An Energy Bull's Take on the Possible Downsides for 3 Stocks

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

In my view, the oil & gas industry is overly discounted at 8.7x past earnings. While I recommend strong diversification and find that natural gas will provide spectacular returns, there is still no point in investing when you think the market will invest. That is, you can have the mind of a long-term bull, but if you are short-term bear--the latter mindset takes priority in the energy market. In this article, I present a more bearish outlook on several companies that I am normally optimistic about.

Chevron (NYSE: CVX): The Bullish & Bearish Views

With crude oil prices dropping, many investors are naturally eying the large integrated oil & gas producers. It's the basic strategy of "buying low and selling high." And at only 8.8x past earnings and a 21.6% return on invested capital (more than 360 bps above industry average levels), the upside looks strong for Chevron. 16 of 21 reporting analysts rate the company a "buy" or better and none recommend a "sell."

There is another huge reason to be bullish on the company. Alberta is now believed to hold 56.8 billion barrels of gas liquids, 423.6 billion barrels of oil, and 32,324MMcf of natural gas in the emerging shale prospects. This would put the deposits within the ranks of some of the largest domestic shale plays--a significant area of untapped potential. Chevron has already amassed a large land position that has yet to be factored into the stock price in light of what other discoveries in the Marcellus and Eagle Ford plays have generated in terms of market responses.

There are also several reasons to be bearish on the company. Management recently increased the cost estimate of its Gorgon LNG project by Australian $15B to Australian $52B, and the first shipments are planned for 1Q 2015 (this may even be delayed). This is particularly disappointing in a time when the company is experiencing its most protracted output decline in over four years. There is $21 billion on the balance sheet to stage a buyout, but the bargaining power is weak right now. Even in China, Chevron expects a weak fracking environment due to poor infrastructure that does not allow for shale exploitation. A fire in the Richmond refinery and a declaration of force majeure at the Kuito offshore production zone add to the list of worries. Despite these and operational misses, I encourage buying shares to take advantage of the low.

Apache (NYSE: APA) Vs. Devon (NYSE: DVN)

As one of the largest natural gas producers, Devon trades attractively at just under book value. Apache similarly trades just under book value, but it is forecasted for a 200 bps greater EPS growth rate at 5.8%. My problem with both companies, however, is that I do not believe they can outperform under such a low growth environment. When you factor in dividend yields on top of the earnings growth, you are looking at between 5.4% and 6.8% average annual returns between the two, assuming the market has priced them right today. Since I believe analysts have properly forecasted growth, out-performance hinges on multiples expansion.

Devon and Apache may both have a low-risk profile and strong track record of executing. But, according to Oppenheimer's Fadel Gheit, they lack a strong return on capital from limited production. Moreover, a series of two production misses has actually caused analysts to downgrade Devon in recent months. After raising 2012 capex thrice for the year, Devon is also cutting into margins at the wrong time. On the other hand, I like the company's recent logistical upgrades and JV agreement with a Japanese investment infirm that will supply $1.4 billion in capital after a $410 million backing so far.

Furthermore, Devon is on the top of Morningstar's 10 conviction buys. The analyst notes that, though the company is perceived as a gas producer, fully 80% of revenues come from oil & liquids. And even though the first 2 Utica shale wells yielded poor results, the company still is going to drill 5 more this year.

Apache has faced its own downgrades--notably from Baird and Deutsche Bank on Monday. From growing tensions in Egypt to an earnings miss in the third quarter, shares have rightfully plummeted to a 52-week low in recent days. And with competitors now moving into shipping LNG to Asia, a once lucrative stream of income is now facing margin pressures. For this reason, I recommend avoiding the stock until greater certainty emerges.


TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Apache and Devon Energy. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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