A Promising Outlook for Oil Stocks

The energy sector has experienced a challenging week, but the individual oil stocks have shown strong fundamentals. It is crucial to trust the market in this situation.

When searching for companies that display growth, value, and momentum, we found several oil-and-gas companies that meet our criteria. Particularly, mid-cap U.S. exploration-and-production firms stand out. This sector is not only more affordable compared to the overall market, but it also exhibits significant earnings growth and outperformed during the recent stock market downturn.

Let's take Diamondback Energy (ticker: FANG) as an example. This company's operations are focused on the West Texas Permian Basin. Currently, its shares trade at approximately seven times the expected earnings for the next year, which is considerably lower than the S&P 500's valuation of 18 times. Moreover, analysts forecast a 16% growth in earnings-per-share for Diamondback Energy in 2024, surpassing the index by four points. Additionally, Diamondback stock has displayed superior performance compared to the S&P 500 this year and even during the market pullback since August. Targa Resources (TRGP), Range Resources (RRC), and Southwestern Energy (SWN) have also met our screening criteria and demonstrated similar results.

Despite the favorable fundamentals and price action presently, the behavior of the oil markets raises concerns about the future. In 2023, oil prices defied expectations and experienced an upward surge, particularly in the first half of October when violence erupted in the Middle East, creating worries about potential supply disruptions. However, after a month into the Israel-Hamas conflict, the geopolitical risk premium has dissipated. As a result, the U.S. price of crude oil dropped to $75 per barrel on Thursday, marking its lowest point in three months and a decline from $90 since mid-October.

The Problem of Supply and Demand

The current challenge in the oil industry revolves around the issue of supply and demand. While Saudi Arabia, Russia, and other oil-producing nations have chosen to extend their coordinated cuts, this has been counteracted by increased supply from other sources. Notably, the United States has seen its crude oil production reach a record-breaking 13.2 million barrels a day in October, according to the Department of Energy.

With higher domestic production, the impact of supply disruptions happening halfway across the world is significantly diminished. This situation is unlike what was experienced after the 1973 Arab-Israeli War when potential global energy shocks were a major concern.

A Potential Issue with Demand

Demand is also a looming concern in the oil market due to various economic factors. In the United States, the labor market is slowing down, and consumer spending is deteriorating as savings dwindle. The euro-zone economy is teetering on the brink of a recession, and China is still struggling to recover after the pandemic.

For energy companies, things are not looking optimistic. Despite utilizing their significant cash flow to pay off debts, increase dividends, and buy back shares, the prospects for improvement seem dim. In 2023, investors were not willing to value energy stocks at multiples anywhere near the market average. Similarly, they are unlikely to do so in an economy that is slowing down.

According to Evercore strategist Julian Emanuel, the unexpected decrease in oil prices adds further pressure to the price/earnings multiple (the "E" in the P/E multiple), making energy stocks less appealing compared to the broader S&P 500 index. Consequently, Emanuel recommends downgrading energy stocks to a neutral rating from a buy rating.

However, there is a silver lining to be found amidst the challenges faced by the oil industry: lower oil prices benefit consumers who are tired of paying high prices at the gas pump. Emanuel still holds a buy-equivalent rating on consumer-discretionary stocks.