Brent crude prices – the global oil benchmark – recently hit a three-and-a-half year high. The commodity popped above $80 a barrel, meaning that Brent oil surged almost 200% from the dark days of February 2016 when it fell to a 13-year low of around $28 per barrel.
While all crude-focused stocks stand to gain from the oil rally, companies in the exploration and production (E&P) sector are the best placed, as they will be able to extract more value for their products. In particular, the international E&P companies – with their dominant exposure to Brent pricing – are primed for upward pressure on both revenues and earnings.
Throughout the downturn, energy producers worked tirelessly to cut costs 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. Moreover, driven by operational efficiencies, these entities have been able to reduce unit costs and live within their cash flows.
Industry Outperforms on Shareholder Returns
Judging by shareholder returns over the past year, it seems that the formerly skeptical investors are buying back into the industry on improving commodity prices and the resultant strength in profit growth. Continued efficiency gains, shorter completion cycle times and exposure to Brent oil pricing have contributed to investors’ optimism surrounding the space.
The Zacks Oil And Gas - Exploration And Production - International industry, part of the broader Zacks Oil and Energy Sector, has outperformed both the S&P 500 and its own sector over the past year. While the stocks in this industry have collectively gained 18.6%, the Zacks S&P 500 Composite and Zacks Oil and Energy Sector have rallied 12.5% and 14.9%, respectively.
One-Year Price Performance
Still Room for the Group to Run
Since upstream-focused oil and gas companies are debt-laden, it makes sense to value them based on the EV/EBITDA (Enterprise Value/ Earnings before Interest Tax Depreciation and Amortization) ratio. This is because the valuation metric takes into account not just equity but also the level of debt. For capital-intensive companies, EV/EBITDA is a better valuation metric because it is not influenced by changing capital structures and ignores the effect of noncash expenses.
Following the industry outperformance over the past year, the valuation picture appears a little pricey, in comparison to the market at large. The industry currently has a trailing 12-month EV/EBITDA ratio of 13.3X, at a premium to the S&P 500’s EV/EBITDA ratio 11.3X. As the chart below shows, the premium to the broader market narrowed materially in early 2018 and the two have tracked each other fairly closely ever since.
However, the group’s valuation leaves enough room for upside when compared with its highest level of 22X and median level of 14.8X over the 12-month period.
Enterprise Value/EBITDA Ratio (TTM)
Comparing the group’s EV/EBITDA ratio with that of its broader sector shows that the industry is trading at a hefty premium. The Zacks Oil and Energy Sector’s trailing 12-month EV/EBITDA ratio of 6.7X and the median level of 6.6X for the same period are well below the respective ratios of the Zacks International E&P industry.
While this might suggest little room for an upside ahead, investors should note that the industry has historically traded at a premium to its sector.
Enterprise Value/EBITDA Ratio (TTM)
Outperformance May Continue on Solid Earnings Outlook
With the OPEC meeting essentially putting a floor beneath crude, the commodity should continue to trade at a price that is well above the breakeven level for producers. Moreover, the tough three years for the industry forced operators to make cost control their primary focus.
And now, most of the companies are able to cover their investment and payouts with cash from operations – something that investors desperately want. In fact, riding on improving commodity prices, a stronger production outlook and healthier cash flows, the exploration and production stocks should continue generating positive shareholder returns in the near future.
But what really matters to investors is whether this group has the potential to perform better than the broader market in the quarters ahead. While the above ratio analysis shows that there is a solid value-oriented path ahead, one should not really consider the current price levels as good entry points unless there are convincing reasons to predict a rebound in the near term.
One reliable measure that can help investors understand the industry’s prospects for a solid price performance is the earnings outlook for its member companies. Empirical research shows that a company’s earnings outlook significantly influences its stock performance.
The Price & Consensus chart for the industry shows the market's evolving bottom-up earnings expectations for it as well as the industry's aggregate stock market performance. The red line in the chart represents the Zacks measure of consensus earnings expectations for 2019 while the light blue line represents the same for 2018.
Price and Consensus: Zacks International E&P Industry
This becomes even clearer by focusing on the aggregate bottom-up EPS revisions trend. The chart below shows the evolution of aggregate consensus expectations for 2018.
Please note that the 28 cents EPS estimate for the industry for 2018 is not the actual bottom-up dollar estimate for every company within the Zacks International E&P industry but rather an illustrative aggregate number created by our proprietary analytics model. The key factor to keep in mind is not the industry’s earnings per share for 2018 but how this estimate has evolved recently.
Current Fiscal Year EPS Estimate Revisions
As you can see here, the 28 cents EPS estimate for 2018 is up from 13 cents at the end of April and 3 cents this time last year. In other words, the sell-side analysts covering the companies in the Zacks International E&P industry have been steadily raising their estimates.
Zacks Industry Rank Indicates Solid Prospects
The group’s Zacks Industry Rank is basically the average of the Zacks Rank of all-member stocks.
The Zacks International E&P Industry currently carries a Zacks Industry Rank #12, placing it at the top 5% of more than 250 Zacks industries. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.
On top of that, our proprietary Heat Map shows that the industry’s rank has been in the top 50% for the past eight weeks with a steady upward trend.
Not only do the near-term prospects look welcoming for investors, the uptrend in revenues and net income over the past year appears promising as well. This might support long-term growth in earnings per share.
Revenues: Zacks International E&P industry
Net Income: Zacks International E&P industry
Crude has been inching its way back up after falling sharply from $100 a barrel in 2014, to a low of $30 in 2016. Supply-side shocks out of Iran, Venezuela and Libya in the face of growing global consumption levels – especially in emerging markets such as China and India – has put the oil market in a fundamentally tight spot. This robust backdrop, which is expected to strengthen over the course of this year, has breathed life back into the sector.
The gradual uptick in crude prices along with efficient strides adopted by the companies during the slump period are now encouraging producers to rev up development. As a result, most international upstream players are off to a strong start in 2018, exceeding their production targets through a combination of a high level of operational execution, lower completion cycle times and impressive cost reductions.
Despite occasional hiccups, Brent crude price should remain north of the $70 mark going into the second half of the year. Importantly, expectations for stabilized oil prices for some time into the future provides investors with an excellent chance to accumulate some quality E&P names – more so the ones with strong earnings outlook.
Below are four stocks with positive earnings estimate revisions and carry a Zacks Rank #2 (Buy).
(You can see the complete list of today’s Zacks #1 Rank stocks here.)
Kosmos Energy Ltd. (KOS - Free Report) : The stock of this Hamilton, Bermuda-based explorer has gained 26.9% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 153.8% upward over the last 60 days.
One-Year Price Performance: KOS
Cairn Energy PLC (CRNCY - Free Report) : The stock of this Edinburgh, UK-based explorer has gained 42.5% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 2.4% upward over the last 60 days.
One-Year Price Performance: CRNCY
Nostrum Oil & Gas PLC (NSTRY - Free Report) : The stock of this Amsterdam, Netherlands-based explorer has lost 50.7% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 16.2% upward over the last 60 days.
One-Year Price Performance: NSTRY
Ophir Energy Plc (OPHRY - Free Report) : The stock of this London, UK-based explorer has lost 36.6% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 183.3% upward over the last 60 days.
One-Year Price Performance: OPHRY
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