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In my 1/3/12 article Oil Exposure in an Equity Portfolio: Does it Make Sense?, I explained why I think a bullish three- to five-year case can be made for oil and showed how the iShares Dow Jones U.S. Energy ETF (IYE) could serve as a worthwhile addition to an equity portfolio. But I further suggested that stock screening could help us do better.

For anybody who has seriously tried to analyze an oil stock, this may seem like an odd idea. If you ever download a 10-K document for an oil producer and read not just the financial statements but also the operating discussions, you know how your head can spin with all the information typically provided; reserves, additions to reserves, production trends, acquisitions of stakes in additional properties, etc. and in some cases, graphic illustrations of geological characteristics of landholdings. There’s a ton of operating information disclosed, more than enough to overload even the hardiest among us. What’s more, this is not fluff: These really are the factors that lead to success, or lack thereof, for the companies. Oil and gas drillers are not all alike, and their stocks do not all move in lockstep with oil prices. So proper picking and choosing is necessary, with IYE, the generic oil-equity play, serving as the benchmark against which our efforts should be measured.

The bad news is that this vital operating information is not the sort that finds its way into screening applications. But there’s good news: The classic financial fundamentals, the sort of data-points with which screeners work, do legitimately encompass what a company has, or has not, accomplished in terms of operations.

To see how this works, let’s get some perspective by seeing where the generalized IYE ETF stands relative to oil-producing companies, a sub-set of the entire Energy sector (which also includes integrated energy companies and oil-well equipment companies).

Figure 1

We see that the oil-producers tend to outperform the energy sector as a whole, but with considerably more volatility.

Figure 2 goes one step further by also considering small oil-producers, those with stocks priced under $10. The latter step is a natural for me given my tendency to favor smaller stocks. In fact, this whole project started as I was examining the greater-than-usual number of energy plays that appeared last month in the model I use in connection with my low-priced stocks newsletter.

Figure 2

The performance of the under-$10 group is actually not impressive. It’s more often than not been better than IYE (not lately) but it has frequently underperformed the oil-producer group as a whole. I show this to underscore that going small is not a panacea, especially when small is defined in terms of stock price (as opposed to market cap). The key to moving down the market hierarchy is that increased inefficiencies, particularly present when stocks are classified based on price rather than capitalization, can make conventional fundamental analysis much more potent.

Figure 3 shows what happens when we stay below $10, but select from the single-digit oil-producer universe, only the five stocks that satisfy my fundamental stock screen. The graph comes from a backtest that assumed the screen was re-run and the list refreshed every four weeks.

Figure 3

Figure 4 shows the backtest results in table format.

Figure 4

The screen, built on stockscreen123.com is a very simple one. After the basics (limiting consideration to companies classified by our data provider as oil-producers, stocks priced below $10, stocks that trade on the NYSE, the AMEX or the NASDQ, and stocks whose 60-day average daily volume is at least 15,000), the screen requires ranks of 50 or better in a Growth model I created for StockScreen123. Passing stocks are then ranked according to a multi-style QVGM (Quality-Value-Growth-Momentum) ranking system and the top 5 are selected.

All this suggests to me that investors wishing to maintain exposure to oil could benefit from doing so, not just through IYE but also small oil producers whose operating merits translate to solid fundamental metrics so long as they are willing to tolerate extra volatility (the average daily returns for IYE and the screen respectively were 0.1% and 0.2%, but the standard deviations of daily returns were 1.9% for IYE and 2.4% for the screen), and who see low correlation as a benefit (the correlation of daily returns between the screen and IYE was 0.34).

The performance characteristics of the screen are consistent with what common sense tells us we should expect when we look toward individual oil-producers, including (perhaps especially) smaller outfits. Although overall oil prices are an important factor, the performance of the individual companies and their shares do not track oil prices in lockstep. For producers, output volume is a huge consideration. A small firm can generate strong earnings and cash flow growth by increasing its production, either by getting more output from existing properties or by adding more properties. The latter is an everyday concern among small producers, and we study financial fundamentals (as opposed to simply tabulating growth in reserves and production levels) to make sure the growth is being implemented in an economically responsible manner.

The volatility comes about because this is not a one-way phenomenon, even when oil prices rise. Reserves can diminish if exploration efforts are unable to replace barrels sold. Production can decline, inadvertently due to operational snags, or strategically if a company decides to sell less oil at times when management believes oil prices are uncharacteristically weak. The latter will likely exacerbate earnings and share price weakness during soft periods for oil, but on a long-term basis, it can be in the interests of companies, and of course their shareholders, to refrain from aggressively selling product into soft markets. So as much as equity investors have gotten into the habit of disdaining volatility, we have to step back sometimes and realize it may not be all bad in all contexts.

The oil patch has a romantic image: hard-nosed, rugged, adventuresome, potentially very lucrative but also potentially very risky. These characteristics are reflected, for better or worse, in an investing strategy geared toward the oil patch.

There is one other aspect of stock screening I need to mention. This activity is necessarily dependent on content provided by major data vendors; Thomson Reuters in the case of StockScreen123. It’s tempting to assume industry classification is pretty simple. Actually, though, it can involve a lot of judgment calls, and as a result, we will from time to time see companies we didn’t expect to see when screening for oil-producing companies. In recent days (including Tuesday), for example, SMF Energy (FUEL) and Longwei Petroleum (LPH) appeared in the lists my screen generated. Both distribute petroleum products, LPH in China’s industrial heartland and FUEL in the southern U.S. There’s a lot of merit to both companies, and I own both issues. But they aren’t drillers, yet still make it onto the screen because Thomson Reuters classifies them as oil-and-gas production companies. We can react in two ways. The first, obvious, response is to cross situations like these off the lists. Another approach borrows from the fine arts insofar as it involves acceptance of “happy accidents” (a phrase I first heard years ago in a watercolor painting class). The fundamental ranking criteria used in this model are rigorous, so I’m often quite tolerant of situations like these and willing to pursue ideas I hadn’t intended to search for. Whether one crosses off things like this or accepts them is a matter of personal taste.

Here are the stocks that make the screen as of now. As noted, two happy accidents, LPH and FUEL, are present, and, in fact, are the two highest ranked stocks. I expended the list to seven for the benefit of readers who, unlike me, would prefer to skip LPH and/or FUEL.

Figure 5

Source: Exploring For Supercharged Oil Stocks