The best way to beat high gas prices

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Six top pros run model portfolios in Strategy Lab, MSN Money's stock-picking challenge. Hundreds of readers are playing along in the Strategy Lab Open. To learn more about the game -- and the contenders -- click here.

With oil and gas stuck at uncomfortable prices, everyone wants an alternative. The company that discovers a realistic alternative to oil will no doubt create a fortune for its investors.

But investing in an alternative-energy company before its technology is proved to be competitive is really risky. The solutions offered by most alternative-energy companies will probably not come to fruition for at least a couple of years. And it seems almost certain that the imbalance between the world's supply and demand for oil will get worse in the meantime.

That's bad news at the gas pump, but as investors, we can make it work for us. We can make money to offset those rising prices -- and protect ourselves against the next worst-case event that sends oil soaring while the economy takes a dive.

Somehow, bargains abound

Many of the leaders of the energy industry are cheap. Their stocks trade at price-to-earning ratios that are often 50% or less than those of the average company in the S&P 500 Index ($INX). That's why I think investors who share my two-year investment horizon should consider the current energy-industry leaders as attractive alternatives to many of today's highflying alternative-energy companies.

Take Valero Energy (VLO, news, msgs), one of just two major independent U.S. refiners. It's in my Strategy Lab portfolio, and it's one of what I call my Best Idea stocks, with the potential to double over two years.

It was also the second-most-held stock in the Strategy Lab Open competition among readers trying to win a spot in the next round of MSN Money's stock-picking game.

At the start of the competition in July, Valero was trading at about $70. Since then, it has traded as high as $78 -- and as low as $60 back in August, when the subprime-credit crunch stoked fears of a recession. After the Federal Reserve cut interest rates, Valero climbed back above $70. Several competitors in the Open jumped at the opportunity to close their positions as soon as they got even.

I took advantage of the opportunity to collaborate with a large group of people who share an interest in this stock. In this journal, I'll round up what they had to say. And please, join the discussion by clicking here. (You'll go to my blog page at Marketocracy.com; click the "comment" button to post.)

Valero a sell?

The person who made the best argument for selling Valero was "jczerw," a competitor in the Open and a longtime member of Marketocracy's m100, investors who've demonstrated their skills over time. The post says:

"This week I dumped VLO. It was just about even, and I began to doubt an upside. It is operating at peak capacity and exploiting its ability to refine sour crude to maximize margins, but how will the company grow?? . . . Don't get me wrong. This is a really strong company but I just can't articulate a growth scenario. And the P/E may move to 10 instead of 6, which would add about $40 a share, but if $85-a-barrel oil isn't a catalyst, I'm not sure what would be." (Read the full post here.)

A number of competitors sold Valero while citing "technical" reasons. Frankly, before I started Marketocracy, I did not hold technical analysis in high regard. However, having now met a number of technical traders who have compiled great track records picking stocks at Marketocracy, I have to concede that there may be something to this approach.

An Open competitor with the handle "scotstrickland" gave us this technical assessment:

"My research shows that (Valero) is due for some downside because of loss of momentum, change in sector movement and some internal changes. Though up for the year (by 34%), it is down for the quarter. I expect these will be only short-term adjustments with the downside target at or near $55." (Read the full post here.)

Hold or even buy?

Of course, not everyone sold. The reasons many Open competitors bought Valero in the first place are still sound, so they held when the recent price jump made them even.

Open competitor "pasifbamphilphd" writes: "Even after the run-up it has a ridiculously low P/E of 7.2. Valero has the capacity to refine the lower grades of crude oil and should do well as oil prices increase. I think that this is a long-term trend that must be reckoned both because of the problems with the dollar . . . and because of the fact that the world is running out of the 'easy oil,' and 'hard oil' costs more." (Read the full post here.)

"Dking084" took advantage of Valero's price dip to buy more shares of the stock, explaining: "The largest refiner is well-placed strategically. It's still trading at a multiple below 7, and should be undergoing a period of re-valuation. I see Valero topping $100 in the next 12-18 months. (Read the full post here.)

The refiners' advantage

I continue to think that Valero is misunderstood by Wall Street because it is included in almost all of the energy indexes. When oil prices go down and Wall Street wants to sell energy stocks, Valero invariably gets sold off as well just because it's part of the energy index.

But Valero does not produce oil; it refines crude. So its profits do not necessarily rise and fall with the price of oil. Valero's earnings have skyrocketed in the past five years not because of rising oil prices but because there is a shortage of refining capacity. That shortage gets worse as the economy grows and our government refuses to allow more refineries to be built.

I think the chances that the government will allow a refinery to be built in this country within my two-year investment horizon are pretty close to zero. This means that unless there is a recession, the shortage of refining capacity will get worse and Valero's profits will get better, whether oil prices go up or down.

Valero's P/E is less than half that of the S&P 500. Yet I would say that Valero's prospects for future growth and profitability are better than that of the average S&P 500 company. That is one reason I think Valero could trade much higher.

Like "jczerw," I don't know what will be the catalyst that causes Wall Street to look at Valero in a different way. But as long as I don't see a recession on the horizon, I am happy to give Valero a spot in my portfolio. Here's why:

If the worst happens

In addition to being a great investment on its own merits, having Valero in the portfolio gives me some protection against one of the real risks I see for investors -- a spike in oil prices. I find it odd that Wall Street seems unconcerned that oil has risen to the $80 range even though there have been no supply disruptions and the weather has been moderate so far this year. Clearly, a terrorist attack or a natural disaster is not required for oil prices to keep steadily rising.

There are, however, a number of easy to imagine scenarios in which the price of oil could spike very quickly. If that happens, I think we would see the market drop but the energy sector rise. By having roughly 25% of my Best Ideas portfolio in Valero and a few other energy companies such as Patterson-UTI Energy (PTEN, news, msgs), Lufkin Industries (LUFK, news, msgs) and Occidental Petroleum (OXY, news, msgs), I can protect clients from some of these worst-case scenarios. And I can do it with stocks that I think will do great if the worst case doesn't happen and things turn out as I expect.

Now tell me what you think

Ready to join the discussion? Click here, and look for the comment button on my blog page. Here are a few questions on which I would most like your opinion:

Do you see any new refineries coming online in the U.S. in the next couple of years?

Do you see any reason Wall Street would not back a management-led buyout of Valero or the other major independent U.S. refiner, Tesoro (TSO, news, msgs)?

How much more can capacity be expanded at existing refineries? That's key to these refiners real value.