Look for E&P and oil-service stocks to once again beat the broad market in 2006 as commodity prices and energy-sector profitability remain robust. Accordingly, be long and overweight these stocks this year. So advises the energy team at Pickering Energy Partners Inc., a Houston-based energy-research firm focused on institutional clients. Based on projected $60 oil and $9.50 gas for 2006, E&P stocks should move up between 15% and 25% in value, predicts Dan Pickering, president. "While a 6% year-over-year rise in commodity prices cannot offset a 15% to 30% increase in costs, E&P companies will still be able to generate great returns, albeit with lower margins per thousand cubic feet." He sees a continued ramp up in drilling activity, particularly in hot resource plays where E&P players are racing to exploit horizontal drilling and completion techniques in previously unprofitable reservoirs. Among these are the Fayetteville Shale in Arkansas, the Pinedale Anticline in Wyoming, the Barnett Shale in Texas and the Blackhawk/Mesaverde in Utah's Uinta Basin. Also, look for upstream M&A to continue unabated this year. Says Pickering, "There is the potential for a feeding frenzy as buyers become afraid of missing opportunity." Potential buyers include ConocoPhillips, Royal Dutch Shell, ChevronTexaco, Devon Energy, XTO Energy and Chesapeake Energy. The potential sellers: EnCana, EOG Resources, Murphy Oil, Noble Energy, Quicksilver Resources, Ultra Petroleum, Southwestern Energy, Western Gas Resources, Newfield Exploration, Equitable Resources, Questar Corp. and Bill Barrett Corp. Within the E&P group, Pickering and his team believe the small-caps that have a meaningful inventory of projects and already contracted rigs and services are the best bet. Examples are Calgary's Compton Petroleum, Oklahoma City's GMX Resources and Midland's Parallel Petroleum. This view notwithstanding, the research group looks for strong gains from producers like XTO Energy-their top large-cap E&P stock pick for 2006-and Southwestern Energy, their top midcap E&P pick. Within the oil-service sector, the team sees sector earnings growing more than 20% through 2007. "And as investors begin paying up for 2007 performance, this implies a 15% to 35% upside in service-stock valuations from current levels," says Pickering. Smaller-cap service stocks, up 107% in 2005 versus gains of 63% for midcaps and 53% for large caps, should yield this year to their bigger brethren, he forecasts. "This is the year of the large- and midcap service stocks, as their geographic breadth, stronger negotiating leverage with suppliers/customers, and broader product/service portfolios translate into impressive earnings growth of 20%-plus." Among these, Pickering and his team favor deepwater and hybrid offshore drillers-those with an inventory of floaters and jackups-more so than pure jackup plays. "Jackup-oriented stocks, particularly those of drillers with heavy Gulf of Mexico exposure, benefited tremendously from investor euphoria over step-function dayrate increases post-hurricanes Katrina and Rita," says the researcher. "Thus, it will be tougher for these names-companies like Rowan Cos., Ensco International and Todco-to maintain a 'sizzle' factor in 2006." The team's top large- and midcap service picks for 2006: Baker Hughes and BJ Services, respectively. Its top picks among smaller-cap service companies: Oil States International and Team Inc. As for energy-related IPOs marching to market these days, those companies should be scrutinized carefully, cautions Pickering. He notes that in 2005 there were $12 billion worth of energy offerings, including secondaries; as the current energy cycle stretches, the list of energy companies trying to access the capital markets will become longer. "Investors must get more jaded and work with a sharper pencil to determine their participation in these offerings," says the researcher. He offers the reminder that the energy industry always has been, is now and always will be cyclical, not secular. "A healthy dose of skepticism wards off cycle complacency. We may still be only in the fifth inning, but it never hurts to stay vigilant for signs of fraying around the edges of the energy upcycle."