In this issue:

We know some sophisticated investment professionals who as a general rule will not buy energy exploration and production stocks. Not because they think energy can’t make money, but simply because they’ve sorted the entire sector into the discard pile labeled “too hard.”

No industry is harder to evaluate, for a host of good reasons:

• Its most valuable assets are hidden underground, and their scale and value are never certain

• Output prices and production costs are volatile and regularly cycle between boom and bust

• The process of finding and extracting oil and gas is complicated, hazardous and subject to major changes without notice

• The accounting is at least as complicated as the industry it attempts to track and possibly even harder to understand. See this skeptic’s post for a rundown of some of the issues

• Sometimes, all this complexity and opacity attract cheats. As with everything, the rule is, buyer beware

We point this out not to discourage investment in energy stocks, but rather to encourage you to do so carefully. That care must include the failsafe of not trusting any particular set of numbers to represent the whole truth.

Numbers are a good starting point for evaluating opportunities in the sector, however, and few numbers matter more in the business than the present value of proved reserves. But here comparisons can be tricky. Our analysis surveys the top U.S. reserves holders, and finds several familiar names looking like bargains at first pass.

But while numbers are nice, the investing business is ultimately about trusting the right people, the more so in the oil patch, where insiders can add or subtract a lot of value in a hurry. And that’s why the three recommendations analyzed at length in this issue are ultimately about the chief executives and the corporate culture they have instilled or might instill.

In the case of Peyto, WPX and Clayton Williams we believe the right people are in charge of exploiting the attractive long-term fundamentals. Buy them while the market is preoccupied with less important matters.   

Portfolio Update

• Peyto Exploration & Development (TSX: PEY, OTC: PEYUF) added to the Conservative portfolio. Buy  PEY.TO below $43 (Canadian) or PEYUF below $38

• Clayton Williams Energy (NYSE: CWEI) added to Aggressive portfolio. Buy CWEI below $100

• WPX Energy (NYSE: WPX) upgraded to #7 Best Buy. Buy Growth portfolio pick WPX below $21

• Chesapeake Energy (NYSE CHK) designated #8 Best Buy. Buy Aggressive portfolio pick CHK below $26

Commodity Update

Just when we thought the worst was past, Saudi Arabia announced a cut in the price of oil delivered to the U.S., which has helped send oil prices tumbling to a four-year low. West Texas Intermediate (WTI) fell to $74.74 a barrel (bbl), down $7.83/bbl from our previous issue. Brent was down $7.44 over the past two weeks to $78.76/bbl. The first real blast of winter air and the rollover to the December natural gas contract saw gas prices rise $0.29 per million British thermal units (MMBtu) from our previous report to $3.95/MMBtu. We are approaching the end of natural gas injection season only 6% below the average for this time of year, which is a testament to the mild summer and a continued rise in natural gas production. Nevertheless, because inventories are lower than normal headed into the cold season, natural gas prices remain $0.43/MMBtu higher than they were a year ago.

In Other News

• TransCanada (NYSE: TRP, TSX: TRP) officially filed with Canada’s National Energy Board for approval of its $12 billion Energy East Pipeline that would carry 1.1 million barrels per day of Alberta crude to terminals and refineries in eastern Canada  

• Argentina has great potential to be the location of the next shale oil and gas boom, but investors are leery of investing in a country with Argentina’s financial history. This week Argentine  lawmakers passed reforms designed to attract more investment in the country’s oil and gas industry

• Shell Midstream Partners (NYSE: SHLX) went public as the first master limited partnership (MLP) formed by a major integrated oil and gas company. Unit prices soared more than 44% in the debut

• Russia and the Ukraine inked a multi-billion dollar deal that would keep Russian gas flowing into the Ukraine and on to the European Union throughout the winter

• Advanced biofuel producer Kior  filed for bankruptcy, as I predicted it would back in January

• Petrobras (NYSE: PBR) ADRs plummeted more than 13% following the reelection of Dilma Rousseff’s as the country’s president. During her presidency, Petrobras has been forced to absorb billions of dollars of losses by selling gasoline to Brazilian citizens below the cost of production

• Continuing with Petrobras, shares continued to slide on news of a corruption scandal, and the subsequent announcement that the company would delay its earnings announcement by a month