Demand for oil is rising and prices aren’t falling, which makes it all the more exciting that energy stocks are at valuations not seen since 2008, writes Elliott Gue of The Energy Strategist.
Naive investors often make the mistake of buying a stock simply because it’s cheap.
Underperforming stocks with weak growth prospects may look like good values, but these stocks only get cheaper as prices continue to slide. Don’t buy value unless you identify a catalyst that will change the market’s perception of the stock.
The S&P 500 now trades at less than 12 times the Bloomberg consensus forward earnings estimate, compared to a long-term average of 18 times. Only in the depths of the 2008-2009 credit crunch did the broader market appear less expensive.
Analysts have lowered their forecasts for corporate earnings growth since late summer, amid fears of a new US recession and a 2008-style credit collapse emanating from Europe.
But a number of catalysts are in place that could shift the market’s expectations. US economic data have improved steadily since August, and third-quarter economic growth came in at its strongest pace since late 2010. Although the US economic recovery remains anemic, the odds of recession are receding.
The larger EU nations are developing a plan to recapitalize the region’s banks and reduce Italy and Spain’s borrowing costs by buying the country’s sovereign bonds in the secondary market. That deal should defuse a potential 2008-style global credit freeze.
Finally, reduced forecasts for corporate earnings make it far easier for companies to beat expectations.
In short, the stars are aligning for a significant re-rating of growth-oriented stocks that have been at the epicenter of the market’s recent malaise.
Energy on Sale
At the end of the third quarter, the S&P 500 Energy Index traded at less than ten times the Bloomberg consensus 2011 earnings estimate, compared to a 15-year average of 17.5 times.
Energy stocks are now at their cheapest levels since late 2008, when oil prices fell from a multiyear high of about $150 per barrel to about $30 per barrel. However, Brent crude oil continues to hover around $110 per barrel, compared to roughly $80 per barrel one year ago.
Don’t expect the uptick in demand to relent anytime soon. The International Energy Agency projects global oil demand will jump 1 million barrels per day this year and 1.3 million barrels per day in 2012 to reach an all-time high.
With oil prices above $100 per barrel, producers aren’t tightening their purse strings. There were 1,071 rigs actively drilling for oil in the US at the end of September, a record number. Drilling activity in the Middle East has also ramped up to its highest level since mid-2008, with major new projects under way in Saudi Arabia, Iraq, and other nations.
Either oil prices are headed for a 2008-style collapse, or energy-related stocks are a screaming bargain and could double in value over the next 12 to 18 months. The latter scenario is far more likely.
NEXT: The Picks
|pagebreak|Weatherford International (WFT)
Oil-services firms perform a variety of functions related to exploring for new fields, drilling wells, and optimizing production. Weatherford is the smallest of the Big Four oil-services firms, a group that also includes Schlumberger (SLB), Baker Hughes (BHI), and Halliburton (HAL).
The North American oilfield-services market has been strong for more than two years, thanks to robust activity in unconventional oil and natural-gas fields such as the Bakken Shale of North Dakota and the Marcellus Shale in Appalachia.
Weatherford International specializes in services that enhance production from older, mature wells. In the second quarter, management indicated that companies in North America are boosting budgets to squeeze more oil from their older fields. As demand strengthens, Weatherford International has hiked the prices it charges.
Spending on oil services has recovered only haltingly outside the US, but all of the Big Four reported that demand and pricing power improved in the second quarter. International oil and gas projects are sensitive to Brent crude oil prices, which are close to record highs; activity is unlikely to weaken in the near term.
Concerns about an accounting restatement earlier this year were overblown and have already been priced into the stock. Trading at a price-to-sales level that’s roughly half the industry average, Weatherford International is a buy under $28. [Shares opened Friday around $16—Editor.]
SeaDrill (SDRL)
Contract drillers own drilling rigs and lease that equipment to oil and gas producers, in exchange for a daily fee.
SeaDrill owns a fleet of 14 operating deepwater drilling rigs and had five rigs under construction in shipyards. All the company’s operating rigs are contracted under long-term deals for fixed, attractive day rates; the total value of these contracts exceeds $8 billion.
Deepwater drilling activity shows no sign of slowing outside the US, and producers anticipate a gradual return of activity in the Gulf of Mexico. SeaDrill owns the newest and most advanced fleet of deepwater rigs in the world; its equipment is in high demand and earns above-average day-rates.
Far too much has been made of SeaDrill’s debt burden. With 88% of its outstanding debt maturing after 2014, the company’s near-term refinancing needs are limited. Many of these loans are also secured by liens on deepwater rigs, which lowers the company’s borrowing costs.
Yielding almost 10%, SeaDrill’s shares rate a buy up to $38. [The stock closed at $34.32 on Thursday—Editor.]
EOG Resources (EOG)
This company holds significant acreage in some of North America’s largest shale oil and gas fields.
With natural-gas prices in the tank and oil prices surging, the company has directed about 80% of its $7 billion capital budget toward boosting oil output in 2011 and 2012. Management expects the firm’s oil production to jump 52% in 2011 and 30% in 2012.
The company will open a new unloading facility with 100,000 barrels per day of capacity in Louisiana in early 2012. The standard crude benchmark at that facility is Louisiana Light Sweet, which currently fetches almost $30 per barrel more than West Texas Intermediate.
On a price-to-earnings and price-to-sales basis, EOG Resources’ stock currently trades at its lowest valuation since late 2009, when oil prices were significantly lower. Buy EOG Resources under $125. [Shares closed Thursday just under $93—Editor.]
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