Oil Stocks May Be Good Bet As Speculators Move Back In

Wild fluctuations in energy stock prices have deterred investors the past few months. But Wall Street analysts say the sector is still a good bet.

Oil-related stocks have lagged behind the S&P 500, declining in lock-step with crude oil's plunge from a peak of $78 a barrel last July to $51 in January, when energy speculators began to smell a bottom. But crude prices have failed to break much past the psychological resistance level of $60 a barrel, leaving some investors scratching their heads.

"A lot of the hot money came out of this trade," said Alec Young, equity strategist at Standard & Poor's. "It came out of both the commodity pits and the stocks in the last few months."

Shares of independent refiner Valero Energy are down about 20% from the all-time high of $69.10 recorded last April, in sharp contrast to the whopping gains of 127% in 2005.

Underestimating Potential

But some Street analysts say their peers may be underestimating the sector's potential this year, particularly the refiners. These companies have been pressured by concerns about refining margins in the wake of President Bush's call for increased use of alternative energy sources such as ethanol.

"I think people are still a little cautious," said Jim Byrne, an analyst who covers Valero for BMO Capital Markets. "There was a big exit in the fall in September and October and we've seen some false starts in the last couple weeks with the cold weather."

In an interview with CNBC.com, Jim Byrne said the recent cold snap has provided a temporary lift for oil stocks, but investor interest may remain weak until July when the summer driving season creates a surge in demand.

"Demand is very strong year over year," Byrne said. "You'll start to see solid earnings numbers for the first and second quarters for the refiners. All in all, I think it'll be a strong year."

Oppenheimer analyst Fadel Gheit said industry fundamentals have improved with upside potential for stocks now that crude oil prices appear to have bottomed around $50.

Gheit said he expects energy investors to rotate out of integrated oil giants such as Exxon Mobil and back into riskier names. This explains why industry heavyweights such as Exxon and Chevron , which are less sensitive to rapidly fluctuating oil prices, saw their stocks rise despite the drop in crude in the second half of 2006. But this "flight to quality," Gheit says, is just about over.

Speculators Driving Market

"Exxon gained the most last year, starting in the second half when oil prices crashed," Gheit told CNBC.com "What is driving the market right now are speculators, they aren't investors. Exxon is not a better company now than it was a year ago, but it had its best gains in history. As oil prices resume their ascent, they don't need Exxon anymore and go to the more volatile stocks, the pure plays like Valero."

The analysts' top picks in the sector include BP and ConocoPhillips among the major oil companies, and Valero and Sunoco among the refiners.

Mike Driscoll, head of equity trading at Bear Stearns, said the action so far this year looks similar to the pattern he saw at the start of last year as antsy investors booked year-end profits.

"It's human nature, you sell the winner and look for what's going to be the next big thing," he said. "You sell the energy names and rotate to other sectors. After a month's time they recognize that nothing else looks and feels like energy stocks and they pile back into them."

The Bear Stearns trader expects energy stocks to outperform the overall market once again in 2007.

"All the factors that made this a great sector to begin with: uncertainty in the Middle East, the maturation of emerging economies in China and India and rest of the world - real or imagined, all this stuff is still with us and more impactful than ever," he said.

Analyst disclosure: Oppenheimer's Fadel Gheit owns a long position in BP, ConocoPhillips and ExxonMobil. BMO Capital Markets has provided investment banking services for Valero in the past 12 months.