Upstream, Downstream, Integrated? Buy Them All

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

While many investors immediately go for the integrated oil & gas picks, you may want to consider diversifying in refiners and upstream producers independently. This will enable you to better spread out your energy investments in the upstream plays you find to be the most undervalued and the refineries you find to have the greatest margin support (since downstream business can be extremely unprofitable). Below, I review several companies that cover different ends of the oil & gas from primarily upstream operations to primarily downstream operations and, finally, integrated operations.

Valero (NYSE: VLO): A Top Oil & Gas Pick

Valero is one of my favorite oil & gas stocks on the Street with an unreasonably low forward multiple of 5.9x forward earnings and 0.94x book value, and strong earnings performance. Over the last 5 quarters, Valero has beaten expectations consistently and done so by an average of 11.7%. It should not be surprising that the company has picked up 20% in value over the last six months.

Fortunately, it is well positioned to gain even more over the next few years. Management is cutting its capex estimate by $100 million to $3.5 billion for the full year and expects 2012 capex to be even lower at $2.5 billion. For the third quarter, EPS of $1.91 came $0.18 ahead of consensus, and this momentum is only likely to improve once the Port Arthur and St. Charles hydrocracker projects kick in next year. While some bears have criticized the closing of multiple refineries for maintenance, it will expand margins in the long-run as efficiency improvements are made.

In addition, I like the company's pursuit of growth through takeover activity. By leveraging an economy of scale, Valero will be able to get more out of each barrel produced. In the third quarter, it was able to increase production by 8,000 barrels per day over the same quarter last year. Management is also separating out its retail business in a tax-efficient distribution. This will better enable investors to allocate risk in higher growth segments.

Buy HollyFrontier (NYSE: HFC), Murphy Oil (NYSE: MUR)

HollyFrontier is another refiner that I believe is worth backing. It trades at 5.3x past earnings and has meaningfully improved free cash flow from significant volatility 5 years ago to nearly $1 billion for the TTM ending 2Q12 (around quadruple the 5-year average). Over the last six months, shareholders have seen the fruits of a strong company with a return of 24.6% during a period when the S&P 500 was roughly flat.

There are several reasons to be optimistic about HollyFrontier going forward. Its refineries are complex and primarily located in the Gulf Coast and Midwest to exploit rising production from Bakken and Canada's sand oils. Over the past 5 years, EPS has taken off like a rocket and yet the Street is predicting that growth will be roughly flat over the next 5 years. I believe this is an extreme pessimistic assumption that has depressed the stock. If management continues to outperform into a stronger macro environment, I foresee shares and multiples recovering substantially from these depressed levels.

If you are looking for more of a smaller scale oil & gas company to supplement an investment in refineries, I encourage backing Murphy Oil (NYSE: MUR). Activist investor Third Point recently convinced management to spin off the domestic retail business in a way that will better draw in risk-averse investors. During the third quarter, management nominally missed earnings but beat revenue expectations by $40 million. With the likelihood of gaining an offshore production contract for shared profits in Equatorial Guinea, the company is well positioned to continue its momentum. It has already done well offshore in the Congo, so I don't little reason to doubt future excellence.

 


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