Great Ways to Play Domestic Oil

Includes: KEX, OIH, STO
by: Glenn Rogers

Two weeks ago, I was discussing the topic for my next column and settled on oil. This was just after the International Energy Agency and the U.S. government prompted a dramatic selloff when they announced that they were releasing 60 million barrels of crude from strategic reserves. About half of that was from the U.S. and the balance from other countries.

In absolute terms, this release did not amount to much, less than one day's consumption on a worldwide basis. But it spooked speculators and oil sold off just in time to reduce gas prices prior to the Canada Day/July 4 weekend. This, along with promises from Saudi Arabia that they would begin producing more over the summer, helped reverse the steady climb in oil prices we had seen in previous months.

In my opinion, this relief is destined to be short-lived. It might extend through this fall but as economic conditions gradually improve worldwide, we will begin to see the return of higher oil prices. In fact, it may already be happening; oil trended higher all last week before pulling back on Friday to close at US$96.20.

Last weekend, Barron's lead story was entitled "Get Ready for $150 Oil." Their prediction was this would happen by spring 2012 and that prices could spike as high as US$170 a barrel before demand destruction kicks in again and additional supplies come on-line, resulting in a reversal of the trend. In addition to increasing global demand, their thesis is based on lack of spare supply from the other major producers, particularly OPEC.

The good news is that the U.S. economy is not likely to be hit as hard as in the past since the percentage of U.S. world consumption as a share of GDP is lower than it was in the early 1980s. Dependence on oil for heating and electrical generation has dropped steadily so that now 70% of oil consumption is used for powering cars, tractors, and airplanes.

But make no mistake: if this prediction comes true, consumers will take a hit. So will airlines and any automobile manufacturer that does not have a sufficient number of fuel-efficient cars to satisfy what is sure to be another spike in interest for transportation that minimizes the out-of-pocket impact of higher gas prices. Also, some low-end retailers are likely to sell out or fold as high oil costs push up wholesale prices and customers turn increasingly to on-line shopping to cut fuel expenses. The same will be true for some lower end lodging chains that cater to the driving public.

But even though a number of industries will be adversely affected, you can count on the oil producers and the oil services companies to do well. Even though I think the entire sector will see significant share price appreciation in the coming months, I want to focus today on U.S. producers and service companies that operate primarily in the Gulf of Mexico and in the emerging Bakken oil region. Bakken is especially interesting because, while there has been a lot of publicity about the natural gas reserves found there, it turns out there is a tremendous amount of oil potential in this area, which is centred on North Dakota. I'll come back to this later but first let's look at a company that is active in the Gulf of Mexico.

Kirby Corp. (NYSE:KEX)

Since last year's BP oil disaster when we sat transfixed looking at the underwater oil camera (has it really been only a year?) there has been a virtual moratorium on drilling in the Gulf. This will change. As the 2012 election approaches, permitting will pick up since this will likely be a key election issue, particularly if oil actually does reach the US$150-$170 per barrel range. There are many companies active in this area but I will focus on one for now and will cover more in a future column.

Kirby Corp. is a large transporter of crude and other liquid products throughout the Gulf and up and down the Mississippi River system. They have over 900 active tank barges and will benefit directly from increased activity in the Gulf. They also have a large fleet of more than 240 towboats. As a bonus, the company has a diesel engine business that is primarily involved with overhauling and servicing engines for the oil and gas industry.

This company has reinvented itself numerous times throughout its history and was a one-time oil and gas producer. They continue to be active on the acquisition front and have completed numerous deals over the past few years to strengthen the business. Kirby is Houston-based and all the employees are in the states so you are investing in an American corporation with little foreign risk or exposure.

Recent first-quarter results showed improving profit margins in both the marine transportation and the diesel engine services business. Net earnings were reported at $32.4 million ($0.60 per share) compared with $24.7 million ($0.46 per share) for the 2010 first quarter (figures in U.S. dollars). Consolidated revenues were $299.4 million compared with $268.3 million last year.

For the full year, the company raised its earnings guidance to between $2.70 and $2.90 a share, up from between $2.55 and $2.80 previously. Per share earnings for fiscal 2010 were $2.15. Capital spending this year is expected to be between $220 and $230 million. This includes about $100 million for the construction of 40 new inland tank barges and three new inland towboats plus approximately $36 million in progress payments on the construction of a new offshore integrated dry-bulk barge and tugboat unit with an estimated total cost of $50 million.

The company was negatively affected in the second quarter by the flooding throughout the Mississippi River system and utilization still remains lower than prior to the BP oil spill. But that is likely to improve in 2012.

I think Kirby is in a good position to benefit from raising oil prices and increased activity in the Gulf of Mexico.

Action now: Buy with a target of $68. The stock closed on Friday at $58.50.

Note: If you prefer to invest in a basket of oil service companies rather than a single stock, take a look at HOLDRS Oil Services ETF which trades on the New York Stock Exchange as OIH. It provides exposure to virtually all the major players in this sector.

Brigham Exploration (BEXP)

If you've been paying any attention to the energy sector, you've probably heard of the Bakken formation. This emerging oil play is located in an area that includes North Dakota, Eastern Montana, and extends into Saskatchewan and Manitoba. Recent estimates predict that there are over 500 billion barrels of oil in this region and that's assuming that only 10% is recoverable. This is far and away the largest domestic oil discovery since Alaska's Prudhoe Bay. There's lots of natural gas in this area also but oil production will be crucial to U.S. national security going forward and this is a tremendous boost for the country's energy supplies.

There are many companies working in this region. I'll mention just one but I would urge you to do some independent research on this area and consider adding two or three other players.

Brigham Exploration has been getting a lot of attention lately and for good reason. The company has over 370,000 acres in the Bakken area and has been increasing production estimates on a regular basis. This independent exploration, development, and production company is U.S.-based and a potential takeover target.

The company has been operating in the area since 2005. In their 2010 annual report they said they had drilled 59 consecutive producing wells and the company believes that they have over 1,000 potential drilling locations within their acreage.

Brigham recently reported first-quarter results and their production volumes were stellar, showing an increase of 190% from the first quarter of 2010 and a slight increase from the fourth quarter. Revenues were up 158% compared to the first quarter of 2010, to $76 million. The company is bullish about the results going forward and the chief financial officer was quoted as saying: "Given our first quarter financial performance, strong balance sheet, and accelerating level of drilling activity as we enter the second quarter, we look forward to 2011 be one of the most exciting years our company's history."

Sounds good to me!

The company's activities do not appear to be adversely affected by the flooding in North Dakota and I think this is a great way to get some exposure to this exciting new domestic oil supply.

Action now: Buy with a target of $38. The stock closed on Friday at $31.18.

Disclosure: I am long KEX, BEXP.