The SPDR S&P Oil & Gas Exploration & Production ETF (XOP) had outperformed the S&P 500 by about 89% as of early June. Four weeks later, the fund is underperforming the index by nearly 25%. Spot prices for natural gas are down by about 25%, West Texas Intermediate crude oil is down by more than 14% and copper is down about 24%.
Commodity prices tend to take a beating when the economy slows (or a recession is threatening) because supply outruns demand. That historical trend may not be a good model for what is going on right now, however, according to Wells Fargo Securities’ analysts Nitin Kumar, Hanwen Chang and Rosalie Chen.
The analysts say that this time is different. The underperformance of U.S. exploration and production (E&P) stocks may have been overdone:
[T]ight inventory levels for both oil and gas, limited foreseeable supply upside, and strong cash flow generation/capital returns make the recent pullback in stocks a ‘buying opportunity’ in our opinion. We also note that our coverage is set to generate ~6.6% quarterly FCF yield in 2Q22 based on actual prices during the quarter. Critically, they could return half or more of that cash to shareholders. This could be a near-term catalyst for investors to refocus on the U.S. E&P sector, in our view.
The analysts’ 6.6% quarterly free cash flow yield implies an annual yield of around 25%. They believe that “based on announced capital return frameworks that include base dividends, variable dividends, and share repurchase plans, we estimate our coverage can return at least ~3.1% of their current market cap to investors in 2Q22 alone.”
With this background, Wells Fargo reiterated its top picks in the E&P industry: Coterra Energy, PDC Energy and Devon Energy. All are rated Overweight by the Wells Fargo analysts. Coterra’s price target of $46 implies an upside potential of 75% based on Friday’s closing price. PDC’s price target of $105 implies an upside potential of nearly 78%, and Devon’s price target of $73 implies upside potential of almost 40%.
Wells Fargo upgraded its rating on Range Resources Corp. (NYSE: RRC) from Equal Weight to Overweight and raised its price target on the stock by 11%, from $44 to $49. Range Resources will begin paying a regular quarterly dividend of $0.08 per share in the second half of this year and already has a $500 million share buyback program. Wells Fargo estimates that the company will generate a free cash flow yield of around 27.6% this year and 15.0% next year, well above the peer group average of 20% in 2022 and 11% in 2023.
Range Resources will report second-quarter results later this month, and consensus estimates call for revenue to rise nearly 390% sequentially and more than double year over year. The stock traded up by about 0.5% late Monday morning, at $25.73 in a 52-week range of $12.37 to $37.44. The stock’s total return for the past 12 months was nearly 52%.
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