4 Smaller Alternatives to BP and Shell

LONDON -- If you want blue chip, dividend-paying exposure to the oil and gas industry, then most investors look no further than BP or Royal Dutch Shell. After all, smaller oil and gas companies are high risk and volatile -- aren't they?

Of course, small oil and gas exploration and production companies can be extremely risky, but there is another class of oil company that does offer a serious alternative. Let me explain.

Staying the course
What happens when a small oil company has major exploration successes? Usually, it sells out to a much bigger company, which has the scale and resources necessary to fully develop the resources of the smaller company.

Just occasionally, however, small companies remain independent and manage to develop their own resources -- transforming themselves into larger independent oil companies, with stable revenues, large profits, and long-term viability.

I recently decided to take a look at some of the top independent companies in the FTSE 100 (UKX) and the FTSE 250, to see if any looked like attractive longer-term alternatives to Shell and BP.

The contenders
I chose the companies using two simple criteria: The companies must be consistently profitable, and they must be as big as possible -- with 2 billion pounds the minimum market cap. I was left with four companies:

Source: Digital Look, Morningstar, company reports.

It's immediately obvious that there are some massive differences between the companies, which are reflected in their price-to-earnings ratios, dividend yields, and commercial reserves.

BG Group
I've tipped BG Group before, and I believe it's a great company. It has delivered remarkable long-term growth and was one of the first big companies to appreciate the importance of LNG and natural gas.

Over the last 10 years, BG Group has delivered an average yearly total return of 17.9%, compared to 6.8% for the FTSE 100 and 6% for Shell. Although its growth is likely to slow, I think that long-term investors who buy in now will still enjoy healthy returns. As an added incentive, BG Group is down 5% so far this year, offering new investors a relatively attractive entry price.

Tullow Oil
Africa-focused Tullow Oil has grown from a standing start in 1985 into a 12 billion pound FTSE 100 company. This growth is mostly due to its outstanding success as an explorer: In 2011, 74% of its exploration wells were successful, and so far this year, 17 of its 22 wells have found hydrocarbons.

These are exceptional success rates and are the main reason Tullow shares are priced so highly, with a P/E of almost 30. Although Tullow's commercial reserves are relatively modest, its contingent resources -- which are discovered but not yet proven to be commercial -- are substantial at 1,445 million boe, and investors are willing to pay for these and for Tullow's expected future exploration successes.

Dragon Oil
Dragon Oil's share price has risen by 4,400% over the last 10 years, thanks to its successful development of two major fields in the Cheleken Contract Area, offshore Turkmenistan.

Today, it's a different type of company and Dragon's low P/E and relatively high yield tell the story. Although it is involved in some exploration -- it was recently awarded a license in Iraq and has assets in Tunisia -- its main business is developing and expanding its Turkmen production assets.

Dragon's sizable reserves are enough to sustain production at current rates for nearly 30 years, making it something of a cash cow.

Premier Oil
Premier recently hit the headlines when it agreed to a $1 billion farm-out deal with Falkland Islands explorer Rockhopper Exploration to develop its Sea Lion field, which has 355 million barrels of contingent resources -- discovered, but not yet proven to be commercially viable.

Premier has assets in the North Sea, Africa, and Asia and its production output is growing steadily. It is also expected to pay its maiden dividend this year, albeit a small one.

Independents vs. supermajors
My selection of independents all offer much lower yields than the U.K.'s supermajor oil companies. Balancing this are the twin attractions of faster potential growth and the possibility of a profitable takeover bid.

Based on these criteria, which of these four independents looks the most attractive?

Perhaps unsurprisingly, I think that the largest -- BG Group -- offers the best potential as a "hold forever" share, while the smallest -- Premier Oil -- is the most likely to deliver strong growth or be taken over. It's also the riskiest, with a lot to prove in the Falkland Islands.

I can't see another oil company wanting to buy Tullow Oil unless it becomes much cheaper, and while Dragon Oil offers good value for money, it is probably the strongest financially. Dragon's net cash balance of $1.5 billion means it has little reason to sell, unless its major shareholders want an exit. However, if oil prices stay high, expect Dragon Oil to deliver considerable further growth, as it's very profitable.

Identifying future successes
The companies I've profiled in this article all offer the potential for respectable capital gains and dividend increases over time. Some may even double or triple in value -- but they won't deliver the spectacular 1,000%+ gains that smaller oil and gas companies can provide.

The challenge for private investors is learning to identify small oil and gas companies that have the potential to be successful -- without taking too many painful losses.

Investing in small oil companies can be hugely rewarding and satisfying, and in my experience, the key to success is having a suitable set of rules to apply when selecting small oil and gas shares.

The good news is that the Motley Fool has recently published a special free report covering this subject in depth. "How To Unearth Great Oil & Gas Shares" provides a safe, repeatable approach to creating and growing a portfolio of small oil and gas shares that can deliver big gains.

I've found the report very useful and strongly recommend it. However, availability will be strictly limited on this new report, so if you would like a copy then download it now -- it's completely free and without obligation.

"Ten Steps To Making A Million In The Market" is the very latest Motley Fool guide to help Britain invest. Better. We urge you to read the free report today -- it may transform your wealth.

Further investment opportunities:

• Top Sectors for 2012
• How To Unearth Great Oil & Gas Shares
• What Every New Investor Needs To Know