News Analysis date published New: 
Monday, January 31, 2011 - 10:00
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Monday, January 31, 2011 - 12:20
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Monday, January 31, 2011 - 10:00

Forget Exxon: Buy This Stock Instead

Monday, January 31, 2011 10:00 AM

When you think about ExxonMobil (NYSE: XOM), you think of oil. A steady focus on "black gold" has enabled the company to become the most valuable company on the planet. But with oil prices steadily rising and natural gas prices flat-lined during the past year, it may surprise you that ExxonMobil really wants to focus on gas.

In a recent report, the company predicted that "natural gas will be fastest growing major energy source, overtaking coal as the second-largest global energy source behind oil, and serving as a reliable, affordable and clean fuel for a wide variety of needs." That's why ExxonMobil shelled out $41 billion to buy gas producer XTO Energy last June. The energy giant seeks to balance its exposure between oil and gas, so look for more deals in the future.

I've been tracking a company that has come to the same conclusion, but from the opposite direction. Sandridge Energy (NYSE: SD) was fully exposed to the natural gas market, but after a series of asset purchases and sales, it will soon have close to a 50/50 balance between oil and gas. The transformation has not been easy, and Wall Street analysts generally avoid recommending its shares right now. Yet within a few quarters, the company will likely prove its doubters wrong as production of oil and gas ramp up to even higher levels in 2011.

While many energy stocks have rallied in the last year, shares of Sandridge fell about 20%. In 2011, it's time to play catch up.

Boosting exposure to oil
After seeing natural gas prices fall sharply, Sandridge decided to diversify away from gas and into oil, acquiring Forest Oil in December 2009 and Arena Resources in July 2010. By the end of the summer, analysts grew concerned that those purchases -- and the debt incurred to acquire them -- would lead to cash flow problems for Sandridge. That concern arose when oil traded below $75 a barrel back in September.

Since then, oil prices have staged an impressive rally and now approach $90. That means Sandridge is likely to generate stronger oil-related cash flow in 2011 than most analysts are currently expecting. The move to acquire Forest and Arena looked risky last summer, but now looks much wiser. If oil moves up to $100 a barrel, cash flow prospects look even stronger.

Sandridge likely produced roughly 20,000 barrels of oil per day in 2010, though that figure is expected to swell to 30,000 in 2011.

The long-term view for natural gas
As noted earlier, ExxonMobil encourages investors not to forget about natural gas. Admittedly, the entire industry has gone through a wrenching phase of oversupply that is taking far longer than anyone expected to correct. But it's only a matter of time. Natural gas fields have a finite shelf life and eventually yield smaller and smaller amounts of gas. As older wells get depleted, total output should drop, allowing prices to rise back up.

You can get a sense of the anticipated supply and demand trends by looking at futures prices. Natural gas is currently value at around $4.30 per thousand cubic feet. Contracts for delivery of natural gas that expire next January are valued at $5.06. At that price, profit margins for the industry would be nicely higher, as fixed costs remain the same. For Sandridge, which will still derive roughly half of its sales from natural gas, rising prices for gas could lead to cash flow growth well above the current consensus.

Shares of Sandridge have fallen about 10% in the past two weeks to around $7, creating a solid entry point. The company could generate roughly $1.25 in cash flow per share in 2011, though I look for that figure to rise above $1.50 in 2012 and approach $2.00 in 2013 -- assuming oil prices stay at $85 or above and natural gas prices approach at least $4.50 per thousand cubic feet. Much of the cash flow growth is predicated on rising production, and not rising energy prices. If prices do rise, those cash flow targets would likely be too conservative.

Action to Take --> Over the course of 2011, I expect analysts to start to see Sandridge in a new light, and many will start to understand the company's considerable cash flow strength. A trade up to $10 -- 40% above current levels -- is where I see shares ending up a year from now.

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David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.