The Right Way to Play Energy in 2013

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Energy stocks have been facing important uncertainties over the last months, and this has produced some interesting opportunities to invest in companies with strong fundamentals and attractive valuations. Investors need to do their homework before buying though; the energy sector is going through important transformations, and this could have material implications for different stocks in the middle and long term.

Cross Currents

On one hand, certain global macroeconomic trends should be positive for energy prices in 2013. Ultra low interest rates are bullish for commodity prices, and they are not going away anytime soon. This is not only a factor in the US; Japan, the Eurozone and the UK are also embarked in aggressive expansionary policies. Money printing is usually bullish for commodities, and rising oil prices could be a very strong tailwind for energy producers.

Besides, the Chinese economy has been showing stabilization signs over the last months, with industrial production and other key variables coming in better than expected. China is a dominant player in oil imports, and its local car market, already the biggest in the world, will generate growing fuel demand in the long term. China is the economic growth engine of the world nowadays, and improving economic statistics in the Asian country bode well for oil prices.

At the same time, political complications in Venezuela and in the Middle East can always be a source of added uncertainty for global oil production. Even if there are no significant disruptions to output levels, mere uncertainty due to political or military conflicts is usually translated into higher oil prices as speculators react to the incoming news and try to anticipate possible scenarios.

On the other hand, new technologies and discoveries have dramatically affected the landscape for production in the US lately, both when it comes to oil and natural gas. The International Energy Association says the U.S. will become the world's largest oil producer by 2017, overtaking current leaders Saudi Arabia and Russia. According to the White House, the U.S. holds a 100-year supply of natural gas and domestic production is at an all-time high.

Even if macroeconomic variables point to higher energy prices in the middle term, increased availability and production could ultimately cause a future of cheap and abundant energy in the US and the rest of the world. This would be great news for consumers and economic growth in general, but a big drawback for some energy stocks.

Big Integrated Energy Plays

There is a lot of potential in big integrated energy stocks at current levels, but the risks need to be monitored closely, especially when it comes to each company's exposure to energy prices.

Brazilian Petrobras (NYSE: PBR) is a clear example about a company offering huge upside potential, but also some serious risks coming from fluctuating oil prices.  The company has made various important discoveries in Brazilian off shore platforms over the last years, and it plans to duplicate its production in the next 10 years. Petrobras is dirt cheap trading at a P/E around 6, so investors in the stock could see some enormous gains if things go as expected regarding the new discoveries.

However, Petrobras will need to invest between $200 and $250 billion to fully develop these resources, and investing requirements mean that the company will continue generating negative cash flows for several years. These maritime reserves have a high extraction cost too, so their profitability depends on oil prices to a considerable degree. If oil prices start decreasing, Petrobras investors could suffer the consequences of falling profitability.

Big American companies like Exxon (NYSE: XOM) and Chevron (NYSE: CVX) would be much safer bets in a scenario of lackluster energy prices. Their asset base is more mature, and they have superior operational efficiencies, which means that they can sustain profitability in a scenario of lower oil and gas prices. Strong balance sheets and active dividend policies are a big plus when it comes to delivering better returns in a scenario of uninspiring commodity prices.

Exxon has better exposure to the natural gas industry, an important asset when the biggest risk to oil prices is probably increased gas usage; it also has size advantages across the board and a very healthy degree of industry integration and international diversification. But Chevron has a higher dividend yield at 3.3% versus 2.6% for Exxon, and it still has a rock solid cash flow statement to continue increasing dividends over the long run.

Betting on Natural Gas Usage

Abundant natural gas can be a problem for some big oil companies, that's why hedging with other stocks standing to benefit from the natural gas boom sounds like a smart idea. Kinder Morgan (NYSE: KMI) owns the largest network of natural gas pipelines in the United States, with more than 62,000 miles of pipeline connecting the major drilling areas to demand centers all over the country.

The company charges a mixture of fixed and volume-based fees for transporting and storing fuel, so it's a bet on higher gas usage, and it's not too sensitive to commodity prices. Kinder Morgan is an unequivocal beneficiary from the natural gas revolution, and the company pays a juicy 4.4% dividend yield while investors wait for gas to become the fuel of the future.

Westport Innovations (NASDAQ: WPRT) is a smaller, riskier, bet on growing natural gas demand. The company designs engines for cars, trucks, and heavy machinery that can run solely on natural gas, or on a combination of natural gas and petroleum-based fuels. Westport is working with industry leaders like Cummins, Ford and Caterpillar to build fuel efficient engines and capitalize the cost advantages that natural gas provides, especially when it comes to heavy vehicles.

Westport is non-profitable at this stage, and it’s hard to make any precise estimate regarding cash flows or growth in the short term. On a longer timeframe, however, if natural gas will continue booming, the company is in a privileged position to benefit from this trend. Investors in Westport may need to tolerate some serious volatility in the middle term, but if the upside potential is huge if the natural gas thesis plays out as expected.

Bottom Line

There are some interesting opportunities in the energy sector, as many fundamentally strong companies are trading at attractive valuations and oil prices could rise in the middle term due to better economic tailwinds. But the industry is going through an important transformation in the long term, and investors need to position themselves accordingly to avoid being hurt by rising oil and gas production.

acardenal owns shares of Wesport Innovations. The Motley Fool owns shares of Kinder Morgan, Westport Innovations, and ExxonMobil. Motley Fool newsletter services recommend Chevron, Kinder Morgan, Petroleo Brasileiro S.A. (ADR), and Westport Innovations. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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