Analysts dropped a bunch of new notes on energy stocks. Here's where we stand on ours

Published Tue, Jul 19 20224:26 PM EDT

Kevin Stankiewicz @in/kevinstankiewicz @kevin_stank

Wall Street analysts issued a slew of notes on the energy sector Tuesday morning, as many companies in the oil and gas industry are slated to release second-quarter earnings in the coming weeks. In this piece, we're going to provide a quick overview on what the analysts at Morgan Stanley, Mizuho Securities, Piper Sandler and Bank of America had to say Tuesday and provide Club members with updated thinking on our energy stocks: Pioneer Natural Resources (PXD), Devon Energy (DVN), Halliburton (HAL), Chevron (CVX) and Coterra Energy (CTRA). Big picture It's important to look at the specifics of what analysts wrote. There is, understandably, a lot of nuance within the commentary as Wall Street tries to wrap its collective hands around the S & P 500 energy sector, which soared to start the year but is now down over 22% from its June 8 peak. At Mizuho, for example, analysts lowered their price targets by roughly 8% on average for the stocks in their coverage universe — but maintained buy ratings on many of those names, including four we own: PXD, DVN, CTRA and CVX. "We continue to view global oil markets as structurally undersupplied and global natural gas even more so," the Mizuho analysts wrote, while adding that inflationary pressures and supply chain issues are pushing up costs for companies. Even so, they continued: "We're frustrated to have missed the June peak, but from here view risk/reward for the group skewed heavily to the upside especially over a twelve-plus month time horizon." Morgan Stanley also warned about rising costs, despite its expectations that companies will stick to plans for "little or no production growth" while returning large chunks of their excess cash flow to shareholders. "Heading into 2Q earnings, we see risk of further budget increases and are generally above consensus on full-year spend — especially for those that did not raise guidance alongside 1Q results," Morgan Stanley analysts wrote, noting their 2022 capital expenditure estimates for Club name Coterra Energy are 9% above Wall Street's estimates. They have an equal weight rating on CTRA shares. Despite those cost concerns, Morgan Stanley has second-quarter cash flow per share estimates above the Street consensus. "Amid continued volatility, we see 2Q earnings as a positive catalyst for the sector and expect another quarter of record FCF to support a further acceleration of cash returns," they wrote. "With oil prices holding [roughly $100 per barrel], we expect inflationary pressures to persist, though not derail the industry's FCF story." Over at Bank of America, analysts downgraded Club stock Pioneer Natural Resources to underperform from neutral. The analysts cited "underappreciated" headwinds to free cash flow as Pioneer becomes a full taxpayer again in the coming quarters once the company's net operating loss (NOL) deductions run out. At the same time, BofA analysts aren't negative on the entire sector — they continue to rate Chevron a buy, and on Tuesday upgraded a few energy stocks we don't own, too, including EOG Resources (EOG) and ConocoPhillips (COP). Going forward, the analysts expect "the next leg of energy sector performance to be heavily bifurcated with differentiation nuanced by three issues," specifically: 1) inflationary pressures that squeeze breakeven oil prices 2) natural gas leverage and 3) impact of cash taxes on U.S.-based exploration and production firms. The Club's take Jim Cramer's Charitable Trust, which is the portfolio we use for the Club, has added to its energy exposure significantly this year. There is basically a two-pronged reason for that, which remains intact even as the sector has gone through weakness in recent weeks, and after we read through Tuesday's analyst note drops. The first part is about using energy stocks as an inflation hedge. We use a long-only investment strategy, so unlike a hedge fund, we aren't shorting any stocks or buying put options to build downside protection for our portfolio. Cash, traditionally speaking, has been our only hedge. This year, however, energy stocks offer protection for our portfolio since many of the factors weighing on the rest of our portfolio — the Federal Reserve's monetary tightening to tamp down inflation and the Russia-Ukraine war — are related in some way to surging oil and gas prices. Our base case is that supply-and-demand mismatches lead oil prices to stay higher for longer, meaning the Fed may have to keep raising interest rates to slow the pace of inflation and, possibly, the U.S. economy overall. In that scenario, our energy stocks should hold up relatively well compared to rate-sensitive stocks we own for their long-term potential such as semiconductor firms Nvidia (NVDA) and Advanced Micro Devices (AMD). The other main part of our energy thesis is about the aggressive capital return strategies companies across the oil patch are deploying. We are especially talking here about Pioneer Natural Resources, Devon Energy and Coterra Energy. All three companies have adopted a disciplined approach to drilling and a base-plus-variable-dividend strategy that returns large chunks of their excess free cash flow to shareholders. In very simple terms, the higher the price of oil, the more cash companies have to pay dividends and repurchase stock. However, as we wrote earlier this month , our energy companies have oil breakevens significantly below where crude is currently trading just north of $100 per barrel. This means that even if oil traded in the low $90s or high $80s for a meaningful stretch, our energy firms would still be able to return capital to shareholders. If things happen that cause oil prices to fall significantly below that range, it would likely mean our energy stocks would trade lower and diminished capital returns — while also providing a lift to other parts of our portfolio that benefit from tamed inflation and a more accommodative Fed. That's the hedge strategy we discussed above. As of now, we continue to believe in our bullish thesis, which explains why we bought 15 shares of Pioneer Natural Resources last week after the stock's recent declines . Of our five ene