(MONEY Magazine) – Many economists were startled when yields on long-term Treasury bonds topped the 8% mark in late October on fears of resurgent inflation. Although the U.S. economy has been nearly flawless this year-3.4% real GDP growth with a scant 2.8% rise in consumer prices-many investors are behaving as though inflation is only crouched and ready to spring.

"The big surprise this year has been the increase in long-term interest rates," said Laura D'Andrea Tyson, who chairs President Clinton's Council of Economic Advisers, when she talked with Money's editors on the same day that bond yields surpassed 8% for the first time since April 29, 1992. Tyson went on to lay out the Administration's economic outlook for 1995, which projects real growth of just under 3% and only a slight uptick in inflation to 3.2%. Then Tyson added: "The main risk to the inflation forecast would be a spike in oil prices." Our own inflation outlook is a little more negative than Tyson's-we expect about 3.5% next year, assuming oil prices increase a buck or two from today's $18.20 a barrel.

That got us to thinking about oil and gas stocks, which would provide a hedge against any worsening of inflation. We last examined that sector in this space in February. Of the six stocks we recommended then, two are about even and four are up 7% or more. So far, no home runs. But the case for energy stocks is stronger than ever. "The oils are my favorite defensive stock group," says Lehman Bros. chief investment strategist Katherine Hensel. She gives three reasons they are smart buys:

- Oil is cheap. The price of crude for the first three-quarters of 1994 averaged $2 a barrel less than it was in the same period last year.

- Big oil stocks are bargains. The internationals offer some of the most attractive yields relative to those of other blue-chip stocks.

- Oil stocks are under-owned. The best time to buy a stock group is when it is out of favor with the pros. Reason: When the outlook for the group improves, a flood of institutional money will pour in and buoy share prices. And institutions have less money in oil today than at any time since 1987.

Among the stocks that Hensel currently recommends are Mobil (ticker symbol: mob; recently traded on the New York Stock Exchange at $83.75 with a 4.1% yield) and Chevron (chv; NYSE, $43.75; 4.2%). Despite its lower yield, she also favors British Petroleum (bp; NYSE, $80.75; 2.6%) and notes that aggressive cost cutting could enable the company to double its dividend by 1996.

Senior oil and gas analyst Paul B. Ting at Oppenheimer & Co. in New York City also recommends those stocks. "Mobil is simply the cheapest big oil company around, British Petroleum would profit most from a rise in crude oil prices and Chevron would benefit most from higher prices for gasoline, natural gas and heating oil," he says. Over the next 18 months, Ting thinks Mobil and BP can both hit $100, a 19% gain for Mobil and a 24% gain for BP. He sees Chevron rising 14% to $50.

Smaller domestic producers also offer aggressive investors a chance for sizable gains. Among analysts' favorite picks is Apache Corp. (apa; NYSE, $27.50; 1%). "In the third quarter, Apache's gas production was up 40% vs. a year ago," says Prudential Securities analyst Ellen K. Hannan. Part of that growth has come from acquiring oil and gas reserves, but Apache also has one of the most active drilling programs among the independents. "The company can keep increasing production up to 10% a year even without acquisitions," says Dean Witter Reynolds analyst Philip J. Kehl.

The stock is also a bargain, says Oppenheimer analyst William D. Hyler. "Apache continues selling near a historically low multiple relative to cash flow," he explains. That measure-a company's share price compared with the cash the firm generates each year-is the one analysts rely on to evaluate independent oil and gas producers, because earnings are often distorted by big depreciation charges. All three analysts say that the stock's current 4.8 cash-flow multiple could expand to 5.5 or more once the prices for oil and gas improve. And they see the stock climbing 24% to $34 over the next 18 months. That's a gain that will fuel the performance of any investor's portfolio.

Wall Street editor Michael Sivy is a chartered financial analyst and a former director of research on Wall Street.