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Tap These 3 Big Oil Stocks for Big Profits

You may have noticed gas prices taking a tumble lately — the biggest two-week drop in about four years. That’s because crude oil prices have been sharply on the decline as well, from just over $100 in September to the mid-$80s currently.

While you may be cheering this trend as a sign to fill up the tank, consider topping off your portfolio, too. Because lower crude oil prices could signal a buying in big-oil mega-caps like Exxon (NYSE:XOM) and Chevron (NYSE:CVX) that offer long-term growth and reliable dividends. And the timing also may be ripe for energy service stocks like Transocean (NYSE:RIG) and Halliburton (NYSE:HAL), among others.

The logic is simple: These oil stocks tend to profit more as crude oil moves higher. oil majors like Exxon can command a higher price for the crude they extract from the ground, but also because a higher price means that companies are willing to spend more on exploration — particularly for costly extraction processes involving deepwater drilling or shale oil deposits. This is true not just for Exxon and Chevron but also for other global players including Royal Dutch Shell (NYSE:RDS.A) or Brazil oil giant Petrobras (NYSE:PBR) or China giant CNOOC Ltd. (NYSE:CEO).

Of course, if crude drops significantly there is a risk that service contracts will dry up and that margins will feel the pain. But I am fairly bullish on the price of oil for these reasons:

  • Superstorm Sandy: The disruptions in the Northeast caused by Superstorm Sandy have sapped energy demand dramatically — look for that demand to come roaring back. People can’t drive thanks to gas distribution bottlenecks, and some people even now don’t have electricity more than a week after the storm. This dip in demand is severe, but sure to be short-lived.
  • A floor in pricing: Look at this five-year chart. Back in 2008, crude oil briefly challenged $150 before crashing as the global economy ground to a halt. But over the past two years or so, oil has managed to find something of an equilibrium between roughly $80 and $115 a barrel. While demand remains soft, oil companies have shrewdly managed supply to avoid a crash in energy prices. Right now crude is significantly below its 200-day moving average.

Oil Spot Price -- Oil Stocks

  • Baseline demand: Despite a China slowdown and despite the European recession with massive unemployment in Spain, Italy and Greece, energy demand is still going to increase in 2013. OPEC has forecast a 3.2% growth in demand next year. That’s almost exactly the same as the growth in 2012. So even in troubled economic times, the one thing that’s certain is that the world will at very least use the same amount of oil in the near future.
  • Secular recovery: Unless you are a true doom-and-gloomer, you have to believe that eventually the world will dig out of the economic doldrums. That could be in 2013 or 2014 or even 2015. When this happens — and it will happen eventually — you can bet that oil demand will increase.
  • Inflation risks: In the short term, there’s also the risk of modest inflation driving up commodities like crude oil. Chairman Ben Bernanke at the Federal Reserve has all but admitted that the central bank is focused on maximum employment and doesn’t care much about inflation. Right now prices increasing at a 2% annual rate and nobody is concerned. Even if hyperinflation never happens, even a continuation of small price increases coupled with a modest boost in demand means oil should move higher longer term.

Beyond the crude issue, there’s also something to be said for the general stability of oil stocks. If you’re a long-term investor, there’s a lot to be said for getting into rock-solid plays like Exxon and Chevron that are some of the biggest companies on the planet. These picks offer reliable dividends and low volatility.

On the top of my list of winning oil stocks are these picks:

Exxon

Exxon is a go-to stock for low-volatility investors. Part of it is obviously the scale of this $417 billion business. Another is its bulletproof 2.5% dividend that has been paid dating back to 1882 when it was part of Standard Oil and remains a very affordable 30% payout of total 2012 earnings — even after a 21% dividend increase at the beginning of the year.

But the story is more than that. Exxon is a killer company with shrewd management and a long-term vision. Consider that Exxon Mobil tops all mega-caps in its revenue-per-employee metric, throwing off some $5.3 million per worker. That’s more than double tech giants like Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG)!

Also consider that its current CEO, Rex Tillerson, got his start at the company in 1975 as an engineer and oversaw work in the arctic in the 1990s. That continuity has helped shape Exxon’s long-term strategy in Russia — a key avenue to growth. That’s a stark contrast to companies like Yahoo! (NASDAQ:YHOO) or Hewlett-Packard (NYSE:HPQ) that have a revolving door of executives and no cohesive corporate strategy.

Exxon is a bit of a sleeper and will never double overnight. But for low-risk investors looking for a place to hide out for long-term gains, you could do a lot worse than this big oil heavyweight. The stock is currently challenging all-time highs not seen since 2007 and 2008, so don’t delay if you want a piece of Exxon — its forward P/E is still an affordable 11.4 based on 2013 earnings estimates.

Chevron

Though a bit smaller than Exxon, I like Chevron perhaps even more.

It too has massive scale, ranking as one of the 10 biggest corporations on Wall Street. So don’t think of this stock as any less “Big Oil” than Exxon is.

It too has a long dividend history, dating back to 1912. Its yield, however, is modestly higher at 3.2% currently. This after an 11% increase in its dividend to start the year, and a very sustainable payout ratio of less than 28% of 2012 earnings.

So why do I like Chevron more? Well, long-term performance is one reason. It has already set a new all-time high in 2012 while Exxon remains slightly under its pre-crash peak. Chevron is up about 25% in the past five years (excluding dividends) while XOM is up only a few percentage points.

Despite this outperformance, the P/E metric of CVX is even more attractive than XOM at just 8.9 based on FY 2013 forecasts.

But most interesting to me is the fact that Chevron is sitting on a mammoth cash hoard of $21.5 billion — prompting talk of a buyout in the near future. An announcement of a big deal could catalyze a move in this stock in the near term as well as result in a big payoff down the road … presuming the deal is a good one, of course.

Transocean

Transocean is a bit riskier play, but one that is worth exploring.

The company doesn’t pay a dividend right now, thanks in part to the hangover litigation and costs from some of the BP (NYSE:BP) oil rig mess in the Gulf of Mexico back in 2010. But it paid 79 cents a quarter earlier this year; even half that amount would give you a yield north of 3% if and when the dividend is reinstated.

Furthermore, the oil majors are not as tapped into growth in crude the way a service stock like Transocean is. That’s because as oil gets more expensive, it becomes more cost-effective to tap into deepwater oil fields — meaning business will pick up for RIG as oil prices do.

And longer term, the bottom line is there is only so much onshore oil, and it’s going to take companies like offshore oil giant Transocean to keep up with global demand in the years ahead. The company has the scale to tap into this trend mightily over the next few years.

On a value basis, RIG has a forward P/E of just 10.8 based on fiscal 2013 earnings. Admittedly, on the fundamental side Transocean is a hard read thanks to big 2011 losses due to the BP spill … but RIG is projecting more than 50% earnings growth from fiscal 2012 to 2013 as both the top and bottom lines move up nicely.

If you aren’t afraid of a little more risk, RIG may be the most attractive large-cap oil stock out there for the long term.

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Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP. As of this writing, he held a long position in Apple but no other stocks named here.

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