Focus on quality when buying oil stocks

Oil prices fell from their July 2008 peak of $148 U.S. a barrel to just under $40 U.S. in February 2009. Prices have roughly doubled since then, but it’s unlikely they will soon surpass last year’s highs. Still, oil is a good hedge against inflation.

We feel that the best way to cut your risk in the volatile resource sector is through well-established oil producers like these three. Their large reserves should last decades. Moreover, they focus on politically stable North America.

SUNCOR ENERGY INC. $37 (Toronto symbol SU; Conservative Growth Portfolio, Resources sector; Shares outstanding: 1.6 billion; Market cap: $59.2 billion; Price-to-sales ratio: 1.7; SI Rating: Average) is Canada’s largest oil producer following its purchase of Petro-Canada on August 1, 2009. Petro-Canada shareholders received 1.28 Suncor common shares for each Petro-Canada share they held.

Suncor’s oil-sands operations, including Petro-Canada’s 12% stake in the massive Syncrude oil-sands development, account for two-thirds of its production. The remainder comes from conventional oil and natural gas. Suncor also owns four refineries, and around 2,000 retail gas stations in Canada and the U.S.

The company intends to keep expanding its oil sands business. As a result, it plans to sell between $2 billion and $4 billion of unrelated assets over the next year. These mainly consist of Petro-Canada’s smaller holdings, including offshore wells in the North Sea and near Trinidad and Tobago. However, Suncor may hold on to Petro-Canada’s oil and natural-gas projects in Libya and Syria.

These sales would cut the company’s production by 10%. But Suncor feels that the start up of new oil-sands projects will make up for this shortfall.

In the three months ended September 30, 2009, Suncor’s earnings fell 64.4%, to $288 million from $810 million a year earlier. Earnings per share fell 73.6%, to $0.23 from $0.87. These figures exclude costs related to the Petro-Canada merger, foreign-exchange gains and other unusual items. Revenue fell 0.8%, to $8.4 billion from $8.5 billion.

The earnings drop was mainly caused by oil prices, which fell 40% from last year’s record highs. Because of the merger, production averaged 507,100 barrels per day, up 80.5% from 281,000 barrels a year earlier. Suncor expects its daily production to reach 600,000 barrels for all of 2009.

The company will probably earn just $1.08 a share in 2009, partly because of the extra shares it issued to Petro-Canada shareholders. The stock trades at 34.3 times that estimate. However, its 2010 earnings should rise to around $2.62 a share, as it realizes more cost savings from the merger. That gives Suncor a more reasonable p/e ratio of 14.1. The $0.40 dividend yields 1.1%.

Suncor is a buy.

ENCANA CORP. $61 (Toronto symbol ECA; Conservative Growth Portfolio, Resources sector; Shares outstanding: 751.2 million; Market cap: $45.8 billion; Price-to-sales ratio: 1.6: SI Rating: Average) will split itself into two separate companies, assuming it gets shareholder approval.

One of the new firms will keep the EnCana name, and will focus on unconventional natural gas. The new EnCana will trade on Toronto under the symbol ECA. The other company will operate as Cenovus Energy Inc. (Toronto symbol CVE), and will specialize in oil-sands projects, oil refineries and conventional natural gas. The new EnCana will account for about two-thirds of the present company’s production and reserves. The rest will come from Cenovus.

EnCana will give its shareholders one new common share in each of the two new companies for every EnCana share they own. As well, investors will not have to pay capital-gains taxes until they sell their new shares. Initially, EnCana intends that the two companies’ combined dividends will equal its current annual dividend rate of $1.60 per share, for a 2.7% yield (all amounts except share prices in U.S. dollars).

The new companies’ shares began trading on a “when issued” basis on November 2. Cenovus is trading at $29. The new EnCana (symbol ECA.W) is at $31. Regular trading will begin on December 3.

Together, that’s a little less than EnCana’s current price. But breakups like this help unlock hidden value, and generally lead to above-average results for a period of years. The company aims to complete the breakup on December 7.

Meanwhile, EnCana has scaled back its production by about 10% and put off investments in new projects. These moves are in response to a 70% drop in natural gas prices over the past year. To further protect itself from gas-price volatility, EnCana is hedging more of its production. It has already locked in prices for 45% of its 2010 production at $6.09 per thousand cubic feet. That’s 36.2% more than the current price of $4.47.

The new EnCana will sell some of its less-profitable operations following the breakup. These include its unconventional natural-gas properties in Wyoming. The sales could generate around $1 billion for the new company.

EnCana is a buy.

IMPERIAL OIL LTD. $41 (Toronto symbol IMO; Conservative Growth Portfolio, Resources sector; Shares outstanding: 847.6 million; Market cap: $34.8 billion; Price-to-sales ratio: 1.6; SI Rating: Average) is a major integrated oil company. U.S.-based ExxonMobil Corp. (New York symbol XOM) owns 69.6% of Imperial’s shares.

Most of the Imperial’s production comes from its oil-sands projects in Alberta. It also has conventional oil and natural-gas operations in western Canada, and holds stakes in offshore projects in Atlantic Canada. Its other operations include four refineries and roughly 1,900 Esso gas stations.

The company is working on several projects to spur long-term growth. One of these is its $8-billion Kearl oil-sands development in Alberta. Imperial owns 71% of Kearl; ExxonMobil owns the other 29%. The company will develop Kearl in three phases, and started working on the first phase last May. It should begin production in late 2012. Kearl’s reserves should last 40 to 50 years.

Imperial is also the lead partner in the proposed $16.2-billion Mackenzie Valley Pipeline, which would pump natural gas from the Arctic Ocean to Alberta. However, the project has suffered a setback because large, more easily accessible gas reserves have been discovered in B.C. and the southern U.S. Imperial will make a final decision on Mackenzie next year, after a government panel issues an environmental assessment.

Meanwhile, Imperial earned $547 million in the three months ended September 30, 2009. That’s down 60.6% from $1.4 billion a year earlier. Earnings per share fell 59.2%, to $0.64 from $1.57, on fewer shares outstanding. The drop was mainly caused by a steep decline in natural-gas prices from last year’s record highs. Revenue fell 41.6%, to $5.6 billion from $9.5 billion.

Because of the drop in oil prices, Imperial’s earnings will probably fall to $1.79 a share this year. The stock trades at 22.9 times that estimate. But rising oil prices should lift Imperial’s 2010 earnings to $2.73 a share, which gives it a more moderate p/e ratio of 15.0. The $0.40 dividend yields 1.0%.

Imperial Oil is a buy.