By JACK HOUGH
Energy profits are booming and Big Oil shares look inexpensive. But investors with an appetite for risk might want to drill deeper into the sector to find smaller firms sitting on U.S. oil-shale riches -- which make tempting takeover targets, analysts say.
Large oil companies are riding a 25% fourth-quarter surge in Nymex crude prices. Analysts estimate that energy companies in the Standard & Poor's 500-stock index saw earnings growth of 34% in the fourth quarter -- more than twice that of any other sector, according to S&P.
The market has bid up these shares only cautiously -- worried, no doubt, that oil prices could dip if world economic growth slows. S&P 500 energy companies trade at 10 times projected 2012 earnings, versus 12 times for the broader index.
Investors underestimate the strength of current oil demand, says Subash Chandra, who covers energy stocks for Jefferies, a New York investment bank.
Share prices imply a 2012 price for West Texas Intermediate crude of $80 a barrel, according to Mr. Chandra's calculations. But WTI crude recently sold at $101 a barrel, and he thinks it will average $95 in 2012.
Small U.S. energy companies are pricier than their larger brethren. Energy companies in the S&P SmallCap 600 index trade at nearly 16 times projected 2012 earnings, versus 15 for the broad index. But small oil companies might be worth their premium because of their holdings and expertise, and the role these play in a profound change in U.S. energy production.
New tactics like horizontal drilling and hydraulic fracturing are unlocking energy trapped in vast shale formations around the U.S., offsetting declines in production from conventional deposits. North Dakota's Bakken shale is expected to begin producing more oil than Alaska's mammoth Pudhoe Bay field this year, The Wall Street Journal reported this past week.
These tactics can be used to extract both oil and natural gas, but with the former rising and the latter slumping, companies are particularly interested in oil-rich shale.
Major oil companies have had to quickly adjust course. For decades, they were net sellers of U.S. assets, because the easiest deposits had been tapped. Smaller companies moved in and became expert at extracting difficult-to-reach deposits, including shale oil. With the recent technological breakthroughs, the majors have been eager buyers of U.S. companies with shale assets and experience, says William Featherston, who covers the sector for UBS (UBS)
Mr. Featherston sees the sector as ripe for a takeover acceleration for three reasons: The shale opportunities are "massive," major oil companies are gushing with cash to invest, and these companies want to put the knowhow of U.S. shale specialists to work in their overseas properties.
Horizontal drilling is the process of drilling deep into the ground and then gradually changing direction to drill into horizontal layers of oil- and gas-rich rock. Hydraulic fracturing, or "fracking," involves pumping a mixture of water, sand and chemicals into the well at high pressure in order to break porous rock apart and release oil and gas.
"In the past, you drilled for oil 10 times and found some maybe four of those times if you were good," says Shawn Reynolds, who manages natural-resources portfolios for Van Eck, a mutual fund company. "With shale deposits, you know where the oil is. And with the new technology you can extract it profitably."
But fracking is controversial. Critics say it could damage natural habitats and water supplies -- and even trigger earthquakes. The industry says fracking is safe and that it takes care to prevent environmental damage.
"You're going to see more regulation, but as politicians take a close look at the science, shale plays aren't going away," says Jefferies's Mr. Chandra. He points to New York Gov. Andrew Cuomo, who has recently sought to lift a ban on fracking.
For stock-pickers seeking smaller U.S. energy companies, Mr. Chandra likes Denver-based SM Energy and Houston-based Oasis Petroleum. "With independents being bought out, these two have the credentials that buyers are looking for," he says.
UBS's Mr. Featherston recently screened 40 candidates for traits including the size of idle energy deposits, the financial resources to exploit those deposits and pay packages for managers in the event of takeovers. He, too, sees SM and Oasis as attractive targets, along with Anadarko Petroleum (APC),
Van Eck's Mr. Reynolds prefers an indirect approach to the shale boom that favors Houston-based Halliburton (HAL)
For fund investors, the Powershares S&P SmallCap Energy Portfolio, an exchange-traded fund, tracks the aforementioned index of U.S. companies. It costs $29 a year per $10,000 invested.
Investors who don't like the higher stock valuations small oil companies carry might prefer the IQ Global Oil Small Cap ETF, despite its higher expenses of $75 a year per $10,000 invested.
U.S. firms make up 57% of the portfolio. In 2011, shares in Europe and emerging markets plunged, dragging the fund down 20% between its May 5 launch and Dec. 31. However, according to IndexIQ, creator of the index underlying the fund, the selloff has left it at just nine times portfolio earnings.—Jack Hough is a columnist at SmartMoney.com. Email: firstname.lastname@example.org