5/28/2013 7:15 PM ET|
13 energy stocks ready to roll
The market looks frothy after a string of new highs, but some areas have been left out thus far. Energy, in particular, has room for a big move up.
Editor's note: This column was updated July 2 to include recent stock and market action.
After a big market run-up and a relatively mild pullback, you may be wondering if there are good ways to put money to work in stocks right now. Here's one attractive option:
Look for sectors that were left out of the long rally.
One such area is energy stocks, including Apache (APA), Devon Energy (DVN), National Oilwell Varco (NOV), Halliburton (HAL), Royal Dutch Shell (RDS.B), Ultra Petroleum (UPL) and seven others that you will read about below.
Many energy stocks, including these, were left behind in the stock market rally. But they are lagging for the wrong reasons, say several money managers who can usually be counted on for outperformance and who own a lot of these names.
These stocks look cheap and are likely to catch up with the market sooner or later.
How cheap is cheap?
Just how inexpensive are they? The discount on energy stocks -- comparing their ratio of price to book value to that of the S&P 500 ($INX) as a whole -- has been higher only twice in the past 40 years, says Will Riley, co-manager of the Guinness Atkinson Global Energy Fund (GAGEX).
This discount is odd, given that oil prices are relatively high, and rising with new tension in the Middle East. Typically, energy stocks trade in lockstep with oil prices.
Here's another curious thing about energy stocks right now. For the first time since 1965, there's a huge divergence between energy stocks and oil, with energy stock valuations sinking sharply even as oil prices have risen over the past two years.
Why are energy stocks so cheap? "This is the market still thinking that $100 oil is not sustainable," Riley says.
What will make energy stocks start moving up? Simply put, investors coming to their senses and realizing oil is not going to sell off much.
"Either the oil price comes down or the stocks go up," Riley says. "We believe oil is at fair value at $100 and it will rise over time." If that assessment is right, then sooner or later the investment crowd will buy up cheap energy stocks.
It's pretty bold to challenge the investment herd when the market seems to think oil prices will decline significantly. Why should you believe Riley and purchase energy stocks?
Well, first of all, his fund outperformed competing funds by 1.4 percentage points a year, annualized, over the past five years, according to Morningstar. Second, the logic behind his oil outlook makes sense, too.
Here are the basics.
Costlier to find and produce
Oil is getting harder and more expensive to find and produce. Most of the major recent discoveries, for example, are in deep water.
Yes, the new source of oil from shale rock in the U.S. adds to supply. But it's not enough to be a game changer, given the steady increase in global demand that Riley expects, linked to ongoing global population and economic growth. "Over time, new sources of demand are still likely to outstrip new sources of supply," Riley says.
Riley expects global oil demand to grow by 1 million to 1.5 million barrels a year, over the next four years.
Another factor at work here, as always, is the Organization of Petroleum Exporting Countries. OPEC openly talks about $100 oil as its take on fair value for crude. Since OPEC, in cahoots with Russia, has a huge influence on the price of oil, this seems to draw a line in the sand at about $100 a barrel, Riley says, though oil could briefly slip into the $90 range from time to time.
Here are three other factors that suggest energy stocks should move higher from here.
1. Insiders are buying. I track insider buying activity every day, and I've noticed a definite uptick in the amount of insider buying at energy names, which has yet to be widely reported. In the past several weeks, insiders have been snapping up shares of Apache, Ultra Petroleum, National Oilwell Varco, Pioneer Energy Services (PES), Key Energy Services (KEG), Ion Geophysical (IO) and Western Gas Partners (WES).
2. The price of natural gas in the U.S. has rebounded. And it is likely to keep rising, Riley says, since production growth has stalled for a variety of reasons. Once it's clear that U.S. natural gas prices will hang in there and advance from here, investors will warm up to energy names. Riley says U.S. natural gas, currently at just under $4 per 1,000 cubic feet, could more than double by the end of the decade. We'll get into this theme a little more, below, since it is controversial.
3. President Barack Obama suddenly seems more energy-friendly than a lot of people assumed. One reason energy stocks are weak is that investors perceived Obama to be hostile to energy, given the foot-dragging on approval of a pipeline from Canada through the U.S., says Tom Karsten, of Karsten Advisors. But the recent approval of a new liquid natural gas processing facility in Texas may have investors changing their view on Obama and energy, he says, which would put a bid under energy stocks.
Here's a quick tour of a baker's dozen of energy stocks that look the most attractive, according to fund managers in the space.
Oil and gas producers
Apache and Devon: U.S.-based producers with good, diversified portfolios of oil and gas reserves, these two are favorites of Riley's. They both look very cheap, as measured by enterprise value (market capitalization plus net debt) to proven reserves. By this measure, Apache trades at about $16 per barrel and Devon is at about $10 per barrel. For context, as a group, U.S. oil and gas producers sell for about $25 a barrel, Riley says, and that's also cheap, compared with historical levels. Apache and Devon are among the cheapest of the cheap, in other words.
Royal Dutch Shell: This one also looks cheap, in part because of unfounded concerns that the company is so large it will have trouble replacing reserves, Karsten says. He doesn't think that will be an issue. Meanwhile, you get paid a 5% annual dividend yield while you wait for Royal Dutch Shell to prove it. Not bad.
Halcón Resources (HK): This stock looks super cheap as well, says Morningstar energy sector analyst Stephen Ellis. He puts the fair value of the stock at $12 a share, meaning this is where it should trade now, based on prospective earnings. Yet shares go for less than $6. At the helm is Floyd Wilson, who has a record of building energy companies and selling them at a solid profit for investors. "Given his track record, we think this one is a pretty interesting bet," Ellis says.
EOG Resources (EOG): This company was among the first to figure out that it was possible to profitably extract oil from shale rock formations in the U.S., says John Groton, an energy sector analyst with Thrivent Financial for Lutherans. So it was a first mover in buying up the best acreage in the Bakken and Eagleford formations in North Dakota and Texas. It got some of the premium properties, which is why its production is so much better than its peers. "They are among the lowest-cost producers of oil," Groton says. "So if oil did drop to $70 a barrel, they are still going to make money, whereas others are not."
Continental Resources (CLR): This company has prime acreage in the Bakken formation in North Dakota and Montana, and also in Oklahoma, one reason it's a favorite of Brian Hicks, co-portfolio manager of the U.S. Global Investors Global Resources Fund (PSPFX), which beats competitors by four percentage points a year, annualized, over the past 10 years, according to Morningstar. Continental has a five-year plan to triple production and proven reserves by the end of 2017. It is off to a good start, since proven reserves increased 54% last year. Another bullish sign here: Harold Hamm, the CEO, chairman and founder, has a huge stake in this stock; he owns more than 68%.
Natural gas producers
Ultra Petroleum (UPL): Brad Evans, who manages the Heartland Value Plus Fund (HRVIX), favors U.S. natural gas plays like this one, because he says the price of natural gas in the U.S. will continue to go up from here, for two reasons.
He says industrial demand in the U.S. from steel, fertilizer and chemical plants, and energy refineries will continue to increase. Next, supply gains will be limited because so many companies that rushed into natural gas production shifted back to oil production over the past few years when natural gas prices fell. Now they are locked in to oil production contracts, so they won't get back into natural gas for at least a year or two. Natural gas plays like Ultra will benefit. "Overall U.S. gas production is really starting to slow down," agrees Ellis, at Morningstar, who also says natural gas prices will head higher from here.
Ultra Petroleum is a favorite of both of these analysts because it has valuable assets in the Pinedale and Marcellus formations, two of the richest sources, located in Wyoming and Pennsylvania.
This company is out of favor because it has been scaling back production to reduce capital spending, but it could reverse that as natural gas prices move higher. Investors also worry the company has too much debt. But Evans says the debt is reasonable, given the company's huge reserves and its sizable cash flow. "Ultra Petroleum is a low-cost producer with long-lived asset base," says Evans, whose fund gets a respectable four out of five stars from Morningstar. His fund has also beaten competitors by about a percentage point a year, annualized, over the past decade.
WPX Energy (WPX): Like Ultra Petroleum, WPX Energy has very valuable natural gas assets, Evans says. They are in some of best natural gas formations in the country, and the company is also a low-cost producer, he says.
The energy services companies
Halliburton: This one looks cheap, says Riley, of the Guinness Atkinson Global Energy Fund, because the ratio of its price to tangible book value – this a theoretical value if the company were liquidated -- is well below its long-term average.A return to its average valuation would add about 50% to the stock price from here. What might make this happen? Halliburton's North American business is recovering, and the company can raise prices again. Plus Halliburton should benefit from the recent spate of deepwater oil finds and the rebound in drilling in the Gulf of Mexico.
National Oilwell Varco (NOV): Shares have fallen to around $70 from above $85 last September, as the company missed forecasts on profit margins. But the setback should be temporary, Ellis says. The reason: National Oilwell Varco is still the go-to equipment company for both onshore and deep-water drilling, he says. This company's equipment is on 90% of the world's oil rigs, and a rig cannot be built in the Western world without using some components from National Oilwell Varco. It also benefits from ongoing rig upgrades by oil companies that want to update their older equipment.
Weatherford International (WFT): This company provides equipment, such as submersible pumps, that helps energy producers squeeze more out of old wells. The stock has been held back by accounting problems related to the timing of tax expenses and possible violations of U.S. rules that prohibit bribes for business abroad. Groton, at Thrivent Financial for Lutherans, says that the first issue has been resolved and that the company has reserved cash to pay possible fines related to the second issue. The stock looks cheap, he says, trading at just above book value, compared with a historical average of 1.8 times book value.
Atwood Oceanics (ATW): This tiny rig provider is a favorite of Mike Breard, an analyst with the Hodges Small Cap fund (HDPSX), which outperformed peers by 3.6 percentage points a year over the past five years, according to Morningstar. One reason is that it's in the process of adding three ultradeep-water rigs to its fleet of 11 rigs. "This will add a lot of earnings potential," he says.
The infrastructure plays
Crestwood Midstream Partners (CMLP): Karsten, of Karsten Advisors, likes the smaller energy infrastructure plays – such as Crestwood – which provide the pipelines, storage and processing facilities that producers need. One reason is that smaller infrastructure companies are more likely get snapped up by larger ones, which are growing through takeovers. They also have the potential for higher growth, just because they are so much smaller. Crestwood operates near the key shale plays in Texas, Arkansas, West Virginia and Louisiana.
Energy infrastructure companies are typically set up as master limited partnerships (MLPs), a structure that allows them to pass profits through to investors untaxed. This explains why MLPs generate nice returns. Crestwood, an MLP, pays an 8% yield. "With Crestwood Midstream, you are getting substantial yield, and you will get continued growth because of the ongoing demand for infrastructure," Karsten says.
In other words, Crestwood should add energy to your stock portfolio in two ways.
At the time of publication, Michael Brush did not own or control the shares of any companies mentioned in this column. Brush has suggested Apache to readers of Brush Up on Stocks, his investment newsletter.
Michael Brush is the editor of Brush Up on Stocks, an investment newsletter. Click here to find Brush's most recent articles and blog posts.
Michael Brush is the editor of Brush Up on Stocks, an investment newsletter. Click here to find Brush's most recent articles and blog posts.
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