Low-Risk/High-Growth Oil & Gas Stocks

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

If you are looking to get into upstream and downstream producers, I recommend buying a basket of low-risk and high-growth stocks. In particular, there is likely going to be increased takeover activity as the major producers seek to scale up and spread out costs in order to hedge against macro uncertainty. Below, I review three oil & gas stocks with this question of risk/reward in mind.

What To Make Of BP (NYSE: BP), ExxonMobil (NYSE: XOM)

Now that the Macondo oil spill is behind us, investors can now focus on BP's incredible value potential. The stock trades attractively at 7.5x past earnings and a 5.2% dividend yield. Analysts forecast just 2.7% annual EPS growth over the next 5 years, which I think understates the potential in light of the 3.9% rate experienced over the past 5 years. Without multiples expanding from these very low levels, however, we are looking at 7.9% annual returns - an absolute minimum. But there are multiple reasons to be optimistic that returns will exceed 10%.

First, there is the takeover chatter. Just a few years ago, Shell was said to be hunting for its rivals. Only a short time before this speculation emerged, Exxon was said to be interested BP's downstream operations. At a $130 billion market cap, I don't see an outright takeover occurring in light of too much uncertainty. Plausible, but still unlikely, is a merger of equals deal.

Aside from a possible buyout, BP has stronger-than-recognized fundamentals in its own right. The company is looking into explore the untapped arctic north, with particular interest in Norway. In addition, a partnership is underway between Imperial Oil, BP, and Exxon to drill in the Canadian Arctic, which may stake claims to 90 billion barrels of oil by the summer of next year. Greater focus on less plays but higher-margin ones will enable the company to improve its return on invested capital, mitigate business risk, and thereby lure back weary investors. This strategy is already underway with the $5.6 billion sale of several non-strategic Gulf of Mexico assets.

On the other hand, despite how I began this article, the Macondo oil spill legacy still lives on. It has become a bit of a regulatory target and was recently caught off guard when it was suspended from new government contracts in the United States because of a "lack of business integrity". BP is, of course, appealing and using its recent $4.5 billion settlement with the Department of Justice to lift the temporary ban. If you are looking for a safer pick, go with the world's largest oil & gas company and a major US employer, Exxon Mobil. It trades fairly chap at 9.3x past earnings, has very limited debt, and is around half as volatile as the broader market. Plus, with Dahlman Rose initiating a "buy" on the stock and a $100 price target, there is around 15% upside from here plus the 2.6% dividend yield

Small Cap Roundup: Earthstone Energy (NYSEMKT: ETSE) & Emerald Oil (NYSEMKT: EOX)

Just as lower risks comes with lower returns, higher risks comes with higher returns. Earthstone Energy and Emerald Oil are two energy companies in the small cap space that are worth considering. Earthstone has no debt on the balance sheet and trades at 9.9x past earnings. EPS has gone up by a rate of 9.8% over the past 5 years, so I believe its high growth curve has been under-recognized given its lower market capitalization. With high oil prices, the company has curtailed its takeover strategy and focused on plays that build upon existing operations. It has operations in Montana, North Dakota, and Montana, as well as Texas and Louisiana. Reuslts have been so stellar that Earthstone was named among the fastest growing public companies located in Colorado.

Emerald Oil similarly carries strong risk/reward. It has no debt on the balance sheet and is more than 25% cheaper than book value. The company also has operations in the Williston Basin with 43.6 thousand net acres and 238 net potential drilling sites discovered. Capital expenditures for this year and next will target the Three Forks and Bakken formations. Furthermore, the company has stakes in the Sandwash Bafsin (45 thousand net acres), Heath Shale (33.5 thousand net acres), D-J Basin, and the Tiger Ridge area. Given how cheap the company is and its access to leading plays, I believe the company is on the takeover screens of several large E&P companies. For this reason, I recommend buying to take advantage of the low price.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of ExxonMobil. 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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