The Safest Oil Stock to Buy Right Now...

Adam Fischbaum's picture

Tuesday, October 18, 2011 - 9:00am

by Adam Fischbaum

A funny thing happens during corrections and bear markets. Selling begins and the usual suspects are punished: second-tier stocks, companies with shaky prospects and even shakier financials, companies with too much exposure to the area that's creating the particular problem or perceived problem. Then the next phase hits, where investors become increasingly nervous and begin to sell other stocks in the bad sector. They may not have any direct, fundamental issues with the selling excuse, but, better safe than sorry, right? The final phase resembles a Third-World country the day after a coup: everyone is taken out and shot.

Currently, this is happening across just about all market sectors, but especially in energy. As the U.S. dollar strengthens, oil prices typically weaken, because all oil trades are made in dollars. In addition, managers have made supertankers full of money on energy, so naturally, economic uncertainty is as good a reason as any to take the risk off the table. Fortunately, this wholesale liquidation is creating a fantastic opportunity for longer-term, income-oriented investors on the hunt for high-quality stocks at bargain prices.

One of the best out there is integrated oil giant ConocoPhillips (NYSE: COP).

When the baby is thrown out with the bathwater... it may be time to buy

As uncertainty grips world markets and the outlook for the global economy grows hazy, commodity prices, especially the price of oil, have come back. The price per barrel of Brent North Sea Crude currently hovers around $105, 15% off  its intra-year high of around $125. Naturally, oil-related stocks have fallen in sympathy with the spot price of the black gold.

ConocoPhillips is no exception. Shares trade around $64.50, a 21% discount from its 52-week high of $81.80. But has ConocoPhillips' business changed simply because the price of oil has fallen? Of course not! And that's when opportunity is created...

ConocoPhillips is a pure exploration and production ( E&P) play, and one of the largest in the business with more than 1.76 million barrels of production daily. The company looks for oil and other fossil fuels, pulls them out of the ground, refines them, and then sells them. But, ConocoPhillips' days as fully-integrated pure play are numbered. But more on that later...

Earnings per share (EPS) growth has followed oil prices during the past few years, rocketing nearly 135% from $3.24 in 2009 to $7.62 in 2010. For 2011, EPS is projected to clock in at $8.50 -- not the kind of staggering growth it put up the previous year, but 11% EPS growth for a company with an $86 billion market cap is nothing to sneeze at. The balance sheet is also pristine, with nearly $12 billion in cash on the books and a low debt-to-capital ratio of only 19%. Clearly, ConocoPhillips is a cash flow monster.

A spinoff could make this an even better deal...
So shares have been knocked back to an attractive price. The company is well engineered, financially. There's obvious value in that alone. However, more value is about to be unlocked. In July, ConocoPhillips announced plans to spin off what is referred to as its "downstream" business, allowing the parent company to focus on its core E&P business. This collection of assets includes its refining business, chemicals division, and the midstream, natural-gas business. The total value for the new company will be somewhere in the $50 billion neighborhood. The transaction, which will be tax-free to shareholders, will be completed sometime in the first half of 2012. Shares of the new company are also expected to pay a dividend, but no numbers have been suggested yet.

Risks to Consider: These days, owning shares of an integrated oil company come with a wagon load of risks. Aside from the obvious associated fluctuation due to commodity price volatility, ConocoPhillips' premiere risk is the location of its reserves and core production. Actually, most of ConocoPhillips assets are quite secure: Three-quarters of ConocoPhillips' production lies in what oil patch expert Bill O'Grady of Confluence Asset Management would refer to as "friendly" places (O'Grady describes "unfriendly" places as "somewhere you wouldn't want to raise children). However, historically, oil from "friendly" places is more expensive to pull out of the ground. The regulatory environment in these places can increase production costs and, subsequently, put the squeeze on margins. The headwinds of an uncertain global economy and softening energy demand also present a considerable challenge. But the value presented and above-average dividend yield is adequate compensation for investor risk.

Action to Take-->
ConocoPhillips shares currently trade for about eight times forward earnings and yield close to 4%. The company's three-year average annual EPS growth rate has been about 54%.

The stock looks very cheap based on the current numbers. Most analysts with a "buy" rating on the stock have price targets between $90 and $93. I think, however, a 12-month price target of $84 seems a bit more realistic, given a modest multiple expansion of just 24% with stellar earnings growth as the catalyst. The downstream business spinoff is also an incentive. Factoring in the dividend, that's a potential total return of almost 30%. If you're looking to add energy stocks to your portfolio, or if you missed the run-up in energy stocks, ConocoPhillips is a nice, conservative addition. If you'd rather pick up the shares when the yield officially reaches 4%, $65 would be your target.

Adam Fischbaum 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.