These 2 Cheap Oil Stocks Deserve A "Strong Buy" Rating

Sep.17.13 | About: BP p.l.c. (BP)

The market has recently experienced a solid rally in the past few days, as the worst-case scenario appears to have been avoided in Syria. The market also seems to be relieved that Larry Summers has withdrawn his name from consideration to head the Federal Reserve. In addition, fears about the impact of a potential "tapering" by the Federal Reserve seems to be easing and that is also helping to fuel a rally. Even as some stocks now appear extended, there are still some great bargains to consider which have significant upside potential.

With the economy in Europe starting to turn more positive and with the U.S. and China continuing to grow, it makes sense to focus on cheap oil stocks, before oil rises further. As the recovery picks up steam and "synchronizes" more fully amongst various countries and regions around the world, demand for energy should increase and take oil prices even higher. With this in mind, here are two undervalued oil stocks that appear to have significant upside potential:

Warren Resources, Inc. (NASDAQ:WRES) is an independent oil and natural gas company that is focused on exploration and production projects in Wyoming, California, Texas, North Dakota, and New Mexico. It is also a leader in coalbed methane natural gas, in the Rocky Mountain region. As a relatively smaller player in the oil industry, this company is not as widely known as some firms and that is why this stock could be a "sleeper" that quietly outperforms in the next couple of years. There are a number of factors that point to why this stock appears to be undervalued now and why it could be poised to move steadily higher:

1) This stock looks cheap when you consider it is trading near book value of $2.85 per share. It also looks very undervalued when compared to other oil firms. For example, analysts expect the company to earn 32 cents per share in 2013, 33 cents per share in 2014, and 42 cents per share in 2015. That means earnings per share could jump by about 35% in the next couple of years. It also means this stock trades for just around 8 times earnings estimates for this year. Compare that to Exxon (NYSE:XOM) which trades for about 11 times earnings and is expected to see little earnings growth in the next couple of years and you can see why this stock looks cheap. Another smaller oil company like Callon Petroleum (NYSE:CPE) has a similar market capitalization and enterprise value, however, analysts expect Callon to lose money in 2013 and earn just 2 cents per share in 2014. Furthermore, Warren Resources is expected to generate about $130 million in revenues, while Callon Petroleum is expected to have revenues of about $108 million for 2013. Warren Resources shares look very undervalued when it is compared to industry peers and even to giants like Exxon.

2) Unlike many smaller oil companies, Warren Resources is profitable and it has been growing reserves in recent years. For example, the latest 10-k filing states that total net proved oil and natural gas reserves in millions of barrels of oil equivalent (MBoe) grew from 21,617 in 2010, to 22,273 in 2011, to 24,919 as of December 31, 2012. That's a jump of about 20%, in just a couple of years. Furthermore, there is tremendous potential upside as 85% of its acreage is currently undeveloped. That means there could be substantial future growth prospects in terms of reserves and production.

3) Warren Resources shares could have near-term upside catalysts as it recently announced a deal to acquire an undivided 62.5% working interest in the Leroy Pine Project area, which consists of various oil and gas leases covering approximately 1,610 acres of land. The Leroy Pine Project is located within the Santa Maria Valley oil field in Santa Barbara County, California which was developed by Unocal between 1937 and 1994. Unocal drilled 24 wells that produced a total of 6 million barrels of oil during those years. Warren Resources expects this new project to generate 19 producing wells targeting the oil zones of the Monterey formation with drilling operations commencing in October 2013 and production operations starting in January 2014. Warren will be the operator of the Leroy Pine Project. This new development is potentially very significant since the U.S. Energy Department estimates that the Monterey oil shale formation accounts for approximately two-thirds of the oil shale reserves in the United States. The closing of this deal is expected to be announced soon and news releases providing updates on drilling operations in October and production shortly thereafter, could provide upside catalysts for this stock in the coming weeks and months.

4) Warren Resources recently reported strong financial results. For the second quarter of 2013, it earned $9.2 million, or 13 cents per share (this includes a gain on derivative financial instruments of $3.3 million), compared to net income of $5.3 million, or 7 cents per basic and diluted share, for the second quarter of 2012 (which also includes a gain on derivative financial instruments of $.5 million). Based on these results, earnings estimates could be poised to rise for the full year of 2013. Philip A. Epstein, Chairman and Chief Executive Officer, stated:

"I am encouraged by our improving production volumes and oil and gas revenues compared to the second quarter of 2012. This increase resulted primarily from a 29% increase in gas production and higher gas prices due, in part, to Warren's Rocky Mountain acquisition activities. On the oil side, after some operational issues that were resolved earlier in the quarter, Warren's production from our two Wilmington Field units has steadily grown from 3,439 gross barrels of oil per day ("BOPD") at March 31, 2013 to 3,892 gross BOPD at June 30, 2013."

5) Downside risks look minimal at current levels for a number of reasons. A major drop in oil prices could be a potential downside risk, but that seems unlikely now especially when seeing how strong oil has traded recently. Balance sheets can be another risk factor to consider with smaller companies but Warren Resources has a solid balance sheet and about $55.5 million of borrowing capacity available at June 30, 2013. In addition, the company's borrowing base was increased by $5 million in May 2013.

6) Analysts are getting bullish on Warren Resources and more could join in thanks to the new shale project in California. Analysts at Sidoti believe this stock could nearly double in value and have set a buy rating with a $5 price target. With the global economy picking up steam, and tensions remaining high in the Middle East, oil prices appear poised to stay strong and even rise in the coming months and years. This general upward trend in oil prices could put a "floor" under this stock and drive it up to the $5 price target, which would be a much more reasonable value considering the profitability, earnings growth and potential of the new shale project.

Here are some key points for WRES:
Current share price: $2.88
The 52 week range is $2.40 to $3.40
Earnings estimates for 2013: 33 cents per share
Earnings estimates for 2014: 34 cents per share
Annual dividend: n/a

BP plc (NYSE:BP) appears to be possibly the most undervalued stock out of all the major integrated oil companies. This is a world-class firm
and it has made substantial progress in dealing with claims since the 2010 oil spill in the Gulf of Mexico. Even so, it seems that some investors are still avoiding this stock and that could be why it is still cheap.

BP reported adjusted earnings of 86 cents per share for the second quarter of 2013, and this was below analyst estimates of $1.09 per share. However, this short-term disappointment appears to be a buying opportunity, especially since BP shares trade for just over 8 times earnings and offer a dividend yield of over 5%.

Analysts expect BP to earn $4.73 per share in 2013 and $5.31 in 2014. This puts the price to earnings ratio at just over 8 times earnings which is a substantial discount of nearly 30%, when compared to the PE ratio of industry peers, like Exxon or Chevron (NYSE:CVX). It's also worth noting that a PE multiple of 8 is about half of what the S&P 500 Index trades at, which is right around 16.

In addition, with a yield of about 5.2%, BP also offers investors more when it comes to the dividend. The average yield for the S&P 500 Index is just over 2%. For Chevron, the yield is around 3.2% and Exxon brings up the rear with just 2.9%. Furthermore, with BP paying a dividend of just over $2, and with earnings estimates at about $5 per share, the dividend appears safe and it could rise over time.

As mentioned above, BP is expected to grow earnings by about 15% by 2014. That represents very solid growth for a company of this size. By contrast, analysts expect Exxon to earn $7.60 per share in 2013 and just $7.98 per share in 2014. That shows very little earnings growth for Exxon, which is trading at a premium to BP. Furthermore, BP still continues to explore and make new discoveries which could drive growth for years to come. The company recently announced that its subsidiary "BP Egypt" has discovered a huge gas deposit in the East Nile Delta while drilling the deepest well ever in that region. The company also has projects with high potential in the Gulf of Mexico, Russia and in other parts of the world.

In addition to the usual risks that come with investing in the oil sector, BP also still faces some litigation and "headline" risks from the oil spill. However, these claims and any remaining investor negativity over the oil spill is likely to fade over time, just as it did for Exxon, years after the "Valdez" oil spill. While waiting for a higher share price, investors will continue to be generously rewarded with a 5.2% yield that few stocks can compete with.

Here are some key points for BP:
Current share price: $42.12
The 52 week range is $39.58 to $45.45
Earnings estimates for 2013: $4.73 per share
Earnings estimates for 2014: $5.31 per share
Annual dividend: $2.16 per share which yields 5.2%

Data is sourced from Yahoo Finance. No guarantees or representations are made. Hawkinvest is not a registered investment advisor and does not provide specific investment advice. The information is for informational purposes only. You should always consult a financial advisor.

Disclosure: I am long BP, XOM. 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.