A bad week for the energy sector stands in sharp contrast to the strong fundamentals of individual oil stocks. This is one situation where it pays to trust the market.
When Barron’s went looking for companies that had growth, value, and momentum, a bunch of oil-and-gas companies—particularly mid-cap U.S. exploration-and-production firms—met our criteria. And for good reason: The sector is cheaper than the overall market, has some serious earnings growth, and has outperformed in the stock swoon since the summer.
The pitch is straightforward. Take
Diamondback Energy
(ticker: FANG), whose operations are concentrated in the West Texas Permian Basin. Shares trade for around seven times expected earnings over the coming year—versus 18 times for the
S&P 500
—while analysts model earnings-per-share growth of 16% in 2024, four points better than the index. And Diamondback stock has outperformed the S&P 500 both this year and during the market pullback that began in August. The same is true of
Targa Resources
(TRGP),
Range Resources
(RRC), and
Southwestern Energy
(SWN), which also passed our screen.
While the fundamentals and the price action look good right now, the action in the oil markets suggests a tougher future. Oil prices defied gravity for much of 2023, including a surge in the first half of October as the Middle East erupted into open violence—giving traders reason to worry about disruptions to supply. But a month into the Israel-Hamas conflict, that geopolitical risk premium has evaporated. The U.S. price of crude oil fell to $75 a barrel on Thursday, its lowest in three months and down from $90 in mid-October.
The problem is one of supply and demand. Saudi Arabia, Russia, and other oil-producing nations have opted to extend their coordinated cuts, but that’s been offset by greater supply elsewhere, particularly in the U.S., where crude oil production hit a record 13.2 million barrels a day in October, according to Department of Energy data. Higher domestic production blunts the impact of supply disruptions halfway around the world. This isn’t the aftermath of the 1973 Arab-Israeli War, as far as potential global energy shocks are concerned.
Demand could be an issue too. In the U.S., the labor market is slowing and consumer spending is deteriorating as savings dry up; the euro-zone economy is on the cusp of a recession; and China continues to stumble in its postpandemic economic recovery.
For energy companies—which have been directing their ample cash flow to pay down debt, boost dividends, and repurchase shares—it’s hard to see things getting better. Investors weren’t willing to give the stocks valuation multiples anywhere near the market average in 2023, and they won’t do it in a slowing economy.
“The surprise of lower oil puts pressure on the ‘E’ [of the price/earnings multiple], which makes Energy names, although trading at a valuation discount to [the S&P 500], less attractive,” writes Evercore strategist Julian Emanuel, while downgrading energy stocks to the equivalent of Neutral from Buy.
But look on the bright side: Lower oil prices are a gift to consumers tired of paying up at the pump. Emanuel has a Buy-equivalent rating on consumer-discretionary stocks.
Write to Nicholas Jasinski at [email protected]
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