Buy Low / Sell High

[dan_s]

By Michael Brush, MarketWatch

Oil is poised to rise, and when it does, high-quality companies will benefit the most

No one said oil prices would go straight up from lows reached in the first quarter.

But that's not necessarily bad news for energy-sector investors.

That's because pullbacks in oil and energy stocks -- like the sharp retreat that just played out over the past week -- offer another chance to buy quality energy companies at cheap prices.

If you do so, please keep two things in mind: Have an outlook of at least one to three years; and plan to buy stocks in two or three swipes to "average in," so you can take advantage of possible volatility.

That's the strategy of two energy-sector portfolio managers I spoke with.

"It's just a normal pullback. I don't think it means much," says Mike Breard, an energy analyst who helps pick energy stocks for the Hodges Small Cap Fund (HDPSX), which has beaten competing funds by an annual 5.5 percentage points over the past five years, according to Morningstar. "Oil made a good run. It was up 35% to 40%. People are taking some profits."

Jonathan Waghorn, who helps manage the Guinness Atkinson Global Energy Fund (GAGEX), points out that U.S. energy stocks are currently at historically low valuations relative to the market. On a price-to-book basis, they now trade at 0.6 times the valuation of the S&P 500. That has happened only twice since 1965 -- in 1986 and 1998. For perspective, during that time energy stocks have traded at 0.9 times the value of the market, says Waghorn, whose fund has exceeded competing funds by a percentage point annualized over the past 10 years.

Companies these managers like in the current weakness include Matador Resources (MTDR), Diamondback Energy (FANG) and Suncor Energy (SU). I've suggested Hornbeck Offshore Services (HOS) in my stock letter Brush Up on Stocks (http://www.uponstocks.com/). I'll suggest three more energy companies below.

But first, why should energy stocks do well from here? Big picture, it's because oil is likely moving considerably higher over the next few years, as supply destruction plays out.

Breard thinks West Texas Intermediate crude could be in the $70-$75 per barrel range as soon as year-end. It recently traded at $59. "I don't think it is going back into the $40 range," he says. Waghorn thinks Brent could trade up to $75 a barrel during 2016-2017, and then move into the $90-$95 range in 2018. Brent recently traded at $65.

Waghorn cautions that how oil trades in the near term is anyone's guess, and a sharp move down, in the short term, is possible. "Through 2015, we will be finding a bottom, but can I tell you exactly where? Not at all." Thus, he suggests planning to stage purchases in three slices, or a third now and the other two-thirds on any significant weakness over the next three months. Also, be psychologically prepared for the volatility.

Why oil is going back up

Breard, at Hodges Capital Management, expects North American production to decline because of the sharp drop in the number of rigs in service. On May 18, Baker Hughes (BHI) reported that rigs in service dropped once again, this time to 888, down from 1,855 a year ago. "Spending on production has dropped dramatically," says Breard.

Next, inventories are falling. U.S. crude-oil inventories fell by 2.7 million barrels in the week ended May 15, the U.S. Energy Information Administration said May 20. That was more than analysts expected.

Summer-drive season kicks off Memorial Day weekend, at a time when gasoline stockpiles are at their lowest levels since December. And then there's the geopolitical wild card, or instability in the Middle East, which could boil over at any moment and put a bid under oil.

Stocks to consider buying

Breard, at Hodges Capital Management, says generalist fund managers are now shopping in the energy space. He thinks it makes sense to go with names that have the qualities they are looking for: strong balance sheets, solid growth prospects and a good track record. Companies that fit the bill include Matador Resources and Diamondback, both of which have quality assets in North America.

If you want to take on more risk, for more potential reward, consider Comstock Resources (CRK), a smaller energy company with oil and gas assets in Texas and Louisiana. Some investors consider Comstock a bankruptcy risk, because of its huge debt load. But a recent debt offering was oversubscribed, says Breard, which he takes as a vote of confidence in Comstock's viability.

Waghorn, at the Guinness Atkinson Global Energy Fund, doesn't see much value in energy giants like Exxon Mobil (XOM) and Chevron (CVX). Instead, he sees much better value in two Canadian names hit by a double whammy: a recent unfavorable election outcome in Alberta, and weak oil prices. On May 7, the New Democratic Party won out over Progressive Conservatives, a change viewed unfavorably by energy investors. That may be an overreaction, though. Two stocks he likes in the weakness are Suncor and Canadian Natural Resources (CNQ).

Morningstar analyst Jason Stevens just upgraded Baker Hughes to a four-star rating out of five. This energy-services giant recently posted a big drop in operating income. But Baker Hughes is cutting costs and bringing on more high-tech pressure-pumping services, which should help with sales and margins. So will a planned merger with Halliburton (HAL), since this will add an attractive portfolio of energy services. It could lead to cost savings.

I like to use insider buying as one starting point when hunting for picks for my stock letter "Brush Up on Stocks," and that's what we see in Hornbeck Offshore Services. Hornbeck provides offshore supply and support vessels that help with exploration, development and inspection and repair, mainly in the U.S. Gulf of Mexico and Latin America. It has a lot of debt, but also a fair amount of cash and cash flow. The insider signal in this one is really strong at $18 to $20 a share, by my system of insider-buying analysis. But purchases at current levels, around $23, make sense too, as part of a plan to add if it falls into that range.

-Michael Brush; 415-439-6400; AskNewswires@dowjones.com

What could go wrong

Waghorn cautions that the sharp decline in the U.S. rig count might not actually make a huge dent in energy production. The reason: Remaining rigs in action might be used more efficiently at the most productive wells. Meanwhile, Saudi Arabia seems determined to keep up production to put downward pressure on energy prices to drive North American competitors out of business. It looks like they want to see "more pain," he says, to cause more capital spending reductions at U.S. producers.

Goldman Sachs analysts Damien Courvalin and Jeffrey Currie, in a May 18 note that weighed on oil and energy stocks, said oil prices have not stayed low enough for long enough, to significantly crimp supply by permanently scaring capital away from the sector.

"We therefore reiterate our bearish oil price view," say the analysts. "Our bearish view has been driven by two surpluses: excess hydrocarbons but just as importantly excess capital." To get the job done, oil will have to go back to first-quarter lows. They think that may happen by the fall.

If they're right, it might be time to take your second and third swipe at the stocks above.

At the time of publication, Michael Brush held shares of MTDR, HOS and CRK. Brush has suggested MTDR, HOS and CRK in his stock newsletter "Brush Up on Stocks." (http://www.uponstocks.com/) Brush is a Manhattan-based financial writer who has covered business for the New York Times and The Economist group, and he attended Columbia Business School in the Knight-Bagehot program.

-Michael Brush; 415-439-6400; AskNewswires@dowjones.com

[jb2257]

It seems there is a concern over the meeting next week with the Saudis. Perhaps it could be a repeat of the November meeting when the whole sector blew up.

[dan_s]

Just about everyone is expecting OPEC to hold production levels high and they lack the production capacity to increase production. Your fear is what is putting pressure on the sector now and probably will keep a dark cloud over it until the OPEC meeting. IMO a "whole lot of nothing" will come from the OPEC meeting. The only "surprise" would be a production cut.

As we move into summer, U.S. production will decline and demand for oil will move up. That should support higher prices.