Energy Bull? Why You Should Go Long These 3 Stocks

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

Recent data from the US Energy Information Administration showed that natural gas prices dropped by 8 cents with the Henry Hub closing at $3.25 per MMBtu (=1000 cubic feet) for the week ending Dec. 19. The general problem with prices can be showcased by how supply has only fallen by 0.5% compared to last year while demand has fallen by 4.9%. The number of natural gas rigs has fallen 49.1% to 416, although horizontal rig types have been relatively less vulnerable. And, as you can see in the picture below, above average temperature largely throughout all parts of the United States, an average of 4.7 degrees compared to last year, has only added to the downside story.

<img src="/media/images/user_13548/screen-shot-2012-12-27-at-122817-am_large.png" />

It's The Future, Stupid

But companies are valued based on their future and not past potential. While the environment looks all doom and gloom, much of this has already been priced into the stocks of oilfield service firms. Halliburton (NYSE: HAL), for example, trades at only 11.2x past earnings despite a 5-year average PE multiple of 14.8x. Baker Hughes (NYSE: BHI), another heavily concentrated oilfield service firm, trades at only 12.2x past earnings despite a 5-year average PE multiple of 18.5x. This is particularly shocking, because the secular tailwinds for natural gas and those that supply the industry are excellent. Exhibit 1 concerns the future of unconventional drilling.

In simple terms, unconventional drilling is the process of extracting oil and gas within dense formations that traditionally see resources percolate into more porous (think "air space" between grains) rock layers. When these resources are trapped between two dense formations after percolating upwards into a porous layer, it forms a hydrocarbon trap, and upstream producers use conventional drilling to extract from this reservoir. What's left behind in the low porosity source rock--commonly "shale"--can be extracted through unconventional means. Common sense would dictate that it would be hard to extract from shale, and it was until the advent of hydraulic fracturing, better known today as "franking."

Unconventional drilling faces a steep growth curve, and Halliburton, not Schlumberger (NYSE: SLB), will be the main beneficiary by virtue of its premier focus on fracking equipment. Unconventional drilling is expected to represent 50% of North American production over the next decade versus 23% in 2010. Oil basin crowding may have driven down margins, but Halliburton is moving around this issue through improving efficiency. The company's revenue per rig has been climbing from $5.6 million in 2010 to $6.3 million in 2011 and $7 million today.

Shale gas, an unconventional resource, currently makes up 20% of natural gas production, and China is believed to hold the largest reserves. It has, however, lacked the geological data and infrastructure to support fracking. Enter Baker Hughes and Halliburton, which have the know-how gained from a relatively active North American scene. China is aiming for 100 Bcf of gas production by 2020 and will need to consult with these producers to get started.

To its credit, Halliburton has already signaled to the market that it will move fast to get Asian clients. It recently reached a $1.2 billion deal with Malaysia-based Dialog Group to help assist in offshore activity in Southeast Asia. Malaysia has seen its energy production drop 26% from 2004 to 630 kboe/d as oil fields have started to mature. As resources get scarcer, they will be in greater need to consult with Halliburton in extracting oil and gas from hard-to-access formations.

Short-Term Will Be Bumpy, So Hedge

But as the CEO of Halliburton has said in the past, the next couple of quarters will be "pretty bumpy." Pressure pumping margins have eroded as land drilling activity has slowed and guar costs have risen. The best way to hedge against this downside is to invest in oilfield service firms that are more heavily exposed outside North America. Schlumberger fits the bill as the largest company in its industry. However, investors will have to pay a premium to buy shares in this safer pick--it trades at 17x past earnings.

Analysts are bullish on Schlumberger all the same and rate the stock a 1.7 out of 5 where "1" is a "buy." The consensus price target is a full 28% above the prevailing price and may close any time when domestic uncertainty mitigates. Assuming the company meets expectations, 2016 EPS will come out to $7.56, which, at a multiple of 15x, translates to a future stock value of $113.40. Discounting backwards by 10% yields a present value of $70.41. This input a 16.2% growth rate to yield a result that was in-line with the current price. While there is an absence of a meaningful margin of safety, the growth alone should drive the stock higher to outperform broader indices.

Schlumberger is not without its own problems. It cut EPS guidance by 7 cents on the high-end for fourth quarter. But the 2.3% negative stock reaction was unwarranted, since this guidance trimming was only due to seasonal slowdowns that do not have any meaning on the future. As it stands, oilfield production outside North America will increase 2013 global upstream spending by 7% to $644 billion, according to a Barclays estimate. There is also the major catalyst coming from what analysts have called a "game-changing" deal with Cameron, wherein the partners will jointly produce subsea oil and gas products. Schlumberger's leading experience in offshore and deepwater drilling is ideally positioned to create value in this deal. I thus strongly encourage investing in Schlumberger, where investors are more focused on the upside catalysts compared to its more North American concentrated peers Halliburton and Baker Hughes. Again, that is not to say that the last two investments are bad; they are riskier and come with higher long-term reward.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Halliburton Company. Motley Fool newsletter services recommend Halliburton Company. 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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