How Should You Play Energy With Turmoil In The Middle East?

Includes: CVX, EOG, MRO, TOT
by: Brian Nichols

Energy stocks have been on the rise as fears of a Syrian conflict become more likely. In the event of conflict, oil tends to rise, but should you be a buyer of the industry?

Why is Syria important?

Fortunately, Syria is not all that important to global oil production. Syria produces less than half a percent of the world's oil per day, falling from 350,000 barrels to just 50,000 in recent months. However, significant oil production runs through the Suez Canal, a thin strip of water.

This canal runs into neighboring countries Iraq and Iran, which are very important to oil production. Hence, in regards to the price of oil, any potential conflict with Iraq or Iran that could arise from a Syrian invasion could become problematic for oil prices. This fact is likely responsible for some of the movement in the price of oil.

An interesting trend

Raymond James analyst Pavel Molchanov points to an interesting trend in the price of oil, both in 2003 and 2011.

Molchanov notes that prices in 2003 ran higher before the invasion of Iraq, but were 23% lower 60 days after its peak. Then, after the NATO intervention in Libya, prices rose and then fell 14% from their peak after 60 days.

Clearly, this trend demonstrates fear causing a spike in prices, followed by a dose of reality, causing prices to fall. Currently, it is U.S. crude suppliers who are believed to see the most to gain. Yet, buying an entire industry might become problematic if oil prices fall, and large companies whose fundamentals are determined by the price of crude begin to sink. This fact might change the way you decide to invest in this space, especially with the sector trading near 52-week highs.

Buy stocks, not the industry

So, how should you play the turmoil in Syria? Clearly, the energy sector itself has performed well, but historically, such performance does not last in the event of conflict. Therefore, doesn't it make more sense to seek the strongest performing companies in the sector, rather than eyeing the largest of corporations that are weighed the heaviest in sector indexes?

Looking at the energy sector, we have the large, well-established companies such as Chevron (NYSE:CVX) and Total (NYSE:TOT). Then, we have a smaller group such as EOG Resources (NYSE:EOG) and Marathon (NYSE:MRO)

Chevron is the world's second-largest energy company, behind ExxonMobil, but had seen its stock decline 7% in the month prior to August 20, which is when many energy stocks began to trade higher. Chevron's weak performance followed a quarter where its revenue declined 8.4% over the previous year to $57.4 billion and net income fell 25.6%. Many investors hold Chevron because it has a massive presence in Europe, which is underdeveloped. Yet, Chevron continues to fight government and regulatory hurdles to monetize its 5.6 million acres. While the stock does pay a 3.3% yield, investors must not ignore the company's large fundamental declines.

For Total, its fundamental performance reflects that of Chevron, as sales for Total declined 4% in their most recent quarter. But much like investors have high hopes for Chevron's European assets, Total investors are optimistic about the company's large presence in Africa. However, oil production in many of the most promising countries such as Nigeria, is now expected to fall. Nonetheless, Total is a massive and diversified company, not only operating in oil but also aviation among other areas. Despite its size and diversity, investors must not discount its declining fundamentals.

Clearly, a trend is developing where the largest of oil companies are seeing a decline in overall revenue. This is evident by both Chevron, Total, and even the juggernaut Exxon, who saw a whopping 13% year-over-year revenue loss in their most recent quarter. The next wave, those such as EOG and Marathon, have performed much better.

Marathon Oil's U.S. production has been on the rise, growing 8% in the second quarter and leading to overall sales growth of nearly 5%. The company maintains a bullish growth outlook despite one of their more exciting plays, its pre-salt Diaman-IB well, encountering gas condensate last month, slowing its progress and creating uncertainty around the discovery. Not to mention, Marathon is one of the few oil companies able to fund its own capital program organically, thus presenting minimal financial risk.

EOG Resources recently produced an incredible quarterly report . The company disclosed a crude oil production growth target of 35% year-over-year for 2013. The company's crude and natural-gas production have both exceeded Wall Street expectations, and many consider EOG to be the best play on crude because of its growth and presence in the lucrative Eagle Ford. At 18 times next year's earnings, EOG is significantly more expensive than the larger names in the sector, but is growing significantly faster.

Final thoughts

Looking at the largest companies in the industry, including Total, Chevron, and ExxonMobil, we have seen significant revenue losses in the last six months. Then, as we look at the next wave of energy companies, including Marathon and EOG, we see significant top-line and bottom-line growth.

As an investor, this is where I want to be in the energy space, where growth is evident and gains aren't determined by conflict in the Middle East. Pavel Molchanov proves his point well about trends in recent history, and if this once again occurs, investors might find themselves best served by purchasing stock in companies that are fundamentally improving, regardless of how much crude costs.

Disclosure: I am long EOG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.