Extreme Value Plays
They say that twice a day a broken clock tells the right time. For most of the miners and oilers, especially the smaller ones, there are a lot of broken ones – if a price chart is your only picture. Over the past five years, the stock prices of many of these struggling companies are down over 90% and investor sentiment has reached extreme lows. We think it’s a good time to be looking for value. The question is why.
In this commentary, we recommend putting on the radar screens two miners, Hudbay Minerals (HBM) and Freeport-McMoRan (FCX), and three oilers, Earthstone Energy (ESTE), McDermott International (MDR) and Montage Resources (MR). We are also following one other company in the oil & gas industry, Baytex Energy (BTE). The table below summarizes our ratings on these companies. We look at each company in more detail below.
Our thesis is a simple one: Commodities are needed to sustain economic development. The world needs economic growth or its most serious conflicts will expand exponentially. At the present time, important international trade deals are being lined up that will facilitate that much needed global economic growth.
In our broad market late-cycle phase, valuations of FAANG stocks (Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL), Netflix (NASDAQ:NFLX), and Google’s parent, Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL)) have been stretched to the point that investor interest is waning. There is also a rapidly diminishing interest in goodwill-laden IPOs (Zoom (NASDAQ:ZM), Beyond Meat (NASDAQ:BYND), Pinterest (NYSE:PINS), Peloton (NASDAQ:PTON), Uber (NYSE:UBER), etc.).
But, today, there are fundamental reasons to become attracted to value-based natural resource investments in mines and oils. We have recently written about seeking income from some of the larger oilers (“Want Yield? Fuel Up”) and from the large cap miners; we could have pointed to Anglo American (OTCQX:AAUKF), Rio Tinto (NYSE:RIO), and BHP (NYSE:BHP) as well.
However, for capital growth, we believe that the best opportunities lie in the smaller oilers and miners.
All the companies we are writing about today are commodity producers, so here are the 5-year price charts of $WTI crude oil, natural gas, and copper that only partly explain their circumstances.
Back in 3Q2014, crude oil was in great demand, and $WTI was trading in the $100-105/bbl range. Industry profits were extremely high, and share prices of the smaller producers also reached extremes. For example, Earthstone Energy was trading in the high 30s, and Baytex was trading then in the mid-40s (USD).
Within 18 months, the price of $WTI collapsed to the high 20s, which was a decline of some -70%. However, along with dropping Oil prices, and even with a large recovery in the past 18-21 months to where $WTI is now down about -50% or less from 3Q2014, the prices of smaller oilers have been beaten down further. ESTE shares have plunged about -90% from their peak to just US$3.47 today, and BTE suffered an even greater catastrophic loss of about -96% to today’s price of US$1.59.
To start 2016 in the high 20s, the crude oil $WTI price did increase to the mid-70s in 4Q2018, following which over-supply was once again reached on the back of those rising prices. Consequently, the $WTI price quickly dipped again to start 2019 in the mid-40s until investors then started to see rapid declines in drilling and excessive use of inventory drawdowns to meet demand. Oiler economics has clearly been changing for the better. Since then, the oil price has rebounded to the mid- to high-50s.
After crude oil prices crashed from 3Q2014 through 2015, the industry began to do what any industry would do in survival mode. Better management, better use of technology, and constrained capex. Production costs/bbl dropped quickly, and gross profit/bbl (or netbacks) began to improve. In 2019, netbacks have in fact improved immensely. Yet, here we are in 2019, where the Oil & Gas Exploration & Production Index (NYSEARCA:XOP) is down about -20%, and for the smaller oilers like Earthstone and Baytex, as we noted, the decline is even bigger.
But why? Many of these small companies are now ramping up free cash flow and using it to pay down debt, increase share buybacks and increase dividends, which is precisely what most equity investors want.
Over the past year, oil and gas drilling in North America has declined -20% in the US and -40% in Canada, so production is peaking, at least for now, and reserves are being drawn down, which is an unsustainable solution. So, oil prices are now rising as already noted and so too are these smaller oilers getting sound financially.
For the oilers, the key is higher oil prices, obviously. But, why? If a company’s production cost is, say, $30/bbl, at $50 oil, the netback might be around $20/bbl. But after all-in costs are factored in, the earnings are minimal. However, at $60/bbl oil, the netback grows to $40/bbl and earnings, from being flat, grow to $10/bbl. At $70/bbl oil, which existed through much of the 2Q and 3Q2019, those earnings double to $20/bbl. At $90/bbl oil, which some of us foresee based on the capex cuts with dramatic reduction in drilling, those earnings double again to $40/bbl.
Earthstone’s revenue is expected to grow by about 27% next year and earnings to grow by 73%. Financials are strong (top 18% among the energy companies that we rank), the company is turning profits (27.2% profit margin), and the forward P/E is only 5.3x. Earthstone is mainly a victim of the negativity in the energy space. If our analysis is correct and demand returns to the crude oil market, Earthstone will be a homerun investment.
Baytex’s earnings are expected to contract by -61% next year, and we see very little in the way of analysts revising higher this negative growth estimate. Hence, our Strong Sell on Baytex. While Baytex is rated a Strong Sell in our rankings, the company is undergoing a massive change in free cash flow that will be apparent next quarter. Our data does not yet reflect what we understand about the company.
For a company like Baytex, guiding daily production to almost 100,000 bbl/day, with a $40/bbl earnings rate, and with constrained capex and administration cutbacks, their free cash flow would balloon. And, it has been. This excess will now continue to be used to reduce their former debt problem to absolutely no problem whatsoever. BTE at some point – within a year or two we believe – will be a ten times winner based on fundamentals. And there are several other oilers that have the same business model and probable outcome for their share prices.
Unlike Baytex, McDermott’s earnings are forecast to grow over 400% (from a loss of -$0.34 to a positive $1.34 EPS in 2020). The company’s valuation numbers are also compelling. However, the company is trying to stave off bankruptcy, so the sell algos are able to tank the stock price.
MDR owns valuable assets that may be sold with proceeds used to shore up their weak financial picture (among the worst in the energy sector, according to our rankings). If the company can hang in for 6 months without a sale, then rising oil prices and increased demand for their oilfield equipment and services at improved prices will quickly restore profitability.
Montage offers extremely attractive valuation with slightly positive forecasted earnings growth. Like McDermott, Montage is another small-cap energy company fighting for survival. Crude oil above $60/barrel next year would save both Montage and McDermott.
Regarding copper, the market supply and demand picture is different. As a commodity, copper this year is in a deficit, and this deficit will be bigger in 2020, according to most analysts. Some of the reason is that demand for electrical vehicles (EV) is growing quickly worldwide. EV production requires copper. Also, as rural society in the emerging economies becomes more urban-centric, the massive increases in real property development need copper. Moreover, as geopolitical strife increases, with the possibility of major war, there is a constant build-up of military armaments and vehicles that need copper.
Freeport-McMoRan’s earnings are forecast to rebound next year (from $0.14/sh to $0.64/sh), and this estimate is highly dependent on the evolution of the copper price. Valuation for Freeport-McMoRan is stretched, but this company tends to trade on the expensive side. Freeport-McMoRan is a high risk, leverage bet on a supply/demand imbalance for copper going forward.
Hudbay’s earnings per share are forecast to rise 49% next year. EPS revisions have not moved in the past month. While valuation is a bit expensive, the anticipated growth rate of Hudbay more than compensates. Our PEG score for Hudbay is among the top 13% of all energy companies. Hence, our Strong Buy Growth rating. Like Freeport-McMoRan, the success of an investment in Hudbay today will be determined by copper demand going forward.
Demand-supply tells us the price of copper is going higher, and profitability of producers like Freeport-McMoRan (FCX US$9.90 today) and Hudbay (HBM US$3.80 today) will soar as a result. The share prices will inevitably rise. But patience might still be required.
Resource stocks have been out of favor and the target of short-selling algorithmic traders. We are investors in resource stocks, not speculators. We cannot predict when the market will again recognize the value in low share prices, combined with earnings capacity based on commodity resources that will always be in demand. Initiating slowly an allocation to the miners and oilers recommended here will prove to be, over time, the start of a winning stock position.
WMA Trade Book & Monitors is a professional investment advisory service on SA Marketplace. Our premium service offers real-time access to our actively managed equity allocation strategies, including the WMA Global High Yield Strategy (over 6% annual dividends, without LPs).
We provide Daily updates highlighting trade ideas generated by our trading models and strategists’ opinions on current market events. All recommendations come with rationale for the trade. Readers can also access our numerous trading tools, including our DGR Macro Trading Model, our Company Watch List & Trading Model, our Daily EPS Revisions Changes Monitor, our Weekly Pops & Drops, our Insider Trading Monitor, Daily Chart Books and more!