How to play the oil boom

Marathon's Garyville, Louisiana refinery

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(Fortune Magazine) -- Superior stock picking requires smarts and luck, and thankfully we had both going for us in our May 28 story "The well isn't dry yet."

Oil was just over $60 a barrel at the time, yet the stock market appeared to be betting on a return to mid-50s oil.

"How else do you explain a stock like Transocean?" we asked, noting that the deep-sea oil driller -- on pace for its fourth consecutive year of triple-digit earnings growth -- was trading at a mere 12 times projected 2007 earnings. We thought signals pointed to oil prices rising, not falling.

Well, in the six months since we wrote that story, oil has soared to nearly $95 a barrel, and the six oil stocks and one oil fund we recommended have since returned an average of 26% (as of Nov. 2) -- trouncing not only the Standard & Poor's 500's 2% total return but the S&P energy index's 18% return as well.

It just goes to show how quickly the conventional wisdom on oil can change.

The thinking last May was that the price spike above $60 a barrel was seasonal -- oil and gasoline prices often climb in advance of summer driving season -- and that oil would be back below $60 by this fall.

Our counterargument was that the inventory cushion between oil supply and demand was too small to expect a price decline. We also noticed a disconnect between the equity market, which seemed to be banking on cheaper oil, and the futures market, where oil traders were betting on further gains.

Convinced oil was headed above $70, we recommended one exchange-traded sector fund, Oil Services HOLDRS (OIH), and six oil stocks: offshore drillers Diamond Offshore (Charts) and Transocean (Charts), oil and gas drilling-equipment maker Cameron International (Charts), oil services giant Schlumberger (Charts), independent oil refiner Valero (Charts, Fortune 500), and natural-gas producer XTO Energy (Charts, Fortune 500).

All but Valero rewarded us with returns in double digits. Our biggest winners: Cameron, up 45%; Transocean, up 38%; and Schlumberger, up 33%.

If you took our advice then, we'd strongly advise you to take some profits now. As much as we still like the business prospects of the companies we recommended, their stock prices do track oil prices, and we think that, while oil may spike over $100, the price is headed anywhere from 20% to 40% lower.

No, we're not suggesting investors unload all long-term oil holdings and trigger hefty capital gains taxes in the process. We just think this is a good exit point for active investors with short time horizons. (Among the stocks we picked in May, the one we would hold on to is Valero -- more on that in a minute.)

We're not alone in our concern that oil is poised for a correction.

Goldman Sachs -- which arguably has more influence over oil prices these days than any oil company -- put out a mildly bearish report on oil on Oct. 29, and oil fell $3 within hours.

Charles Ober, manager of the T. Rowe Price New Era energy fund, tells Fortune his fund's cash position is now 6%, up from the 2% to 3% that he normally keeps. "That doesn't mean I believe these stocks are overpriced," says Ober, who has large holdings in Cameron, Diamond Offshore, and Schlumberger. "It's just that oil stocks tend to go down when oil prices fall, and barring some sort of event with Iran, I think oil prices are coming down."

The supply and demand fundamentals of oil haven't really changed since the spring. All that's different is the fear factor. Anything that threatens the flow of oil from the Persian Gulf is going to sound alarms in the oil market, and right now there's a lot for traders to be anxious about.

Their biggest concern: a military showdown between the United States and Iran over the latter's nuclear program -- a possibility that became more real in September after the Senate approved a resolution declaring Iran's Revolutionary Guard a terrorist organization. Other geopolitical crises now inflating the price of crude include Turkey's threat to invade Kurdish-controlled (and oil-rich) northern Iraq, as well as instability in Afghanistan and Pakistan.

Problem is, the oil market almost always overreacts to world events. And the overreaction this time around is especially egregious, says Oppenheimer & Co. oil industry analyst Fadel Gheit. "It's a bubble," he says bluntly.

Gheit thinks the appropriate price for oil is $65 a barrel. Were a slowing U.S. economy to slip into recession, "oil would definitely fall below $50," he adds.

In the U.S., oil demand already seems to be easing. Lehman Brothers oil analyst Edward Morse notes that high fuel prices and a slowing economy are changing American driving habits, and U.S. oil consumption has actually declined, compared to 2006, since May. This could mark a turning point for oil, given that a quarter of global oil demand growth from 1990 to 2005 came from the U.S.

"All of this suggests to us that the cycle works--the best cure for high prices is high prices," Morse observes. "If the U.S. falters, one major reason why oil markets tightened so severely this decade will be lost."

Within the oil industry, the only clear beneficiaries of a major price correction would be independent refiners like Valero and Marathon Oil (Charts, Fortune 500). Since May, oil refiners have been caught in a margin squeeze: Oil prices have risen 50%, but gasoline prices have fallen 10% over the same period. (The drop in gasoline prices is yet another indication there's a bubble in crude.)

At $69 a share, Valero stock is down 11% from its summer high of $79. Marathon, at $60, is also down 11%. We see this as a buying opportunity. Both stocks have modest valuations (eight and ten times estimated 2007 earnings, respectively), and a substantial drop in oil prices would greatly improve their profit margins.

"Refiners would certainly benefit from any drop in oil prices," says Michael Hoover, manager of the Excelsior Energy and Natural Resources fund. "Their raw material costs -- crude oil -- would in all likelihood come down faster than gasoline prices."

Refiner shares could be caught in the downdraft of any oil price plunge, but as we see it, that would just make the buying opportunity that much sweeter.

Reiterating what we wrote in May, the biggest bottleneck in the oil industry is refining capacity, not crude oil production, and the lack of new refineries coming online worldwide -- coupled with soaring construction costs for anyone thinking of building one -- bodes well for the long-term prospects of companies like Valero.

Also, refiners are positioned to get a boost from the one niche of the energy market where there's a big glut: ethanol. Wholesale ethanol prices peaked at around $3.75 a gallon in June 2006 and have been falling ever since -- down to $1.50 a gallon in October.

That is terrific for refiners, which blend ethanol into gasoline, since their healthiest profit margins come from selling blends with high octane. "And ethanol," says Ober, "allows them to add octane much more cheaply."