Four Tips for Buying Energy Stocks

Given the high price of oil and natural gas recently, many investors are considering buying energy stocks. However, we don't suggest diving into energy stocks just because oil and gas prices are high. Finding a quality energy stock can be difficult, because so many companies produce, transport, refine, and market energy products. We've put together a small list of guidelines that we think can help the average investor get started. We aren't suggesting that any one tip will make you a great stock-picker. But, by creating a sound process for analyzing businesses, we think you can improve your odds at making better investment decisions over time.

1. Avoid companies that focus primarily on refining and marketing.
Although this year has been an exception, economic profits have rarely flowed downstream to refiners and marketers. Despite flat capacity growth and numerous megamergers over the past 20 years, the industry remains highly fragmented and commoditized. The largest player,  ExxonMobil (XOM), claims less than 8% of total market share. Competition is fierce and profits are slim and volatile for most refiners.

In our opinion, marketing is a necessary evil for most major energy companies, not a great investment. As a stand-alone segment, distributing gasoline and operating corner retail outlets generates fairly steady (but tiny) profits. Because everyone is selling the same commodity, energy companies can't easily build a brand based solely on their energy products. Some companies boost returns by selling coffee and other products. However, just selling energy products at the wholesale or retail marketing level does not spawn long-term economic returns. One example of an energy company focused on refining and marketing is  Tesoro Petroleum .

2. Stick with high-quality management teams.
This is easy to say, but how does an investor determine management quality? First, keep in mind that energy companies are very capital-intensive businesses. Much of what makes a great energy executive is his or her ability to allocate capital wisely. One way to measure management’s ability to allocate capital is to examine past acquisitions. How successful have these mergers been? In some cases, such as  Vintage Petroleum , the record will be clear. Over the past couple years, Vintage has recorded goodwill write-downs and asset-impairment charges following a bad acquisition in 2001.

In addition to allocating capital wisely, make sure management has a record of superior operating performance. Finding and development (F&D) costs can be a great way to measure management’s exploration and production competency. F&D costs reveal how much it costs for a company to add new reserves. (You can figure F&D by adding exploration costs plus development costs and dividing by total reserve additions). Because F&D costs can swing widely from year to year, we recommend using a multiyear average when making comparisons.

Over the past three years,  BP (BP) has led the major oil companies by keeping F&D costs close to $4 per barrel of oil. Contrast that with  Amerada Hess’ (AHC) F&D costs of nearly $14 per barrel of oil.

One measurement that we repeatedly reference at Morningstar, return on invested capital (ROIC), is great for evaluating management’s ability when it comes to both capital allocation and daily operations. Of the energy firms we follow, ExxonMobil has consistently outperformed its peers in terms of ROIC.

3. Don't be deceived by low P/E ratios.
Investors routinely compare price/earnings (P/E) ratios when researching stocks. However, we recommend using caution when applying price-multiple analysis to energy companies.

Both production and refining profits experience boom/bust cycles that can wreak havoc on simple P/E analysis. For example, when energy profits are at their highest levels, P/E ratios for energy firms tend to shrink relative to firms in other industries. Experienced investors are likely to recognize this phenomenon (low P/Es during times of peak profits) as part of a cyclical energy industry. But, if an investor takes a simpler view of these relatively low P/E ratios--concluding that energy stocks look cheap without considering the other half of the cycle--he or she could be in for an unpleasant surprise. As the energy companies' earnings decline, their P/Es may indeed rise while their stock prices fall.

4. Remember that bigger is usually better.
One of the clearest advantages in the energy industry is scale. Large firms have an advantage when trying to keep unit costs low because they are able to spread their payroll and other costs over a wider base of production. While small energy acquisitions may draw hundreds of competitors, multibillion-dollar projects are limited to a much smaller audience. Also, large energy companies tend to have integrated operations that help them gain greater control over their own destinies.

When examining the universe of energy firms we cover, we've found that companies with greater scale advantages consistently produce higher ROICs. This advantage is magnified because these larger firms also have higher credit ratings and lower costs of capital. As a result, the spread between their ROIC and cost of capital is much wider than at smaller energy firms. And the wider this spread, the better a company is at creating economic value for its shareholders. This advantage means the big players like ExxonMobil, BP,  Royal Dutch Petroleum  , and  Shell Transport & Trading   should be at the top of your list when you begin your search to find a good energy investment.