2007 Energy Investment Strategy: Pick the Laggards

TWST: What are you telling investors to do at this point in the space?

Mr. Gheit: To expect oil and gas price volatility to continue. Try to understand what drives energy stocks and be able to live with oil and gas price volatility. They need to have an investment strategy that is both disciplined and flexible. I believe the easy money in the energy sector has been made and the stock performance in the last three years is unlikely to be repeated any time soon.

Our investment strategy for 2007 is to pick the laggards, provided there is an internal catalyst that would improve the company's outlook. We picked four stocks, one in each industry group, as our top picks for 2007. They are BP (BP) among the majors, Murphy Oil (MUR) among the integrated companies, Valero (VLO) among the refiners, and Anadarko (APC) among the E&P independents.

BP lagged its peer average in the last 12 months, gaining 4.5% in 2006, the lowest among the major oils, which gained 20.5%. BP has had its shares of operating problems, and hopefully the worst is over. The CEO is retiring at the end of 2008 and is likely to do something to improve the stock performance, which we expect to come in the form of increased dividend and share buyback, as well as possibly a large merger that creates shareholder value.

Murphy Oil's stock also lagged with a decline of 5.8% in 2006 on a combination of operating problems and poor exploration results. Most of the operating problems have been corrected, and both production and refining capacities have been largely restored. The catalyst to the stock performance is the startup of the company's largest development project offshore Malaysia in the second half of this year, which is expected to boost its net production by 50% in 2008 and 80% in 2009.

Valero is the largest and most sophisticated and geographically balanced refining company in the US, the world's largest and most profitable refining market. The shares declined by 1% in 2006, despite record earnings as refining margins peaked. Even at much lower margins, we expect the company to generate significant free cash flow, which it will use to reduce debt, increase dividend and buy back shares, all of which should boost the stock performance. Valero is also trading at the lowest multiple of earnings and cash flow among refining stocks.

Anadarko's stock also lost more than 8% in 2006, with most of the decline following the cash acquisition of Kerr-McGee and Western Gas Resources in the first half of the year. Anadarko is undergoing massive restructuring and plans to use cash proceeds from asset sales to reduce debt and regain financial flexibility. The acquisitions significantly improved the company's competitive position and production and reserve growth prospects. The divestiture is ahead of schedule, and cash proceeds from asset sales exceeded the original forecast.