Weighing the Pros, Cons Of Oil & Gas Investments

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Oil and gad producers are forecasted for around 7.6% annual EPS growth over the next 3-5 years. Fortunately, they trade at historically low multiples and are thus likely to appreciate substantially from this growth curve, which is ahead of what is forecasted for broader indices. But which oil & gas companies, in particular, will outperform? Below, I look at operational strategies and growth opportunities to make my case.

The Pros To A Hess Corp (NYSE: HES) Investment

At a respective 11.1x and 7.9x past and forward earnings, Hess is trading where it historically has over the last decade removing outliers (maybe slightly on the cheaper side). But on a competitive basis, it looks way undervalued at 0.87x book value (versus an industry average of 1.6x). Operating margins of 9.9% are still well below the industry average 16.2% and have room for improvement. But having missed 4 out of the last 5 quarters, shareholders have lost confidence in the underlying fundamentals. In particular, they were not conformable with the capex increase.

There are still several reasons to still be optimistic. After being closed from Sandy, the Port Reading refinery resumed production at 70,000 bbl/d with full rates now achieved. Management is also looking to sell Samara-Nafta, its Russian subsidiary, which, if completed, will enable the company to better focus its geographical exposure. It will showcase a sensible downscaling. Free cash flow is also recovering from the trough of $2.7 billion lost by 2Q12 (ttm)--on a TTM-basis, only $500 million was lost by 3Q12.

Assuming Hess can meet expectations, 2016 EPS will come out to $7.21. At a multiple of 13x, the future value of the stock will be $93.73. Discounting backwards by 10% yields a present value of $58.20. This is at around a 20% discount to the current market assessment and represents a compelling buying opportunity.

Occidental Petroleum (NYSE: OXY) A "Buy"

If you are looking for even greater upside, one may consider backing Oxy. No analyst rates the stock a "sell" but 14 out of 20 reporting analysts call it a "buy" or better. It is generating a 16.9% return on invested capital--much more than what is necessary to generate value creation and above that being generated by the S&P 500. What concerns me, however, is that the company is over the hill--it is only forecasted for 3.8% annual EPS growth over the next three to 5 years versus a rate of 7.6% for the E&P industry.

However, the company can change the trajectory. It is looking to acquire Yates Petroleum, a closely held oil company, and this would spike production estimates substantially. Yates provides exposure to Permian Basin and is in a desperate position of trying to avoid higher taxes next year. More radically, the company may consider spinning off underperforming plays after seeing the success Murphy Oil experienced when it agreed to split. According to one Deutsche Bank analyst, the company trades below net asset value, because "investors have major questions over strategy and execution". Even if it maintains the status quo, it has better-than-recognized operations. 3Q12 EPS of $1.70 was 7 cents ahead of consensus.

I believe the company could appreciate to the multiples that Anadarko Petroleum (NYSE: APC) trades at if growth continues to best analyst forecasts. The Street is highly bullish on the stock despite it trading at 20.3x past earnings and mild growth trajectory. 15 out of 28 analysts rate the stock a "strong buy", 9 rate it a "buy", and 0 rate it a "sell". Over the past 5 years, EPS has still grown at a snail's pace, basically going nowhere. In 2007, EPS was $7.98 and then it dropped to $1.52 and even lost $5.32 last year. Given how successful Oxy has been relatively, I encourage preferentially buying shares in that company.

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