Energy stocks have seesawed this week as conflicting news of increased supply courses through commodity 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 — retreated from eight-year highs this week as war raged in Ukraine, leading to sanctions on energy-rich Russia.
Should you buy this pullback? Yes, say energy analysts I spoke with. Here are four reasons why.
1. They are still cheap
Exploration and production companies are trading on profit expectations derived from West Texas Intermediate crude CL.1, -0.22% prices of around $65-$75 a barrel, says Ben Cook, portfolio manager of the Hennessy BP Midstream Fund HMSIX, -2.40%, Hennessy Midstream Fund HMSFX, -2.37% and the Hennessy Transition Investor Fund HNRGX, -1.60%. Yet Brent BRN00, -0.49% trades much higher, at around $112 a barrel.
“There is plenty of upside remaining 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 U.S. exploration and production companies trade at an enterprise value to cash flow ratio that’s 60% below that of the S&P 1500. That’s more than the average 35% discount over the past 10 years.
Put another way, U.S. energy producers trade at a free cash flow yield of around 15%, compared with 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 spread is too wide,” says Thummel, who has a good perspective because he has covered the energy sector for three decades.
2. Oil prices will stay elevated
Yes, oil may continue to decline. That might have some traders exiting energy stocks. But oil prices will stay high this year — given the renewed attention to geopolitical risk. There are also chronic shortages related to underinvestment in development, and the newfound preference for returning cash to shareholders among U.S. producers. Elevated oil prices will support these names.
Goldman Sachs analyst Jeffrey Currie forecasts $135 a barrel for oil this year, reasoning this is what it will take to destroy enough demand to push prices back down. Prices will come in at $115 per barrel in 2023, says Currie.
Goldman Sachs thinks there’s a risk the U.S. will block the transfer of Russian oil and gas proceeds from getting back into Russia, provoking counter-sanctions by Russia in the form of reduced exports. That could spike energy prices again.
JP Morgan energy analyst Natasha Kaneva is more conservative, predicting Brent will average $110 per barrel in the second quarter, and then $90 to $100 in the second half of the year. But that is still way above the $65-$75 per barrel oil price embedded in energy stock valuations.
Increased supply from Iran, Venezuela and the global strategic reserve could help. But don’t expect a quick assist from U.S. shale producers. It would take six to nine months for them to ramp up production if they start down that road today, says Thummel.
Given their commitment to shareholder payouts and clean balance sheets, it’s not even clear they’ll commit cash to ramp up production. In fourth-quarter earnings calls, U.S. producers mostly reiterated conservative investment budgets in favor of dividend hikes, share buybacks and debt reduction, says Thummel.
3. Energy stocks are an inflation hedge
Rising prices are here to stay for a while. On top of the supply-chain issues linked to Covid, we now have runaway prices of energy and food commodities because of supply disruptions in Russia and Ukraine. Together they are big suppliers of energy and grain to the world. But one way to offset the pain at the pump and in the grocery store is to buy energy stocks, believes Ed Yardeni, at Yardeni Research. He thinks gains in energy stocks will help offset the hit to your budget from rising prices.
4. Insiders are buying
I’ve tracked insiders every day for over two decades, to gather insights for this market column and for my stock newsletter Brush Up on Stocks (link in bio below). Typically, insiders go against the crowd. They step up their buying when the market or a sector are weak. Insider buying dries up in strong sectors. The energy sector is up over 30% this year. Yet, we still see insider buying, which is a bullish signal for the group.
The insider names
Three energy stocks to consider are the ones insiders recently bought. Last week we learned that Warren Buffett’s Berkshire Hathaway BRK.B, +0.40% bought another 61.3 million shares of Occidental Petroleum OXY, -0.31% at $47.62 to $56.28, taking Berkshire’s stake up to 91.2 million shares. Berkshire Hathaway reports as an ”insider” because of that huge stake. The position is so big, we can assume they know the company as insiders do.
Buffett’s exposure makes sense because Occidental has quality assets, but also because the company is focused on using cash to boost its dividend, buy back stock, and improve its balance sheet strength, which are all characteristics that Buffett likes, says Cook at Hennessy Funds. Berkshire owns warrants to buy over 80 million additional shares at $59.62.
Next, in late February the chief financial officer and a director at APA APA, -2.47% reported buying a sizable $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.
In late February and early March, Coterra Energy CTRA, -2.66% CEO Tom Jorden bought about $1 million worth of stock at prices up to $24.12. This oil and natural gas producer is the product 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 expert Eric Green at Penn Capital Management thinks North American oilfield-services companies are the place to get exposure to the energy group because producers will be boosting output.
“They are scrambling to get equipment. There is no question the rig count has to go up considerably,” he says. “At any prices over $80 a barrel, these companies will want to drill more.”
He won’t share specific holdings, but this 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 have ever been,” says Green. It might make sense to average in on weakness here because the group has been so hot, he says.
A liquid natural gas play
Europe gets so much of its natural gas from Russia, the current crisis in Eastern Europe serves as a great reminder that it needs to diversify its sourcing. One solution is super cooled liquid natural gas (LNG) imported from the U.S.
An LNG name to consider is Cheniere LNG, -2.35%, says Thummel, the energy analyst at TortoiseEcofin.
“Demand for U.S. LNG will continue to rise and Cheniere will benefit from that,” he says.
Cheniere is expanding its capacity at its Corpus Christi site. This plus increasing LNG demand from China, Taiwan, South Korea and Europe had RBC Capital Markets analyst Elvira Scotto recently raising her price target for Cheniere to $151 from $116.
U.S. producers and pipeline companies
Among U.S. producers, top positions and favored names at the Hennessy Transition Investor Fund include Pioneer Natural Resources PXD, -2.21%, Diamondback Energy FANG, -3.28% and EOG Resources EOG, -2.67%.
“On a cash flow basis, they are trading at the lower end of their historical valuation range,” says Cook. “Even if the oil prices fell dramatically, the risk-reward is still attractive.”
He also like midstream pipeline companies.
“Midstream will do well as the industry begins to ramp spending and build production capacity, which has atrophied,” he says. Pipeline companies will be called upon to deliver more volumes. Top 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 has suggested OXY, APA, CTRA, HP, NBR, HAL, PUMP, FANG, WMB and KMI in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.