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Cashing in on the oil boom
The safest strategy is buying stocks like Apache and Anadarko that have valuable reserves.
August 9, 2005: 8:09 AM EDT
By Michael Sivy, CNN/Money contributing columnist
A 17-part series on how to achieve maximum returns for the right amount of risk. See all the lessons.

NEW YORK (CNN/Money) - The price of crude oil reached a record high on Monday, nearly breaking through the $64-a-barrel mark. Moreover, given multiple sources of tension in the Middle East and strong energy demand worldwide, forecasters think that the price of oil is likely to remain high for the foreseeable future.

At this point in a boom, investors inevitably feel torn.

On the one hand, there's plenty of historical evidence that extended periods of high oil prices are followed by busts. The reason: Oil companies expand production while prices are high -- boosting supply -- and then don't cut back even if demand weakens.

On the other hand, it's hard to remain on the sidelines, waiting for a pullback in prices that might be several years away.

You can find a rational strategy in this situation, however, if you look at the forces pushing up oil stocks and the types of stocks that are likely to be the least risky long-term beneficiaries.

Oil stocks could move higher still

Several factors could help keep the prices of energy stocks high:

First, leading producers Iraq, Saudi Arabia and Iran all face issues that could disrupt production.

Second, global demand is so strong that there is very little spare production capacity. Anything that puts a major producer -- or even a major refinery -- out of commission for several months could create a squeeze.

Rapidly growing China needs to guarantee itself new energy sources. Not only does that argue for continued high global demand, it also means that China will remain a potential bidder to acquire asset-rich oil and gas producers.

Protracted high oil prices are creating a cash-flow windfall for production companies, which are increasingly able to use their excess cash to buy back stock and acquire smaller producers with valuable reserves.

The bottom line: tight supplies and ample free cash will likely lead to higher valuations for safe, high-quality reserves.

A sensible strategy

If you already have oil and gas investments in your portfolio, there's nothing wrong with waiting out whatever further runup occurs for energy stocks.

But if you don't, and you want to add some of those stocks, it's fairly clear what the smart strategy is.

Look for companies with large quantities of oil and gas reserves. Much of those reserves should be located in places that have low political risk, especially North America.

Also look for stocks that are trading at fairly low price/earnings ratios. They're at lower risk of an eventual easing in oil prices. They're also more likely to profit from stock buybacks and restructuring.

In addition, such low-P/E producers are more likely to be targets of takeovers or offers for friendly mergers. Although Unocal is no longer the subject of a Chinese takeover offer, it will probably complete its deal with Chevron at a price that will be a premium over Unocal's original market value.

Among the stocks that look most attractive by these standards, analysts favor Apache and Anadarko Petroleum, both of which have substantial oil and gas holdings in North America.

Over the past five years, Apache (Research) has enjoyed compound earnings growth of 18 percent annually. And growth is projected at 10 percent annually over the next five years, although continued high oil prices could accelerate that rate. At $69.68 a share, Apache is trading at less than 10 times estimated earnings for this year and next.

At $87.79 a share, Anadarko (Research) is also trading at less than 10 times earnings for this year and next. Profits have risen only about 9 percent annually over the past five years, and are projected to grow at a 10 percent compound rate over the next five years.

Anadarko has undertaken an aggressive restructuring campaign, however, selling off less desirable assets and using the proceeds to pay down debt and buy back stock. Analysts who like the strategy think Anadarko has the opportunity to evolve into a slightly smaller and leaner energy producer with a significantly higher growth rate.

Sivy on Stocks resources:

Sivy 70: America's best stocks

Guide to Growth

___________________

Michael Sivy is an editor-at-large for MONEY magazine. Click here to receive Sivy on Stocks via e-mail every Tuesday.  Top of page

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