This year was supposed to be a better one for the energy sector. With OPEC stepping in to drain the oil market’s inventory glut, most in the industry expected that oil prices would be in the mid-$50s this year. While crude did touch that level earlier in the year, it has come unglued in recent weeks and tumbled into the low $40s due to surging shale output, which has counteracted OPEC’s best efforts.
That upending of the apple cart sent many top-tier energy stocks down sharply this year, including EOG Resources (NYSE:EOG), Kinder Morgan (NYSE:KMI), and Core Laboratories (NYSE:CLB). All three stocks are down by double digits since the start of the year, which now has them trading at much more compelling prices.
The low-cost oil stock now features a lower price tag
Leading shale driller EOG Resources puts a premium on drilling for returns over increasing its oil output. That’s why the company slammed on the brakes of its oil growth engine during the market downturn and refocused its efforts on driving out costs and improving drilling returns so it could thrive at lower oil prices. As a result of those efforts, the company has identified more than 7,000 future drilling locations on its acreage where it can earn premium returns, which it defines as achieving a 30% after-tax rate of return at $40 oil. Its focus going forward will be to drill these wells, which sets it apart from rivals that are drilling for growth and not returns. For example, Encana (NYSE:ECA) also had delineated its drilling inventory into premium and non-premium. However, Encana’s hurdle rate is a 35% return at $50 oil. To put that into perspective, EOG’s premium wells would make a 60% return at that oil price.
With crude oil sinking closer to $40 a barrel every day, EOG’s decision to use that oil price as its return hurdle is becoming a significant competitive advantage. That’s because the company can still make money on new wells at a time when many rivals would become unprofitable. In fact, it can earn an adequate 10% return at $30 crude. While EOG does trade at a premium valuation compared to most peers, its price has come down 13% this year due to the drop in oil prices, which makes now an even better time to buy this top-tier oil stock.
Ridiculously cheap cash flow
Pipeline giant Kinder Morgan’s stock has tumbled in recent weeks along with oil, and is down more than 10% for the year, despite the fact that it generates robust free cash flow. In fact, after a slightly better-than-expected first quarter, the company remains on track to generate $4.46 billion of distributable cash flow, or $1.99 per share, for 2017. That’s roughly even with last year as asset sales will offset expansion projects entering service.
At the company’s current mid-$18 stock price, Kinder Morgan trades at a mere 9.3 times distributable cash flow. That’s well below the mid-teens rate that’s typical for a pipeline company. That cheap valuation comes despite the significant improvement in its balance sheet over the past year as well as its ability to lock up financing for all its major growth projects, which should fuel healthy cash flow growth in the years ahead. With those strategic initiatives complete, Kinder Morgan appears poised to start returning a substantial portion of its steady cash flow to investors via dividends, which could make it a gold mine for income seekers.
Healthy cash generation with growth on the horizon
Oil-field service specialist Core Labs is another company that has had no problems generating gobs of free cash flow during the oil market downturn. Last year it generated $121 million of free cash flow, converting a whopping 20% of every dollar of revenue into free cash, which was by far the best in the oil-field service sector since many rivals lost money last year.
Core Labs continued churning out free cash in the first quarter, pulling in another $23.3 million. It expects that number to expand throughout the year as its revenue and margins rise due to new long-term projects announcements from its customers. That said, despite the expectations that Core Labs’ financial results will experience a “V-shaped” recovery this year, its stock has done nothing but sink along with crude, falling more than 17% for the year. That means investors can pick up this cash-gushing oil service company for a much lower price these days.
It’s entirely possible that crude could have farther to fall, especially as shale producers continue their unrelenting push to increase output at all costs. However, many shale drillers are getting close to hitting their breaking point since fewer new wells can make money once crude goes below $40 a barrel. Because of that, we might be closer to the bottom of this most recent sell-off than many investors realize. That could make now a great time to do some bargain shopping and scoop up these top-tier energy stocks while they’re on sale.
Matt DiLallo owns shares of Core Laboratories and Kinder Morgan and has the following options: short January 2018 $30 puts on Kinder Morgan and long January 2018 $30 calls on Kinder Morgan. The Motley Fool owns shares of and recommends Core Laboratories and Kinder Morgan. The Motley Fool owns shares of EOG Resources. The Motley Fool has a disclosure policy.