Why Oil Stocks Could Have Much Further to Run

Crude oil has been on a blistering pace over the past year. The price of a barrel of Brent, the global benchmark, is up nearly 60%, while its U.S. counterpart, WTI, has risen more than 40%. Because of that, oil stocks have rallied sharply, with the average one held by the iShares U.S. Oil & Gas Exploration & Production ETF up almost 30%.

However, given the current state of the oil market, oil stocks could have much further to run, which means there’s still plenty of opportunity for investors.

Image source: Getty Images.

Drilling down into the oil market

The International Energy Agency (IEA) recently released its monthly oil market report, which provided its first glimpse at 2019. The IEA noted that the rapid rise in oil prices over the past year has started to cool off demand, which was red-hot to start 2018. However, even though the IEA pared its 2018 demand growth forecast back slightly to 1.4 million barrels per day (BPD), it doesn’t anticipate a further slowdown in 2019. Instead, it expects oil demand to maintain its current pace and rise by another 1.4 million BPD next year.

Meanwhile, the IEA sees oil production rising to roughly match demand. The U.S. will lead the charge, contributing about 75% of the increase in supplies next year. Meanwhile, OPEC appears poised to boost its output in 2019. However, supply issues in Venezuela and the impact of new sanctions on Iran likely will offset much of that increase.

Because of that, the IEA concluded that the “market will be finely balanced next year.” That leads it to believe that oil prices will remain around the current level even if OPEC boosts its output to compensate for the supply issues in Iran and Venezuela. However, it also warned that those supply concerns leave the oil market “vulnerable to prices rising higher in the event of further disruption” in supply.

Image source: Getty Images.

Oil stocks with ample upside

The IEA’s forecast bodes well for oil stocks, especially those that have underperformed during the rally over the past year. Two that stand out are Newfield Exploration (NYSE: NFX) and Apache (NYSE: APA), since both have lost value even though oil has been red-hot. Because of that, they trade at dirt cheap valuations versus their peers. That underperformance doesn’t make sense given the growth these companies can deliver at much lower oil prices.

In Newfield’s case, it expects to grow production per debt-adjusted share — which takes into account debt reduction and stock buybacks — by a 15% to 20% compound annual rate through 2020. Further, Newfield can achieve that fast-paced growth while living within the cash flows it can generate at $55 oil, which is well below the current price, implying that the company can produce a gusher of free cash in the coming years. Meanwhile, Apache sees output rising at an 11% to 13% annual rate through 2020. That growth should lift these oil stocks even if oil prices slip from here.

Another oil stock that could be a standout performer in the coming years is Noble Energy (NYSE: NBL). For starters, its stock has significantly underperformed the iShares E&P ETF, only gaining about 16% over the past year. That trend could reverse as Noble’s operations kick into high gear in the next couple of years.

Under the company’s current forecast, at an average oil price of $50 a barrel, Noble can grow production at a 20% compound annual rate through 2020 and generate $1.5 billion of excess cash. Noble Energy plans to return a significant portion of that money to investors via its share repurchase program and has already authorized a $750 million buyback. Given that similar programs have fueled big-time outperformance from rivals, Noble’s stock could be a top performer in the coming years.

In addition to the potential of these underperformers, there’s still untapped upside from oil stocks that have risen sharply over the past year. That’s because many of them are using their windfall from higher oil prices to buy back significant amounts of their still-cheap shares. Devon Energy, for example, could potentially retire 20% of its outstanding stock by the end of next year. Meanwhile, several others have multibillion-dollar buybacks underway that should push their shares even higher.

Still in the early innings of the recovery

On the one hand, it seems as though oil might be topping out, especially as OPEC winds down its production reduction agreement. However, even if that happens, the current crude price is well above the level most oil stocks need to fund their growth plans. Because of that, they should still have plenty of upside from here, especially those that missed the rally over the past year or have big-time buybacks underway.

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Matthew DiLallo has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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