Small oil companies have become attractive takeover targets because they have something that oil majors like Exxon Mobil Corp. (NYSE:XOM) and Chevron Corp. (NYSE:CVX) want—expertise in the hydraulic fracking and horizontal drilling methods that are used to extract oil from North America's vast shale reserves.
And many of these takeover targets are companies based in North America.
"The main opportunities to profit from mergers and acquisitions (M&A) will be in the U.S. and Canadian markets," said Dr. Kent Moors, Money Morning global energy strategist and editor of the Oil & Energy Investor.
Ironically, many of these small companies developed their expertise after buying assets the majors sold as soon as easy-to-reach deposits were tapped. Many of those assets contained shale oil, which is much harder and more expensive to extract.
But since the global price of oil is high enough to make shale oil drilling profitable, the oil majors have been seeking out smaller players to retrieve their assets and expertise.
"These shale prospects are exploration frontiers and the big international players see them as a runway to growth," Mark Hanson, an analyst at Morningstar Inc. told Bloomberg News.
Shale oil becomes profitable when global oil prices are in the $70/barrel (bbl) range. The higher the price of oil goes, the more attractive shale oil formations become.
The price of West Texas Intermediate (WTI) averaged about $95/bbl in 2011, but will keep rising. Moors believes oil will reach $150/bbl as early as this summer.
So the big oil companies, with billions of dollars of profits burning a hole in their deep pockets, have plenty of motivation to shop around.
For investors that means they need to stake out their positions before all the buying starts.
That's the only way to take advantage of the sudden jump in the stock price that occurs when a takeover deal is announced. Luckily, several oil sector analysts have already identified the most likely takeover targets.
According to Subash Chandra, an analyst specializing in energy stocks for Jeffries Group Inc., the stocks to watch are SM Energy Co. (NYSE:SM) and Oasis Petroleum Inc. (NYSE:OAS).
"With independents being bought out, these two have the credentials that buyers are looking for," Chandra told SmartMoney.
Another oil sector analyst, William Featherston of UBS AG (NYSE:UBS), screened 40 potential takeover targets for the best combination of desirable characteristics. Traits that would appeal to the big oil suitors include untapped energy deposits and the financial ability to extract those deposits.
Featherston agreed with Chandra's choices, and came up with several more: Texas-based Anadarko Petroleum Corp. (NYSE:APC), Houston-based Cabot Oil & Gas Corp. (NYSE:COG) and Southwestern Energy Co. (NYSE:SWN).
For investors who'd like exposure to the entire group, there's also an exchange-traded fund (ETF), the Powershares S&P SmallCap Energy Portfolio (NASDAQ:PSCE). Those who want to cast an even wider net can try the IQ Global Oil Small Cap fund (NYSE:IOIL), which also includes small oil companies outside the United States.
Meanwhile, Money Morning's Moors advises investors to look for small companies who already are operating successful oil shale fields, have good prospects for expansion, and are well managed financially.
"On average, we will once again find that small companies that satisfy these criteria tend to produce higher return for investors than larger vertically integrated oil companies," Moors said.
Moors also advises investors not to overlook what he considers the most promising players in the oil industry, the midstream providers, which are involved in the transportation and storage of oil, and particularly ,aster limited partnerships (MLPs).
"The market will produce a rising number of pipeline, processing, gathering and storage facilities mergers, with the position of MLPs and the equity issuances from them, becoming even more decisive," Moors said.
For more information on shale oil investment opportunities, you can sign up for Moors' free newsletter, the Oil & Energy Investor, by clicking here.
David Zeiler, Money Morning