Five Energy Stocks to Keep on Your Radar Screen

You can't do anything these days without being reminded of high oil prices. Last week, the Energy Information Administration reported that the average retail price for regular gasoline in the U.S. topped $2.61 per gallon, a $0.73 increase over this time last year and a nominal high for the third straight week. Adjusted for inflation, oil prices have not been higher since the early 1980s.

After struggling to turn a profit in 1998 and 2002, energy companies are now basking in the sun, and investors have taken note. The Dow Jones Oil and Gas Index has appreciated by more than 65% since the end of 2003. At Morningstar, we look for stocks that trade at a meaningful discount to our fair value estimate, and the outstanding performance of energy stocks has left us with few compelling investment ideas today. As of Aug. 24, the average price/fair value ratio for the 100-plus energy-related stocks we cover stood at 1.37. None of these stocks currently has a Morningstar Rating for stocks of 5 stars, our highest rating, and only a handful carry our 4-star rating. Besides  Devon Energy (DVN) and  Suburban Propane (SPH), which are both discussed below, the only other 4-star stocks are  TC Pipeline  (which I own) and  TransCanada (TRP).

That being said, we think investors would benefit from keeping a few energy companies on their radar screens. Most of these stocks are inherently volatile, and even a small dip in oil and gas prices can send them down significantly. During these sell-offs, the good firms typically get punished along with the bad. This can create an opportunity for investors to purchase these stocks at a more reasonable price.

Here are five stocks, operating in various segments of the industry, that we think are worth keeping an eye on.

Devon Energy (DVN)
Analyst: Justin Perucki
Fair Value Estimate: $66
Consider Buy: $50.90
From the  Analyst Report: Devon is the largest U.S.-based independent oil company. With about 90% of its reserves and production in North America, Devon has a lower risk profile than some of its more internationally focused competitors. Moreover, Devon's proximity to the US market should allow the firm to enjoy robust sales and higher-than-average margins for the foreseeable future. Devon has an eclectic group of assets. The 2003 merger with Ocean Energy made Devon one of the five largest leaseholders of promising deep-water Gulf of Mexico properties. A 2001 acquisition added large tracts of western Canada, including the largest gas holding in the untapped Mackenzie Delta. Although much of North America's gas deposits are mature, Devon's deep-water and Mackenzie Delta properties are still in their infancy. Even the company's developed reserves have a lot of life left in them. Devon is the largest producer in the prodigious Barnett Shale deposit in Texas.

BP PLC (BP)
Analyst: Mark Uptigrove, CFA
Fair Value Estimate: $62
Consider Buy: $52.80
From the  Analyst Report: After a long period of mergers and restructuring, BP has built itself into one of the largest and most highly profitable companies in the world. Among its supermajor peers, BP's production outlook is the rosiest, and its cash-flow-generating ability is remarkable. Thanks to these acquisitions and climbing energy prices, BP has dramatically boosted revenue and profits over the past few years. At the same time, the company has made large capital investments that have now set the stage for strong internal production growth. The firm aims to increase output roughly 5% annually over the upcoming five years, which is about double the average of its peer group. Also, BP has avoided higher-cost unconventional oil developments (such as oil sands in Canada and extra-heavy crude oil in Venezuela), which many competitors are pursuing. We think this is a strong statement about the attractiveness of BP's current project portfolio. Although BP has not shied away from taking large calculated risks, it has also not had an unprofitable year in decades. Subsequently, it has a nominal amount of debt for a company its size. This is the case even as it has been paying out a healthy dividend, repurchasing shares, and scooping up smaller competitors. Furthermore, management has committed to distributing 100% of excess free cash flow to investors as long as oil prices remain higher than $20 per barrel.

Buckeye Partners 
Analyst: Michael Cumming, CFA
Fair Value Estimate: $45
Consider Buy: $38.30
From the  Analyst Report: Buckeye Partners has made two big acquisitions in the past year. On the heels of its purchase of pipeline and terminal assets from  Shell (RDS.A), Buckeye Partners announced similar plans to buy assets from  ExxonMobil (XOM). We like these deals for several reasons. Both the acquired pipelines and most of the terminals are attached to Buckeye's current network, making the new assets a natural extension of the company's operations. Both Shell and ExxonMobil formerly used these assets for their own operations. The Shell pipelines have spare capacity that Buckeye can now open to other customers, and Buckeye can use spare capacity on its own system to relieve the overflow from the ExxonMobil pipelines. Most important, these acquisitions will enable the company to increase cash distributions to unitholders by at least $0.15 per unit annually. Most of Buckeye's refined-products pipelines are in competitive markets, and are allowed to charge market-based rates rather than the inflation-based, regulated rates charged by most other pipelines. Pipeline operators favor market-based rates because they generally rise when regulated rates rise and stay steady when regulated rates fall.

Suburban Propane (SPH)
Analyst: Elizabeth Collins
Fair Value Estimate: $37
Consider Buy: $28.50
From the  Analyst Report: Suburban's core business--propane distribution--enjoys high customer switching costs and generates impressive returns on invested capital. The firm's average returns on invested capital over the past five years are better than peers Amerigas APU and Ferrelgas FGP. Suburban's propane customers have little incentive to switch, either to other fuels or to other providers. Most customers live or work in rural areas where natural gas service is not available. And since most home appliances are designed for a specific type of fuel, switching from propane to other fuels would be costly. Also, the majority of customers don't own their storage tanks; they lease the tanks from Suburban. Switching providers could mean having the yard ripped up to remove the tank. As a result of these hefty switching costs, it would take a great price differential to motivate Suburban's customers to leave. Although propane distribution is a mature industry, Suburban still generates solid returns. Over the past five years, returns on invested capital have averaged 14% including goodwill. Suburban would be a great fit for income-oriented investors. The firm's units yield 6.6% at our $37 fair value estimate.

Cheniere Energy (LNG)
Analyst: Justin Perucki
Fair Value Estimate: $37
Consider Buy: $23.60
From the  Analyst Report: Cheniere was founded as an oil and gas exploration company, but in late 2000, management believed a natural-gas shortage in the United States was imminent and began evaluating properties on which it could build LNG terminals. Like management, we think LNG could play a major role in meeting domestic natural-gas demand over the next several decades. Cheniere Energy has ownership interests in four LNG terminals: two on the coast of Louisiana and two in Texas. The Federal Energy Regulatory Commission has approved three of the terminals, and the firm is beginning the approval process, which usually takes 12-18 months, for the fourth. Including Cheniere's terminals, there are about 20 terminals proposed in and around the Gulf of Mexico. Even if a fraction of the facilities were built, there would probably be abundant regasification capacity. Cheniere has mitigated this risk by preselling capacity at its first two approved terminals under long-term contracts to high-quality customers. LNG is going to be integral part of the future of natural gas, and Cheniere's first mover status and long-term contracts should allow it to profit nicely from this changing dynamic of the natural-gas industry.