Barring a recession, which doesn’t seem likely, oil prices seem intent on rising higher.
Some investors still don’t believe it. They haven’t bought into the trend yet. That makes energy stocks a contrarian play, despite the 48% gain in the SPDR S&P Oil & Gas Exploration & Production ETF XOP, +2.46% since last summer, compared with 13% for the S&P 500 Index SPX, +0.74%
Here’s a guide to energy stocks to buy. And my column Monday on the reasons why crude oil prices are headed higher.
Total (TICKER:TOT) and Royal Dutch Shell (TICKER:RDS.A)
Morgan Stanley thinks Brent crude LCON8, +0.87% will reach $90 a barrel by 2020. That would be a healthy move off recent levels of around $79. A good way to play that is to buy the majors, or the biggest of the big energy companies like Shell and Total, says Morgan Stanley analyst Martijn Rats. He thinks a move to $90 for Brent would boost their valuations by 30%.
A significant move up in oil revenue against what will most likely be flat capital spending at these companies — combined with some asset sales — will boost their free cash flow substantially. This will also help them right-size their balance sheets. Rising free cash flow and balance sheet deleveraging have historically supported higher valuations at energy giants like these. Meanwhile, you get pretty decent dividend payouts if you buy the energy giants now. On average, the majors yield 4.8%.
Rats singles out Royal Dutch Shell for its healthy pipeline of projects that will add cash flow, its strong network of retail gasoline stations, and a growing chemicals business. All of this will support improvements in balance sheet strength, which will back dividend growth and reduce worries among investors about Shell’s debt. Rats thinks the stock could advance 25% in the next year. Shell currently yields 5.2%.
Rats singles out Total because it will post the fastest production growth among the majors. He expects 5% annual production growth over the next four years on a flat capital spending budget. He also likes the high free cash flow coverage of its dividend payout. The strengthening free cash flow will support 10% annual dividend growth for the next few years and a multi-billion dollar share buyback. Total currently pays a 4.6% dividend yield.
Continental Resources (TICKER:CLR)
Investors continue to misunderstand the Continental Resources story, and this creates a buying opportunity, says Morgan Stanley analyst Drew Venker. The knock on Continental Resources is that it has excessively high costs, too much debt, and lower quality assets in the Bakken Formation at a time when everyone is hungry for Permian Basin plays.
“We disagree on each,” says Venker.
As a portion of sales, costs are among the lowest in the group. Adjusted for debt levels, production growth is among the best. And the perception of high leverage is “outdated” since Continental’s net debt to cash flow is only slightly higher than at the favored oil companies operating in the Permian. “Continental is one of few stocks within our diversified large-cap coverage that offers investors exposure to low-cost oil outside of the Permian,” says Stifel analyst Derrick Whitfield.
Comstock Resources (TICKER:CRK)
This little Texas-based natural gas company has been battling bankruptcy worries for the past year. Hence the wicked volatility of its stock. But all that changed in May when Dallas Cowboys owner and oil magnate Jerry Jones struck a deal with management. In the deal, Comstock will swap a huge amount of newly issued stock for oil and gas assets owned by Jones. He’s putting in North Dakota oil and gas properties valued at $620 million. Jones will own 84% of the company, assuming shareholders sign off, which is likely. Cash flow from those properties will help Comstock pay off debt maturing near term, and quell bankruptcy worries, for starters. Medium term, the Jones property cash flow should fund healthy production growth.
Comstock owns decent natural gas properties in the Haynesville Shale, and it has been posting solid production growth even without help from Jones — 55% in the first quarter. Cash from Jones properties’ oil production will support much more Haynesville drilling for natural gas. This will create 30% natural gas production growth in 2018 and 50% growth in 2019, Comstock predicts.
“That’s why Jerry invested. He wants to see all this happen,” says Comstock CFO Roland Burns. “His properties are generating a lot of cash. He is marrying his assets with assets that have a tremendous amount of investment opportunity. We can really ramp up activity without raising debt because we have all this internal cash flow that needs to be reinvested.”
All of this suggests the stock could rise. “The new Comstock Resources is one of the biggest transformations we’ve seen in exploration-and-production land,” Coker Palmer analyst David Beard wrote in a recent research note. “Most, if not all, of the balance sheet issues should be resolved.”
He puts a fair value of $13 on the stock, which recently traded at $10.60. His fair value assumes the stock trades in line with peers in terms of enterprise value to cash flow. (Enterprise value is market value plus net debt.) Beard thinks the stock has upside potential to $25. “We feel the shares have more upside from here and are buyers on weakness.”
Four energy-services companies
Last summer, most energy stocks were a contrarian play. The crowd is not fully on board yet. They still aren’t, but now you have to drill down a bit more in the sector to find the really out-of-favor names. Heartland Advisors money manager Colin McWey thinks he’s found one in TechnipFMC FTI, -0.44% a company that helps develop and produce offshore energy fields.
Offshore assets can be more expensive to develop, and it takes a long time. So these projects got shelved when oil prices tanked. Now that oil has come back, offshore projects probably will, too. And that should help TechnipFMC .
The bullish twist for investors is that TechnipFMC offers a wide range of services and equipment. This saves customers from having to assemble customized production tools from several different suppliers. “Historically, energy producers were cobbling together different solutions from different vendors in a way that was clunky,” says McWey. “TechnipFMC has a completely integrated model.”
Back onshore and in the U.S., rising prices for West Texas Intermediate CLM8, +0.21% creates more cash flow for energy companies. So they are increasing production. This will continue to be good news for companies offering production services and equipment, says Mike Breard, an energy analyst at Hodges Capital Management.
Three he favors are: Helmerich & Payne HP, +0.86% which supplies rigs; Propetro Holding PUMP, -1.90% which offers production equipment and services; and Solaris Oilfield Infrastructure SOI, -2.70% which supplies specialized gear like silos to help manage the delivery of sand used in fracking.