By Michael Brush
Energy stocks have seesawed as conflicting news of increased supply courses through commodity oil and gas prices.
The Vanguard Energy Index Fund ETF /zigman2/quotes/202541791/composite VDE +2.10% , Energy Select Sector SPDR Fund /zigman2/quotes/206420077/composite XLE +1.98% and VanEck Oil Services ETF /zigman2/quotes/207596637/composite OIH +2.56% — among the most popular energy-related exchange traded funds — retreated from eight-year highs last 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 /zigman2/quotes/211629951/delayed CL.1 -1.16% prices of around $65-$75 a barrel, says Ben Cook, portfolio manager of the Hennessy BP Midstream Fund /zigman2/quotes/200664705/realtime HMSIX +0.43% , Hennessy Midstream Fund /zigman2/quotes/201966438/realtime HMSFX +0.44% and the Hennessy Transition Investor Fund /zigman2/quotes/201964518/realtime HNRGX +1.94% . Yet Brent 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 /zigman2/quotes/210599714/realtime SPX -0.16% , says Rob Thummel, an energy sector expert at TortoiseEcofin who helps manage the Tortoise MLP & Pipeline Fund /zigman2/quotes/201923631/realtime TORTX +0.16% . 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.