3 Oil & Gas Stocks To Buy Based On Risk and Reward
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
No geologist can say for sure how much oil or gas a well will produce. This uncertainty, coupled with strong demand, drives volatility and risk in the sector. While some producers have taken the actions to limit downside, others have focused on adding to the upside at the cost of deepening the downside. Ultimately, investors are advised to invest based on the risk/reward preference.
Buy Chesapeake Despite Corporate Governance Woes
Having followed activist investments for some time, I believe the market has not fully appreciated billionaire Carl Icahn's stake in Chesapeake Energy (NYSE: CHK). Like all good activist investors, Icahn only goes after firms that he believes are trading at a substantial discount to intrinsic value. After all, how else could you justify all of the expenses that go into proxy filing? Going into an overvalued stock for greenmail is way too much of a risky proposition when there are an abundant number of firms that could outperform from an improved recognition of the fundamentals.
Chesapeake ultimately has a world class portfolio whose parts are worth much more than the sum. Ultimately, these rich gas assets have become undervalued due to the degree of leverage held on the balance sheet. Should they be auctioned off on the private market, a substantial premium to today's market assessment would thus likely result.
Ultimately, Chesapeake does not have to be a complete "asset stripping" play. Announcements for sales in the Permian and a Midstream deal are likely to follow. After this, the company will be more of a hard core exploration & production firm with great diversification in Miss Lime, Utica, Eagle Ford, Mid-Con, Haynesville, Barnett, Marcellus, and PRB. I thus strongly recommend buying shares in anticipation of this oil & gas producer emerging clean at just the right time of a full recovery.
Devon, Linn: Safer Than Chesapeake But With Lower Upside
Investors still have many reasons to be hesitant about Chesapeake. With all of the smoke surrounding the CEO, it's reasonable to want to say on the sidelines. This does not mean, however, that you ought to back out in the sector as a whole. Linn Energy (NASDAQ: LINE) and Devon (NYSE: DVN) both have excellent exposure to natural gas and come with less risk.
Linn is able to provide stability through acquiring long-life oil & gas assets whose cash flow volatility is hedged against commodity prices. In fact, 100% of projected natural gas production over the next 5 years is hedged. Moreover, its annual distribution is at around nearly an 8% yield, which is likely to increase in the next few years under around a 1.2x approximate distributable cash flow coverage ratio. Quarterly distributions have increased north of 80% since the company went public in 2006.
After pursuing $5 billion worth of takeover activity over the last three years, Linn still has a balance sheet that is rich enough to further increase scale and dilute fixed costs. A strong track record in M&A grants the company reduced volatility for future acquisitions. Drilling and optimization complement takeovers for "organic growth".
Like Linn, Devon has also made strong efforts to mitigate risk. The firm has hedged against 85% of oil production and 65% of gas production. It has an attractive balance sheet and, despite running into operational challenges, is ramping up production at the Permian Basin. With daily production reaching nearly 680 mboed in 2Q12 against higher capital expenditures, management is showcasing confidence over the underlying fundamentals. Under such momentum, the stock is highly compelling for risk-averse investors
TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Devon Energy and has the following options: long JAN 2013 $16.00 calls on Chesapeake Energy, long JAN 2013 $25.00 calls on Chesapeake Energy, long JAN 2014 $20.00 calls on Chesapeake Energy, and long JAN 2014 $30.00 calls on Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.
