These two energy companies are pumping money into investors and their stock prices are cheap

We are in a perfect storm for energy commodity prices, and not just because of the disruption caused by Russia’s invasion of Ukraine.

A long period of underinvestment in oil exploration and the development of new sources of oil and natural gas supplies is also holding back supply. This is bad news for consumers who still rely on fossil fuels.

But there’s a silver lining for shareholders of good companies, according to Sam Peters, portfolio manager at ClearBridge Investments.

ClearBridge is based in Baltimore and has approximately $208 billion in assets under management. Peters co-manages the ClearBridge Value Trust LMNVX,
-2.86%
and the ClearBridge All Cap Value Fund SFVYX,
-2.69%.

US energy companies are of course benefiting from higher oil prices and their stocks have risen. But even before Russia began the buildup of armed forces that led to its invasion of Ukraine, “we were in for regime change for energy markets,” according to Peters.

During an interview, Peters said that the transition from fossil fuels to green or sustainable/renewable energy would take several decades.

“Spending will increase from $1 trillion a year for alternative energy to $4 trillion – this will be the largest spending cycle yet,” he said.

But we are still at a very early stage in the transition cycle. And the angst in Europe over its reliance on Russia to supply natural gas for winter heating is an example of how markets can be skewed when a long-term policy on which people can easily agree comes up against more short-term realities.

The need for fossil fuels during the decades-long energy transition and the current underinvestment environment point to an opportunity for investors right now, even though energy stocks have already risen so much.

For fossil fuels, Peters thinks focusing on reducing their own carbon emissions will give U.S. producers a long-term advantage.

Energy stock prices are still relatively low

set of facts


Above is a three-year chart showing the price movement of West Texas Intermediate (WTI) CL00 initial crude oil contracts,
+3.95%.

WTI for delivery in April CL.1,
+3.95%
was trading at $109.71 a barrel at the start of March 2. It’s a good recovery from the early pandemic plunge, but WTI was well below $70 in the second half of 2019.

The S&P 500 energy sector is up 27.9% this year and is the only sector in the S&P 500 SPX,
+0.99%
showing a gain from 2022 through March 1. In 2021, the energy sector grew by 90%. But over the past three years, the energy sector is up just 10.6% — by far the worst among the 11 S&P 500 sectors, despite skyrocketing oil prices.

Here is a comparison of the forward price-to-earnings ratio (based on rolling consensus estimates among analysts polled by FactSet) for the S&P 500 energy sector and the full index:

Sector or index Current forward P/E 10-year term average P/E Current valuation at the 10-year average Current S&P 500 valuation 10-year average valuation on the S&P 500

S&P 500 Energy

17.01

18.54

92%

82%

96%

S&P500

20.71

7:31 p.m.

107%

Source: FactSet

Despite the surge in oil and energy stocks, the energy sector is still trading relatively low compared to the full index and its average valuation over the past 10 years.

Silver lining for investors

Peters shared this graph, showing the movement of the energy industry’s estimated capital expenditures for oil exploration, source development and production relative to the level of US inventories from 2004 to 2021:

On the left, the graph shows that capital expenditures increased when supply was low. On the right side of the chart, you can see a dramatic drop in capital expenditures as inventories began to decline.

Capital expenditures have fallen for more than one reason. In a depressed price environment (as you can see in the first chart above), oil producers had to cut back their investments if they were below breakeven where they were exploring. There have also been regulatory and legal hurdles with pipelines and the influence of activist investors in some companies, particularly Exxon Mobil Corp. XOM,
+1.36%,
focus more on alternative energy sources while placing less emphasis on oil exploration and supply development.

Oil producer boards have also become more disciplined when it comes to spending, according to Peters. They don’t want to be burned again the next time oil prices plunge. Peters expects this discipline to continue, with increased cash flow more likely to be paid out to shareholders than invested in capital expenditures.

Peters sees a perfect setup for investors. Even if oil prices were in the range of $75 to $80 a barrel, “you’ll get very high free cash flow at most US power companies,” he said. A company’s free cash flow is its remaining cash flow after capital expenditures. It is money that can be used for expansion, to pay dividends, to buy back shares or for other corporate purposes.

He thinks oil prices are likely to stay high for some time, not just because of a possible disruption in Russia’s contribution to the global oil market, but because “OPEC is under-producing its quotas.

Two choices of energy stocks for natural gas and oil

Here are two energy stocks Peters says are particularly attractive right now:

EQT Corp. EQT,
+1.19%
produces natural gas and controls about 6% of the US market, according to Peters. The stock closed at $24.42 on March 1. With a regular quarterly dividend of 50 cents per share, the dividend yield is 2.16%. Peters likes the stock because of its potential as the global natural gas market goes through its own transition, with European countries seeking additional sources to reduce their dependence on Russia.

“EQT will generate more than 100% of its current market capitalization by [free cash flow] over the next three or four years,” he said, which could mean increases in dividends, special dividends and increased share buybacks (which reduce the number of shares, increase profits and cash flow per share and support rising stock prices).

EQT’s annual regular dividend rate of $2 per share appears to be well covered. The consensus among analysts polled by FactSet is that free cash flow per share is $2.94 in 2022, and increases significantly to $4.51 in 2023 and $5.60 in 2024. The company also has a $1 billion share buyback program in place, which is a big clearance relative to its $9.18 billion market capitalization.

When discussing the environmental impact, Peters said: “EQT will have effectively reduced its produced carbon and methane emissions to zero by 2025.”

He added: “Russian natural gas is one of the dirtiest substances, but EQT produces some of the cleanest molecules around. And they do it cheaply and no one seems to care. It’s incredible.”

The other energy stock named by Peters was Pioneer Natural Resources Co. PXD,
+0.29%,
who is an oil producer and explorer. PXD closed at $240.47 on March 1 and pays a variable dividend. For example, for the first quarter, the company paid a dividend of $3.78 per share, which Pioneer said consisted of a “base” dividend of 78 cents and a variable dividend of $3.00. The basic dividend increased by 62 cents and the variable dividend decreased slightly from $3.02 in the prior quarter.

Peters said PXD is “drowning in free cash flow” and expects a cash dividend yield of around 11% for 2022, “in addition to debt repayment and the buyout of shares”. The company has a $2 billion share buyback program in place and its market capitalization is $58.4 billion.

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