Energy Investors Have Been Drilled: One Way To Reposition

by: Alan Brochstein, CFA

With just a few days to go in 2012, investors in the Energy sector (NYSEARCA:XLE) must be looking forward to a new year. Through 12/21, the sector has returned just 3.31%, more than 10% behind the S&P 500's 13.72% price return. It's even worse for smaller stocks:

  • S&P 400 Mid-Cap Energy: -1.12% (compared to 16.29%)
  • S&P 600 Small-Cap Energy: -0.11% (compared to 14.61%)

There are 43 stocks in the S&P 500 Energy Sector, including the four largest stocks, which have remarkably similar performance:

  • Exxon Mobil (NYSE:XOM): +3%
  • Chevron (NYSE:CVX): + 3%
  • Schlumberger (NYSE:SLB): + 2%
  • ConocoPhillips (NYSE:COP): +6%

These four stocks represent market cap of $871 billion, which is about 61% of the sector's market cap. While SLB has put up reasonable growth this year (sales up 16% YTD, EPS up 25% from continuing operations and 18% overall), it has seen its PE multiple contract. CVX and XOM, on the other hand, haven't had much top-line growth.

The easy answer to the question of why the sector is out of gas seems to be low commodity prices. Oil has declined. Coal has declined. Natural gas has actually rallied slightly, but from very depressed levels at year-end 2011.

There has been one bright spot: Refiners. The best stock in the sector is Tesoro (NYSE:TSO), up 87%. Not far behind are Marathon Petroleum (NYSE:MPC) at 87%, Valero Energy (NYSE:VLO) at 62% and Phillips 66 (NYSE:PSX) at 53%. Note that PSX was spun-out this year, with the big gain from April and not for the full year.

There's been another bright spot, and that's where I want to focus. Why is it that some E&P companies, like Cabot Oil & Gas (NYSE:COG) and EOG Resources (NYSE:EOG), have done so well while others have struggled? Production growth. Energy investors need to focus on production growth in this period of "profitless prosperity" that I first mentioned a few years ago when I discussed the likely impact of huge shale reserves and modern technology leading to a glut. COG (+34%), focused in the Marcellus, and EOG (+25%), focused on several big shale areas including the Eagle Ford and the Bakken, have been able to grow revenue (and earnings) substantially this year despite weak prices due to strong production.

I think that a strategy of investing in companies capable of growing production makes a lot of sense. We can't count on price to be the driver, and there are not too many favorable hedges that will boost sales and earnings. The capital markets remain tough on the sector, forcing many companies to divest assets in order to fund drilling growth. Long gone are the days of drilling on debt, with companies now constrained to drilling within cash flow, or at least reasonably close. This constraint makes recent production growth all the more impressive for several companies.

So, which companies are using the well-bit to create value? To find the answer, I ran a screen on Baseline of all E&P companies in the Russell 3000 with market caps > $1 billion and growing sales over the past four quarters in excess of 15% and expected to grow sales in excess of 15% in 2013. Here are 11 that made the cut:

Note that Plains (NYSE:PXP) has agreed to be acquired by Freeport McMoran (NYSE:FCX). I will leave it to the reader to parse through the list to better understand what is precisely driving these remaining 10 companies, but it's probably worth spending the time. It looks like a good mix of oil and gas and a variety of shale formations. I have included some other information.

First, note that I sorted the list on YTD return. The green-shaded stocks are up more than 20% YTD, while the red-shaded ones have actually declined. The balance are up between 3% and 11%.

I have included two statistics to help judge the balance sheet, including the traditional net debt to capital, as well as a comparison of the debt to market cap. I highlighted debt-free Gulfport (NASDAQ:GPOR), which actually just issued stock (not reflected, as this is through Q3) to pay for some Utica shale acreage. They are guiding massive production growth for 2013: 7.6-7.9mm BOE after the acquisition (up from 6.5-6.8mm BOE) vs. 2.7-2.8mm BOE for 2012. Several of the other companies have less than 20% debt to market cap.

The very least revenue growth in 2013 is 17%, with most above 35%. While "EPS" may not be the best metric for E&P companies, five of the 11 companies have grown earnings more than 20% over the past four quarters. GPOR is the only company not expected to grow EPS faster than 17% in 2013.

I included PE, EV/EBITDA and Price to Tangible Book. Again, most investors in the sector probably aren't relying on PE, but most of the companies have PE ratios below 20. I highlighted two with EV/EBITDA below 8, including PXP and Rosetta Resources (NASDAQ:ROSE). Several others are below 10, which isn't bad for rapidly growing E&P companies.

Energy has been tough in 2012. I think that pressure on the sector due to lackluster price action for the underlying commodities may have obscured some very impressive growth. The companies I shared have, for the most part, trailed the market this year despite strong sales and earnings growth. While there is always the risk that prices decline, offsetting the production growth's impact on sales and earnings, but these companies will really benefit in the event prices do pick up. In the long run, production growth is likely to be the key driver.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.