3 Oil & Gas Stocks With Solid Risk/Reward

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Sometimes it is best to invest in a company that has been overly beaten down, versus one that is glittering gold. When analysts make low growth assumptions, for example, they set the bar low for high risk-adjusted returns. Over the last six months, BP (NYSE: BP), Chevron (NYSE: CVX), and Marathon Oil (NYSE: MRO) have gone up 18.9%, 27.7%, and 41%, respectively. Despite this rise, I still find that they are discounted against historical multiples due to poor forecasts for the future. In my view, this makes them undervalued with favorable risk/reward.

BP & Chevron

Trading at 7.9x past and forward earnings, BP is one of the cheapest stocks on the Street. Despite all of the talk about it being risky, the firm offers a dividend yield of 4.5% and has fairly low long-term debt. Analysts forecast just 3.1% annual EPS growth over the next 5 years, which I believe sets the bar much too low given that annual EPS growth has been around 4% for the period covering the recession.

The firm also moves fast. BP recently generated its first gas in the North Sea's Devenick field. This play is expected to hit a peak output of 100 million scf/day - so much that it will grow the UK's gas output by 3%. Exploration wells are being completed in Namibia and Angola, and the firm recently increased its exposure to high-risk plays by obtaining 43 drilling leases to the Gulf of Mexico. At the same time, BP is divesting superfluous downstream assets, such as its California and Texas refineries.

In regard to the Macondo oil spill, the company is on the fence between pushing for a $15 billion settlement or agreeing to pay the US government $18 billion. If BP settles, there will be an inevitable outpour of shareholder lawsuits. Ultimately, I believe BP will be successful in reducing its liability, since much of the devastation resulted from failure by multiple parties. I do not believe the market is factoring this in yet, and thus encourage investors to buy now to capitalize on a recovery.

Chevron similarly looks under-appreciated. Analysts are anticipating it to grow EPS by just 1.6% annually over the next 5 years ,despite the company growing EPS by 11.5% annually over the last 5 years. Due to this poor speculation, it should not be surprising that Chevron trades at low multiples of 8.7x and 9.3x past and forward earnings, respectively. Risk, like BP, is limited with a dividend yield of 3.1% and a beta of 0.8.

Performance has beaten expectations 3 of the last 5 quarters. 2Q12 EPS of $3.66 was 13.3% ahead of consensus. In addition, momentum is solid. The company generated $11.9 billion in free cash flow for the TTM ending 2Q 2012, which is decently ahead of 2Q 2010's generation of $10.9 billion.


Marathon oil is also a highly compelling buy. Although it has gained 59% from its 52-week low, it still trades 15% below the 52-week high—very reasonable levels. Sure, performance has been weak with a string of misses from the 4 quarters between 2Q 2011 and 1Q 2012, but the tide has started to change.

The company is nearing what will be a wave of production, and investors need to be patient during this period of high capital expenditures. For example, the company will pay upwards of $50 million for a play in Ethiopia, while purchasing a 20% working interest in the South Omo concession. Investors who look beyond the short-term costs will find considerable upside in the long-term as oil & gas prices recover from a low. 

Given the low 1.5x short ratio, it is clear that investors are, indeed, starting to appreciate Marathon's diverse portfolio. Headwinds in Libya have largely dissipated, with international sales increasing drastically from operational resumption. Acquisitions in Eagle Ford, plans for 6 well in Poland before the end of next year, and a ~70% increase in Bakken shale production have all added to the upside story.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Chevron. 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.

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