Opinion: Energy stocks have rallied amid a pullback in global supplies – ‘lots of upside potential remains’

Energy stocks tumbled this week on conflicting news about rising supply through oil and gas prices.

The Vanguard Energy Index Fund ETF VDE,
-0.92%,
Energy Select Sector SPDR Fund XLE,
-0.80%
and VanEck Oil Services ETF OIH,
-1.48%
– among the most popular energy-related exchange-traded funds – fell eight years this week as war raged in Ukraine, prompting sanctions against energy-rich Russia.

Read: Twelve stocks of clean energy, fossil fuels and uranium are expected to continue to soar – up 79% from here

Should you buy this pullback? Yes, say the energy analysts I spoke with. Here are four reasons.

1. They’re still cheap

Exploration and production companies are trading on earnings expectations derived from West Texas Intermediate CL.1 crude,
-0.22%
prices around $65 to $75 a barrel, says Ben Cook, portfolio manager of Hennessy BP Midstream Fund HMSIX,
-2.40%,
Hennessy HMSFX Intermediate Fund,
-2.37%
and the Hennessy HNRGX Transition Investor Fund,
-1.60%.
Yet Brent BRN00,
-0.49%
is trading much higher, at around $112 a barrel.

“There’s still a lot of upside in a lot of these names,” he says.

Morgan Stanley oil strategist Martijn Rats also describes the industry as attractive based on “compelling valuations”. He estimates that U.S. exploration and production companies are trading at an enterprise value to cash flow ratio 60% lower than the S&P 1500. That’s more than the average 35% discount over the past 10 last years.

In other words, US energy producers are trading at a free cash flow yield of around 15%, compared to 5% for the S&P 500 SPX,
-1.30%,
says Rob Thummel, an energy sector expert at TortoiseEcofin who helps manage the Tortoise MLP & Pipeline Fund TORTX,
-1.99%.
With free cash flow yield, defined as free cash flow divided by market cap, high means cheaper.

“That gap is too wide,” says Thummel, who has a good outlook having covered the energy sector for three decades.

2. Oil prices will remain high

Yes, oil can continue to fall. This could cause some traders to exit energy stocks. But oil prices will remain high this year, given the renewed focus on geopolitical risk. There are also chronic shortages related to underinvestment in development and a new preference for returning cash to shareholders among US producers. High oil prices will support these names.

Goldman Sachs analyst Jeffrey Currie forecasts $135 a barrel of oil this year, believing that’s what it will take to destroy enough demand to drive prices down. Prices will hit $115 a barrel in 2023, Currie says.

Goldman Sachs believes there is a risk that the United States will block the transfer of Russian oil and gas revenues back to Russia, prompting counter-sanctions from Russia in the form of curtailed exports. This could cause energy prices to soar again.

JP Morgan energy analyst Natasha Kaneva is more conservative, predicting that Brent will average $110 a barrel in the second quarter and then $90-100 in the second half. But that’s still well above the $65-$75 a barrel price of oil priced into energy stock valuations.

Increased supply from Iran, Venezuela and the Global Strategic Reserve could help. But don’t expect quick help from US shale producers. It would take them six to nine months to ramp up production if they went that route today, says Thummel.

Given their commitment to payouts to shareholders and clean balance sheets, it is not even clear that they will commit cash to increase production. In fourth-quarter earnings calls, U.S. producers mostly reiterated conservative capital budgets in favor of dividend hikes, stock buybacks and debt reduction, Thummel says.

3. Energy stocks are a hedge against inflation

The price hike is here to stay for a while. In addition to Covid-related supply chain issues, we now have exorbitant energy and food prices due to supply disruptions in Russia and Ukraine. Together they are major suppliers of energy and grain in the world. But one way to offset the pain at the pump and the grocery store is to buy energy stocks, says Ed Yardeni, at Yardeni Research. He thinks gains in energy stocks will help offset the hit to your budget from higher prices.

4. Insiders Buy

I’ve been following insiders every day for over two decades, gathering insights for this market column and for my Brush Up on Stocks stock newsletter (link in bio below). As a rule, insiders go against the grain. They step up their buying when the market or a sector is weak. Insider buying is drying up in buoyant sectors. The energy sector is up more than 30% this year. However, insider buying is still observed, which is a bullish signal for the group.

Preferred shares

Insider names

Three energy stocks to consider are those that insiders have recently bought. Last week we learned that Warren Buffett’s Berkshire Hathaway BRK.B,
+0.40%
purchased an additional 61.3 million shares of Occidental Petroleum OXY,
-0.31%
at $47.62 to $56.28, bringing Berkshire’s stake to 91.2 million shares. Berkshire Hathaway presents itself as an “insider” because of this huge stake. The position is so important that we can assume that they know the company like insiders.

Buffett’s exposure makes sense because Occidental has quality assets, but also because the company is focused on using cash to increase its dividend, buy back stock and improve the strength of its balance sheet, all of which are features that Buffett likes, says Cook of Hennessy Funds. Berkshire holds warrants to buy more than 80 million additional shares at $59.62.

Then, at the end of February, the financial director and administrator of APA APA,
-2.47%
said they bought $1.5 million worth of stock at prices up to $33. APA has attractive energy assets in the Permian Basin. Morgan Stanley analyst Devin McDermott has an overweight rating on Occidental Petroleum and APA.

At the end of February and beginning of March, Coterra Energy CTRA,
-2.66%
CEO Tom Jordan bought about $1 million worth of stock at prices up to $24.12. This oil and natural gas producer is the result of the recent merger between Cabot Oil & Gas and Cimarex Energy. Coterra has an attractive inventory of oil and gas assets in the Permian, Marcellus and Anadarko.

Energy service companies

Energy expert Eric Green of Penn Capital Management thinks North American oil service companies are the perfect place to gain exposure to the energy group as producers will ramp up production.

“They are scrambling to get materials. There is no doubt that the number of platforms must increase considerably,” he says. “At any price above $80 a barrel, these companies will want to drill more.”

It will not share specific holdings, but that group includes Patterson-UTI Energy PTEN,
-0.12%,
Helmerich & Payne HP,
-2.17%,
Nabors Industries NBR,
-2.61%,
Halliburton HAL,
-1.42%,
ProPetro Holding PUMP,
-1.89%
and NexTier Oilfield Solutions NEX,
-2.61%.

“Even with a pullback in oil prices, these companies will be as busy as they’ve ever been,” Green says. It might make sense to average out the weakness here because the group has been so hot, he says.

A liquid natural gas deposit

Europe gets so much of its natural gas from Russia that the current crisis in Eastern Europe reminds it that it needs to diversify its supply. One solution is super cooled liquid natural gas (LNG) imported from the United States

One LNG name to consider is Cheniere LNG,
-2.35%,
says Thummel, energy analyst at TortoiseEcofin.

“Demand for US LNG will continue to grow and Cheniere will benefit,” he said.

Cheniere expands capacity at its Corpus Christi site. In addition to growing demand for LNG from China, Taiwan, South Korea and Europe, RBC Capital Markets analyst Elvira Scotto recently raised her price target for Cheniere from $116 to $151.

U.S. producers and pipeline companies

Among U.S. producers, top positions and favored names in the Hennessy Transition Investor Fund include Pioneer Natural Resources PXD,
-2.21%,
Diamondback Energy FANG,
-3.28%
and EOG EOG Resources,
-2.67%.

“Based on cash flow, they’re trading at the lower end of their historical valuation range,” Cook says. “Even though oil prices have fallen dramatically, the risk-reward ratio remains attractive.”

He also likes midstream pipeline companies.

“Midstream will do well as the industry begins to increase spending and build up production capacity, which has atrophied,” he says. Pipeline companies will be called upon to deliver more volumes. Major holdings here include Williams Cos. WMB,
-1.82%
and Kinder Morgan KMI,
-2.43%.

Michael Brush is a columnist for MarketWatch. At the time of publication, he owned KMI. Brush suggested OXY, APA, CTRA, HP, NBR, HAL, PUMP, FANG, WMB and KMI in his newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.

Comments are closed.