U.S. crude prices hit recently their highest levels in more than two years. Recently, the commodity climbed to above $55 a barrel, meaning WTI oil more than doubled from the dark days of February 2016 when the commodity fell to a 12-year low of just over $26 per barrel.
Even natural gas has rebounded from its 17-year lows reached in March 2016 and while the commodity may not be at a level many thought it would be at this time of the year, even at today’s price of around $3 per MMBtu, certain companies are in a position to earn profits.
As a proof, over the past four quarters, the number of rigs searching for oil and gas in the country has been surging. According to Baker Hughes, a GE Company’s closely watched weekly report, oil rig count was 729 last week and the natural gas rig count was 169 – each of them up substantially from year-earlier levels of 450 and 117, respectively.
Throughout the downturn, energy firms worked tirelessly to cut costs down to a bare minimum and look for innovative ways to churn out more oil and gas. And they managed to do just that by improving drilling techniques and extracting favorable terms from the beleaguered service producers.
Oil’s recovery to $55 and natural gas touching the magic $3, predictably, has had a positive effect on stocks in the sector. In particular, savvy investors might view the price bump as the impetus the stocks need after freefalling for more than three years. Undoubtedly, still a long way to go, but improving crude and natural gas prices may have already primed certain energy producers and linked entities for upward momentum.
True, the energy market faces many uncertainties and it may not be time to buy stocks indiscriminately, but there are players that look like pretty compelling investments.
Improving Margin Outlook to Aid Refiners
Among the handful of energy subindustries that are showing strength during this shaky period, we believe the U.S. downstream (refining and marketing) space is the most attractive one.
The business of the downstream players is negatively correlated with crude prices. This is because the companies use oil as an input from which they derive refined petroleum products like gasoline, the prime transportation fuel in the U.S. Hence, lower the oil price, higher will be their profits.
Overall, the income from converting crude into gasoline and diesel – also known as refining margin or crack spread – has been going up over the past few months. As per industry data from British oil major BP plc (BP), the indicator averaged $16.3 per barrel in the third quarter, which depicts a strong gain of 18% on a sequential basis.
Gasoline prices jumped to two-year highs in the wake of tropical Harvey that struck the U.S. Gulf Coast – home to more than 45% of domestic oil refining capacity – and caused weeks of disruptions, creating supply shortages. With oil prices essentially remaining unaffected, crack spreads soared. We expect this improving refining outlook to buoy their bottom line.
Apart from Zacks Rank #1 (Strong Buy) Par Pacific Holdings Inc. (PARR - Free Report) , we advocate the likes of HollyFrontier Corp. (HFC - Free Report) and PBF Energy Inc. (PBF - Free Report) . You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
Oil Producers Are Thriving in the Booming Permian Basin
One oil-producing region that continues to attract investors is the low-cost Permian Basin - spread over west Texas and New Mexico. According to some estimates, the region – that has been churning out crude continuously for nearly 100 years – has produced in excess of 30 billion barrels of oil since output began in 1921.
Experts say that it’s cheaper to drill and complete oil wells in the Permian Basin than most other major fields. Moreover, there are certain parts of the shale play whose well-returns are the best in the U.S. With crude prices still down significantly from their 2014 levels, well returns have become a very important metric to gauge profitability.
Permian’s attractive economics means that producers can still make money there at the current, just over-$50-a-barrel price. This is mainly because of the region's extensive pipeline infrastructure, plentiful labor and supplies, and relatively warm winters that makes year-round work possible. Most other domestic shale regions need prices above $60 to support new developments and expansions.
As a result, the Permian currently constitutes a lion’s share of the industry's recovery. In 2016, more than a third of the total amount spent on all U.S. deals was spent on Permian land purchases and leases. No other major oil region in the country came close to this activity.
With the hectic pace of land grab set to continue in the Permian basin and investor’s strong appetite for stocks focused in that region, we have shortlisted four companies – Diamondback Energy Inc. (FANG - Free Report) , Concho Resources Inc. (CXO - Free Report) , EOG Resources Inc. (EOG - Free Report) and RSP Permian Inc. RSPP – that might fetch you outstanding returns.
Integrated Majors Shake Off Oil Slump
In this current turbulent market environment, we advocate the relatively low-risk energy conglomerate business structures of the large-cap integrateds, with their fortress-like balance sheets, ample free cash flows even in a low oil price environment and steady dividends. These companies continue to benefit from their scale and diversification that result in the strongest returns on capital in the industry. More importantly, they are able to cover their investment and payouts with cash from operations -- something investors really want right now.
Thanks to their integrated structures, entities like ExxonMobil Corp. (XOM - Free Report) , Royal Dutch Shell plc (RDS.A - Free Report) , Chevron Corp. (CVX - Free Report) and BP have been able to withstand plunging oil prices better than the rest and protect their top and bottom lines to a certain extent.
Most of them remain in excellent financial health, with ample cash on hand and investment-grade credit ratings with a manageable debt-to-capitalization ratio. On top of this, managements have established quite a track record of conservative capital management and cash returns to shareholders. They also pay a safe dividend, yielding attractive returns.
Moreover, large integrated companies – unlike their small or medium-sized producers – are not known to hedge a major share of their future production. So, they are more likely to benefit from any event-driven higher spot prices – like the OPEC agreement.
Check out our latest Oil & Gas Industry Outlook here for more on the current state of affairs in this market from an earnings perspective, and how the trend is looking for this important sector of the economy.
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