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This post originally ran on my subscription site on December 1.

The entire energy sector was up Wednesday on OPEC’s agreement to cut production–but not every stock rose to the same degree.

I think these themes defined the way that the market grouped stocks in the energy sector.

  1. Big gains on Wednesday, November 30, went to U.S. oil from shale producers–and especially to producers with big positions in the low-cost Permian Basin. Pioneer Natural Resources (PXD) was up 10%; Parsley Energy (PE) climbed 15.75%; and RSP Permian (RSPP) rose 14.66%. Logic here is pretty straightforward. Companies operating in the Permian are working on a low cost geology with break-even a $30-$40 a barrel and because of new discoveries in the geology they have the ability to rapidly increase production in response to any increase in oil prices. These companies were adding drilling rigs even before today’s announcement of an agreement on production cuts from OPEC with companies such as Pioneer projecting 13% to 17% increases in production. Higher oil prices will, Wall Street was projecting today, lead to an even quicker ramp in production. The problem with this group is that they were already moving up in price before today’s OPEC news and with the jumps today the upside to Wall Street target prices is getting a bit slim. According to Yahoo Finance, the median target price on Parsley is $43.06 (shares closed Wednesday at $38.15); on RSP Permian $50.80 (Wednesday’s close $44.65); and on Pioneer Natural Resources $214.63 (Wednesday’s close $191.04.) Remember that before today’s news Wall Street was projecting that oil might climb to $55 a barrel on a “strong” announcement. West Texas Intermediate at today’s close of $49.00 a barrel and Brent at today’s close of $50.47 aren’t all that far away from that $55 a barrel projection. All these target prices, however, were based on lower oil prices and I expect that Wall Street analysts are burning the midnight oil tonight in an effort to figure out how fast the Permian Basin companies can expand production now that oil looks to be headed for $55 a barrel over the next few months. (Pioneer Natural Resources is a member of my long-term 50 Stocks portfolio where it has gained 91.4% since I added it on January 13, 2012.)
  2. Smaller gains on Wednesday went to Big Oil stocks such as ExxonMobil (XOM), up just 1.63%. The vertically integrated majors–those that are in the business of producing oil, refining it, and marketing refined products such as gasoline–aren’t as leveraged to the price of oil as the pure exploration and production companies of Group One. When oil prices are low, for example, they take a hit to oil production revenues but balance that from increased profits in refining–and their marketing arms continue to churn out revenue as long as people fill up their cars. Some integrated majors have substantial positions in U.S. oil shales but those reserves are out weighed by investments in off-shore fields, conventional international reserves, and Canadian tar sands. On November 30, besides ExxonMobil’s 1.63% gain, Chevron (CVX) was up 2.03%, and Royal Dutch Shell (RDS-A) climbed 4.16%. (ExxonMobil is a member of my long-term 50 stocks portfolio. The shares at up 39.16% since I added them to that portfolio on December 30, 2008.)
  3. All the oil drilling and service stocks were up on November 30 with the biggest gains going, oddly enough, to ocean drillers with no exposure to the U.S. oil shale sector. I think the big gains in companies that specialize in ocean drilling came on hopes that OPEC’s action would put in a bottom for these battered stocks. If day rates for rigs and the number of rigs under contract climbed, these stocks would rocket off the bottom. At least that seems to be the thinking in the 17.06% gain today for Transocean (RIG), the 24.97% rise in Ensco (ESV), and the 24.97% climb in Rowan Companies (RDC.) Even Seadrill (SDRL), the deepwater specialist that is struggling to get out from under a mountain of debt, was up 13.88% today. In my opinion, that hope is, well, a bit early. The ocean drilling sector is still working through a surplus of active rigs and there’s a substantial supply of stacked and idle rigs just waiting for a turn in the market before they head back out to sea. That means it’s going to take quite a while for increased drilling activity to result in rising day rates, especially since ocean drilling is far riskier and more expensive than drilling in land-based shale geologies. Whenever oil companies get ready to increase capital spending again, the bulk of the first wave of new money is going to go to exploration and production on land. Which is why land-drilling specialists such as Patterson-UTI (PTEN), up 16.16%, and Helmerich & Payne (HP), up 11.96%, had such good days. (An oil service company with exposure to both wet and dry worlds, Schlumberger (SLB) climbed “just” 5.17%. But that is partly because the stock–and the company’s business–had held up relatively well during the savaging of energy stocks. Schlumberger is a member of my long-term 50 stocks portfolio. Shares of Schlumberger are up 124.9% since I added them to that portfolio on December 30, 2008.) I’d also add the fracking sand suppliers to this group. If drilling activity picks up in U.S. oil shale geologies, these companies will show big increases in sales volume and price of sand used to fracture the shale in order to release oil and natural gas. Hi-Crush Partners (HCLP), for instance, gained 14.78% on the day.

Besides these main groups, I think a few “oddities” from Wednesday’s market deserve a look. Stocks that I’d put in this category include Chesapeake Energy (CHK), which is primarily a natural gas producer. It was up 9.89% on November 30 on the belief that higher oil prices would push natural gas prices higher too. (Chesapeake does produce oil too, of course.) In a similar higher oil prices mean higher natural gas prices vein, shares of Cheniere Energy (LNG), the market leader (so far) in the export of liquified natural gas from the United States climbed 4.85%. Statoil (STO), a specialist in extreme weather production and the dominant producer in the waters of Norway’s outer continental shelf, moved ahead 6.42%. ConocoPhillips (COP), which is no longer integrated since it spun off its refining operations as Phillips66 (PSX), but which has a capital structure that makes the stock very leveraged to changes in oil prices, was up 9.7%. (Cheniere and Statoil are members of my Jubak Picks portfolio. Chesapeake is a member of my 50 Stocks portfolio. ConocoPhillips is a member of my Dividend portfolio.)

So how do you handicap these three groups and “oddities” after Wednesday’s surge?

Let me list the downside and then upside.

The downside includes the possibility that the OPEC agreement will either fall apart before its scheduled renewal in May or be rendered meaningless by the kind of rampant cheating on quotas that has characterized OPEC in the past. Either alternative would mean that the agreement would not remove as much supply from the market as traders and investors assumed today. There’s also the extremely likely possibility that U.S. oil shale producers will ramp up production so quickly that they will cancel out OPEC’s production cuts. Continental Resources (CLR), for example, said today that it will put some of its 175 drilled but uncompleted wells into production after OPEC’s agreement. The U.S. oil shale industry has responded to OPEC’s pressure on oil prices by driving costs out of its operations–which means that many oil shale producers don’t need to see $60 oil before increasing production. That added supply, of course, makes it less likely that oil will hit $60 and stay there. The drive to cut costs hasn’t been limited to oil shale producers either. The result has been that even some older resources, such as the fields in the North Sea, are now profitable at levels far lower than $60–or even $50. For instance, estimates put operating costs in the North Sea at $25 a barrel for some producers. Oil producers have aggressively pursued a policy of high-grading production projects so most companies now have a very good idea of what projects turn profitable at what price points. And finally, higher oil prices won’t fix the reserve problems at some of the majors that have been struggling to find enough oil to replace what they’re currently pumping out of reserves. (Higher oil prices will, indeed, fix the accounting problems at some of the majors since they won’t have to write down the value of reserves that aren’t viable at oil prices in the $40s.)

The upside includes, well,obviously, the fact that oil companies will make more money if oil prices move up. The biggest winners from any price increase that sticks for weeks or months will be companies that can quickly increase production–which means U.S. oil shale producers. Service companies that provide the immediate supplies for increased drilling activity–fracking sand for instance–will benefit from any quick increase activities designed to complete wells. Higher oil prices will be the biggest relief at debt-strapped producers, such as Chesapeake Energy, and service companies, such as Seadrill, since the improved cash flow will enable these companies to reduce and restructure debt. For some energy companies, cuts in oil production and any consequent rise in drilling, is relatively unimportant. Cheniere Energy’s fortunes, for instance, are tied more closely to the company’s ability to get added trains on line at its Sabine Pass and Corpus Christie LNG plants.

So where would I be putting money now–if I were to put any to work–given the current mix of risk and reward?

The obvious winner from OPEC’s action is the U.S. oil shale sector. In that sector I’d go with Pioneer Natural Resources because of its large position in the low cost Permian Basin. The company is the largest producer in the Permian Basin’s Spraberry/Wolfcamp geology with a potential reserve of 11 billion barrels of oil equivalent and 20,000 horizontal drilling locations. I think there’s easily another 30% in the stock. I’d also look at one of the fracking sand producers. Hi-Crush Partners was still slightly below its 52-week high after Wednesday’s surge. It may take land-drilling companies Helmerich & Payne and Patterson-UTI a little longer to get rolling since the collapse of drilling in the United States has left a lot of idled drilling equipment on the market. But improvements in power at newer rigs give them a cost and efficiency edge over older equipment that should make the existence of some part of this inventory of older equipment irrelevant.

A lot of the “when” here depends on how the market reacts over the next week or so to Wednesday’s huge move higher. 15% or 20% moves in a day are an over-reaction to an OPEC agreement that doesn’t include cuts big enough to bring supply and demand immediately back into line. So we could get some profit taking in the next session or two–or we could get a rush to buy from investors worried about being left out. I’d try to avoid overpaying here because there’s no doubt in my mind that increased supply from U.S. oil shale producers will make this agreement seem less important a few months down the road.