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The smart way to play oil
The more uncertain the Middle East looks, the more sense it makes to buy producers with North American reserves.
By Michael Sivy, MONEY Magazine editor-at-large

NEW YORK (MONEY) - I've said during the past year that the current runup in oil prices should end and be followed by a decline to less than $50 a barrel. Instead, the oil price has continued to soar and has reached record levels above $70.

Under normal circumstances, the forces of supply and demand would have brought the oil boom under control by now. But this time, there are two special factors -- China and the Middle East -- that have kept the boom going.

Oil producers have responded to soaring prices by trying to boost supply. And over time, the high oil price will encourage exploration and new production. But there's not a lot of extra capacity available immediately and finding additional reserves is a slow, expensive process.

Unfortunately, demand is rising faster than supply can increase. The chief reason is rapid economic growth in India and China, which has become the world's second-biggest oil importer, after the United States. For the first quarter, China's oil imports were up 25 percent from year-earlier levels, thanks to a 66 percent increase in auto sales.

Even if China's oil consumption can't continue to soar at the current rate, overall global demand should remain strong for the foreseeable future.

The oil market could accommodate that, but it can't take account of the possible risks in the Middle East. It's not hard to imagine scenarios in which conflict with Iran leads to the interruption of oil shipping in the Persian Gulf. Sabotage in Middle Eastern oil fields is conceivable as well.

Tensions with Iran could easily last longer than 18 months, even in a best-case scenario, and that means oil prices are unlikely to come down much anytime soon. There's no way to guard against the possibility of even worse disruptions, other than making sure you have some oil and gas stocks in your portfolio.

Sidestepping the turmoil

Last August, I wrote a column recommending Anadarko Petroleum and Apache, and I still think they are smart choices, chiefly because 85 percent of their oil and gas reserves are in North America and other safe places.

So far, the two stocks have risen along with the broad energy stock indexes over the past two years, but they are still reasonably priced. Since I wrote the column, Anadarko shares have gained 27 percent, while Apache is up only 7 percent. Commodities producers tend to have low price/earnings ratios, but both Anadarko and Apache still trade at P/Es below 10.

Stocks like Anadarko and Apache are attractive, first of all, because they represent ownership of billions of barrels of oil (and its natural gas equivalent) in the ground.

A second factor that will likely help the share prices of both Anadarko and Apache is that they have mostly North American reserves. Investors who become more concerned about violence in places like Iran and political turmoil in places like Venezuela are likely to start paying a premium for stocks with reserves in safe places.

Finally, high energy prices have boosted cash flow for both Anadarko and Apache by at least 28 percent over the past year. And that money is available to fund exploration or acquire additional reserves.

Anadarko (Research) has added more reserves than it consumed for 24 years in a row. The company has also used excess cash to repurchase $2 billion of stock at prices well below today's levels.

Apache (Research), which has lagged over the past year, may be the sleeper in the group. The company has added more reserves than it consumed for 20 straight years. Last year, however, additions were more than twice the amount used up, a stellar replacement ratio. And almost all of that came from exploration.

Now Apache has announced that it is buying 18 oil fields in the Gulf of Mexico from BP for $1.3 billion. Apache also plans to repurchase $1 billion of its own stock.

Investing in the Gulf of Mexico is an excellent long-term choice. Production in that area is depressed in the aftermath of last year's hurricanes and may not be back full-strength until 2007 or later. But the key for success in the oil business is to use the excess cash flow in boom times to lay the foundation for years of growth to come.

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