in the industry, has lost more than a fifth of its value. Small oil and gas companies, as represented by the S&P SmallCap 600 Energy Index, have done far worse, swooning 47%.

“Surely, there are bargains here,” a friend of mine insisted the other day.

I admire his contrarian attitude.

[ad#Google Adsense 336×280-IA]Are there bargains?

Almost certainly.

(Marc Lichtenfeld listed some of his favorite ideas here.)

But a sure thing? Not so fast.

At $45 a barrel, no one in the industry is making money – and that can’t last.

As low prices persist, production will dry up and prices will inevitably adjust higher.

So the conventional wisdom is you have to buy these stocks now… while they’re cheap.

But this analysis is far too facile.

Yes, oil prices will eventually rise out of the doldrums. But when?

Bank of America analysts predict that U.S. oil prices will fall to $32 a barrel by the end of March before climbing to $57 in December.

This kind of forecast – the type the financial media thrives on – sounds impressive at first blush but, on even a moment’s reflection, is entirely without value. No one knows what oil prices are going to do in the weeks and months ahead, not even the top people in the industry.

For example, heavy insider buying is a proven indicator when analyzing individual companies. But I’ve learned over the years that it works less well in the natural resources sector than almost any other.

As oil prices slid last September, for instance, Continental Resources (NYSE: CLR) chairman and CEO Harold Hamm stepped up and bought 72,000 shares at just under $68, a $4.9 million bet and a strong vote of confidence that the shares were undervalued.

Yet he couldn’t know where oil was headed. (That’s why I gave the stock a miss in my Insider Alert service.) And today the shares trade closer to $45 a share.

If Harold Hamm and other longtime industry executives don’t know where oil is headed, how does anyone else?

That’s just it. They don’t. So the first requirement for bargain hunters is patience and the long view.

Here are a few other things to consider. Small companies and highly leveraged firms that took on loads of debt to finance new drilling are particularly vulnerable. Many of these “bargain stocks” won’t be around for the eventual recovery. I wouldn’t touch them with a barge pole.

Master limited partnerships (MLPs) – the pipeline and storage firms that earn their money transporting and storing oil and gas – are a better bet. This sector has lost 14% of its value over the last six months. And average yields are 6.1%. (Like real estate investment trusts, MLPs pay out most of their net income to shareholders.)

However, you shouldn’t buy the line that these investments are completely uncorrelated with oil prices. (You think that 14% plunge was an accident?) MLPs are better insulated from falling prices than exploration and production companies, but they are not immune to a slowdown in demand.

Granted, we are not seeing that in the U.S. right now. But if the malaise overseas spreads here, we could in the future. Plus, hurting oil company customers could press transportation and storage companies for lower prices.

Caveat emptor.

Personally, I think the best bets in the sector are in blue-chip producers like Exxon Mobil (NYSE: XOM) and Chevron (NYSE: CVX). Their diversified operations, rock-solid balance sheets and ability to keep producing during the downturn offer downside protection. And their fat dividends – which, granted, may be trimmed a bit in the months ahead – give shareholders a comfortable wait for energy prices to rebound.

Or you could buy the biggest energy-focused ETF: the $11 billion Energy Select Sector SPDR (NYSE: XLE). Here you get the safety of broad diversification, ultra-low annual expenses (0.15%), high liquidity and a 2.4% yield.

In sum, oil can’t be profitably produced at $45 a barrel. So it’s a given that prices will bounce back eventually.

But no one knows when. And it may not be soon.

So blue-chip investments like these offer the greatest probability that your contrarian instincts – for which you should be commended – are eventually rewarded.

Good investing,

Alex

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Source: Investment U