Veteran oil analyst Bernie Picchi has two good reasons for revisiting oil and gas stocks. First, he says that natural gas prices are heading higher, which usually coaxes shares higher, too. Second, he has determined that there’s likely to be a takeover wave of reserve-rich domestic companies by larger producers. Speaking before the New York Society of Security Analysts yesterday, Mr. Picchi likened the energy industry to a runner on a treadmill — working harder and harder, but not really getting anywhere.

The underlying caution to investors is not to be fooled by recent weakness in oil and gas markets. Big Oil is spending an ever-increasing amount of money, and drilling a rising number of wells, to replace what the world consumes. As a result, the long-term trend for oil and gas prices is inexorably higher. Mr. Picchi expects this reality to encourage a spate of takeovers, and also to favor development of compressed natural gas, and oil and tar sands.

For natural gas, the long term is already here. “The worst is over for gas prices,” Mr. Picchi said in a follow-up conversation. “They are already up between 70 and 80% from the lows reached towards the end of summer.” He noted that gas markets had been riled in part by the panic selling of Amaranth Advisors, the hedge fund that got caught on the wrong side of energy trades and ultimately imploded. His view is that the overhang of inventory among American gas producers is not large, and could in fact be eliminated with two or three cold weeks.

Interestingly, though gas prices have jumped since early fall, stock prices of natural gas producers have not fully participated. Investors have moved on, reading from the overall marketplace weakness that the big move in energy stocks is over. Mr. Picchi disagrees.

Mr. Picchi released a report for his firm, Wall Street Access, on the top 10 most likely takeovers in the oil and gas business in America. He compared stock prices to the present values of domestic producers’ reserves, using a 10% discount rate, and concludes that the values are compelling. Just as Anadarko Petroleum (APC $48) paid huge premiums over market prices to buy Kerr-McGee and Western Gas Resources, so may other producers end up paying substantial premiums for companies that will supplement reserves.

Topping Mr. Picchi’s list are Whiting Petroleum (WLL $45) and ATP Oil and Gas (ATPG $43). Both companies have sizeable oil and gas reserves in friendly territories. Whiting’s reserves are in the Permian Basin, Michigan, the Gulf of Mexico, and other prime American regions. The stock is up only 5% over the past 52 weeks, underperforming the S&P 500 which is ahead 12.3% over the same period. ATP has reserves in Britain and in America, and has outperformed this year.

Mr. Picchi was inspired to write his most recent report by analyzing the energy industry’s long-term position, and then considering the merger and acquisition environment. His conclusion? “All roads lead to consolidation.”

Paramount is the expected widening gap between demand for oil and supply. He projects that production will soon begin to decline around the world. Assuming a fairly conservative 1.5% rate of annual growth in consumption, demand could outstrip supply by as much as 31 million barrels per day (mb/d) by 2020. This dire projection was reinforced by a release earlier in the week by the International Energy Agency, which projected that even with a big price increase, capital spending in the sector will not be able to meet demand. Even assuming no growth in demand, supplies will likely fall short, driving prices higher.

The challenge for the equity investor, says Mr. Picchi, is to figure out how that gap will be filled. Higher prices will encourage numerous alternatives, including liquefied natural gas, gas and coal-based liquids, and oil sands. All these products are suitable for various applications, though all are more costly on both a capital spending basis and on an operating basis than conventional fuels.

Compressed natural gas, for instance, is cheap and clean, but requires sizeable retooling of vehicles before it can be used for transportation. LNG is clean and has a high thermal efficiency, but is not usable for transportation. Coalbased products not only require high capital costs, but also present environmental challenges. While conventional oil and gas require an equivalent of $5 to $8 a barrel of oil in capital expenditures and $5 to $10 of operating expense, most unconventional uses of coal and gas need $6 to $11 of capex, and $10 to $20 of operating expense per BOE.

That presents a pretty compelling case for an oil company to wade in and try to buy up reserves in the stock market. When Anadarko made its move on Kerr-Mcgee and Western Gas, it claimed to be buying reserves at less than $12/BOE. According to Herold’s review of 220 oil and gas companies’ exploration costs in 2005, finding costs were about $11.95/BOE. As we said at the time of the Anadarko purchases, it makes all the sense in the world to bet your money on a sure thing — namely through making an acquisition as opposed to drilling a well, which could after all, come up dry.

Also, the increasingly hostile attitude of once-welcoming host governments such as Bolivia, Ecuador, and Venezuela has put a premium on domestic reserves. With Cambridge Energy Research Associates highlighting countries such as Nigeria, Angola, Kazakhstan, Russia, and Libya as sources of most future incremental production (offsetting countries like Mexico in decline), the urge to invest abroad is certainly tempered.

It also happens to be a period of low interest rates and benign government oversight of acquisitions. Mr. Picchi is not projecting that the majors will buy up each other. Rather, he is looking at the enormous profits and subsequently lush cash flows and balance sheets of the large oil companies, and projecting that they will look for the most efficient way to boost reserves.

His top 10 list is probably a good place to start.

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