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Which Oil Company to Buy?

Which oil company to buy? There is good reason to include an oil company stock in a well-rounded portfolio.  First, carbon fuels are the largest industry in the world after agriculture, so some exposure to oil gives representation to that industry, which is an important part of our economy.  Second, Peak Oil will eventually come to pass.  Fossil fuels are a diminishing resource.  As they are used up, their scarcity increases and so will prices.  While production has not yet peaked, due in part to renewed North American production, it is certainly on a long plateau.  At the same time, world population continues its geometric expansion, and emerging economies continue their uneven, but overall rapid growth.  If the cost of gas skyrockets, an oil company in your portfolio gives you a kind of hedge.  As you shell out dollars at the pump, you will be secure in the knowledge that your oil company stock is appreciating.

Kodiak Oil & Gas Corp (USA) (NYSE:KOG)

The price of oil of late has been on a roller coaster ride.  It was above $100 in the spring and some people were predicting $5 gas by summer.  Then it hit the skids, down into the 80s, and I paid $2.95 per gallon a couple of days ago.  Oil has dropped because of fears that China’s growth is slowing and because Europe is a mess, due to sovereign debt problems.  On Friday, June 29th, there was a bit of optimism on the European front, and oil prices jumped over 9% in a day.  Don’t expect this to last; this was short-covering from an oversold position.  I confidently predict that oil will give back that 9% and more, before it makes a more permanent comeback.  The European crisis is not fixed; just another band-aid has been applied.  The root problem in Europe is that more money is owed than can possibly be paid back.  No progress is possible until some sort of formal default or bankruptcy is declared in the peripheral countries like Greece, Spain, Portugal and possibly Italy, or the Eurozone is dissolved and the countries are free to inflate their debts away through sovereign currencies.

Nonetheless, Europe is not the world and oil will eventually resume its upward bias.  So which companies to buy?  Below, I discuss one company to avoid, one to consider buying, and one that is safe today.

One to Avoid:  Kodiak Oil and Gas

Kodiak Oil and Gas (NYSE: KOG)  is a shale oil producer focused on the Bakken shale in the Williston Basin in North Dakota, which has been the area where the largest amount of shale oil has been produced in North America.   Kodiak is sitting on about 52 million barrels of proven reserves.  Production in the first quarter of 2012 was up 450% from the year earlier period, and even higher in dollar terms.  So why isn’t Kodiak a buy?

During its wonderful first quarter, Kodiak posted all of $0.01 per share in GAAP profits.  That is with oil at over $100 per barrel.   Bakken shale is expensive to produce because of the cost of labor in North Dakota, where the oil boom has ballooned wages.   There is also a relative scarcity of water in that arid region.  Water is needed for the fracking procedure used to release the oil from shale.  In June, Occidental Petroleum (OXY) announced that it was pulling rigs out of Bakken because of the expense.  If OXY, with its huge resources, can’t make it work, it seems unlikely that Kodiak can do a lot better.  And Kodiak is essentially a pure play on the Williston area.  Don’t buy this stock until oil climbs back above $100.

One to think about:  EOG Resources

EOG Resources (NYSE: EOG) was placed on Goldman Sach’s conviction buy list on May 29th, 2012.  Although EOG is an international producer, with holdings in North America, the Caribbean, Argentina, and even China, it was EOG’s position in the Eagle Ford shale in Texas that got Goldman excited about the company.  CEO Mark Papa is also excited about because it “generates the highest direct (after tax rate of return) of any current large hydrocarbon play,” as he said in an analyst’s call.    Eagle Ford has the advantage of being in Texas close to the large coastal refineries.  According to recent government projections, Eagle Ford production will shortly match that of the Bakken area.

EOG also produces in Bakken and has now begun shipping oil by rail to its St. James, LA terminal, bypassing the Midwest refiners who have been reaping a huge cost advantage due to all the landlocked shale production. EOG also has been able to reduce its cost of production by producing its own fracking sand.

EOG has been doing well lately; first quarter earnings doubled those of the year earlier quarter while its production levels were up 49%.  However, EOG is still mostly a shale play and shale oil is still expensive to produce relative to the huge oil fields in the Middle East or Venezuela.  If oil resumes its decline, EOG will certainly be less profitable.  While EOG does some hedging, it represents only a small portion of their production.

A Safe Oil Company—Exxon Mobil

Exxon Mobil is the world’s largest oil company as well as the biggest natural gas producer in the United States.  Although it makes most of its money on production, it is also a major refiner with refineries located all over the developed world.  It is also one of the world’s largest chemical companies.  It’s holding are international, so it can shift production to where the highest profit lies.  Its position as a refiner and chemical company cushion it, to some extent, from vagaries in the price oil or natural gas.

Exxon pays out more in dividends than any other company in the world.  With a recent hike, its dividend rate is about 2.66%.  Chevron (CVX) and ConocoPhillips (COP) yield 3.4% and 4.7%, respectively. Exxon’s EPS increased at an average rate of 5% per year over the past five years. Analysts expect that Exxon Mobil’s EPS will grow at an average rate of 8.6% per year for the next five years. The plunge in oil prices, if sustained, and a possibly weaker demand for oil amid an economic slowdown could adversely affect revenues and earnings. Given that Exxon Mobil is the largest U.S. natural gas producer, depressed natural gas prices also bode poorly for the company. Exxon Mobil shares are trading at a premium relative to Chevron’s and COP’s shares, but below the firm’s own historical ratios. We like the diversified nature of Exxon’s business and think the stock deserves the premium. You can buy this company and sleep at night. Billionaires Ken Fisher and Ken Griffin have large positions in this stock as well (see Ken Fisher’s top picks).

Note: This article is written by Steven Edwards.

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