My Two Favorite Energy Stocks Today

Remember just over a decade ago when the subprime mortgage crisis made homebuilders a bargain? That’s where energy stocks are today.

two oil rigs in a field

Given the state of today’s housing market it may seem strange to look just a little over a decade in the rear-view mirror and revisit the subprime mortgage crisis, widespread housing price crash and the Great Recession. If you were an investor at the time you likely remember the wild volatility and significant daily losses that were unlike anything we’d seen in years and which wouldn’t be replicated until the pandemic sell-off just last year.

And while the broader equity markets rebounded at a reasonable pace (the Dow and S&P 500 reached pre-crisis levels in 5-6 years, Nasdaq in a little over 3), a few sectors languished and traded sideways for years. When these events arise they may seem unique, but students of the market know that the sectors and companies may change but the song remains the same. An ignored and neglected sector inevitably becomes a potentially profitable turnaround target.

Back in 2011, that turnaround situation was housing, which had been declining for six years and saw many stocks completely fall apart—Lennar (LEN), a major homebuilder, fell as much as 95% from its highs (the ultimate bottom was in 2008) and even in 2011 was still sitting 82% off that all-time high. But it (and the sector as a whole) began to change character and business showed signs of picking up, which allowed homebuilders to enjoy a solid run during the next year or so.

Today, we’re seeing a similar situation play out with traditional energy stocks – whether it’s explorers (down 89% from mid 2014 through October of last year) or service firms (down more than 90%), the entire group went through the wringer for many years due to debt worries, falling prices, imploding demand and the like.

But similar to homebuilder stocks years ago, that caused a change in the sector’s thinking—whereas oil companies were all about new basins and production growth a few years ago, today most have slashed expenses, are growing output at a manageable pace and, now that prices are rising, should spin off mountains of free cash flow. Throw in positive momentum on the chart (the sector has been outperforming the market for more than four months, the longest stretch of time in years) and we think there’s opportunity here, especially after the next pullback in the group.

If you want to keep it simple, there’s nothing wrong with just owning a broad ETF—we prefer the SPDR Oil & Gas Fund (XOP), which focuses on explorers and isn’t too concentrated (top holdings are 3% to 5% of the fund) in mega-cap stocks. Like most names in the group, the fund has come alive since November and is under extreme accumulation.

My Two Favorite Energy Stocks Today
As for individual stocks, two of our favorite names are Diamondback Energy (FANG) and Pioneer Natural Resources (PXD)—two good-sized explorers that have two things in common that are attracting big investors.

The first is that both were on the offensive even during the prolonged industry bust and last year’s pandemic. Diamondback just completed a buyout of Guidon (from a private equity firm) and will soon finish its purchase of QEP Resources, which together will net them 80,000 acres in the Midland basin. Pioneer, meanwhile, just completed its takeover of Parsley Energy, which many said had some of the best acreage in the Permian Basin when it was a standalone outfit.

The second factor is even more important—after years of downtimes, these (and others) explorers have shifted their focus. Instead of taking on tons of debt and expanding production at all costs, these operators have cut costs, boosted efficiencies and, now that prices and demand are back up, are beginning to throw off tons of cash. In 2021, Diamondback is aiming to keep production relatively flat, but believes it will produce $4 per share of free cash flow (after CapEx) even at $40 oil. At $60 oil, that figure should be north of $7.50 per share!

Pioneer is on a similar track—its breakeven oil price is in the high $20s, it cranked out $689 million of free cash flow last year and sees $2 billion of free cash flow this year (more than $9 per share) at $55 oil. (Current oil prices are in the mid-$60s, though usually these firms collect a bit less than the market price.)

Both FANG and PXD have had huge runs since the November cyclical stock blastoff (FANG has been down just three of the past 17 weeks!) that look like the initial leg up of a new bull phase. (Interestingly, the initial housing stock advance lasted 18 weeks before chopping around for a while.)

We wouldn’t chase energy stocks up here, but the next pullback into support will probably offer some tempting opportunities if the overall market is still holding up.

What’s your favorite energy play for the sector turnaround?

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