The year 2022 has been kind to oil companies, largely because price surges tied to Russia's war on Ukraine.
The S&P Oil & Gas Exploration & Production Select Industry Index has climbed 16% year to date, while the S&P 500 has dropped 20%.
But over the last month, the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) has underperformed the S&P 500 by 27 percentage points. The ETF has plunged 29%, while the S&P 500 has lost only 2%.
That shift has come “as investors have focused on the likelihood of a recession,” Wells Fargo analysts wrote in a commentary. So where do oil producers stand?
“While an economic slowdown is certainly a risk for shale operators and commodity prices, the recent weakness is overdone,” the analysts said. They offer several reasons:
1. “Discounted valuations for the sector,"
2. “Tight global commodity markets that should underpin product prices above current [levels],” and
3. “The potential for even stronger shareholder return initiatives in the third quarter, as Shale 3.0 [the latest phase of shale production] allows [producers] to generate significant cash flows.”
Sharp Commodity Declines to Start
As for an economic downturn, “commodity prices tend to decline sharply at the early stages of a recession/slowdown, as demand destruction leads to over-supply,” the analysts said.
“Shale operator cash margins and balance sheet leverage deteriorate at lower commodity prices, making them less desirable.”
That conventional wisdom is what’s likely behind recent underperformance of oil producer stocks, the analysts said.
“However, tight inventory levels for both oil and [natural] gas, limited foreseeable supply upside, and strong cash flow generation/return of capital makes the recent pullback in stocks a buying opportunity,” they said.
The companies they cover are poised to generate a 6.6% free-cash-flow yield for the second quarter. “Critically, they could return half or more of that cash to shareholders,” the analysts said.
Where to Jump in
“This could be a near-term catalyst for investors to refocus on the U.S. exploration and production sector. Indeed, with some of our favored names declining more than 25% in the last month, this may be an opportune time for investors to get off the sidelines.”
In choosing stocks, investors should “stick with quality,” the analysts said. “We entered the year with a bias for large-cap, quality stocks with deep inventory, solid balance sheets, commitment to Shale 3.0 capital discipline, and a transparent capital return framework.”
And the recent decline in their stocks hasn’t shifted the analysts’ view.
Their top picks are Coterra Energy (CTRA), PDC Energy (PDCE) and Devon Energy (DVN).
On the oil side, the analysts also like Diamondback Energy (FANG) and Pioneer Natural Resources (PXD).
And on the natural gas side, they like Chesapeake Energy (CHK), Antero Resources (AR) and EQT (EQT).
