Our interest in oil and natural gas exploration and production (E&P) companies has been warming up lately. Many of these stocks are beaten down, yet oil prices have remained resilient, leaving producers like ConocoPhillips (COP) meaningfully undervalued, notes Bruce Kaser, editor of Cabot Undervalued Stocks Advisor.
Four issues seem to be weighing on E&P stocks like ConocoPhillips. First, investors are increasingly looking to avoid climate-unfriendly companies. Also, investors have low interest in exposure to volatile and unpredictable oil and gas prices, especially since the entire energy sector has a tiny 2.6% weighting in the S&P 500 index.
Another concern is that company managements will lose their new-found capital spending discipline. And there is always the risk that OPEC+ opens their oil production spigots, sending oil prices down.
Yet, supporting energy prices is resilient demand. Subdued supply growth should also support oil prices. Given this, we see a contrarian opportunity in ConocoPhillips.
The company is the world’s largest independent E&P company, with most of its production in the United States, Canada and Australia. With the news that it is acquiring Royal Dutch Shell’s Texas assets for $9.5 billion in cash, we believe the time to buy has arrived.
We like Conoco’s low valuation at about 5x EV/EBITDAX. It also offers a free cash flow yield of close to 12% — an indicator of the company’s strong cash production as well as its discounted price. Conoco’s balance sheet is robust, with an investment-grade balance sheet.
While it is spending most of its cash hoard on Royal Dutch Shell's Texas assets, we see its strong free cash flow leading to a rebuilding of its balance sheet. Conoco has publicly stated that it will limit its capital spending to 50% of its annual cash flow, even after its Shell purchase. We believe that the management is unlikely to renege on this commitment.
Conoco currently has a dividend yield of about 2.8%, offering a respectable base-level cash inflow to shareholders that appears rock-solid. We are placing an $80 price target on ConocoPhillips shares. The shares have jumped some on the Texas acquisition news, so investors may want to buy a partial position now, then wait for any pullbacks.