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Oil and Gas - U.S. E&P Stock Outlook: Future Still Promising

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West Texas Intermediate (or WTI) — a benchmark for oil prices in the United States — recently hit a three-and-a-half year high. The commodity popped above $75 a barrel, meaning that WTI oil surged almost 200% from the dark days of February 2016, when it fell to a 13-year low of around $26 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 domestic E&P companies — with their dominant exposure to WTI 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 Winning 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 WTI oil pricing have contributed to investors’ optimism surrounding the space.

The Zacks Oil and Gas - Exploration and Production - United States 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 16.5%, the Zacks S&P 500 Composite and Zacks Oil and Energy Sector have rallied 14.7% and 14.3%, respectively.

One-Year Price Performance

 

 

Still Some Juice Left for the Group

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 12.8X, at a premium to the S&P 500’s EV/EBITDA ratio 11.7X. As the chart below shows, the industry used to track the broader market fairly closely but has opened up a premium since late 2017.

However, the group’s valuation leaves some room for upside when compared with its highest level of 14.2X 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 United States E&P industry.

While this might suggest little room for upside, investors should note that the industry has historically traded at a premium to its sector.

Enterprise Value/EBITDA Ratio (TTM)

 

 

Strong Earnings Outlook Points to Further Gains

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 United States 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 $1.53 EPS estimate for the industry for 2018 is not the actual bottom-up dollar estimate for every company within the Zacks United States 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 EPS estimate for 2018 is up from $1.34 cents at the end of April and 69 cents this time last year. In other words, the sell-side analysts covering the companies in the Zacks United States 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 United States E&P Industry currently carries a Zacks Industry Rank #60, placing it at the top 23% 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.

 

Industry Promises Long-Term Growth

The long-term EPS (3-5 years) growth prospects for the industry look appealing when compared with the broader Zacks S&P 500 composite. The group’s mean estimate of long-term EPS growth rate is currently pegged at 15.9%. This compares to 9.8% for the Zacks S&P 500 composite.

Mean Estimate of Long-Term EPS Growth Rate

In fact, the basis of this long-terms EPS growth could be the recovery in top line and net income that domestic oil producers have been showing since the beginning of 2017.

Revenues: Zacks United States E&P industry

 

Net Income: Zacks United States E&P industry

 

Bottom Line

Crude has been crawling its way back up after falling sharply from $100 a barrel in 2014 and a low of $26 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 — have 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 are now encouraging producers to rev up development. As a result, most domestic 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, WTI crude price should remain north of the $65 mark going into the back end 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 a bullish Zacks Rank.

Bonanza Creek Energy, Inc. (BCEI - Free Report) is an independent exploration and production company with core operations in the in the Rocky Mountain and Mid-Continent regions.The stock of this Denver, CO-based explorer has gained 31.4% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 23.2% upward over the last 60 days. Bonanza Creek flaunts a Zacks Rank #1 (Strong Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.

Price and Consensus: BCEI

 

Northern Oil and Gas, Inc. (NOG - Free Report) is a non-operator explorer and producer with primary focus on the Williston Basin in North Dakota and Montana.The stock of this Minnetonka, MN-based explorer has gained 160% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 17.1% upward over the last 60 days. Northern Oil and Gas carries a Zacks Rank of 1.

Price and Consensus: NOG

 

Penn Virginia Corporation (PVAC - Free Report) is an oil and gas exploration and production company with operations primarily focused on the Eagle Ford shale in south Texas.The stock of this Houston, TX-based explorer has gained 110.9% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 18% upward over the last 60 days. Penn Virginia also has a Zacks Rank #1.

Price and Consensus: PVAC

 

 

California Resources Corporation (CRC - Free Report) is an independent oil and gas company having operations mainly in the San Joaquin Basin. The stock of this Los Angeles, CA-based explorer has gained 345.8% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 630% upward over the last 60 days. California Resources flaunts a Zacks Rank #2 (Buy).

Price and Consensus: CRC

 

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