Oil Producers Have Surged. Here Are 5 Stocks to Drill Into.

For oil investors, the sudden arrival of good news can raise the question of whether bad news is around the corner. Maybe not, based on recent conversations with Devon’s new CEO and a pair of Wall Street analysts—their top stock picks in a moment.

Energy was the worst-performing sector of the 2010s, and technology, the best. But so far this year, energy is leading tech by 23 percentage points—the second-biggest spread in history, according to Bank of America Securities. It points out that the energy sector remains inexpensive, at 11 times forward earnings estimates, versus an average of 17 times since 1986.

Oil has gotten a lift from predictions that the pandemic has peaked, and that travel will soon pick up. Texas crude is up from $53 a barrel a year ago to $85 recently. This past week, the International Energy Agency estimated that global oil demand in 2022 will top prepandemic levels. A large portion of the population will have gained Covid-19 immunity by the end of the first quarter, through infection or vaccination, and travel restrictions later this year could be minimal, it wrote in a report.

Stephen Richardson, who covers energy and chemicals for Evercore ISI, says that investors who expected oil producers to rebuild lean inventories have been surprised by scattered production challenges. These include political unrest in Libya, protests in Kazakhstan, sabotage in Nigeria, and the threat of war between Russia, a major energy producer, and Ukraine, a key energy transit hub.

Doug Leggate, who heads energy coverage at BofA Securities, sees history repeating, and Saudi Arabia regaining control of pricing. In the late 1990s, faced with a slumping oil price and a rogue producer in Venezuela, the kingdom flooded the market, sank the oil price, and forced widespread production cuts and consolidation. More recently, the rogue producer from Saudi Arabia’s view has been U.S. shale drillers, so during the pandemic downturn, it produced too much for too long, and forced another industry reckoning.

“This Machiavellian strategy…has worked,” Leggate says. “It has forced capital discipline on the [exploration and production] companies. I think we’re in a new world for the investment case.”

Longer-dated oil futures imply a price of around $20 below the recent one, but Saudi Arabia needs a $60 to $80 oil price to balance its budget, so investors might be guessing too low, Leggate says. Add $10 to the back end of the oil curve, and oil stocks could rise another 40% to 90%, he says. His top picks include

Occidental Petroleum

(ticker: OXY) and

APA

(APA), parent company of Apache. Both have significant debt, but also enough cash flow to pay it down, which could attract a higher valuation for shares. Leggate also likes

Exxon Mobil

(XOM) for its large U.S. shale holdings. Shale drilling is easier to stop and start than drilling for large conventional deposits in faraway places, affording flexibility.

What about electric vehicles and the effect on oil demand? The math is straightforward, Evercore’s Richardson says. There are a billion cars worldwide, with 90 million to 95 million sold each year. Assume EV penetration goes from 4% of sales to 15% by 2025, and to 30% by 2030. The decline in oil consumption of three million to four million barrels a day would be more than offset by increased oil demand from economic growth.

The rise of green investing has done little to curtail current supply, but it has forced oil producers to commit to limiting production growth, which has had an important effect on market psychology, Richardson says. Investors, meanwhile, have warmed to the yields for oil stocks, which, counting dividends and stock buybacks, can run in the high single-digit percentages.

Richardson, too, likes Occidental, and he recently upgraded

BP

(BP), whose shares already reflect aggressive vows to limit carbon production, but not the bright outlook for dividends and buybacks, he says. His other favorites are

ConocoPhillips

(COP) and Devon (DVN).

Devon’s free cash flow rose eightfold year over year, to $1.1 billion, during the third quarter of last year, a company record. Around half of Devon’s price hedging from last year will roll off this year, which could give free cash flow another goose.

After merging with WPX Energy last year, the company announced a fixed-plus-variable dividend. The fixed part is uninspiring, recently yielding less than 1%. But if the latest variable payment is an indication of future ones, shareholders could receive close to 7% in all.

CEO Rick Muncrief, who came from WPX, has capped Devon’s production growth at 5% a year. “We’re not interested in double-digit growth anymore,” he says. He hears similar things from peers. “We’ve had some head fakes where commodity prices rallied, only to see too much activity. I think that discipline is going to stick.”

Mutual funds with an environmental theme have long outperformed the stock market by shunning oil and embracing tech. Do well by doing good, they have said. But such funds have done poorly so far this year.

BofA’s Leggate expects these funds to adopt a more nuanced approach of embracing oil companies that are addressing their concerns.

“It’s easy to use [environmentalism] as a disqualifier for a sector that’s not doing well,” he says. “That’s a much harder discussion when the sector is outperforming.”

Write to Jack Hough at [email protected]. Follow him on Twitter and subscribe to his Barron’s Streetwise podcast.