Big Oil Could Fuel Big Gains in 2011

by: Alan Brochstein, CFA

The year is young, but one trend is clear: Energy stocks are on fire (click to enlarge images):

S&P 500 Sector ReturnsClick to enlarge

As the third largest sector of the S&P 500 (12.7%, after Tech and Financials), the over 2X return relative to the 3.7% return of the overall index is substantial. The trend is across market capitalization as well, as it is the leader in both the S&P 400 Mid-Cap (8.67%) and in the S&P 600 Small-Cap (8.53%). Curiously, this happens at a time that oil prices are flat.

This reminds me of last year, when Industrials bolted out of the gate and ended up the year as one of the top performing sectors. Will Energy continue to be a star in 2011?

For Energy in the S&P 500 to keep working, it will probably require the biggest stocks to do well. The top 10 stocks by market cap represent 74% of the value of the entire group of 41 stocks in the sector. 2 of the stocks, Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX) are among the 10 largest stocks in the overall index. Let's take a look at just those 10 stocks:

Top 10 EnergyClick to enlarge

I highlighted 2 service companies in orange, while the other 8 are E&P. Importantly, that group can be segmented further into integrated companies, which would include XOM and CVX, as well as ConocoPhillips (NYSE:COP) and Marathon Oil (NYSE:MRO). The downstream operations of these four have been big drags on the stocks but the tide appears to be turning on refining.

As a group, the company, as I show in the averages below, is up (like the sector) about 9% (not too surprising!). Many of the companies have practically no net debt, with a below-market 12% average for the group. The average PE is 15.5, but it is elevated by Anadarko (NYSE:APC) as well as the two service companies. While the sector has outperformed the market now for the past two years, if we look at the 4 integrated companies alone, they have all lagged. My thesis is that improved profitability could help push earnings and expand those low PE ratios (9-12) for the group. Note that MRO is breaking itself up.

I own CVX in the Conservative Growth/Balanced Model Portfolio, adding it initially this summer at about 70 and doubling the position in January to make it the largest. I expect earnings growth and a little multiple expansion could push the stock towards 140 over the next year. I expect that this could happen in my expected case of oil prices remaining between 80 and 100 and note that 2003 is perhaps the scenario I envision. Oil prices were steady, but CVX rocked coming out of the recession as the "crack spread" improved.

CVX stands out to me, but the other three as well as some of the other E&P companies look attractive as well. I noted the MRO spin, and it looks like COP has gotten a lot smarter in recent years after struggling with high management turnover and terrible capital allocation. So, I look for these stocks to keep working this year.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Long CVX in a model portfolio at Invest By Model