While the commodity benchmarks have retreated from their multi-year highs on recession and demand-related fears, they are strong enough for the Zacks Oil and Gas - Exploration and Production - International industry to notch substantial gains during the remainder of this year and in 2023. In this context, investors might want to focus on Tullow Oil TUWOY, EnQuest PLC ENQUF and VAALCO Energy EGY.
The Zacks Oil and Gas - International E&P industry consists of companies primarily operating outside the United States and focused on the exploration and production (E&P) of oil and natural gas. These firms find hydrocarbon reservoirs, drill oil and gas wells, and produce and sell these materials to be refined later into products such as gasoline, fuel oil, distillate, etc. The economics of oil and gas supply and demand is the fundamental driver of this industry. In particular, a producer’s cash flow is primarily determined by the realized commodity prices. In fact, all E&P companies are vulnerable to historically volatile prices in the energy markets. A change in realizations affects their returns on drilling inventory and causes them to alter production growth rates. These operators are also exposed to exploration risks where drilling results are uncertain.
4 Key Investing Trends to Watch in the Oil and Gas - International E&P Industry
Energy Prices Stay Up: Energy remains the best S&P 500 sector this year, even as fears revolving around high inflation and slowing growth have somewhat clouded its outlook. The space has generated a total return of more than 28% in 2022 against the S&P 500’s loss of around 21%. Apart from a constructive fundamental picture, the sector is enjoying support from geopolitical uncertainty amid Russia’s military operations in Ukraine. In March, crude prices surged to multi-year highs of $130 on concerns about supplies from Russia, which is one of the world's largest producers of the commodity. Agreed, oil has pulled back from those lofty levels. However, the commodity still has enough reasons to stay elevated in the near-to-medium term, with the conflict showing no sign of a quick resolution, the risk of dwindling inventory and the influential oil exporters’ group OPEC sticking to a conservative production profile. Meanwhile, natural gas hit $10 per MMBtu for the first time since 2008 earlier this year and is still trading some 75% higher year to date on the back of favorable weather and strong LNG shipments. Importantly, commodity prices appear to be at levels where the operators can generate free cash flow through their drilling activities.
Sustainable Cost-Cutting Efforts: The energy companies have changed their approach to spending capital. Over the past few years, producers have worked tirelessly to cut costs to a bare minimum and look for innovative ways to churn out more oil and gas. They managed to do just that by improving drilling techniques and extracting favorable terms from the beleaguered service providers. Moreover, driven by operational efficiencies, most E&P operators have been able to reduce unit costs, while the coronavirus-induced collapse in crude has forced them to adopt a more disciplined approach to spending capital. These actions might restrict short-term production but are expected to preserve cash flow, support balance sheet strength, and help the companies eventually emerge stronger. In particular, despite continued inflation and supply-chain challenges, cash from operations is on a sustainable path as revenues improve and companies slash capital expenditures from the pre-pandemic levels amid sharply higher commodity prices.
Strong Financial Returns for Shareholders: The sharp increase in crude prices has allowed the upstream operators to deliver a solid financial performance. In particular, cash from operations should be on a sustainable path as revenues improve and companies slash capital expenditures from the pre-pandemic levels amid sharply higher commodity realizations. To put it simply, the environment of strong prices has helped the E&P firms to generate significant “excess cash,” which they intend to use to boost investor returns. In fact, more and more energy companies are allocating their increasing cash pile by way of dividends and buybacks to pacify the long-suffering shareholders.
Concerns About Economic Growth: The year 2022 has been full of volatile back-and-forth action in the stock market, with inflation and recession concerns at the fore. Even now, the picture is quite mixed. While Fed’s scaled-back rate hike of 50 basis points, following four back-to-back increases of 75 basis points each, provided a much-needed respite to the economy, worries over a tight labor market and the lowering of next year’s GDP to 0.5% from the previous estimate of 1.2%, played spoilsport. As such, trading is expected to be choppy for the U.S. stock markets ahead, even as investors have been witnessing extreme volatility since the beginning of 2022. Risks stemming from recession fears, geopolitical tensions and dwindling liquidity may also lead to a rough road for oil/gas equities. In particular, worries about weaker energy demand due to the threat of recession might jeopardize the post-pandemic rebound in commodity consumption.
Zacks Industry Rank Reflects Upbeat Outlook
The Zacks Oil and Gas – International E&P industry is a 9-stock group within the broader Zacks Oil - Energy sector. It currently carries a Zacks Industry Rank #80, which places it in the top 32% of around 250 Zacks industries.
The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates improving near-term prospects. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.
The industry’s position in the top 50% of the Zacks-ranked industries is a result of a positive earnings outlook for the constituent companies in aggregate. Looking at the aggregate earnings estimate revisions, it appears that analysts are highly optimistic on this group’s earnings growth potential. While the industry’s earnings estimate for 2022 has surged 70.6% in the past year, the same for 2023 has risen by an astounding 458.8% over the same timeframe.
Considering the encouraging near-term prospects of the industry, we will present a few stocks that you may want to consider for your portfolio. But it’s worth taking a look at the industry’s shareholder returns and current valuation first.
Industry Outperforms Sector & S&P 500
The Zacks Oil and Gas - International E&P industry has fared much better than the broader Zacks Oil - Energy Sector as well as the Zacks S&P 500 composite over the past year.
The industry has rocketed 50.8% over this period compared with the broader sector’s increase of 25.3%. Meanwhile, the S&P 500 has lost 19.6%.
One-Year Price Performance
Industry's Current Valuation
Since oil and gas companies are debt-laden, it makes sense to value them based on the EV/EBITDA (Enterprise Value/ Earnings before Interest Tax Depreciation and Amortization) ratio. This is because the valuation metric takes into account not just equity but also the level of debt. For capital-intensive companies, EV/EBITDA is a better valuation metric because it is not influenced by changing capital structures and ignores the effect of non-cash expenses.
On the basis of the trailing 12-month enterprise value-to EBITDA (EV/EBITDA) ratio, the industry is currently trading at 3.04X, significantly lower than the S&P 500’s 11.72X. It is also slightly lower than the sector’s trailing-12-month EV/EBITDA of 3.16X.
Over the past five years, the industry has traded as high as 16.32X, as low as 2.19X, with a median of 7.05X.
Trailing 12-Month Enterprise Value-to EBITDA (EV/EBITDA) Ratio (Past Five Years)
3 Oil and Gas - International E&P Stocks to Watch For
VAALCO Energy: Founded in 1985, VAALCO Energy’s productive capacity is based offshore West Africa, where it focuses on growth through a combination of acquisitions and active drilling. The operator of Gabon offshore Etame license, EGY is known for its operational excellence and cost discipline, which are expected to generate significant free cash flows at current strip pricing.
Valued at around $489.9 million, VAALCO Energy has a trailing four-quarter earnings surprise of roughly 61.8%, on average. EGY currently carries a Zacks Rank #2 (Buy). VAALCO Energy’s shares have gained 34.8% in a year.
You can see the complete list of today’s Zacks #1 Rank stocks here.
Price and Consensus: EGY
Tullow Oil: Tullow Oil is a London-based hydrocarbon producer and explorer, focusing mainly on Africa. TUWOY’s significant positions in discovered and emerging basins and focus on capital discipline should result in a noticeable improvement in profitability. In particular, the oil and gas finder’s operational excellence and technical expertise stand it in good stead.
In addition to the favorable fundamentals, TUWOY enjoys a Zacks Value Style Score of A and Growth of B. Tullow Oil carries a Zacks Rank #3 (Hold). TUWOY’s shares have lost 20.3% in a year.
Price and Consensus: TUWOY
EnQuest: This London-based upstream operator has key operations in the UK North Sea and Malaysia. The company’s impressive production efficiency across the portfolio is at the crux of ENQUF’s growth story. EnQuest has adjusted its capital plans to the prevailing market conditions, resulting in strong operating cash flows. ENQUF also possesses an active hedging program that provides further downside protection from commodity price fluctuations.
The 2022 Zacks Consensus Estimate for EnQuest Energy indicates 46.2% earnings per share growth over 2021. The #3 Ranked ENQUF’s shares are up 6.9% in a year.
Price and Consensus: ENQUF
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