This is the second part of my special report on why energy stocks are primed to soar for years. Part 1 explained why current conditions and global oil supply levels have set the stage for massive gains.
Now comes the fun part: choosing which stocks to buy now so that we can profit off the coming rally.
Table of Contents
- An Overlooked Investment Opportunity
- Undervalued and misunderstood
- Price catalyst
- Long-term tailwinds
- Why Buy Energy Stocks Now?
- Three Ways to Invest in Energy Companies
- The conservative approach: ETFs
- The moderate approach: the big names
- The aggressive approach: create your own ETF
- Energy Stocks to Buy Now
- Stocks to Buy Now #1: Arch Resources (ARCH)
- Stocks to Buy Now #2: Enerplus (ERF)
- Stocks to Buy Now #3: Magnolia Oil & Gas (MGY)
- Stocks to Buy Now #4: ExxonMobil (XOM)
- Manage Risk with a Trailing Stop
- Keep Energy as a PORTION of Your Portfolio
- Additional Stocks to Buy
An Overlooked Investment Opportunity
The reason I provided such extensive background information in Part 1 (which is just a nice way of saying “ridiculously long”) is because most people hate oil and gas companies. Therefore, they don’t even consider them as an investment opportunity.
As a reminder, my recommendation of the Energy sector—specifically companies engaged in fossil fuels—is not a value statement. I’m not taking a moral—and certainly not a political—stance on these businesses by labeling them as “good” or “bad.”
My decision to invest in them is grounded in the same reasons that I invest in other companies for the long term:
- Undervalued and/or misunderstood
- Price catalyst
- Long-term tailwinds
Undervalued and misunderstood
For all the reasons I described in Part 1, I believe that the market (and the general public) misunderstands how much we depend on fossil fuels and how that’s not going to change for decades.
The Energy sector’s performance in 2022 was a just a taste of the returns that we could see for 5-10 years…or more. The sector has cooled off in 2023, which presents a buying opportunity.
A price catalyst refers to an upcoming event that has the potential to launch a stock’s price. The fragility of the global oil supply coupled with growing tensions between the U.S. and Russia means that a single news headline could send the price of oil soaring—and Energy stocks along with it.
The re-opening of China will also lead to hundreds of millions of people commuting and traveling again, and thus demanding more oil and gas.
Shaky oil supply combined with growing demand is a textbook recipe for rising prices. And high oil prices lead to big stock returns (more on that below).
A tailwind is a factor, or factors, that power a stock’s rise for an extended period of time.
As I explained in Part 1, we are very far off from phasing out fossil fuels. To be sure, it’s necessary to do so. Even if we ignore the negative environmental impact of fossil fuels, we still need to replace them because they are a limited resource. By definition, we can’t tap them forever.
But we simply don’t have a viable alternative to fossil fuels now or in the near future. And, as the U.S. Energy Information Administration reports, global energy demand will increase for decades.
Why Buy Energy Stocks Now?
The price of oil makes or breaks oil companies.
When prices are low, these businesses struggle. They lay off thousands of workers and can even go years without a profit.
Oil and gas companies can only make money when energy prices climb above a certain level. For oil, the breakeven price is around $40-$50 per barrel.
But when prices rise, everything changes. When oil reaches $100 per barrel, these companies—and their stocks—will soar.
At the time of this writing, Brent crude oil is at $83.90 per barrel, and WTI crude is at $77.17 per barrel. We want to buy energy stocks now…before the price of oil climbs from here.
Part 1 of this report detailed why I believe that oil prices will rise…and stay high…for years. If my hypothesis is correct, energy investors could enjoy excellent returns for several years.
Three Ways to Invest in Energy Companies
With any investment, you want to buy while the price is depressed. The price of oil has been in a holding pattern for months. Now is a great time to get in before it jumps.
While it’s true that the price of oil could drop from here, we’re going to be long-term investors. Therefore, we’ll be able to weather the inevitable price dips as the long-term uptrend materializes.
Below are three ways that you can invest in the coming oil boom. I’ll describe them from the most conservative to the most aggressive.
1. The conservative approach: ETFs
The iShares U.S. Energy ETF (XLE) tracks the investment results of an index composed of U.S. equities in the energy sector. As of Feb. 23, 2023, XLE held 42 positions, which are weighted based on the market cap of each company.
For example, oil and gas giants ExxonMobil (XOM) and Chevron (CVX) combine to make up over 40% of the ETF’s total assets.
The SPDR S&P Oil & Gas Exploration & Production ETF (XOP) corresponds to the performance of the S&P Oil & Gas Exploration & Production Select Industry Index.
XOP is similar to XLE in that it’s comprised of a basket of oil and gas stocks. As of this writing, XOP had 59 holdings. A key difference, however, is that while XLE is a market-cap weighted ETF, XOP is nearly equal-weighted.
For example, ExxonMobil makes up 24% of XLE but only about 2% of XOP. This means that XOP is more reliant on midsize companies to determine the price direction of the fund.
XOP is also more narrowly focused. While XLE provides exposure to the broader Energy sector, XOP is concentrated on the Integrated Oil & Gas, Oil & Gas Exploration & Production, and Oil & Gas Refining & Marketing sub-industries.
Pros and cons of ETFs
Both XLE and XOP will give you exposure to energy companies. The choice comes down to whether you want more of a concentration in major companies (XLE) or smaller ones (XOP) and/or if you want broad energy exposure (XLE) or more of a focus on oil and gas (XOP).
Whichever one you choose, it’s important to note the pros and cons of investing in ETFs vs. individual stocks.
- You don’t have to pick just one company: ETFs give you exposure to several companies. Your money will be spread across the holdings based on the ETF’s weighting.
- You spread your risk across many companies: With ETFs, you hold a basket of stocks. This means that if one crashes, others can pick it up. This doesn’t guarantee a positive return, however. It simply means that your risk is spread out across several stocks instead of concentrated in the performance of just one business.
- You can easily buy several companies at once: Even though XOP has 59 holdings, there’s just one ticker and one price for all of them. That also means that you only have to track one stock ticker as opposed to monitoring several individual companies.
- Diversification cuts both ways: While spreading your money across several stocks via an ETF reduces your risk, it also tempers your profit potential. If one of your ETF’s holdings skyrockets, you won’t realize the full benefit because of weighting. The laggard stocks in the ETF will weigh down your best performers.
- You’ll hold stocks you don’t like: With ETFs, you don’t have a choice over which stocks you own. There may be some companies in the ETF that are pure garbage, ones that you would never put your money into. ETFs are all or nothing, however. You have a share in all their holdings or none at all.
- You can’t weight stocks on your own: If you buy individual stocks, you decide how much to invest in each one. For example, if you feel very confident in a company, you may decide to put twice as much into it as you would a more speculative bet. With ETFs, however, the fund chooses how your money is weighted toward each stock.
2. The moderate approach: the big names
Let’s say that you want to invest in the Energy sector but don’t want to spread your money as far as an ETF requires. At the same time, you don’t want to take on too much risk with smaller companies.
If that’s the case, consider investing in the behemoths of the industry.
ExxonMobil (XOM) and Chevron (CVX) are two of the largest integrated oil and gas companies in the world. “Integrated” means that the company is involved in nearly every area of the oil and gas exploration and production industry, from searching for new reserves to delivering refined products like gasoline and jet fuel.
Both companies also boast a dividend yield of over 3%, and that’s likely to increase for years to come.
Because of their size, XOM and CVX are unlikely to achieve the types of gains of smaller companies, but they aren’t as risky either.
3. The aggressive approach: create your own ETF
The approach that offers the highest profit potential is to find companies that are undervalued yet have significant growth potential. These businesses fit into the growth-at-a-reasonable-price (GARP) strategy that drives The Antagonist Blend Portfolio.
The aggressive nature of this approach also means that it carries more risk than the previous two methods. You can mitigate that risk, however, by building your own sector ETF.
Let me explain.
The first step is to identify a sector or trend that you believe is ready to pop. In our case, this is Energy.
Next, screen for stocks that meet the GARP strategy.
Lastly, buy a handful of the best ones.
With your basket of stocks in hand, you’ve effectively built your own ETF. You will then get the benefits of true ETFs like XLE and XOP, but you’re in control.
Don’t like a stock? Simple. Don’t buy it.
High on a stock but lukewarm on another? No problem. Overweight the one you’re more confident in.
The beauty of this approach is that you only need one or two big winners to turn a huge profit. You will likely end up with a laggard or even a stock that loses money. After all, no one gets 100% of their picks correct.
If one of your selections makes a big run, however, those gains will more than make up for the laggards and losers. That’s also how you mitigate risk. You don’t put all your money into one stock.
Energy Stocks to Buy Now
Any of the above three approaches can achieve excellent results. For the Blend Portfolio, however, I’m going with the third option. That approach fits well with our GARP strategy and gives us the best opportunity to double our money or more.
In the February 2023 monthly edition of The Antagonist, I outlined my process for screening and selecting stocks. I took that approach to choose these additions to the Blend Portfolio.
Since these are long-term holdings, I especially focused on each company’s return on capital, earnings yield, free cash flow, revenue growth, and dividends. I examined each of those metrics individually and then assessed what the combination of those data points tell me about the company as a whole. It’s a stringent, time-consuming process, but it’s also a great way to identify outstanding businesses.
Here are the four companies that made my list along with a brief summary of each.
Stocks to Buy Now #1: Arch Resources (ARCH)
One of the Blend Portfolio’s strategies is to find companies that are out of favor and undervalued by the market. Well, I’m not sure there is a more hated industry than coal right now. And that’s where our first pick comes from.
Arch Resources, Inc. is one of the top producers of coal in the U.S. The company’s reportable business segments are based on two distinct lines of business: metallurgical coal and thermal coal. It produces and sells metallurgical products to utility, industrial, and steel producers in the U.S. and internationally.
While developed countries despise coal, emerging markets still depend on it for energy production. I experienced this firsthand while I lived in two different East African countries. Coal was sold on the street everywhere, especially in poverty-stricken areas.
The rising global demand for metallurgical coal has been a tailwind for Arch. The company has been ramping up production volume and securing long-term supply contracts. Arch also commenced operation at the Leer South longwall mine, which is expected to boost its low-cost met coal production for the next two decades.
As I described in Part 1 of this report, global demand for fossil fuels is rising as countries struggle to secure sufficient supplies of energy to support their recovering economies. Arch Resources is a direct beneficiary of that demand.
In addition, the company continues to penetrate new markets and expand the global reach of high-quality coking coal. Once the pandemic is over, key coking coal import regions are expected to see solid demand growth. Given its low-cost production and high-quality coking coal, Arch is poised to benefit from any increase in demand for the fuel.
Arch Resources launched a capital return program in May 2017. According to a Jan. 31, 2023 report from Zack’s, Arch has returned $1.05 billion to shareholders through buybacks and dividend payments. Under this program, Arch plans to return nearly 50% of the prior quarter’s discretionary cash flow to stockholders.
Arch’s business fundamentals are strong. Over the last three years, its return on capital increased from a long-run average of 7.7% to 9.1%.
The company is also gushing free cash flow (FCF) and managing its expenses well:
- Free cash increased 14,588.7% year over year to $1,036.8M in Q4 2022.
- Accruals decreased -22.2% year over year to $-121.4M in Q4 2022.
- Capital expenditures have decreased by -29.6% over the last year while free cash flow has increased by 14,588.7%.1
I plan to add shares of Arch Resources (ARCH) to the Blend Portfolio and hold them for at least a year.
Arch is a relatively small company with a market cap of just $2.6 billion, and its stock can occasionally swing significantly. To manage our risk, I’ll employ a 40% trailing stop (more on that strategy below).
Given its small market cap and specific niche, consider limiting your position size to 1%-3% of your overall portfolio.
Stocks to Buy Now #2: Enerplus (ERF)
Oil is a tough business. For decades, most of the industry has taken a high-risk, best-guess approach to drilling. Companies borrow money, drill, and hope they strike oil.
That works well…until it doesn’t.
When the price of oil is high, funding is abundant. When it’s not…it’s not.
That’s why the oil and gas industry is plagued with bankruptcies. When the price of oil drops, debt-laden companies can’t pay their bills.
Our second portfolio addition breaks this cycle, however.
Enerplus Corporation (ERF) explores and develops crude oil and natural gas in the United States and Canada. The company operates differently than most of its competitors, however.
Instead of borrowing, drilling, and hoping, Enerplus buys proven oil wells when they’re at a bargain price. This strategy lets the company avoid the cost of building the infrastructure needed to produce oil. It also doesn’t have to spend millions of dollars on testing or take wild risks to buy new properties.
Enerplus’ strategy has resulted in loads of free cash flow (FCF), which is one of my favorite metrics to assess the health of a business.
FCF shows the cash that a company can produce after deducting the purchase of assets such as property, equipment, and other major investments from its operating cash flow. In other words, FCF is a quick way to determine how much cash is available for a company to distribute at its discretion.
Enerplus is in great shape. It could pay off all its debt today with one year’s worth of free cash flow. This also means the company can swoop in when its competitors are hurting.
Low breakeven price leads to big profits
As I previously mentioned, oil and gas companies live and die by the price of oil. When the price drops, the industry gets desperate. That’s when Enerplus pounces. They buy up existing, proven wells on the cheap.
It’s like buying a stock when it’s low and then holding on while it rises.
Because of its buying strategy, Enerplus owns wells for a low breakeven price. That means that even when the price of oil drops, the company can still make money.
For example, if oil plunges to $50 per barrel, most of the industry will be hurting. Enerplus, however, has hundreds of wells with a breakeven price that’s below $45 per barrel. That means that it’ll still make money even if the price of oil falls significantly from today’s prices.
Now consider the flip side.
When the price of oil rises, Enerplus will rake in massive profits, and its fundamentals will continue to improve.
Below are two illustrations of how Enerplus compares to the industry average and specific competitors.
I plan to add shares of Enerplus (ERF) to the Blend Portfolio and hold them for at least a year.
Like Arch, Enerplus has a smaller market cap. As of this writing, it’s a $3.5 billion company. ERF is also a volatile stock, so expect some big price movement. To manage that risk, I’ll track the position with a 40% trailing stop.
Given its small market cap and specific niche, consider limiting your position size to 1%-3% of your overall portfolio.
Stocks to Buy Now #3: Magnolia Oil & Gas (MGY)
Our third addition is another small-cap ($4.7 billion) company engaging in the acquisition, development, exploration, and production of oil, natural gas, and natural gas liquids. Magnolia Oil & Gas (MGY) has properties primarily in Karnes County and the Giddings area in South Texas. The company was incorporated in 2017 and is headquartered in Houston, Texas.
This is the 3rd small-cap company that I’m selecting, and it’s also the riskiest. Given how undervalued I believe the business is, however, MGY’s upside makes it worth adding to the Blend Portfolio.
Like others in the industry, Magnolia’s value will rise with the price of oil. The company’s management, however, makes it stand out from many of its peers.2
Magnolia has done a commendable job of restricting adjusted cash costs, which has led to attractive margins and cash flows. The business is one of the few upstream independents to generate substantial free cash flow after capital expenditures.
Magnolia plans to use its excess cash to repurchase 1% of its total shares outstanding each quarter. Beginning with the distribution in the second quarter of 2022, MGY has moved to a quarterly dividend payout from a semi-annual distribution schedule.
The company’s debt-to-capitalization also stands at a modest 18.3% compared with many of its peers that have massive debt burdens, accounting for around 50% of their total capital structure. With an undrawn $450 million revolving credit facility and $675.4 million in cash and cash equivalents, Magnolia’s liquidity is solid.
Magnolia’s commitment to creating value for shareholders is also appealing. On its latest earnings call, CEO Chris Stavros said the following:
We run Magnolia for our shareholders and my objective will always be to do what is in the best interest of our investors. We plan to maintain our discipline around capital spending while keeping low levels of debt. And we expect to continue our track record of achieving moderate annual production growth while generating significant amounts of free cash flow with strong operating margins…
We generated a record $823 million of free cash flow last year and returned 54% of this amount to our shareholders in the form of share repurchases and a regular base dividend which is paid quarterly. We repurchased more than 15 million Magnolia shares during 2022, reducing our diluted share count by 8% compared to 2021 levels.
This diagram shows MGY’s valuation and management effectiveness compared to several of its peers:
I mentioned earlier that MGY carries greater risk than the other companies I’ve profiled. This is largely due to its asset concentration. All of its output is skewed toward a single region in South Texas. This lack of geographic diversity exposes Magnolia to more regional risks than its more-dispersed competitors.
Magnolia also doesn’t engage in commodity price hedging. While this policy will help the company capture greater upside exposure to oil markets, lack of any hedge protection also makes it more exposed to potential weakness in crude prices.
Despite the risks, I believe that Magnolia’s valuation, upside, and management make it a worthy addition to the Blend Portfolio. Like the other stocks, I plan to hold MGY for at least a year.
MGY’s price can be volatile, so I’ll manage the position with a 40% trailing stop.
Since MGY has more risk than our other holdings—but still significant upside—considering limiting your position to 1%-2% of your overall portfolio.
Stocks to Buy Now #4: ExxonMobil (XOM)
My final addition to the Blend portfolio is also our only mega-cap.
With a market cap of $450 billion, ExxonMobil (XOM) is the biggest integrated oil and gas company in the U.S. and the largest refiner and marketer of petroleum products in the world.
Including XOM in our Blend Portfolio balances our small-cap holdings. XOM may not share the explosive profit potential of small-to-mid sized companies, but it doesn’t carry as high of a risk either.
Also, “less” profit potential doesn’t mean “small” profit potential.
ExxonMobil’s production costs are only around $41 per barrel for oil produced in 2022. That means that if the price of oil rises and stays high as I anticipate, the company’s profits will soar. Its low costs also mean that ExxonMobil can still make money if oil prices drop.
Just like our other three positions, I’ll add shares of ExxonMobil (XOM) to the Blend Portfolio and hold them for at least a year.
Since XOM doesn’t have as much growth potential, I’m going to track the position with a smaller trailing stop of 25%.
Even though XOM is incredibly large and established, I still recommend limiting your position size to no more than 5% of your overall portfolio.
Manage Risk with a Trailing Stop
To reduce downside risk and secure profits, I’m adding a trailing stop to each position.
A trailing stop means that I will close the position if it drops a certain percentage. There are two ways to employ this strategy.
The first is based on the price at which you buy the stock. To make math easy, let’s pretend that you buy XYZ for $100 and decide to use a 25% trailing stop.
Now let’s say that the stock immediately goes south after you buy it. If the stock drops to $75, you’ll hit your trailing stop of 25%. I use closing prices to determine my stops. If the stock closes for that amount, I sell it the next day no matter what. This helps keep emotions at bay.
But what if the stock climbs?
That’s where the “trailing” part of the strategy comes in.
Let’s use the same example of XYZ with a purchase price of $100. But this time, the stock leaps to $150. You’re up 50%! Using a trailing stop will help you protect those gains.
You simply apply your trailing stop amount—in our case 25%—to the highest closing price. So, if XYZ is $150, it means that if the stock drops 25% from there, you sell it the next day.
In this example, XYZ would need to fall to $112.50 before you closed it. If that happens, you’ll be disappointed that you didn’t sell at $150, but selling at the exact top is nearly impossible.
Also, employing a trailing stop gives your stock a chance to recover. For example, if XYZ hit $150 but then dropped to $135, you wouldn’t sell (as long as you still believed it was a good investment). If you’re correct in your assessment, the stock is probably just going through a temporary downturn like all stocks do.
The trailing stop, however, lets you know when to cut bait. In this case, that’s $112.50. Sure, you wouldn’t gain 50%, but you’d still realize a profit of 12.5%.
Notice that this is a very different strategy than setting a stop price.
With a trailing stop, you move the stop as the stock price climbs. Following this strategy means that you will protect your profits after a stock has made a good run.
This is also much better than letting the stock continue to fall and watching it go from a winner to a loser.
Keep Energy as a PORTION of Your Portfolio
I need to make this last point especially clear. While this report is focused on Energy, you should absolutely NOT put your entire portfolio into this sector. Doing so would put you at a huge risk. Your entire portfolio would get crushed if the sector crashed.
If you’re just getting started, consider putting no more than 1%-4% of your overall portfolio into each company. That way, even if the stock tanks, it won’t sink your overall portfolio.
Additional Stocks to Buy
By now, you know that I’m very bullish on the long-term profit potential of the Energy sector.
I can’t tell the future, but the data suggests that the price of oil specifically, and the price of energy in general, will rise and stay high for years. The four companies that I selected for our Blend Portfolio all stand to benefit from this mega-tailwind.
To be sure, there are great companies with the potential to soar along with the price of oil. I will continue to monitor the Energy sector, and when an investment opportunity arises, I’ll add it to our portfolio.
Of course, the Blend Portfolio isn’t limited to the Energy sector. Each month I’ll share other stocks that fit our growth-at-a-reasonable price (GARP) strategy.
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Thanks for reading,
- Data and calculations from Mclean Capital Research.
- The following data is from Zacks.
Disclosure: Jason Milton holds an ExxonMobil bull call spread option that expires on March 3, 2023.
Disclaimer: I’m not a stockbroker or financial advisor. I cannot and do not provide personal investment advice, and The Antagonist should never be interpreted in such a way. The Antagonist is an online financial literacy resource. All materials from The Antagonist are intended for informational and educational purposes only. They are not, nor are they intended to be, trading or investment advice or a recommendation that any security, futures contract, transaction or investment strategy is suitable for any person. Trading securities can involve high risk and the loss of any funds invested.
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