News Analysis date published New: 
Tuesday, June 26, 2012 - 13:00
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Tuesday, June 26, 2012 - 16:00
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Tuesday, June 26, 2012 - 13:00

A Safer Way to Invest in Energy, with 60% Upside

Tuesday, June 26, 2012 1:00 PM

The hunt is on. With oil prices below $80 per barrel and natural gas prices still at depressed levels, I've been heavily researching the best stocks in this sector, hoping to scoop up bargain stocks and ride the next wave of surging energy prices.

Last month, I highlighted that energy firm Chesapeake Energy (NYSE: CHK) was a hated stock but worth considering as an investment. It is one of the largest pure plays in the domestic natural gas industry and has some of the most appealing production assets out there. A couple of billionaire investors have also made recent investments.

I still believe Chesapeake is undervalued, but my estimate of potential gains was pretty wide at between 40% and 135%. This is because there is a lot of uncertainty regarding Chesapeake. Though it has great assets, the rapid plummet in natural gas prices means it currently has a funding gap between what it would like to spend to explore for gas and what it will generate in profits this year. The company also almost blew up in 2008 when credit markets tightened and it was stuck with billions in planned spending.

Chesapeake is what I would qualify as a high-risk, high-potential reward stock. Investors who would like to sleep a bit more easily at night might want to consider a much safer rival. In fact, its upside is just as compelling and the downside risk is lower, in my estimation.

Apache Corp. (NYSE: APA) has an explicit strategy to develop a balanced portfolio of energy assets. This means diversifying risk by geography, through a mix of oil and natural gas-producing properties, and reserve life. For instance, it looks for and extracts oil and gas in onshore and offshore locations. It is a big player in the United States, but also has sizeable assets in Egypt and elsewhere.

Apache has also been active so this year in acquiring new assets. In January, it announced the $439 million purchase of a 49% interest in an ammonia fertilizer plant in Australia, as well as a multi-billion dollar purchase of private firm Cordillera Energy Partners and its Central Anadarko basin assets. Past purchases have been from energy titans Exxon Mobil (NYSE: XOM) and BP (NYSE: BP), and gives me a great comfort level that the assets purchased are quality and have high production potential.

Apache describes its approach as a relentless pursuit of opportunity and seeks to do so by controlling costs at the same time. The company has a solid track record of acquiring existing exploration and production properties and exploiting them to their fullest potential.

At the same time, it is conservatively managed. It has the third-lowest debt levels in the industry, with a debt-to-equity ratio of only 26%. It also generated plenty of cash flow to look for drilling plays, explore for oil and gas throughout the world, and return capital to shareholders. It buys back stock regularly and currently pays a $0.17 quarterly dividend, which has grown from just a $0.06 payment in 2004. And although this only translates to a small yield right now, I expect this kind of dividend growth to continue.

The proof of Apache's successful approach to the energy industry can be seen is through its growth and profit levels. During the past three years, revenue is up 11% annually from $8.6 billion to almost $17 billion. Analysts project another 9% bump this year to nearly $18.5 billion Earnings have jumped at a downright impressive 76% annual rate and are set to hit close to $12 per share by the end of this year.

Risks to Consider: As the volatility in natural gas prices indicates, energy price movements can be volatile and unpredictable. Apache is still vulnerable to this.

Actions to Take -> I find great appeal in Apache's balanced growth approach across the globe. The disconnect so far this year is that the stock is down around 15% while the market is up 2%. Chesapeake is down even further, having fallen close to 29% so far in 2012. So while Chesapeake's stock could double, it also has a chance of falling further if it can't cut costs and raise capital to meet its spending plans.

Apache lives within its means and therefore better controls its own destiny. The stock currently trades at a forward price-to-earnings (P/E) of less than 10. I would argue Apache deserves an eventual premium to the average industry multiple of 16, which would send the stock up 60%, probably within a couple of years.

[Note: This new trend in natural gas is bound to be one of the biggest energy stories for some years to come. In fact, I dedicated the inaugural issue of Nathan Slaughter's Exploration & Paydirt advisory to the topic -- including analysis of one stock in the field paying a dividend yield of more than 6.5%. For more information about Nathan's advisory, you can watch this presentation here].

Ryan Fuhrmann does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of XOM, COP, CHK in one or more of its “real money” portfolios.