Energy stocks are still a buy after big gains — here are 12 to consider

Why would it? Normally when the popular media like a group, it is time to think about moving to the sidelines because the endorsement is a sign the crowd has arrived. Once everyone in a group likes a particular stock or sector, who is left to buy?

This time, however, it’s different. Those are some of the scariest words in investing, I know. But below are three reasons why, and 12 stocks to consider. At a high level, the bullish case has two parts.

1. Energy stocks are up a lot in the past year, but they still are nowhere near pre-pandemic levels — while energy prices are back up there or much higher.

2. Organization of the Petroleum Exporting Countries (OPEC) and U.S. shale producers probably won’t rush to over-produce — the risk because it would knock down energy prices. Supply growth will be limited. Demand will remain strong.

Let’s take a closer look at the basics here.

Room to run

Energy stocks are really up a lot in the past year. It’s the kind of big move that makes you think it’s time to step aside. How big?

On Nov. 20, I predicted energy stocks would be 60% higher in a year. I was wrong. The eight oil stocks I suggested in that column were up 77% as of the Sept. 28 close. The three natural gas stocks were up 97%. That’s more than four times the 18%-23% gains for the Dow Jones Industrial Average DJIA, -0.78% and the S&P 500 SPX, -0.27%. My stocks also beat the five energy ETFs I mentioned in that column, which were up 57.4% as a group.

Despite this advance, there’s headroom for more gains. Consider the following.

1. The SPDR S&P Oil & Gas Exploration & Production ETF XOP, +0.31% is still 46% below pre-Covid highs in October 2018. But the price of oil has returned to those levels. Natural gas is 30%-80% higher. And energy prices are probably destined to stay high.

2. Energy stocks are still arguably cheap. Stocks in the Guinness Atkinson Global Energy Fund GAGEX, -0.40% have a free cash flow yield (free cash flow divided by market cap) of around 9%-10%. That’s the highest level in the past decade, including 2014 when Brent oil was at $100 a barrel, says Will Riley, who helps manage the fund. (Free cash flow yield increases as stock prices decline.)

 “We think energy equities discount oil price in the low $50s [per barrel],” says Riley. “If you believe, like we do, that a long-term price of $60 is appropriate, then there is upside,” he says.

Goldman Sachs this week raised its year-end oil price target to $90, citing the global demand recovery and tight supply. Riley is worth listening to because his fund beats its energy equity category by four percentage points, annualized, over the past five years, according to Morningstar.

Energy stocks have an enterprise-value-to-EBITDA ratio of around four compared to a pre-pandemic level of five to seven, says Benton Cook, who manages the Hennessy BP Energy Transition Fund HNRIX, -0.11%. “The valuation reflects a long-term oil price of $50 to $55,” says Cook, whose fund outperforms competing funds by 3.8 percentage points, annualized, over the past five years, says Morningstar.

Supply will remain constrained

Typically, price increases attract supply, which pushes down prices. Oil has been notorious for this, because U.S. shale producers have been quick to pump more oil to capitalize on higher prices. Likewise, OPEC members have been prone to boost production or cheat on quotas, to book more sales.

That’s not likely to happen this time for a simple reason. The OPEC countries and other major energy producers like Russia have underinvested in well development over the past several years. So now there’s limited new supply coming online as old wells decline and demand picks up.

“We went through a period of significant underinvestment,” says Stan Majcher, a co-portfolio manager at the Hotchkis & Wiley Mid Cap Fund HWMAX, -0.51%. “The world has underspent and demand is coming back and there might not be the supply that people think.”

New projects can take two to 10 years to come online, so even if investment picked up now, it wouldn’t help for several years. Saudi Arabia is unlikely to go along with OPEC production increases that knock down oil prices because oil has to be at $70 for its budget to balance.

U.S. shale oil producers are unlikely to come roaring back. Banks are cautious about lending to them, and these companies are focused on paying down debt and returning cash to shareholders, says Simon Wong, vice president equity research at Gabelli Funds. “All the producers I talk with are discipled about holding back on production,” he says.

U.S. energy companies including Devon Energy DVN, +0.03% and Pioneer Natural Resources PXD, -1.27% have introduced a variable dividend on top of the regular dividend, and investors like it. Their stocks are outperforming. U.S. shale producers have gotten the idea that capital discipline is being rewarded by the stock market, says Riley, and they are likely to stick to the game plan.

Given the regime change in Washington, D.C., following the last presidential election, U.S. producers are also cautious about investing because of the risk of heightened government regulation, says energy sector investor Steven Schuster of Bridge Street Asset Management.

Demand will remain strong

Covid cases and hospitalizations are in a significant downtrend. This is likely to continue because vaccines and herd immunity are controlling the spread of the virus. Last year, the flu season did not bring a significant increase in cases. So maybe we can expect the same again this year.

As Covid recedes, the economy will continue to normalize, and this will boost energy demand. It’s already happening. “Energy demand numbers are surprising to the upside in this Covid recovery period,” says Riley. “The main area lagging was aviation fuel. Even that segment of oil demand is picking up.”

Meanwhile, the economy will benefit from factors like increased government spending, meaningful pent-up demand, and a Fed that will be cautious about killing off growth with monetary policy tightening.

The transition to renewable energy remains a risk for fossil fuel demand, but this will be gradual.

“We are not going to be able to transition overnight to a world powered by wind and solar backed by storage,” says Cook, at the Hennessy BP Energy Transition Fund. “The easiest transition will be toward cleaner hydrocarbons, and that is natural gas.”

Stocks and ETFs

Goldman Sachs recently suggested six energy stocks that will benefit from turnarounds as well as strong energy prices, including the producers Exxon Mobil XOM, -0.76%, Occidental Petroleum OXY, -0.81% and Baker Hughes BKR, -0.54% in energy services.

Wong at Gabelli likes Canadian energy producers that look cheap because they are trading at elevated free cash flow yields of around 20%, including Cenovus Energy CVE, +0.50% and Suncor Energy SU, +0.27%. He also singles out the services companies Halliburton HAL, -1.94% and Schlumberger SLB, -1.66%, which will benefit as development picks up.

Majcher at the Hotchkis & Wiley Mid Cap Fund favors cash flow rich companies with strong balance sheets. Their financial strength means they could benefit from stock buybacks and from a possible M&A wave — either as targets or buyers who benefit from cost cutting. He cites Marathon Oil MRO, -0.04% and Penn Virginia PVAC, +6.68%.

In natural gas, Cook at Hennessy likes Cheniere LNG, +1.30%, a liquid natural gas play that is starting to pay dividends, and Comstock Resources CRK, +0.53%, a natural gas producer in the Haynesville shale — a good location because it is close to the Gulf Coast.

In my stock letter, Brush Up on Stocks (the link is in bio below), I recently reiterated the natural gas company Continental Resources CLR, -0.19%. It’s up more than 400% from where I suggested it last year during the depths Covid crisis, but a repeat signal in the system I use to find stocks suggests it is still buyable around current levels.

For exchange traded funds, consider Energy Select Sector SPDR Fund XLE, -0.58%, iShares Global Energy IXC, -0.11%, VanEck Vectors Oil Services OIH, -0.92%, SPDR S&P Oil & Gas Exploration & Production and Alerian MLP AMLP, -0.09%.

Be careful with uranium stocks. Sprott Asset Management has been purchasing uranium for its Sprott Physical Uranium Trust (ticker: SRUUF), driving up the spot price. Uranium stocks have moved up with that spot price, and the stocks look fairly valued here, says Cook.

Michael Brush is a columnist for MarketWatch. At the time of publication, he owned XOM, LNG and CLR. Brush has suggested XOM, OXY, BKR, HAL, SLB, LNG, CRK and CLR in his stock newsletter, Brush Up on Stocks. Steve Schuster subscribes to Brush Up on Stocks. Follow Brush on Twitter @mbrushstocks.