How Should You Play the International Upstream Oil & Gas Industry?
China's economic slowdown has cast a shadow on the crude demand outlook, impacting the Zacks Oil and Gas - Exploration and Production - International industry. Concerns deepen with the potential for more interest rate hikes to combat persistent inflation. Natural gas hasn't escaped the market's downturn, trading notably lower year to date. Although macro challenges create demand uncertainties, there's resilience in the sector, especially for operators prioritizing growth and operational efficiency. Vermilion Energy VET and Tullow Oil TUWOY emerge as stocks to watch for investors navigating this complex landscape, offering potential amid the prevailing economic headwinds.
Industry Overview
The Zacks Oil and Gas - International E&P industry consists of companies primarily operating outside the United States and focused on the exploration and production (E&P) of oil and natural gas. These firms find hydrocarbon reservoirs, drill oil and gas wells, and produce and sell these materials to be refined later into products such as gasoline, fuel oil, distillate, etc. The economics of oil and gas supply and demand is the fundamental driver of this industry. In particular, a producer’s cash flow is determined by realized commodity prices. In fact, all E&P companies are vulnerable to historically volatile prices in the energy markets. A change in realizations affects their returns on drilling inventory and causes them to alter production growth rates. These operators are also exposed to exploration risks where drilling results are uncertain.
3 Key Investing Trends to Watch in the Oil and Gas - International E&P Industry
Signs of Softening Consumption: While Brent oil, the global benchmark, is currently trading at around $80 a barrel, signals of incremental crude supplies and a deteriorating consumption outlook loom large on the commodity. Several factors, including loosening U.S. sanctions on Venezuela, stuttering growth in China and bearish economic data from Europe, have clouded the outlook for medium-term energy usage. Coming to natural gas, the fuel slumped to a 25-year low in June 2020 but hit $10 per MMBtu for the first time since 2008 in August last year. Now, it is hovering below $3 thanks to record production and ample storage.
Inflationary Pressure: Most energy companies (including the upstream operators) have been experiencing rising costs in the form of increased expenses related to maintenance and inventory. The inflationary environment, together with supply-chain tightness, is not only pushing costs higher but also affecting their capital programs. Apart from being hard to ignore, escalation in expenses is also drowning out the benefits of any commodity price increase. In our view, the inflation-associated headwinds will continue to challenge growth and margin numbers with little chance of a quick resolution. Finally, what this means is that the central banks will be persistent with their aggressive policies to stem inflation. This may lead to a rough road for oil/gas equities. In particular, worries about weaker energy demand due to the threat of recession might jeopardize the commodity’s ascent.
Substantial Shareholder Returns: While oil companies’ profits have gone down this year due to a tickdown in commodity prices, the record profits that they reaped in 2022 has allowed upstream operators to continue giving back the cash to stakeholders. In particular, cash from operations is on a sustainable path, with revenues stabilizing and companies slashing capital expenditures from the pre-pandemic levels amid commodity realizations at a healthy enough level for market participants. To put it simply, the environment of strong prices in 2022 helped the E&P firms to generate significant “excess cash,” which they intend to use to boost investor returns. In fact, more and more energy companies are allocating their increasing cash pile by way of dividends and buybacks to pacify the long-suffering shareholders.
Zacks Industry Rank Reflects Bearish Outlook
The Zacks Oil and Gas – International E&P industry is a 10-stock group within the broader Zacks Oil - Energy sector. It currently carries a Zacks Industry Rank #222, which places it in the bottom 12% of more than 250 Zacks industries.
The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates challenging near-term prospects. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.
The industry’s position in the bottom 50% of the Zacks-ranked industries is a result of a negative earnings outlook for the constituent companies in aggregate. Looking at the aggregate earnings estimate revisions, it appears that analysts are becoming pessimistic about this group’s earnings growth potential. While the industry’s earnings estimates for 2023 have gone down 66.8% in the past year, the same for 2024 have fallen 61.8% over the same timeframe.
Despite the dim near-term prospects of the industry, we will present a few stocks that you may want to consider for your portfolio. But it’s worth taking a look at the industry’s shareholder returns and current valuation first.
Industry Underperforms Sector & S&P 500
The Zacks Oil and Gas - International E&P industry has fared worse than the broader Zacks Oil - Energy Sector as well as the Zacks S&P 500 composite over the past year.
The industry has fallen 14.8% over this period compared with the broader sector’s decrease of 4.4%. Meanwhile, the S&P 500 has gained 14.9%.
One-Year Price Performance
Industry's Current Valuation
Since oil and gas companies are debt-laden, it makes sense to value them based on the EV/EBITDA (Enterprise Value/ Earnings before Interest Tax Depreciation and Amortization) ratio. This is because the valuation metric takes into account not just equity but also the level of debt. For capital-intensive companies, EV/EBITDA is a better valuation metric because it is not influenced by changing capital structures and ignores the effect of non-cash expenses.
On the basis of the trailing 12-month enterprise value-to EBITDA (EV/EBITDA) ratio, the industry is currently trading at 3.94X, significantly lower than the S&P 500’s 13.07X. However, it is higher than the sector’s trailing-12-month EV/EBITDA of 3.77X.
Over the past five years, the industry has traded as high as 16.32X, as low as 2.17X, with a median of 4.35X.
Trailing 12-Month Enterprise Value-to EBITDA (EV/EBITDA) Ratio (Past Five Years)
2 Oil and Gas - International E&P Stocks to Watch
Vermilion Energy: Vermilion Energy is an oil and gas explorer with producing properties in Europe, North America and Australia. The energy explorer’s diversification across different continents provides it with certain advantages relative to the other upstream players. VET, with its unique portfolio of high-margin, low-decline assets, is currently focused on cost reductions and positive free cash flow generation.
Over the past 90 days, Vermilion Energy Energy saw the Zacks Consensus Estimate for 2023 move up 2.7%. Valued at around $2.2 billion, VET currently carries a Zacks Rank #3 (Hold). Vermilion Energy’s shares have declined around 31.1% in a year.
You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
Price and Consensus: VET
Tullow Oil: Tullow Oil is a London-based hydrocarbon producer and explorer, focusing mainly on Africa. TUWOY’s significant positions in discovered and emerging basins and focus on capital discipline should result in a noticeable improvement in profitability. In particular, the oil and gas finder’s operational excellence and technical expertise stand it in good stead.
The 2023 Zacks Consensus Estimate for TUWOY indicates 25.1% year-over-year revenue growth. Tullow Oil carries Zacks Rank #3. TUWOY’s shares have lost 18% in a year.
Price and Consensus: TUWOY
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Vermilion Energy Inc. (VET) : Free Stock Analysis Report
Tullow Oil PLC (TUWOY) : Free Stock Analysis Report
