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Stock Strategist

Five Energy Stocks for Your Radar Screen

Market uncertainty has presented us a handful of investment ideas.

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Since we ran a similar column in March, natural-gas prices have continued to fall, and they are now hovering around $6 per thousand cubic feet (mcf), nearly 60% lower than the $15 per mcf we saw last December. The drop in prices has been due to a seasonal drop in demand and a bump in production from new projects in addition to Gulf of Mexico production gradually being restored. While natural-gas prices have fallen, oil prices remain stubbornly high. For the better part of six weeks, oil prices have hovered around $70 per barrel thanks to persistently strong demand, production restraints, and potential supply shocks.

This disparity in prices has caused some uncertainty in the market, and as a result, energy stocks have been trading down. Since the beginning of May, the Dow Jones Oil and Gas Index has declined by nearly 8%. The sell-off has given us a handful of investment ideas in the upstream and midstream side of the business; we still feel, however, that the oil services and refining sectors of the industry remain overvalued. Within the upstream and midstream sectors, 53 stocks we follow are currently trading at a discount to their fair value estimates, while nine of those stocks garner our highest rating, 5 stars.

Most of the stocks in the industry are inherently volatile, and even a small dip in oil and gas prices can send them down significantly. During these sell-offs, the good firms typically get punished along with the bad. This can create an opportunity for investors to purchase these stocks at a more reasonable price. Here are five stocks that are trading below or around our "consider buy" price, and we think they are worth keeping an eye on.

Sempra Energy (SRE)
Analyst: Paul Justice
Fair Value Estimate: $56.00
Consider Buy: $43.20
From the  Analyst Report: We are particularly excited by Sempra's early entry into the LNG import business and its pipeline partnership with  Kinder Morgan (KMI). Sempra plans to build three LNG import facilities in North America, with one already under construction. Sempra is scheduled to begin importing LNG within three years into Costa Azul, Mexico, under long-term contracts it has secured with  BP (BP) and  Shell (RDS.A). The pipeline partnership with Kinder Morgan will bring abundant natural-gas supplies from the Rocky Mountains to the Midwest. Both of these projects will require substantial capital investments over the next three years but offer future returns that should consistently exceed their cost of capital. Additionally, both projects involve long-term supply contracts that should provide stable and predicable cash flows for several years.

Southern Union (SUG)
Analyst: Jason Stevens
Fair Value Estimate: $29.00
Consider Buy: $24.70
From the  Analyst Report: Southern Union is a company in the midst of transformation. The March 1 acquisition of Sid Richardson, a private natural-gas gathering and processing operation in West Texas, and the planned sales of Pennsylvania and Rhode Island gas distribution businesses later this year are the two sides of this major course change. We think Southern Union's move up the value chain from natural-gas distribution and into the gathering, processing, and transportation of natural gas will offer investors higher returns on invested capital, but we would encourage investors to consider this opportunity carefully.

Imperial Oil (IMO)
Analyst: Elizabeth Collins
Fair Value Estimate: $45.00
Consider Buy: $34.70
From the  Analyst Report: Imperial Oil's history of generating sizable returns and dividend growth is enviable. As conventional oil and gas reserves decline in Canada, Imperial is focusing on its long-term oil sands projects. Oil sands are a mixture of oil, sand, and clay from which low-quality oil is extracted and upgraded into higher-quality crude oil. Oil sands accounted for 56% of Imperial's 2005 total energy production, and that percentage is set to rise. But as the firm wades deeper into Alberta's expensive oil sands, its dependence on high oil prices is increasing. Even so, we think oil prices are likely to stay high enough, and we like Imperial's prospects.

Newfield Exploration (NFX)
Analyst: Catharina Milostan
Fair Value Estimate: $57.00
Consider Buy: $44.00
From the  Analyst Report: Newfield Exploration's rapid transformation into a broadly diversified U.S. exploration and production company is about to bear fruit; the Woodford Shale discovery in Oklahoma should provide a major boost to production. We like the company's balanced approach of investing in both developmental and exploration opportunities. The firm uses excess cash flow from mature but very profitable traditional Gulf of Mexico operations to invest in new onshore, deeper offshore, and foreign prospects that could boost production. Newfield devotes about 20% of its capital expenditures to exploration drilling; the lumpy cash flows from this are smoothed out by the steady cash generation from lower-risk drilling opportunities in the Mid-Continent and Rockies.

Apache (APA)
Analyst: Justin Perucki
Fair Value Estimate: $80.00
Consider Buy: $61.70
From the  Analyst Report: As a growing exploration and production company, Apache is different from its reserved and more mature peers. Apache has chosen to sell stock and reinvest most of its cash flow to expand, instead of buying back shares and paying out a robust dividend. Most of Apache's growth has been through purchasing legacy properties piecemeal from the oil majors, instead of exploring for reserves itself. Apache's asset base has more than doubled in size since 2000. As one of the lowest-cost producers in the oil patch, Apache can remain profitable even when commodity prices decline. Over the past three years, Apache's average lifting costs were only $7.30 per barrel of oil equivalent produced.

Justin Perucki does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.