Two Picks in the Oil Patch

We're now seeing a handful of investment opportunities in the oil patch after raising our long-term oil price outlook. We raised our oil price deck to reflect higher costs and incorporation of an upside risk premium to reflect current dynamics in the oil industry. Our higher oil price outlook boosted our fair value estimates for many energy companies. Read on to learn more about the change in our assumptions, as well as which stocks we'd consider buying.

Since our last oil-price update (September 2006), we have continued to see oil finding and development costs and operating costs climb. In particular, we've seen significant cost escalation in marginal projects in the oil sands in Canada (a major source of future oil supply). We think the price required to induce new marginal producers to invest in new supply will be around $50-$60 per barrel over the next five years.

There's always a chance that a deep recession could reduce the demand for crude, temporarily driving the price of oil closer to producers' ongoing operating costs. However, such a pricing scenario would likely be unsustainable for an extended period of time, in our opinion. Even despite global economic strength, we've been surprised by the healthy growth in demand in the face of rising oil prices over the past few years. One contributing factor is the weakening U.S. dollar, which has damped the shock of rising oil prices for consumers outside of the United States. In addition, oil fields' output naturally declines over time, which means oil companies have to invest in new supply in order to maintain even flat production levels. Therefore, given our long-term expectations for healthy demand, we think oil prices will need to remain high enough to motivate investments in new supply.

In the past we have used a cost-plus-cartel-premium framework when forecasting oil prices. We clearly think the cost portion of the equation will be higher in the future than what we had assumed before, contributing to part of our decision to increase our oil price forecast. We also continue to expect the OPEC cartel will be a powerful force in oil markets over the next decade, as the cartel is likely to increase its overall market share. 

We've added a third input to our framework, which is best described as an upside risk premium or "fat tail" component. This premium captures the risk of a supply shock due to above-ground conflicts or below-ground limitations from a major supplier of crude. Although some of these risks have existed in the oil patch for decades, given the present supply/demand dynamics and level of conflict and uncertainty in the Middle East, we've added this component to our old cost-plus-cartel-premium framework.

Given the increase in our oil-price deck and the resultant boost in fair value estimates, we'd now consider buying the following stocks of oil-producing companies (based on closing stock prices on Nov. 19, 2007).

 Canadian Natural Resources (CNQ)
Energy analyst Kish Patel thinks this dominant Canadian energy player should experience years of outsized returns. The first phase of the company's wholly owned Horizon oil sands project is on track for first production in 2008. The economics of Horizon's upgraded oil are promising, and the project should provide large resource opportunities with low maintenance capital requirements for several years to come.

 Devon Energy Corporation (DVN)
Energy analyst and small-cap strategist Justin Perucki, CFA, points out that Devon is one of the five largest leaseholders of promising deep-water Gulf of Mexico properties where recent discoveries in deeper Lower Tertiary zones have generated excitement in the oil sector. Devon has a host of new projects slated to come online over the next few years, which should meaningfully boost production.

You can see more  5-star oil stock recommendations as well as fair value estimate changes on a firm-by-firm basis. Simply take a free, 14-day trial to access all Analyst Reports for our oil and gas firms, plus more than 1,900 other stocks.

Learn more about our oil forecasts and these picks by watching Pat Dorsey's recent video report.