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How to Bet on OilWhether Bull or Bear


The surge in oil prices has been so rapid and relentless--up 28% just in the past five months and 94% over the past year--that investors may think it's too late to grab a piece of the action.

Of course, they may have thought that when oil was at $80 a barrel, or $100, or $125. But now many forecasters think oil could go beyond the low $130s it reached in late May--maybe toward $200 a barrel over the next year.

At the same time as oil bulls paint a picture of dwindling supply coupled with record demand from India and China, dissenters maintain that prices are driven increasingly by speculation, not by a long-term shift in fundamentals (BW--June 9). With views about oil prices for the next six to 12 months all over the map, here's a guide to investing in oil whether you buy into the bullish case, are agnostic on the future price of oil, or are a downright bear.

IF YOU'RE AN OIL BULL...

Few investors are as bullish as Matthew Simmons, president of Houston investment bank Simmons & Co. International, who predicts oil will hit $200 to $500 a barrel over the next six months to five years. But a growing number of investors think $150 to $200 is within range over the next year. Those investors should consider some of the Canadian oil sands stocks, says Tim Guinness, chief investment office for Guinness Asset Management in London. Unlike major integrated oil companies, these producers aren't struggling to expand production, with reserves, which are owned by the Province of Alberta, seen lasting 40 years.

Guinness' favorite is Suncor Energy (SU), based in Calgary, Alta. Its production is expected to increase by two-thirds over the next 8 to 10 years, and earnings should rise 10% a year. "Its revenue stream will rise proportionately to the oil price," says Guinness. The reserves are near the surface, and it's easy to establish where and how thick deposits are, he says. Since Suncor negotiated an increase in the royalty rate it pays Alberta this year, he expects the rate to be stable for a few years. At 68.56, Suncor trades at 18.7 times 2008 earnings, and is up a split-adjusted 54% from a year ago. If oil prices top $150, Suncor could reach 80, says Guinness.

Integrated oil companies--the outfits that do it all, from exploration to refining--also need rising oil prices to offset cost inflation, or profit margins start to contract, says Tim Parker, an energy analyst at T. Rowe Price (TROW). An attractive integrated producer is Murphy Oil (MUR), he says. Its production is expected to grow 35% this year as its offshore, deepwater Kikeh oil field in Malaysia ramps up. Kikeh is scheduled to reach full production of 120,000 barrels a day by yearend.

Murphy also has 25 exploration wells in Malaysia and the Gulf of Mexico that start up in June. "They're not all going to work, but it's a nice portfolio of exploration coming up," says John Segner, senior portfolio manager of the $2.5billion Aim Energy Fund (FSTEX). "It's fairly valued, and you're able to get all this exploration work started for free because the stock isn't reflecting the potential for new [reserves]," he says. At 94.88, Murphy trades about 12 times projected 2008 earnings. Shares are 2.2% below the 52-week high, hit on May 20, of just above 97.

Daniel Rice, who co-manages the $1.47 billion BlackRock Global Resources Fund (SSGRX), prefers exploration and production companies, since profits at integrated producers are constrained by refining and marketing businesses. The stocks could move another 20% as long as oil prices continue to rise, he figures. One of his top picks in the sector is Plains Exploration & Production (PXP) (GO-A.TO), mainly because its production mix is 50% oil and 50% gas. That's relatively rare in North America, where most producers have an 80% tilt toward natural gas with oil reserves depleting quickly, he says.

IF YOU'RE AN OIL BEAR...

If you think oil prices will correct 30% or so, your best bet may be independent oil refiners. These companies, which sell gasoline and other fuels made from crude oil, have suffered as fuel prices haven't kept up with the rise in crude oil prices. Soleil Securities Group analyst Jacques Rousseau calculates that the stocks of the five independent refiners have dropped an average of 42% over the past year, as of May 27. Clay Hoes, lead energy analyst at RiverSource Investments in Minneapolis, singles out Valero Energy (VLO) for its ability to turn heavier grades of crude into refined products. "It's been one of those companies that read the market early and invested in capital equipment that allows them to produce diesel and gasoline products from heavy, high-sulfur crudes," he says. Valero's stock, at 52.88, has fallen nearly 25% from a 52-week high on July 10. Rousseau, who bases his one-year price target on the company's five-year average refining margin, thinks it could climb to 65 over the next year.

IF YOU'RE OIL-PRICE AGNOSTIC...

Oil service and drilling companies should do well under all of the price scenarios, since their revenues are determined by producers' capital-spending budgets. Oil's current price isn't as important as the price that oil producers have budgeted for, says Robert Mackenzie, an equities analyst at Friedman, Billings, Ramsey Group in Arlington, Va. "If they're budgeting $60 to $70 a barrel, oil could fall to $90 or $80 without having any material impact on spending plans." That doesn't mean the stocks wouldn't be hurt if oil prices plummeted. But lower prices wouldn't fundamentally alter the companies' revenues. "We're in the middle of a very prolonged expansion phase in this industry," says Mackenzie.

One stock he thinks has a strong upside is Schlumberger (SLB), based on demand for its seismic processing technology, which improves the success rate of producers in finding potential new reserves to develop. Schlumberger is trading at 19.4 times Mackenzie's earnings target for the next 12 months, vs. a 12-year average multiple of nearly 26 times.

Mackenzie also likes FMC Technologies (FTI).While richly valued at 21 times projected 2008 earnings, FMC is seeing rising demand for its energy unit's unique equipment--called "subsea trees"--used in deepwater projects. By enabling producers to process oil and gas, and separate out water at the sea floor instead of at the surface, the equipment makes production more efficient and lowers producers' costs. With 70 of 79 of new deepwater rigs being built having already inked multiyear rental contracts with oil companies, "you've got to believe that [FMC's] trees are going to be used," says T. Rowe Price's Parker.


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