5 things I’m looking for in a oil stock investment – Derek Pilecki, Gator Capital (BEXP, DEN, MRO)

Derek PileckiAuthor: Derek Pilecki, Gator Capital Management

Covestor model: Long-Only Energy

Disclosures: Long BEXP, SU, DEN, MRO

I believe that oil prices are headed significantly higher over the next five years, but that investing in Exxon Mobil Corporation (NYSE: XOM) or other major integrated oil companies like BP plc (NYSE: BP) or Royal Dutch Shell plc (NYSE: RDS.A) is not the best way to respond.  Although Exxon is a very well managed company with great assets, it is not the energy company that will benefit the most from higher energy prices.  Instead, I’m picking other companies that have more leverage to higher prices over the long-term. Here’s what I look for in energy companies to try to maximize my view that oil prices will move significantly higher over the next few years:

1. Long duration oil assets – I’m aiming to invest in exploration companies with large oil and gas assets that will take decades to fully develop and exploit.  The best examples of this are some of the companies operating in the Canadian oil sands.  Suncor Energy Inc. (NYSE: SU) has enough acreage in the oil sands that it will take 70 years to fully develop.  On the other hand, the major integrated oil companies often have less than 10 years of reserves compared to their current production rates.

2. Assets in low tax geographies – Because the major integrated oil companies like Exxon are so big, they need to work with foreign governments to get access to large oil fields.  In negotiating these deals, the foreign governments are often able to place a cap on the energy company’s upside leverage to oil prices.  An example tax regime would be: 1) no taxes on the first $35 per barrel of oil receive, 2) 25% tax on oil prices between $35 and $70/barrel, and 3) 75% tax on oil prices above $75.  A regime like this turns the energy company into a service company instead of an asset owner.

3. No or low exposure to refining – I do not like the refining business.  It is a commodity business where once capacity is added, it stays in service for a very, very long time.  About 6 years ago, many refining stocks had huge upside moves because crack spreads were wide.  This happened because the industry had added no capacity since 1978 and gasoline demand finally caught up with and passed industry capacity.  I believe this was a one-time event. Since then, the refining industry has added capacity. Plus, part of my view for significantly higher oil prices is because the oil industry is not going to meet demand on the supply side. If we have lower oil volumes due to lower supply, the refining industry will have excess capacity and disappointing profits.  I want to invest in energy companies with either no or low presence in the refining industry.  This is the reason the stock market reacted so well to Marathon Oil’s (NYSE: MRO) proposed spin-off of its refining operations.

4. Minimal political risk – I like energy companies with production in the United States and Canada because of the lower political risk.  I see owning oil assets in foreign countries with unstable governments as an unnecessary risk for investors.  It seems that the new oil discoveries are coming from the likes of Russia, Nigeria and the Middle East.  There is huge technical difficulty in extract oil from some of these geographies and the major integrated oil companies has the expertise to do so, but their assets are one bad election or coup away from being nationalized.  Plus, higher oil prices will put pressure on these foreign governments to keep the profits for themselves at exactly the time the oil companies should begin earning windfall profits.  Most of us are able to own smaller companies with their assets completely in the U.S. and Canada.  One of my favorite holdings that fits the bill is Brigham Exploration (NASDAQ: BEXP) which has a huge acreage position in Bakken Shale in North Dakota.

5. Management with the same energy price view – Since company management is allocating capital on behalf of shareholders, I want them to share my view that energy prices are going higher.  It is difficult to know exactly what management’s view is, but one can find clues.  Some managements tell investors what oil price deck (or forecast) they use when they evaluate new investments.  Some companies, like Chevron (NYSE: CVX), run ads in major print publications suggesting that oil prices are headed higher.  Other management teams advertise themselves as building companies leveraged to higher oil prices.  An example would be Denbury Resources (NYSE: DNR), which advertises the company to investors as “The Peak Oil Company.”

Again, I’m investing in energy companies because I believe oil prices are headed higher, so I want to invest in those energy companies best positioned to benefit from higher prices. I believe it is a mistake to invest in Exxon or the other major integrated oil companies if you want to benefit from higher oil prices. I manage a Covestor model that attempts to benefit from higher oil prices by investing in companies with more leverage to higher prices. In managing the Covestor model, I use these tactics above to select my investments.