When oil is cheap, buy these companies

• The price of oil isn't the best indicator
• The exception to the rule
• Three companies to buy today and hold forever

It's tempting to look at the price of a barrel of oil, or the price of a gallon of gasoline as a way to evaluate when oil companies are cheap.

But there's little correlation between oil price and profitability, value or future share price for most of the companies in the oil sector. There are a few exceptions that I'll talk about in a minute...

Not to go into too much detail, but most oil companies, large and small, hedge their production in the futures markets. When you hedge your production, it has the effect of evening out the highs and lows in the market.

You can easily see the effect of hedging by looking at two charts stacked on top of each other: the percentage performance of a price of a barrel of oil plotted with the percentage performance of the AMEX oil index (AMEX: ^XOI).

The AMEX oil index compiles the price movement of the 13 largest publicly traded oil companies. And no, you can't buy it - unfortunately it's not a traded index.

As you can see, the price of oil (in blue) tripled between 2005 and mid-2008. But the index of the 13 largest oil companies (the red line) only doubled.

Then again, when the price of oil retreated below 2005 levels, the return of the oil index stayed positive.

Of course there are other reasons why oil companies tend to be less volatile than oil prices, but the point stands: I'd caution anyone from looking at oil prices as a way to know when to buy or sell oil companies.

There's an exception to the rule.

One sector of the oil industry DOES correlate strongly with changes in the price of oil. Many companies in this sector even manage to outpace gains in the price of oil...

I'm talking about oil services, and more specifically, deep-sea drillers.

The reasons these companies typically make much higher profits when oil prices are high is that they're incentivized to do so when prices are higher. That's when oil companies that require their services need them to work around the clock to bring oil to market.

We saw these companies skyrocket much higher on a percentage point basis than the price of oil, even as the large blue-chip producers didn't come close to matching gains.

Here, I've plotted the price of oil (in red) vs. three of the biggest offshore drilling companies: Noble Drilling NE in blue, Transocean RIG in green and Diamond Offshore DO in pink.

You can see that Noble Drilling trades in very close tandem with the price of oil, and Diamond and Transocean seem to do a good job of multiplying gains in the price of oil.

The reason I bring this point up now is that oil prices are currently stuck in a trading range between $70 and $80. This trading range is dependent on many factors, including oil inventory, oil reserves, the strength of the world economy, etc.

But the point is - it won't last. We'll see much, much higher prices in the next 12 or so months - and higher prices still in the years to come - for a simple reason: the world is running out of oil at an astounding rate, while growth in Asia is increasing demand at the same time.

When those higher prices arrive, these specialized oil services companies should see major stock price appreciation.

I'd recommend picking up shares of all three. My favorite one of the bunch right this minute happens to be Diamond just because it's the cheapest relative to its earnings - but I do plan on picking up shares of all three over the coming months.

As always, do your own due diligence to find the company that's right for your portfolio, but I believe the oil services sector is one of the most potentially profitable in the stock market today.

Good investing,

Kevin McElroy

Editor

Resource Prospector