Source: TexasRaiser via Wikimedia Commons.

There are lots of ways to analyze stocks, but when you get down to the nuts and bolts of it, you want your investment in a stock to generate a return over the long run. While there is no surefire way of finding those companies, looking at metrics such as return on equity can help separate the wheat from the chaff. 

Just because a company has a great return on equity, however, that doesn't necessarily mean it's a great investment, especially in the energy industry. So let's look at the 10 best performing oil and gas stocks on a return-on-equity basis, but let's also see what can make a company's return on equity look deceptively good on paper.

The best in the business
These are the 10 companies in the oil and gas space with the highest returns on equity, based on the company's most recent financial reports:

CompanyReturn on Equity
Ultra Petroleum (UPL) 9,787%
Core Laboratories (CLB) 229%
Alon USA Partners, LP (NYSE: ALDW) 91.4%
Sprague Resources, LP (SRLP) 72.5%
Western Refining Logistics, LP (NYSE: WNRL) 68.7%
Northern Tier Energy, LP (NYSE: NTI)  61.6%
Phillips 66 Partners, LP (PSXP) 56.2%
Emerge Energy Services, LP (NYSE: EMES) 53.5%
Seadrill (SDRL) 44%
Magellan Midstream Partners, LP (MMP) 43.1%

Source: S&P Capital IQ.

Whoa, whoa, whoa!
I can see you licking your chops through the screen at those return-on-equity numbers. Before you run out and buy any company I've mentioned here, though, you should know some of the pitfalls in the return-on-equity calculation that can make these numbers look much better than they are. 

One thing you'll notice is that several of the companies on this list have an "LP" after their names. As publicly traded limited partnerships -- or master limited partnerships, if you prefer -- these companies don't retain earnings but pass them onto their unitholders in the form of generous distributions. Doing so exempts the companies from paying taxes, but it also means there are no retained earnings on the balance sheet. Equity in the company is kept deliberately low and by default increases a partnership's return on equity. 

That leaves us with only three companies on this list -- Ultra Petroleum, Core Laboratories, and Seadrill. However, these are special cases as well, although for completely different reasons. Ultra Petroleum's absurdly high return on equity comes from carrying massive retained losses on the balance sheet from close to $3 billion in asset writedowns in 2012. These retained losses mean that total equity in this $2.5 billion company is only $220 million today. So when it generates some profits at today's natural gas prices, it makes returns look out of this world. As these retained losses get wiped off the books, equity will increase, but it will also decrease return on equity.

Core Labs also has little to no equity on its balance sheet -- $26.5 million per its last financial report. However, the equity stays low not because of retained losses, but because management has bought back about 33% of all shares outstanding over the past 15 years. These are held as treasury stock on a balance sheet and reduce total equity -- hence, higher returns on equity.

Then there's Seadrill. There are two primary reasons its return on equity is so high:

  1. The company has a really high debt-to-capital ratio of 57%. The best analogy for debt and return on equity is like taking steroids. By juicing on debt, a company can grow its assets -- and hopes to profit in the process -- and equity will eventually catch up as the company retains earnings. Today, Seadrill is like the Barry Bonds of offshore rigs. That much debt makes its returns on equity look awesome.
  2. Up until recently, Seadrill had a massive dividend payment. High dividends mean fewer earnings are retained, just as in a limited partnership, and therefore keeps the total equity portion down. 

Is there a better way to measure returns?
Since equity can be so skewed by the methods I've mentioned, and since energy is traditionally an asset-heavy business, it's a little bit better to look at return on assets than at return on equity. These numbers can also be skewed by things such as massive writedowns -- cough, Ultra Petroleum, cough -- but are generally more reflective of how a company can generate a return on the assets it has on the books.

Here is the return on assets for the same companies I listed earlier.

CompanyReturn on Assets
Ultra Petroleum 10.2%
Core Laboratories  30.1%
Alon USA Partners, LP  16.3%
Sprague Resources, LP  8.61%
Western Refining Logistics, LP  14.2%
Northern Tier Energy, LP  19.8%
Phillips 66 Partners, LP  9.9%
Emerge Energy Services, LP  16.2%
Seadrill  4.14%
Magellan Midstream Partners, LP 10.5%

Source: S&P Capital IQ.

Some of these names now don't look quite as good as the returns on equity would have suggested. However, some of these companies are still cranking out some solid returns for an asset-heavy industry such as oil and gas.

What a Fool believes
Obviously, we want our investments to generate high returns for us, but relying simply on a return-on-equity figure can be misleading if you don't take a deeper look into how that number is calculated. Still, several companies on this list do look quite attractive from both a return-on-equity and a return-on-assets basis, and you might want to consider putting them on your radar for a potential portfolio add in the future.