I think the hydrocarbon sector looks incredibly attractive from a value perspective. A quick glance across the sector throws up a lot of companies trading at double-digit free cash flow ratios and other similarly attractive metrics. Considering the current generally overvalued market environment, these figures stand out.
There's Consol Energy (CEIX, Financial) in the coal sector. This stock is selling at a forward price-earnings ratio of 4 for 2022 and a price-to-free-cash-flow ratio of 3.6. The free cash flow yield is 30%. Natural gas production company EQT Corp (EQT, Financial) is selling at a forward price-earnings ratio of 9 and has an average historical free cash flow yield of 9%. In the same sector, California Resources (CRC, Financial) is selling at a forward price-earnings ratio of 8.3 and a free cash flow yield of 10%. Then there's ExxonMobil (XOM, Financial). This stock is selling at a forward price-earnings ratio of 10.6 and trades at a free cash flow yield of 9.1%.
Cheap for a reason
It is clear that these companies are cheap. However, it is also clear that they are cheap for a reason. When it comes to sector-wide undervaluation like this, it means that almost the entire market believes the sector deserves to be cheap.
First of all, the price of oil and gas has been incredibly volatile over the past couple of years. Last year, as the pandemic raged worldwide and oil prices collapsed due to dramatically reduced travel, pushing some producers into bankruptcy. This was the worst environment for hydrocarbon companies in several years. Since as far back as 2014, oil prices have been under pressure due to oversupply, which has had a significant impact on the sector.
At the same time, institutional and individual investors have been dumping exposure to oil and gas stocks due to environmental concerns. These companies are facing immense pressure to reduce their emissions and spend more money cleaning up their act. It is unclear at this point what the ultimate liability will be for hydrocarbon producers. In some regions such as the North Sea, companies are already required to spend billions cleaning up their oil fields when they reach the end of their lifespan.
These are the significant risks the businesses have to contend with, but there are also opportunities. Some analysts believe that due to chronic underinvestment in oil and gas production, the price of these commodities will remain elevated for the next decade or so. The world is still consuming a vast amount of these hydrocarbons (and the same goes for coal). Even the most optimistic forecasts do not see oil demand peaking until the middle of this decade. The energy transition is happening, but it is going to take time.
Where's the catalyst?
The big question is, will these companies be good investments at their current prices? Even if energy prices remain elevated, and these businesses earn excessive profits for the next decade, unless the market sentiment changes, the value of the shares will likely remain depressed.
This is the challenge all value investors face when picking investments. A stock can remain cheap for years unless there is a catalyst to drive a re-rating of the business. For hydrocarbon stocks, it is not clear what this catalyst will be. Even higher oil prices have not changed market sentiment.
Finding companies with managers that are working to create and unlock value may offer a solution. Exxon is planning to do just that with a $10 billion share buyback plan alongside its regular dividend. The stock currently yields around 5%.
Another option could be to own the companies investing heavily in renewable energy. Many green energy stocks are highly sought after and highly valued because investors see a long future for these compared to an inevitable end for fossil fuels. Most oil companies are not investing in green energy, but some are, like U.K.-based BP (BP, Financial), which plans to invest considerable sums in boosting its renewable energy capacity over the next decade. This could be a potential catalyst for the stock as the balance tips from the firm being a hydrocarbon operator to a green energy producer and attracts a different class of investors.
