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With oil sky high, a look at four best buys

The fact that oil prices are through the roof doesn’t mean all energy stocks will pay off. This Canadian advisory suggests four best buys.

It was just three years ago that crude oil surged past $50 a barrel, prompting all kinds of excited comment about how high it was going to go. Try $109.09. That’s where it stood when the dust settled yesterday.

Oil has always been the source of larger-than-life expectations. So what expectations should investors have for energy stocks in light of these booming prices?

You should feel pretty optimistic, says one leading Canadian advisory, and not just about the prospects for oil. Natural gas prices are coming around after an extended period of the blahs.

But get the most for your money, says The Investment Reporter. Not all energy stocks are due to harvest superior returns in the months ahead. Some are already overvalued. This advisory has four best buys in the field. And it has several good reasons why these four stocks will do better than most of their peers.

Out of Sudan

The best measuring stick for energy stocks, says this advisory, is the price-to-cash-flow ratio. To get this, you simply divide the share price by the estimated cash flow per share. If the expected ratio for the year ahead is less than five, it’s good for most energy firms. Six is the upper limit for the big integrated companies.

Three of the advisory’s four best buys comfortably meet this criterion, while the other is right on the edge. Each of the four gives investors a different angle on the oil patch.

One is a big integrated Canadian firm. Petro-Canada (TSX-PCA) is the best among the big Canadian firms that have “upstream” (exploration), “mid-stream” (refining) and “downstream” (gas stations) activities. It trades at 4.5 its expected cash flow for 2008.

By the way, the advisory reports that another well-known giant, Imperial Oil (TSX-IMO), is now a hold in its books. At a forward multiple of 12.4 times expected cash flow, it’s just too costly.

Among senior producers, Talisman Energy (TSX-TLM) is the best buy. For years, Talisman took lots of heat for its presence in Sudan, whose government is roundly criticized for the chaos in Darfour.

Talisman abandoned Sudan five years ago and maintains a strong portfolio of properties around the globe (the fastest-growing is in Southeast Asia), but the advisory doesn’t think the market has fully acknowledged Talisman’s successful transition. The company trades at 3.8 times expected 2008 cash flow.

From Alberta to Persia

Among small and junior producers, one stock stands out for The Investment Reporter and its operations are entirely in Canada. Entirely in Alberta, in fact.

Masters Energy (TSX-MSY), which was born from a merger some five years ago, divides its production evenly between petroleum and natural gas reserves. The advisory likes its very attractive prospects and its price-to-cash-flow ratio of just 3.1 for 2008. The recovery in natural gas prices should make those prospects that much more attractive.

Another smaller producer the advisory previously favoured is now a hold. Duvernay Oil (TSX-DDV) has seen its shares rise by some 30 per cent in recent months. They’re still worth holding, says the advisory, since this firm has much of its production in natural gas. But investors might also wish to take some profits and consider Masters as an alternative.

Fourth among the best buys is the number one producer among international firms, according to this advisory. BP plc (TSX-BP.U), aka British Petroleum, began its history with a rugged oil expedition in Persia in 1908. This world-famous giant just barely meets the criterion for forward cash flow, at a ratio of 6. But its return on equity, another strong indicator for energy stocks, is nothing short of spectacular. It exceeds the average of its U.S. and international peers with a robust 17.5 per cent.

These four best buys certainly fit the magic investment word, diversity. They vary in size, vary in geography and vary in the amount of production they reserve for oil and natural gas. If you had no oil and gas stocks in your portfolio, but were looking to add some, you could start very nicely with these four very different stocks, in the advisory’s opinion.

Finally, let’s see how long this oil bonanza is liable to go on.

Wasters and smokers

Here’s a refrain that never seems to wear out: demand for oil is still growing — fast — in China, India, Russia and the Middle East. Even if the global economy grows by four per cent in the next year or two, instead of five, that demand will still be pretty lively.

“Then again, the U.S. consumes a quarter of the world’s oil — far more than any other country,” says the advisory. “So if the U.S. slowdown turns into a full-blown recession, the price of oil could fall.” If the U.S. imports less, both the economy and oil demand elsewhere could also fall. That is the greatest risk to the generally positive outlook for oil.

But there are a few other concerns over the horizon, as well. Will consumers start using oil more sparingly, buying smaller cars, putting in more insulation and turning down the furnace?

Will this become a social issue? The advisory wonders whether or not “wasters of oil may be lumped in with die-hard smokers.” Along the same lines, the global warming outcry and the development of alternative energy sources, which once seemed a marginal concern, becomes a more serious issue by the day.

On the other hand, supplies of oil are not easy to come by, and will be harder to come by as the years go by. Many are located in places that are fraught with danger, or at odds politically with western nations. Nor is it getting any easier to find big new oilfields. But all this suggests one big advantage for this country.

This situation, comments the advisory, “can only raise the reputation of Canadian producers as stable and reliable suppliers.”

And there’s still another “then again,” namely that higher prices could loosen up supply and make more oil available. They could also make high-cost projects like Alberta’s oil sands more economically feasible.

Projections on the future of oil prices have baffled more experts than predictions on the Stanley Cup playoffs. So don’t worry too much about the endless debate over supply and demand, says The Investment Reporter. Just put in a demand for the right stocks and supply yourself with some tidy profits while the experts fight it out.