After suffering a frightening crash in 2020, the Zacks Oil and Gas - Exploration and Production - United States industry has been uphill since the start of this year, thanks to surging demand from the economic reopening. As oil and natural gas prices continue to move higher, upstream firms like EOG Resources, Devon Energy, Diamondback Energy, APA Corp and SilverBow Resources are likely to see impressive revenue and cash flow growth.
About the Industry
The Zacks Oil and Gas - US E&P industry consists of companies primarily based in the domestic market, focused on the exploration and production (E&P) of oil and natural gas. These firms find hydrocarbon reservoirs, drill oil and gas wells, and produce and sell these materials to be refined later into products such as gasoline, fuel oil, distillate, etc.
The economics of oil and gas supply and demand is the fundamental driver of this industry. In particular, a producer’s cash flow is primarily determined by the realized commodity prices. In fact, all E&P companies' results are vulnerable to historically volatile prices in the energy markets. A change in realizations affects their returns and causes them to alter their production growth rates. The E&P operators are also exposed to exploration risks where drilling results are comparatively uncertain.
3 Key Investing Trends to Watch in the Oil and Gas - US E&P Industry
Strong Tailwinds Across the Oil & Gas Spectrum: Energy recovery is gaining steam at a faster-than-expected pace as investors welcome the reality of a post-vaccine world. Mobility restrictions have been rolled back and most parts of the economy have reopened. Also, adding to this bullish narrative are the OPEC+ production cut and supportive government policies.
Consequently, the demand for oil and gas is flourishing. With WTI crude — the U.S. benchmark — rallying past $80-a-barrel and natural gas surging to 13-year highs amid the macro tailwinds, the E&P companies will greatly benefit for obvious reasons. Importantly, commodity prices appear to have entered a protracted period of stability at levels where the operators can generate free cash flow through their drilling activities.
Shale’s Restrained Drilling Programs: One has to remember that the rise in oil prices might open the door for U.S. shale operators that were forced to dial back production in response to the decimation in demand and prices. Generally, the shale patch constituents are quick to pick up drilling activities on any steep rise in the price, which may thwart the fuel’s bull run. Yet, this time, the companies seem to be in no hurry to boost output.
Finally, learning their lesson, shale operators are focusing primarily on improving cost and increasing free cash flow rather than looking at boosting production. While oil at $80 is profitable for almost all shale entities, the industry, for its part, is sticking to the mantra of capital discipline and sustainable production.
According to the weekly data provided by Houston-based Baker Hughes, the last time that WTI crude traded at these levels, some 1,600 oil rigs were operational. Now, it’s just around 450, which is proof of the wariness on the part of the producers to raise output too quickly.
Continued Execution of Cost Cut Initiatives: The energy companies have changed their approach to spending capital. Over the past few years, 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 providers.
Moreover, driven by operational efficiencies, most E&P operators like Coterra Energy, Pioneer Natural Resources Company have been able to reduce unit costs, while the coronavirus-induced collapse in crude forced them to adopt a more disciplined approach to spending capital. These actions might constrain short-term production but are expected to preserve cash flow, support balance sheet strength and help the companies eventually emerge stronger. In particular, cash from operations is on a sustainable path as revenues improve and companies slash capital expenditures from the pre-pandemic levels amid sharply higher commodity prices.
Zacks Industry Rank Indicates Positive Outlook
The Zacks Oil and Gas - US E&P industry is a 43-stock group within the broader Zacks Oil - Energy sector. The industry currently carries a Zacks Industry Rank #4, which places it in the top 2% of more than 250 Zacks industries.
The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates fairly strong near-term prospects. 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.
The industry’s position in the top 50% of the Zacks-ranked industries is a result of a positive earnings outlook for the constituent companies in aggregate. Looking at the aggregate earnings estimate revisions, it appears that analysts are highly optimistic about this group’s earnings growth potential. While the industry’s earnings estimates for 2021 have surged 334.2% in the past year, the same for 2022 have risen 330.1% over the same timeframe.
Considering the encouraging dynamics of the industry, we will present a few stocks that you may want to consider for your portfolio. But it’s worth taking a look at the industry’s shareholder returns and current valuation first.
Industry Outperforms Sector & S&P 500
The Zacks Oil and Gas - US E&P industry has fared better than the broader Zacks Oil - Energy Sector as well as the Zacks S&P 500 composite over the past year.
The industry has soared 188.9% over this period compared with the broader sector’s increase of 82%. Meanwhile, the S&P 500 has gained 35.5%.
Industry's Current Valuation
Since 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.
On the basis of the trailing 12-month enterprise value-to EBITDA (EV/EBITDA), the industry is currently trading at 10.2X, significantly lower than the S&P 500’s 16.23X. It is, however, well above the sector’s trailing-12-month EV/EBITDA of 5.51X.
Over the past five years, the industry has traded as high as 16.54X, as low as 2.93X, with a median of 9X.
5 Top Stocks to Buy Now
SilverBow Resources: SilverBow has operations across roughly 130,000 net acres in the Eagle Ford and more than 80% of its total output comprises natural gas. The company’s exposure to premium markets and focus on costs and margins should help it to benefit from high natural gas prices. SilverBow, which focuses on growth through a combination of acquisitions and active drilling, maintains a strong balance sheet with no near-term debt maturities.
Over 60 days, SilverBow Resources has seen the Zacks Consensus Estimate for 2021 increase 27.8%. The Zacks Rank #1 (Strong Buy) company’s shares have gained 423.2% so far this year. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
Diamondback Energy: Diamondback Energy focuses on growth through a combination of acquisitions and active drilling in the Permian Basin. Diamondback's leading position in the unconventional play got another leg up with the recently completed takeover of QEP Resources.
Diamondback appears well-positioned with its low-cost structure and investment-grade balance sheet, which should allow it to thrive in the ongoing commodity upcycle. The company also approved a new share repurchase program worth $2 billion in September.
The 2021 Zacks Consensus Estimate for Diamondback Energy indicates 241.5% earnings per share growth over 2020. The company currently carries a Zacks Rank #2 (Buy). Meanwhile, the fuel producer has seen its shares gain 128.7% since the start of 2021.
APA Corporation: APA boasts a large geographically diversified reserve base with multi-year trends in reserve replacement. One of the largest oil producers in Permian, the company’s Suriname portfolio is exciting too, where it continues to achieve drilling success.
APA is on track to generate $1.6-$1.7 billion in upstream free cash flow for the full year. This, together with the company’s aggressive cost management initiatives, should help in its debt reduction goal and achieve its leverage target of less than 1.5 times debt-to-EBITDA. Last month, APA got approval from the board of directors to increase the quarterly dividend by 3.75 cents to 6.25 cents per share.
Sporting a Zacks Rank of 2, the 2021 Zacks Consensus Estimate for APA indicates 433.3% earnings per share growth over 2020. The company’s shares have gained 91.6% since the beginning of this year.
EOG Resources: EOG Resources is a top-tier U.S. shale play. The United States accounts for more than 92% of the total production volumes, with the Eagle Ford and Delaware Basin being the primary contributors. Internationally, the company has operations in China and Trinidad. EOG, which pays a special dividend along with a regular dividend, should benefit from its attractive growth profile, a huge inventory of drilling opportunities, upper quartile returns and a disciplined management team.
The 2021 Zacks Consensus Estimate for #2 Ranked EOG indicates 427.4% earnings per share growth over 2020. The company’s shares have gained 88.7% so far this year.
Devon Energy: Devon is an independent energy company whose oil and gas operations are mainly concentrated in the onshore areas of North America, primarily in the United States. The company’s assets are spread across the key oil assets of Delaware Basin, Eagle Ford, Anadarko Basin and Powder River Basin.
The company’s recent merger with WPX Energy has strengthened its operations in the prolific Permian Basin. Devon’s cost management, divestiture of Canadian assets, and completion of the Barnett Shale gas assets sale will allow it to focus on its holdings in four high-quality, oil-rich U.S. basins. The company’s innovative dividend policy should also attract investors.
The 2021 Zacks Consensus Estimate for Devon Energy indicates 3,322.2% earnings per share growth over 2020. The company currently carries a Zacks Rank #2. Meanwhile, the upstream player has seen its shares gain 161.7% since the start of 2021.
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