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U.S. oil producers’ stocks have risen nearly 70% this year, but some analysts think that they’re still undervalued. To see why, it’s worth looking at the stocks on a longer time horizon. The
SPDR S&P Oil & Gas Exploration & Production
ETF (XOP) has still recorded a 14% annualized loss over the past three years.
Morgan Stanley analyst Devin McDermott wrote in a note published Friday that oil and gas stocks remain at double their historical valuation discount to the
S&P 500 index.
They normally trade at about a 30% discount in terms of earnings before interest, taxes, depreciation, and amortization to their enterprise value, but are now at a 60% discount. Meanwhile, the macro setup looks good for oil.
“In the U.S., as we head into the seasonally strong summer driving season, gasoline and distillate demand have already recovered to above pre-Covid levels, while inventories have drawn to below normal,” he wrote. “For oil prices, Morgan Stanley oil strategist Martijn Rats recently increased his long-term forecast to $60/bbl Brent and sees the potential for spikes to $80/bbl in the near term.”
Oil companies have embraced a more-restrained approach to drilling, holding back on adding rigs even as oil prices have risen. OPEC and its allies have also cut back on production, meaning that the only major factor that could cause prices to pull back in the near term is if consumers started to balk at rising prices and reduced their use of fuel.
To play a potential rebound, McDermott advises investors to look for oil stocks that have trailed peers and appear to be “on sale” as well as those that depend more heavily on changes in oil prices.
Among the discounted names, McDermott’s favorite is
ConocoPhillips
(COP), which he thinks “checks all the boxes for sustained outperformance: excellent management, disciplined investment, and consistent return of cash coupled with a high-quality, low-cost portfolio that can deliver an attractive combination of free cash flow and growth.” His price target is $85. The stock was down 0.5% in Friday trading to $58.71.
Among the names that are considered more sensitive to changes in oil prices, McDermott likes
Occidental Petroleum
(OXY),
Ovintiv
(OVV), APA (APA), and
Diamondback Energy
(FANG).
McDermott also likes Hess (HES), which he calls a “a differentiated high-return growth story.” Hess has a stake in a major project off the coast of Guyana that is likely to produce oil for years, as well as acreage in the U.S. Bakken shale that gives it more potential upside.
Among major oil companies, Morgan Stanley likes
ExxonMobil
(XOM), whose improving balance sheet has made it a favorite among analysts and investors this year.
McDermott also downgraded some stocks because of the shift to the new strategy. He dropped
Devon Energy
(DVN) and
Cimarex Energy
(XEC) to Equal Weight from Overweight because they have outperformed peers, though he still thinks Devon has 16% upside. He also lowered EQT (EQT), a major natural-gas producer, to Equal Weight, as its free-cash-flow yield may trail oil-focused producers.
Write to Avi Salzman at [email protected]