3 oil and gas stocks to buy

Oil prices are at multi-month lows. Why? And where are the opportunities for investors? John Stephenson, president and CEO of Toronto-based Stephenson & Company Capital Management Inc. says savvy investors should be looking for refiners who buy cheap oil and convert it into higher-value-added products such as gasoline and diesel. He picks three oil and gas stocks that benefit from cheap crude and good geographic diversification.

Oil prices have now fallen to multi-month lows. One immediate factor behind this? American weekly inventory data showed a small increase in U.S. crude production. Recent government data had shown production peaking in March before falling slightly in April and May; however, the latest weekly production estimate showed that output rose by 52,000 barrels a day to 9.5 million barrels per day. At the same time, President Obama has begun urging lawmakers to support the proposed Iranian nuclear deal.

Oil Gas StocksMore broadly, oil prices have slumped in recent weeks on concerns that persistently high production in the U.S. and elsewhere could keep the global market oversupplied through the end of this year. Output remains near multi-year highs in the United States, Saudi Arabia and Iraq. The Iran nuclear deal, if implemented, would lift sanctions on that country’s crude exports, allowing it to sell more oil on the already-glutted market.

Take persistently high global output, then add Iran

In a speech at American University in Washington, D.C., President Obama put his political opponents on notice by warning that the consequences of Congress rejecting the Iran nuclear deal could mean another war in the Middle East. Mr. Obama said that whether lawmakers approve or reject the Iran deal next month will determine the future of America, which is still recovering from a decade of war in the Middle East.

The deal negotiated between Iran and a six-nation negotiating bloc—the U.S., U.K., Russia, China, Germany and France—strictly limits Tehran’s nuclear activity for at least a decade in exchange for the lifting of economic sanctions.

How much oil would Iran add?

The agreement curbing Iran’s nuclear program in return for easing sanctions is expected to lead to increased oil shipments. Iran is seeking to produce almost four million barrels a day within seven months of sanctions being removed, expanding to 4.7 million barrels a day as soon as feasible. Anticipation that Iran will add to a global glut has been weighing on crude oil prices. Adding to the pressure on crude prices are leading members of the Organization of Petroleum Exporting Countries (“OPEC”) that are pumping oil at record levels to protect market share.

A glut, even without Iran

Last month, oil slumped the most it has since 2008 on signs the global surplus was persisting, with the U.S. continuing to pump out oil at its fastest rate in three decades and OPEC opening the spigots. Goldman Sachs Group, Inc. said recently that the global crude oversupply is running at two million barrels a day and storage may be filled by the fall, forcing the market to adjust.

Supply is exceeding demand

U.S. refineries have been running at their highest rate in years to process the glut of crude oil into petroleum products. But stockpiles of gasoline and other fuels rose in the week, which suggests consumption isn’t high enough to absorb the oversupply in the market. Gasoline stockpiles were most recently expected to fall by 600,000 barrels over the week, yet they rose by 800,000 barrels, according to the U.S. Energy Information Administration. American crude inventories remain 100 million barrels above the five-year seasonal average—the highest levels since records began.

And oversupply is a global issue

The oversupply can be seen globally and spans both crude oil and refined fuels such as diesel and gasoline. Low crude oil prices and a seasonal pick-up in demand for motor fuels have prompted refineries to run flat-out in recent months, which could ultimately lengthen their downtime for maintenance later this quarter.

European inventories in key storage facilities are also at record highs; Singapore stocks of refined fuels are at levels last seen in 2011; and the Saldanha Bay strategic storage hub in South Africa is filling up.

Global refiners respond to seasonally weaker demand

Maintenance closures aside, refiners are bracing for a period of lower margins after a strong first half of the year. Gasoline has been a superstar performer so far this year, but seasonal changes should result in weaker gasoline prices.

Japan’s biggest refiner, JX Nippon Oil & Energy Corp., has said it will cut the amount of crude it will process in August as refined product stockpiles remain high. Taiwan’s Formosa Petrochemical Corp. is also making reductions. Large volumes of crude destined for Asia have had to find alternate homes recently. Chinese traders are reselling cargos; some Angolan oil has gone into storage; and a tanker of North Sea crude that was sailing to South Korea was abruptly halted off Portugal recently before changing its destination back to the U.K.

While July was a terrible month for oil bulls, they might want to hold on tight for further turbulence. Oil demand is heading for its seasonal lull as drivers scale down summer road trips, people and businesses turn down their air conditioning, and the world’s refineries undergo maintenance ahead of winter. Together, these changes will strip away factors that lent some support to oil prices in recent months.

OPEC output rises to record levels . . .

Last month oil plunged as production from OPEC countries rose to record levels even as U.S. shale output continued to prove resilient in the face of lower prices. Turmoil in Greece, Chinese equity market tumult, and a stronger U.S. dollar all combined to add additional pressure to crude oil prices.

. . . an increase that’s ‘large, significant & bearish’ for prices

Some of the factors pressuring oil prices are proving resilient, including both U.S. shale oil output and non-OPEC production (including, for example, Russia). And this is occurring as OPEC crude oil output has increased from 30.4 million barrels a day in November 2014 to 31.9 million barrels a day in June 2015. The lion’s share of this increased OPEC production has come from Saudi Arabia and Iraq. According to Paris-based Société Générale, the increased production from Saudi Arabia and Iraq is “large, significant and bearish” for oil prices because it further delays the rebalancing of the global oil market.

What I recommend

With oil prices under pressure, the logical place for energy investors to pivot is toward the independent refiners who have managed to weather the storm rather well. That’s because lower crude oil prices translate into lower feedstock costs for refiners. Refiners with good geographic diversification of operations can take advantage of the price differential between Brent crude oil (the European benchmark) and West Texas Intermediate (or “WTI”: the U.S. benchmark). Similarly, integrated oil and gas companies can benefit from their “downstream” (i.e., refining and marketing) operations when global crude oil prices are weak.

Valero: Largest independent refiner in the U.S.

One stock that I really like is Valero Energy Corp. (NYSE─VLO), which is the largest independent refiner in the United States. I like Valero for its significant leverage to the U.S. Gulf Coast refining market. Valero has great optionality in its refinery portfolio and should be able to take advantage of either wide WTI-Brent spreads or wide light-heavy spreads. (In other words the gap between WTI and Brent prices or between heavy and light crude oil prices.) Valero also has a very long runway to add value through “drop-downs” of assets into its sponsored master limited partnership. I have a buy recommendation on the stock and a 12-month target price on the shares of $78.

Tesoro: Best recent execution among U.S. refiners

Another stock I like is Tesoro Corp. (NYSE─TSO) an independent refiner. Tesoro has demonstrated some of the best operational execution of all the refiners over the last 18 months. It also has the best position in the California refining market and a very solid inland refining portfolio. Like Valero, the company also has the ability to drop down mature assets into its master limited partnership, which should help to unlock additional value for shareholders. I have a buy recommendation on the stock and a 12-month target price of $111.

ConocoPhillips: Meeting performance targets as it sharpens its focus

Beyond the pure-play refiners and integrated oils, one name I like is ConocoPhillips (NYSE─COP), the world’s largest independent exploration and production company. (Years ago, ConocoPhillips sold its filling station network. More recently, it spun off its refining operations.) The company has continued to slim down and sharpen its focus and, with asset divestitures near the top end of its target, is well positioned to meet its performance targets over the next few years.

There is good visibility on near-term growth because much is coming from lower-risk countries that are members of the Organization for Economic Co-operation and Development (or “OECD”).

As well, ConocoPhillips has a new management team that is more collaborative than its predecessors. It’s also focused on driving higher returns by using the firm’s technical skills. I have a buy recommendation on the stock and a 12-month target price of $75.

Focus on companies that benefit from weak oil prices

While oil prices are likely to remain under pressure for some time, savvy investors should be looking for companies that are benefitting from the weak oil price environment. In general, refiners who buy cheap oil and convert it into higher-value-added products such as gasoline and diesel should be favoured over exploration and production companies that ride up and down with the commodity price.

 

The MoneyLetter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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