Energy stocks are set to get hotter. 6 that can get you a piece of the gusher.

  • By Avi Salzman,
  • Barron's
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Two years ago, oil companies were global pariahs, banished not only from the high-minded peaks of Davos but also from lowly index funds. Energy’s weight in the S&P 500 (.SPX) fell below 2%, an astonishing drop for a sector that once accounted for more than 20% of the index’s market value. Exxon Mobil (XOM) was briefly worth less than Zoom Video Communications (ZM).

The turnaround since then has been just as astonishing, if not more so. Exxon just hit a new all-time high and is now worth more than 10 times as much as Zoom. Energy stocks are up 62% this year, after rising 48% in 2021.

The question now is whether the party is over. At times in recent months, energy stocks have flatlined even when oil prices were rising, a sign that investors hadn’t fully bought into the story. Generalist investors have shunned the industry because of poor past returns and environmental worries.

Energy has more room to rise, though. There’s still time to buy into the stocks, particularly for investors willing to consider the term “energy” broadly. That means buying renewables-focused companies, too, and evaluating companies in part on their efforts to lower carbon emissions, a key trend going forward—and one that will be at least as big an economic driver in the longer term as traditional energy uses are today.

Even after the stock gains of the past two years, energy is still the cheapest sector in the S&P 500, trading at 9.8 times expected earnings over the next year—the only sector below 10 times earnings. Energy now makes up 15% of the index’s earnings and some 5% of its market cap, a “spread that is likely to not persist, in our view,” wrote Truist analyst Neal Dingmann. And the balance sheets in the sector are healthier than they’ve been in years.

There’s also a political shift going on that may benefit oil and gas companies. Nick Deluliis, CEO of Pittsburgh gas producer CNX Resources, says politicians who had been urging energy companies to cut back are now being “mugged by reality,” as gasoline prices soar and Europe struggles to divest from Russian fossil fuels.

The ESG movement isn’t going away, but some investors see sentiment on Wall Street shifting enough that energy investments become more palatable. “We don’t want to need crude, but people are starting to realize that not wanting to need it is different than not needing it,” says Rebecca Babin, senior energy trader at CIBC Private Wealth US. “And I do think investors have come around to that, as well.”

Energy is due for a major investment cycle. Capital expenditure in oil and gas production has fallen 61% since peaking in 2014, and overall primary energy investment has dropped 35%, according to Goldman Sachs. The next three years should see a major rebound as producers ramp up supply to meet demand. From 2021 to 2025, annual energy investment should grow by 60%, or $500 billion, Goldman’s analysts say.

For now, some of the biggest beneficiaries should be companies in sectors facing severe capacity constraints.

Oil services

One of the sectors where suppliers have more power now is oil services. For the past few years, the big service players like Schlumberger (SLB) and Halliburton (HAL) have had to cut expenses as producers have cut expansion plans. As some producers expand again, they’ve found there aren’t as many crews or as much equipment available, and they’re been writing bigger checks.

“This tight market has been coming for quite a while, and in the service sector, it’s even more dramatic,” says Chris Wright, CEO of Denver-based Liberty Energy (LBRT), a big provider of oilfield services.

Liberty bought Schlumberger’s hydraulic fracturing, or fracking, business in 2020, with Schlumberger taking an equity stake in Liberty. Liberty now has substantial scale and the ability to raise prices as producers prepare to expand. Wright said that industry dynamics have clearly changed.

“A thing I laugh about a lot is that we have customers now who want to pick up the lunch tabs,” Wright says. “We’re a service company; we always take our guys out to lunch. Customers now want to pick up the tab. And I’ve had several customers say, ‘Hey, can I come to Denver and visit you?’ I haven’t heard that for three or four years.”

Liberty stock has risen 14% in the past year, well behind Halliburton’s 74% rise. But the company has less debt than its larger competitor, and analysts see gains ahead. Citi’s Scott Gruber thinks Liberty’s shares could rise to $20 from a recent $17 in a “more normalized” drilling environment similar to the period from 2018 to 2020.

Refiners

Another capacity-constrained area is refining. In the U.S., 20 refiners have closed in the past decade, with several of those closures coming since the pandemic. Refining capacity has come down more than a million barrels since early 2020, making it harder for refiners to supply the 20 million barrels of petroleum products that Americans use every day, and the millions more that the industry ships overseas. That has led to record “crack spreads,” a measure of the margins that companies make processing crude. Adjusted crack spreads have risen to $30 per barrel this quarter from $12 in the first quarter, says Matthew Blair, an analyst at Tudor, Pickering, Holt.

BofA Securities analyst Doug Leggate expects second-quarter earnings for many refiners to hit record levels, and the momentum is likely to continue. If futures prices for various oil products hold, “the scale of potential earnings is staggering versus any prior period,” he wrote this past week in upgrading his earnings estimates by 57% on average. His favorites include Valero (VLO) and PBF Energy (PBF).

Another refiner worth considering is Phillips 66 (PSX), which has trailed its peers, in part because it’s more diversified. Phillips has refineries in the Northeast—a particularly supply-constrained region—and has the largest dividend yield of the big refiners, 3.6%. Leggate thinks it could rise to $139 from a recent $108.

Energy conglomerates

The big multinational oil companies have slimmed down and cut underperforming operations. All of the stocks have risen, and their financial results are as strong as ever.

Shell (SHEL), which has the highest revenue of European oil and gas companies, has become a more multifaceted business since the pandemic, adding growing wind and solar divisions. It announced on June 7 that it will start selling renewable-generated power in Texas. One of Shell’s big advantages is its liquefied-natural-gas business, the world’s largest. Demand for LNG has skyrocketed as Europe attempts to divest from Russian natural gas, and U.S. prices have more than doubled in the past six months. Shell trades for less than seven times expected 2023 earnings, below peers, and has a lower dividend payout ratio, meaning it has more room to increase the dividend in coming quarters.

Oil and gas producers

Another company with underappreciated natural-gas exposure is EOG Resources (EOG), a Houston producer that made a major gas find a few years ago in south Texas. CFRA analyst Stewart Glickman thinks the gas play gives EOG an edge over producers farther from ports. EOG can get its gas onto ships in liquefied form and send it to Europe, where prices are even higher than in the U.S. “It’s an obvious value proposition,” he says.

EOG has long had some of the best land holdings and strongest finances in the industry, and it’s now focusing on returning cash to shareholders. The company pays out $3 per share in dividends annually, double the rate it paid two years ago. It also has gotten in the habit of giving shareholders hefty special dividends, including two last year and a $1.80 payout after the first quarter. In total, the payouts could result in a 6.5% shareholder return this year, according to Mizuho Securities analyst Vincent Lovaglio. He thinks shares could rise to $175 from a recent $142.

Renewables

The rebound for oil and gas companies doesn’t mean countries are abandoning environmental goals. In fact, Europe is clearly accelerating the development of its renewable infrastructure, recently announcing plans to double solar capacity by 2025 and boosting its goal for the amount of power it gets from renewables to 45% by 2030. One beneficiary is Italian utility Enel (ENLAY), whose Enel Green Power subsidiary is a top producer of renewable power, allowing it to take advantage of government funding for the green shift. The EU Innovation Fund, for example, will pay 20% of the cost of an expansion at a Sicilian solar panel factory. Enel is trading at less than 10 times next year’s earnings estimates, and J.P. Morgan calls it “the cheapest way to play renewables growth.”

The U.S. has been slower to adopt green policies than Europe, but lately regulation has grown friendlier. President Joe Biden recently announced that he would exempt some imported solar panels from a proposed tariff that had hurt the industry, and would use the Defense Production Act to speed up U.S. solar-panel production. Congress is also debating an extension of solar tax credits. One beneficiary of these policies is Sunrun (RUN), which develops solar projects for residences, leasing the power they produce to homeowners. Sunrun is the largest U.S. residential solar developer. Credit Suisse analyst Maheep Mandloi says the company is best positioned to benefit, given its scale and cost structure and that the shares can rise to $70 from a recent $27.

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