It’s time to buy the selloff in energy stocks

[Bong Hwan Ahn]

Opinion: It’s time to buy the selloff in energy stocks, starting with these 4 namesLast Updated: July 7, 2022 at 8:38 a.m. ETFirst Published: July 7, 2022 at 6:23 a.m. ET

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Michael BrushFollow

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Unfounded fears have pushed these stocks lower

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Length8 minutes

It’s never really a bear market until all the stragglers get taken out and shot. So it was just a matter of time before energy stocks, the big winners for much of the first half of this year, got nailed.

Now the Energy Select Sector SPDR Fund XLE, -0.04% and the SPDR S&P Oil & Gas Exploration & Production XOP, -0.29% exchange-traded funds (ETFs) are down 27% to 36% from their 2022 peaks – official bear-market territory.

This is an opportunity for anyone who missed the energy rally. The reason: Unfounded fears are driving the declines.

“More to come? We don’t think so,” says Ben Cook, an oil and gas sector expert who manages the Hennessy Energy Transition Fund HNRIX, -0.15% and the Hennessy Midstream Fund HMSFX, +0.60%.

Cook and I were last bullish on energy together in November 2021. After a little volatility and sideways action, XLE and XOP went on to gain 52% to 58% in eight months.

Now three factors suggest another strong move ahead for energy names, believes Cook: decent underlying fundamentals, good valuations and solid cash flows. Goldman Sachs predicts large-cap energy stocks will gain 30% or more through the end of the year and that its buy-rated stocks could be up 40% or more.

Just remember, no one can ever call the precise bottom in the market or a group. This is not a bet-the-farm-for-instant-riches kind of call.

Here’s a closer look.

1. Favorable fundamentals

U.S. exploration and production stocks have fallen so much that they are pricing in expectations of $50 to $60 a barrel for West Texas Intermediate CL.1, +2.01%, says Cook, down from around $100 now. “We think equities are pricing are more dire situation than is currently reflected in market fundamentals,” he adds.

Indeed, the 2023 futures curve for WTI suggests $88 a barrel oil next year.

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Prices for future delivery are notoriously fickle. But this oil price “forecast” of $88 for WTI is in line with Goldman Sachs “mid-cycle” oil price forecasts of $85 for WTI and $90 for Brent. It also makes sense for the following reasons.

Supply is constrained. That’s because oil companies have been underinvesting in exploration and production development. This helps explain why inventories are now meaningfully below historical seasonal norms.

“With very little supply cushion available, any further disruption to produced volumes, either geopolitical or storm-related, could send pricing meaningfully higher,” says Cook.

More: U.S. oil has tumbled — What that says about recession fears and tight crude supplies

Plus: U.S. crude-oil stockpiles likely declined in latest Energy Department data, analysts say

Demand will hang in there. The looming prospects of recession have hit the energy group hard. But this may be a false fear. While a recession would lower demand in the U.S. and Europe, demand will grow in China as it continues to lift COVID lockdown restrictions.

Besides, recession is not even necessarily in the cards. “While the odds of a recession are indeed rising, it is premature for the oil market to be succumbing to such concerns,” says Damien Courvalin, the head of energy research and senior commodity strategist at Goldman Sachs. “We believe this move[ in energy-sector stocks] has overshot.”

The global economy is still growing, and oil demand is growing even faster because of reopening in Asia and the resumption in international travel, he notes.

“We maintain a base case view that a recession will be avoided,” says Ruhani Aggarwal of the J.P. Morgan global commodities research team. The bank puts the odds of recession over the next 12 months at 36%.

Russian oil continues to flow. Despite well-founded outrage over Russia’s invasion of Ukraine, the European Union hasn’t been really effective at keeping Russian supply off the market. Europe still buys Russian oil, and any shortfall in demand there will be offset by buying in China and India.

Europe’s latest plan is to set price caps to limit financial gains by Russia. It’s not clear how this will work out. But it could backfire. In a worst-case scenario, Russia retaliates and cuts production enough to send oil to $190 a barrel, writes Natasha Kaneva of the J.P. Morgan global commodities research team. “Russia had already showed its willingness to withhold supplies of natural gas to EU countries that refused to meet payment demands,” says Kaneva.

2. Valuations

As measured by enterprise value to expected cash flows, the energy group is the cheapest sector out there now, says Hennessy’s Cook.

3. Free cash flow

U.S. energy companies continue to return lots of cash to shareholders via dividends and buybacks, notes Cook. This will support stock prices.

The free cash flow yield (cash flow divided by share price ) for the energy companies in the S&P 500 is higher than that of any other S&P sector. Based on consensus analyst estimates for 2022, U.S. energy companies will generate a 15% free cashflow yield, and exploration and production companies will generate a 20% free cashflow yield, says Cook.

These numbers confirm‎ the cheapness of the group.

This chart from Goldman Sachs s