DIY Investing

Best ways to profit from beaten-down energy stocks

The oil storage depot at Indonesian oil company Pertamina in Jakarta
Beawiharta | Reuters

An investor could drive themselves to the point of paralysis trying to figure out the exact moment for an opportunistic energy stock investment. One day the oil prices are back up 5 percent—signaling a "bottom" has been reached—until the next day, when oil prices are back down by an equal amount—signaling that oil prices can, and will, continue to surprise to the downside.

It's hard not to be interested in the energy sector, but it's also wise to simplify your thinking. There are too many factors—and too many unknowns—to make a call with conviction that "it's straight up from here" with oil prices and that energy stocks will follow.

So here are five primary ways to think about U.S. energy stocks during their dog days. This is not intended to tell you the specific energy stocks to bet on. It will not lead to the largest possible gains if the energy sector does strongly rebound. What it presents is a primer on the most influential, overriding themes for energy stocks in 2015 if you perceive it as a potential profit opportunity.

1. Yes, downside catalysts have diminished.

Barring a complete collapse of the global economy, how many downside catalysts are left for the energy sector? Most of the bad news is out there now—surging production from the U.S., a bigger uptick from Libya in the fall than expected, greater energy efficiency, slowing global growth (i.e. energy demand) and the OPEC refusal to cut its production as it makes its bid for market share in the "new normal" of more supply and lower prices.

As energy consultant IHS wrote in a recent report, "For several years, two historic trends have been in play in the oil market—war and turmoil in parts of the Middle East and North Africa and the 'Great Revival' of American oil production. Either factor without the other would have been a dominant force in shaping oil price trends. But the simultaneous unfolding of these trends has meant they largely offset. The stalemate has broken. Strong supply growth has gained the upper hand over geopolitical concerns in shaping oil price trends. ... Such large supply gains outweigh, for now, an exceptionally fraught geopolitical environment."

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"Lots of the fundamental levers to move prices lower have been pulled," said David Meats, Morningstar energy analyst.

Further, "Low oil prices for an extended period of time increases the geopolitical risks associated with low oil prices," said Matthew Marietta, Stephens analyst. "Instability becomes more likely in oil exporting countries the longer oil stays down," he said, though he added that the most important catalyst for higher prices is simple: increased global demand stimulated by low commodity prices.

An investor wouldn't be viewing the sector with rosy glasses, then, to reasonably expect that eventually there are more catalysts for oil to go up than down from here.

2. There's no need—and maybe little reason—to rush in.

If recent Wall Street guidance on the timeline for a recovery in oil prices is to be trusted, the first half of the year is not going to see an oil price chart moving dramatically up. It is going to take at least a few quarters for the supply/demand situation to settle.

Goldman Sachs forecasts that on a three-, six- and 12-month basis, Brent will likely trade at $42, $43 and $70 a barrel. For WTI, Goldman has $41, $39 and $65 a barrel forecasts on three-, six- and 12-month horizons.

"There are going to be opportunities, but I wouldn't hold my breath on the first half of the year," said Capital One analyst Brian Velie, who covers exploration and production stocks. He explained that stocks won't see significant investment until oil prices show some stability and company spending and production plans firm up, which is likely to be a second-half 2015 event.

"I don't feel urgency to invest in the sector right now," Meats said. "The opportunities are there, but investors are not in danger of missing the boat. The rebound, optimistically, is the second half of 2015, or maybe even 2016," Meats said.

He stressed, as did the other analysts, that he believes the energy sector is already oversold, and any subsequent downward move in oil is more sentiment-driven than fundamentally supported at this point. So at some point, the sentiment will turn and investors will perceive greater risk being on the sidelines of energy stocks than in them. Investors need to have a "year-plus value-type mind-set to be dipping toes here," Velie said. "The way in which oil has continued to decline has made it very difficult for investors seeking short-term returns to call the bottom."

Mid- to long-term investors have time as all of the bad news settles into the stocks, and it hasn't settled into them completely yet for one very good reason. ...

3. The sell side is still playing catch-up: Another leg down for stocks could be coming.

This may be the best reason not to rush.

"In this situation, the stock market is ahead of sell-side numbers," Marietta said. "It's very challenging because it's hard to have conversations about valuation when companies don't even know what revenue will look like because their customers can't decide on capital spending," he said, referring specifically to oil-service stocks and their customers, the exploration and production companies.

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Marietta explained that the first half of the year will be challenging for a majority of these stocks because that's when rig-count decline is occurring. "No one has a sense for the magnitude; we just know it's happening today and the level will be high for the first couple of quarters of 2015. ... It will take a few earnings seasons for the sell side to fully grasp the magnitude of declines," he said.

In fact, investors looking for the best opportunities in the first half of the year may look to all of the sectors other than energy that benefit the most from the oil price plunge. "There are industries that benefit from lower commodity prices, and if you just think about North America as an importer of crude, this will help other industries, which will make it harder for some investors to dedicate money to energy stocks," Marietta said.

4. Company-specific catalysts are hard to bet on, at least in the near term.

One can be bullish on oil prices and energy stocks but still feel less than comfortable today with the actual thesis for the stocks they like.

One reason is that the hedges that exploration and production companies currently have allow them to pretend as if the actual 2015 environment doesn't affect them, and hope that oil prices recover faster than anticipated. If they don't, that will also filter down to the oil-service stocks once the reality of the operating situation, and spending budgets, are more fully revealed. So there may still be a bit of procrastination—maybe delusion—in company planning in the first half of 2015.

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One example of how that can affect energy stocks is in M&A, which could serve as a catalyst for opportunistic buyers of distressed exploration and production companies, but it may take a while before those deals to come about. Buyers aren't likely to find sellers moving too quickly, because those sellers will be reluctant to sell properties for half of what they were valued at a short time ago and won't be forced until they are facing unhedged positions.

5. The safest way to evaluate energy stocks right now is to focus on fundamentals.

For the truly adventurous, looking to shoot the lights out on an energy-sector rebound, there are the highly leveraged companies, which in a situation like this will trade down as if they might go bankrupt, and for good reason. For most investors interested in the energy space right now, though, the best way to proceed is by focusing on one factor: strength of balance sheet. All of the energy stocks are down to such a significant degree that an investor betting on a rebound does not need to get greedy and bet the house on the highly indebted companies.

"Investors need to be cautious on companies that had extended balance sheets," Marietta said, especially since oil prices remaining low for longer than expect cannot be ruled out.

The Stephens analyst said that less than two times net debt to mid-cycle EBITDA is where he draws the line in terms of separating the good balance sheets from the bad (mid-cycle EBITDA because energy stocks can go from boom to bust so quickly). Second is free cash flow in the context of a healthy balance sheet, which will enable companies to buy assets at good prices as they become available, buy back stock and pay back debt, all of which can serve as catalysts for shares.

"Balance sheet and liquidity are the No. 1 things right now for any energy stock," Velie said.

Meats said the near-term strategy needs to be picking business with good cash flow relative to spending and the ability to cover the interest on their debt. Investors should deemphasize more "normal market" reasons to invest in energy stocks, such as dividends. "A dividend is only great if a company doesn't cut it," Meats said.

3 energy dogs the analysts are bullish on

The analysts stressed that they remain bullish on stocks within their coverage, especially some stocks that have declined the most. Here are three of the stocks they believe have the most upside, and why, when taking company-specific potential into account. (Two of the three stocks—QEP Resources and Denbury—were highlighted recently by as S&P 500 stocks that will go up the most if oil rebounds, based on data analysis from CNBC partner Kensho.)

Nabors Industries
Stephens analyst Matthew Marietta

Rig counts may be declining, but Nabors is in the process of replacing older rigs with 33 new AC rigs, which are far more efficient than traditional drilling equipment. Once those rigs are replaced, it will have the second most AC rigs of any oil field service company, after Helmerich & Payne.

That's good news for investors, as AC rigs are in high demand, and lower oil prices will ultimately support greater adoption of these rigs as the drillers need to become more efficient.

Nabors is also in the process of selling its underperforming completion and production business—a division that sets up wells for production and then eventually plugs them up—to C&J Energy Services for $2.86 billion. "This allows them to return to its core competency of contract drilling," Marietta said. "The money will also help keep its balance sheet in order as it builds its newer rigs."

The deal has been pushed back—and has faced recent court challenges—but Marietta believes the companies are committed to getting the deal done, even if on a delayed time frame, and the $1 billion in a cash payment will be key to Nabors executing on its AC fleet upgrade.

Denbury Resources
Morningstar analyst David Meats

Denbury focuses on "tertiary recovery," meaning that after the majority of a well is drained, it comes in and squeezes the last bits of oil out using a CO2 flooding strategy.

It's able to recover the final third of the oil that's in these reserves. There aren't many companies that do this—most focus on the first and second phases of extraction—which means its services will always be in demand.

Meats said that while it does own reserves in Montana, North Dakota, Wyoming, Texas and other states, it doesn't own in the new shale plays that should be a greater drag on prices because they require more expensive drilling.

"They don't own the hot deposit," he said. "They're buying existing conventional fields and applying their technology to squeeze out extra production." That makes the company's drilling more predictable, since it's working on plays that have already proved to have oil.

It also has a conservative management team and announced recently that it was halving its capital expenditures in 2015 because of lower oil prices. "It's looking after its balance sheet, and that's good for investors," Meats said.

QEP Resources
Capital One analyst Brian Velie

Until early December, QEP was both an oil and gas producer and a mid-stream company that processes, stores and transports the commodities it pulls out of the ground.

Going forward, though, it will be a pure play operator—it just sold off its mid-stream operation and generated proceeds of more than $2 billion just in time to explore what is shaping up to be a buyer's market as 2015 progresses.

It's not yet clear what it will do with the deal proceeds, but with a debt-to-EBITDA ratio of less than 1 time, Velie noted that it doesn't have to use those dollars to pay down debt—key at a time when balance sheet is the No. 1 factor for energy stocks. "They received an influx of cash at an opportune time. An opportunity that most other E&P operators do not enjoy," Velie said.

The company does need to move on acquisitions because its main oil play in North Dakota's Williston Basin is maturing, with three to five more years of drilling locations remaining. "They have a lot of dry powder now, and they're in a position where they can pick up some strong acreage," Velie said.

"From a downside risk standpoint, you hear people asking who's in trouble, and these guys aren't. They're not leveraged, so they can stand pat if they don't find something to buy right away," Velie said. He added that it does all hinge on management making the right buys.