Energy stocks tend to be superstars after a recession, rebounding sharply as the economy recovers. And this time around, the biggest winners may be midsize stocks most people have never even heard of, like Consol Energy or Pride International. Sure, Big Oil looks cheap, with firms like Chevron trading below the market’s average price/earnings ratio and paying dividends upwards of 3 percent. But many midsize firms are growing faster than the giants, which helps explain why Exxon Mobil is willing to spend $30 billion in stock for shale-gas producer XTO Energy. These midsize players’ stock may offer more potential to pop than the big boys’. “We’re far more optimistic on the midcap names,” says Ted Harper, comanager of the Frost Dividend Value Equity fund and a veteran energy analyst.
With oil rebounding to about $80 a barrel at the start of 2010, the big producers have been gushing profits, which could flow to other firms in the industry. Worldwide rig counts have stabilized around 2,530, down 25 percent from 2008, leaving plenty of upside for a production rebound. While some major producers have trimmed their capital budgets for 2010, independent companies are planning to hike their budgets by an average of 12 percent, to $41.6 billion this year. The upshot? Rising revenue and pricing power for energy services and gear firms. The industry should see a “good uptick in drilling activity in 2010,” says William Herbert, cohead of research for Simmons & Co., an investment bank specializing in energy stocks.
Energy stocks could still falter, of course, for a variety of reasons. Natural gas prices haven’t fully bounced back with the economy, and the new shale fields are yielding “heroic” amounts of natural gas, says Herbert, which could result in a glut for years. A double-dip recession in the U.S. or slowdown in China could also whack oil prices. And crude has gotten a big lift from the dollar’s slide, which may not last either. “You could say oil is about $20 to $25 a barrel higher simply [because] it’s priced in dollars and there’s a weak dollar,” Exxon Mobil CEO Rex Tillerson told an energy roundtable in the fall. Still, many analysts expect a gradual rise in energy prices, particularly if a global recovery takes hold. To find our picks among the lesser-known players, we looked for companies with a competitive edge, trading at reasonable prices relative to their growth prospects.
La Salle County, Texas, is among the poorest places in the country, a sparsely populated patch of rolling hills with an abundance of scrub brush and grasses. But the region does have one thing going for it: 19 trillion cubic feet of natural gas in the Eagle Ford shale, a rock formation around 11,000 feet below the surface. Petrohawk (HK) announced the first major discovery in Eagle Ford in 2008 and has drilled 20 wells there—with 50 to 60 more planned for this year. The geology of the formation makes for relatively easy drilling, with costs as low as $5 million per well, half that of other shale fields. And companies in Eagle Ford can break even with gas prices at just $3.88 per million British thermal units, compared to $5 in other areas. “The economics are very compelling down there,” says Petrohawk CEO Floyd Wilson.
That could be a big advantage for Petrohawk. The firm specializes in horizontal shale drilling—a technique that’s opening up vast deposits of natural gas. Petrohawk expanded production by about 75 percent in 2009 and plans another 43 percent increase this year. Its costs are about 20 percent below the industry average, and it has built a reputation for smart land acquisitions, enabling it to profit even with gas prices near rock-bottom lows. “It’s all about location,” says Manuj Nikhanj, an analyst with the Ross Smith Energy Group, an industry research firm in Calgary, Canada. “They picked their areas very well.”
Even with the economy recovering, gas prices may not bounce back to their highs. Inventories were recently at their highest level since 1994, according to the U.S. Energy Department, and the glut may only grow with rising imports of liquefied natural gas and supplies from the new U.S. shale plays. Several coal-fired power plants are coming on line over the next few years and could curtail gas demand—where much of the increase in gas usage has occurred, says Jen Snyder, an industry analyst with Wood Mackenzie, an energy-research firm. And without a big jump in industrial or consumer demand, Wall Street’s 2010 earnings estimates for gas stocks could prove too optimistic.
None of this has been lost on Wilson, who says Petrohawk has “battened down the hatches” to gird for a gas glut. The company plans to sell more than $1 billion in noncore assets, partly to pay down debt, and Wilson says the firm will have “plenty of money” to execute its expansion plans. The company has also hedged much of its 2010 production at prices above today’s levels, allowing it to profit even if natural gas prices fall. Longer term, the stock has room to rise based on its cash flow and growth rate, says Dan Rice, manager of the BlackRock Energy and Resources Trust fund, which owns the stock.
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