[Editor's note: A version of this story appears in the June 2020 edition of Oil and Gas Investor. Subscribe to the magazine here.]

Low oil prices might be the cure for low oil prices by year-end, but for now, “There ain’t no cure for the summertime blues,” as the song covered by the likes of The Who and Alan Jackson said.

Oil and gas equities were under siege well before the OPEC+ price war erupted in early March and COVID-19 simultaneously swept the globe to stop economies in their tracks, killing oil demand. Storage tanks began to fill. Then came April 20; let’s call it Black Monday. The near-month contract for WTI briefly plunged below zero, dragging energy stocks along for a hairy ride. Both recovered somewhat over the next few weeks, but uncertainty left investors mulling their options.

It has been difficult for analysts to make any Buy calls for the near term, much less for longer, when E&P companies under coverage are in flux and suspending their production guidance and markets are gyrating. Many analysts have suspended price targets or earnings estimates until the second half of this year comes into focus, much less 2021.

John White, managing director at ROTH Capital Markets, said he suspended all coverage of the E&P and service sectors and that all his ratings became Neutral until companies revise their guidance. He’s emphasizing free cash flow, a good credit position and hedge strength. Later, however, he issued a Buy on Earthstone Energy Inc. because it is 80% hedged for the year at a blended rate of $58.90/bbl. Later, he upgraded Talos Energy Inc. to a Buy, citing its low leverage, hedges and a low decline rate.

“Visibility is virtually nonexistent. Take all of this [our report] with a grain—no, a fist—of salt,” said the E&P analysts at Simmons Energy Co. in one of their reports in mid-April.

At press time, WTI for June delivery was hovering between $13/bbl and a whopping $17/bbl, with the 12-month strip a woeful $25/bbl. In a research note, Simmons highlighted the problem E&P companies face: They need $15/bbl to cover production costs, $20 to cover all cash costs and $50 to hold production flat within cash flow in 2020 (not counting any hedging gains they may be lucky enough to book).

As oil fell to $20 and below, Bakken and Eagle Ford producers were starting to shut in some wells. First-quarter conference calls indicated many companies intended to stop drilling, hoping to keep production flat at best. Announced production cuts totaled about 600,000 bbl/d, and analysts estimated U.S. oil output could fall by as much as 1MMbbl/d or 2 MMbbl/d by year-end.

The U.S. oil-directed rig count was down by about 50% from 2019 levels to the lowest count since July 2016, dropping below 500 in the week ending April 24, according to Baker Hughes Co. The Permian count fell below 250.

Leo Mariani with KeyBanc Capital Markets.
“I don’t think valuations matter much in the near future. It’s more about which companies will have less damage and can come out the other side,” said Leo Mariani with KeyBanc Capital Markets.

In such an unprecedented environment, can any long-term Buy signals be found? Surely this is a great time to hunt for bargains. At this point, analysts said, it is really about identifying which companies will lose the least this year.

“I don’t think valuations matter much in the near future,” Leo Mariani, analyst at KeyBanc Capital Markets, told Investor. “It’s more about financial liquidity, not having any bonds due soon, hedging and which companies will have less damage and can come out the other side.”

He said he hoped for a U-shaped recovery, which is his base case. 

Looking for multiples 

Multiples of EBITDA won’t expand in 2020 because most companies will report lower production and lower cash flow through year-end. However, analysts think these metrics will improve in 2021 as cash flows rise, and even if their production is held flat, oil prices should recover enough to be above $30/bbl, therefore improving cash flows.

“Today, there is no discussion about which company has a multiple of X or Y; it’s more about survivability,” Mariani said. “Stocks are trading down to the point that investors are assuming no recovery or that we stay at or below $40/bbl, but no one knows how this will play out.”

Multiples were trending lower compared to historical numbers before the dual oil price/virus crisis hit, he said. Traditionally, E&Ps have traded at five to 10 times earnings over the past 10 years, but lately they were trading at multiples of only three to six times, he said.

Mariani covers 29 names, from small caps under duress such as Gulfport Energy Co. to much larger and more solid players like EOG Resources Inc., so he has plenty to chew on. He’s bullish for 2021, thinking WTI will get back into the $50s as the economy recovers—indeed, his official forecast is $55/bbl for oil and $2.30 for natural gas next year.

In addition, he said he is optimistic because many companies on his coverage list are well hedged and many have less debt than they did in the last big downcycles seen in the ’90s or in 2008 to 2009.

Others are not as optimistic, with bankruptcy tracker Haynes and Boone LLP telling Reuters that the law firm expects that up to half of the top 60 independent producers will need to restructure their balance sheets.

Safety in hedge books 

In these trying times replete with dire forecasts, analysts and investors will have to rely on highly selective core holdings rather than going out on a limb. That means stocks of companies with the strongest balance sheet, best assets, scale and lower costs can survive.

“Buying E&P stocks during an oil freefall doesn’t typically work out, so our message is to sit tight and remain patient,” John Freeman of Raymond James said in a written note. “However, now is the time to get your shopping list ready.”

E&P Stocks to Watch: Looking for Gain, Not Pain Illustration
(Illustration by Robert D. Avila)

In late March Freeman said a buying opportunity would open up in the second quarter, with some names approaching low valuations never seen before. Despite the crash in oil prices, he cited Permian pure-plays such as Diamondback Energy Inc. and Parsley Energy Co., noting both can generate free cash flow even at these low oil prices. He said Concho Resources Inc., Devon Energy Corp. and WPX Energy Inc. also screened well, with “Concho, in particular, looking safest given its robust 2020-2021 hedge book.”

In such an environment, it’s no surprise that analysts recommend taking a defensive posture. They favor companies with a good hedge position and geographically diverse operations. Mariani’s stock picks in April reflected this philosophy.

“Anyone who buys EOG now will have really good upside; it could be almost a double,” he said. “The pure-play Permian names should do well. A SMID [small and midcap] I like a lot is WPX; it’s trading at $4 and could double. SM Energy Co. has been absolutely clobbered but could go up a multiple of the current price. It’s 90% hedged.

“And I like Concho a lot. It’s done well on the downside compared to some other names. Parsley could potentially double,” he said.

Mariani cited SM Energy as an outlier of sorts, although its stock price at the time certainly indicated it is viewed with a lot of concern by most observers. He also cited Gulf of Mexico explorer Talos Energy Inc., which is well hedged.

He said he favors some of the well-hedged small-cap E&Ps because they have been beaten down so much that their upside looks good, mentioning Magnolia Oil & Gas Corp., Brigham Minerals Inc., Diamondback Energy and WPX.

“The companies that will survive and do well are pretty obvious,” another analyst told Investor off the record. “But at the end of 2019, no one on the buy-side cared about the oil and gas sector, and now they care even less. I’ve been told that the buy-side in all sectors is not looking at valuations right now anyway. They are looking at what’s going to happen to a business during this crisis and what it will look like after the crisis.

“I think this situation is going to change everything forever. It’s going to change how investors look at equities and how banks look at lending—and that’s true for every industry, not just oil and gas,” the analyst said.

For Morgan Stanley’s E&P team, the core holdings meant a lineup of the usual favorites often touted by many other sell-siders: Chevron Corp., ConocoPhillips Co., Noble Energy Inc., Hess Corp., Pioneer Natural Resources Co., Concho, EOG, Parsley and Cimarex Energy Co.

The team at Simmons Energy developed a list based on where things stood on April 24, placing the E&Ps under coverage into three main buckets:

  • Bottom fishing: stocks that are in longterm decline but starting to make a multimonth rounding bottom;
  • Positive developing: a much longer list, where stocks have reversed their woeful decline or have crossed back above their 50- to 200-day moving average; and
  • Positive trending: stocks that are trending positive to make a new series of higher highs or higher lows and are above their 50- to 200-day moving average.

Only two stocks were on the latter list, and unsurprisingly they were gas-oriented: Range Resources Co. and Cabot Oil & Gas Corp., both heavy-duty Marcellus producers.

The bottom fishing list included disparate core holdings such as global giants BP Plc, Royal Dutch Shell Plc and Total SA as well as U.S. independents Callon Petroleum Co., Chesapeake Energy Inc., EOG and Viper Energy Partners.

At Siebert Williams Shank & Co. LLC, analyst Gabriele Sorbara listed Diamondback Energy, Concho, Parsley and Pioneer, all Permian oil-weighted names, as top picks. His Buy ratings were Devon Energy, PDC Energy Inc., WPX and Cimarex.

Jeff Grampp of Northland Capital Markets listed Earthstone Energy Inc., Rattler Midstream LP, Ring Energy Inc., Diamondback, Parsley and Callon as his favorites.

“We continue to prefer ‘resilient’ companies including Overweights Chevron, Conoco, Noble Energy and Hess…,” wrote Devin McDermott at Morgan Stanley & Co. “While Pioneer and Cimarex also screen well against peers, Texas regulatory interventions into free markets could become a risk … this is also a risk for much of our midstream coverage.”

Like most observers, McDermott thought OPEC production cuts and additional cuts by U.S. companies would be unlikely to match the decline in global demand this year, estimated to be anywhere from 25% to 35% off the norm. He predicted that well shut-ins in the U.S. are a given.

If oil ends up soaring later this year, Bernstein’s Bob Brackett said his Buys would include what he called “lower-tier” stocks such as Devon and Apache Corp. In mid-March he analyzed the near-term note obligations of 80 E&P names and noted that if oil was $30/bbl, then the following would generate enough cash to pay off debt but might also have to refinance or cut dividends to do so: Canadian Natural Resources Ltd., Chesapeake Energy Corp., QEP Resources Inc., Apache and EQT Corp.

Until the direction of health trends becomes clear and the pace of the world’s economic recovery is known, the price of commodities is in doubt, so estimating the stock performance of most E&P companies over the next 12 months is not going to be a rewarding game. Laggards could linger, or a V-shaped recovery could reward investors with huge upside off these terrible lows.

“The hot potato clearly has a name, and it is called [oil] storage,” said Rystad Energy in a report as April drew to a close.