Hedge Funds' Top Energy Stocks: 2 To Buy, 2 To Avoid

By Ashish Sharma - June 26, 2012 | Tickers: APC, XOM, HAL, SLB | 0 Comments

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Every quarter, Bank of America analyst Mary Ann Bartels comes up with an analysis of 13F filings by the major hedge funds. Her report consists of the major buys and sells by the big funds and lists their top holdings in each sector. Here’s a list of the top ten energy stocks that major hedge funds were holding at the end of last quarter according to her report:

I scanned the above list for good long candidates, and Schlumberger (NYSE: SLB) and Exxon Mobil (NYSE: XOM) appear to be the most compelling of the group.

Schlumberger’s disproportionate exposure to international offshore and international deep-water drilling makes it a good buy as compared to its competitors, such as Halliburton (NYSE: HAL). Schlumberger derives over 50% of its operating income from international drilling, compared to Halliburton’s 22%. While the US land drilling market is facing challenges from cost inflation, as shown by Halliburton’s recent downward guidance revision, international offshore markets continue to do well.

Although Schlumberger is trading at a premium to its domestic peers, I believe this is justified. Schlumberger’s exposure to international drilling mitigates headline risk from slowdowns/cost-inflation in the US, and at the same time makes it a high-quality defensive play on secular growth in international, deep-water activity. I believe SLB deserves a premium valuation as the industry leader in size, technology, and market penetration. Additionally, the company has a good track record of delivering top-tier returns to shareholders, and I believe this is likely to continue. At valuations of just 11.57x forward earnings, I find the risk-reward profile of the stock very attractive.

Exxon Mobil is a good contrarian bet. I like this company because of its greater-than-peer exposure to natural gas. More than 50% of Exxon’s reserves and production volumes are linked to natural gas. Also ~35% of Exxon’s proven natural gas reserves and ~30% of current natural gas production are in the US. Hence, domestic natural gas prices are particularly important for Exxon Mobil.

Natural gas prices in the US are at historically low levels and are currently trading at over an 80% discount from crude oil prices. I don’t think such a deep discount can continue in the long term; industries traditionally using crude oil and its derivative products will shift to natural gas as their primary energy source if it does. Also, a lot of natural gas rigs will be shut down if such low natural gas prices continue, thus reducing the supply. This may take some time, as usually rigs are leased for a relatively longer duration of time, but I am pretty sure it will happen eventually. Exxon is currently trading at 9.51x forward earnings. I believe the risk reward profile for the company is skewed on the upside and would recommend buying it from a long term perspective.

Two stocks in the above list that I would recommend avoiding are Halliburton and Anadarko Petroleum Corporation (NYSE: APC). I discussed Halliburton’s weak international presence as compared to Schlumberger above. In addition, Halliburton’s over-exposure to North America (~64% of operating income) and rising costs (Gaur Gum prices in particular) make it a less attractive investment. Anadarko Petroleum, though I like it from an operational standpoint, puts me on the sidelines with its Tronox liability. The case went to trial around mid-May and could drag on for a year or two. There is upside potential if the company continues its success with exploration programs, but it is balanced by the downside risk of the Tronox litigation.

To sum up, Schlumberger’s international presence and Exxon Mobil’s involvement in natural gas make them good buys. On the other hand, Halliburton’s North American exposure and Anadarko’s Tronox liability make them risky bets, and I would hence recommend avoiding them.

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