Written by Sam Kovacs
Introduction
Here we go again, that Kovacs dude writing another article telling readers to buy energy stocks.
I do apologize if you've heard this time and time again.
But when it comes to it, since late 2020, there have been few investments in the equity space which have been as high conviction as the energy trade.
There was a time, over a year and a half ago now, when the world believed that oil prices would never recover as we transitioned to a green economy. I called this "the biggest lie of 2020".
At the time, we were building positions in the highest energy companies.
Then a year ago, I suggest investors "forget tech & renewables" because "".
Since then, I have repeatedly included energy stocks in our lists of stocks to buy.
Even after fantastic gains in the sector in 2021, there remained plenty of opportunities.
In January 22, I suggested that one of the outrageous claims you needed to hear to beat the market this year, was that wokeness had to subside to let place to common sense.
As the energy crisis continues, and valuations still fail to adapt to the reality of the market, many energy stocks are still fantastic buys.
Why Exxon and Chevron aren't the best buys now
To understand why the stocks we present below are better buys for dividend investors, I first need to present why Exxon (XOM) and Chevron (CVX) aren't the best buys now.
That wasn't always the case.
There was a time when Chevron was our highest conviction buy in the energy sector, because of uncertainty around when the world economy would pick up.
Our thesis was simple: Buy the best-run oil major. Chevron was the obvious winner.
In August 2020, Robert told investors they'd be "laughing to the bank with Chevron's 6% yield".
Since then Chevron has returned 98% when including dividends. That is 4x the return of the S&P 500. While nobody goes to the bank anymore, I'm sure you can still have a good laugh if you outperformed so much with Chevron.
That doesn't mean that we are perma-bulls in the space.
In fact, when Chevron reached $170 earlier this month, we sold 1/5th of the position from our portfolios.
We did this, because CVX was trading at yields which made it historically overvalued, as suggested by the MAD Charts above.
Chevron would need to increase its dividend at 7.5% per annum based on our proprietary required dividend growth formula, to be an attractive dividend stock.
While this is certainly possible, it is not obvious that they will manage to sustain this level of growth. Combined with the fact that CVX hasn't yielded less than 2.9% in the past decade, there is somewhat a cap on capital appreciation.
Exxon isn't the best buy for other reasons.
While, unlike CVX, it is still trading below its 10-year median yield, it is within a range which the stock hasn't managed to break out of these past 7 years.
This challenges stock appreciation but doesn't in and of itself justify not purchasing the stock at these prices.
The rationale lies more with XOM's 4% yield. At this level of yield, we expect 5% dividend growth for it to provide sustainable income. While it is possible that XOM grows the dividend at this rate, management has been extremely cautious in the past few years, and I doubt they will aggressively increase their dividend.
We lightened a little of our position at $80, and are now holding until higher levels, where we would look to scale out.
As you can see, within our universe of high-quality equities, our selection process relies on a stock both being undervalued relative to its historical yield and having a combination of yield and expected growth which is satisfactory.
This isn't to say CVX and XOM won't go higher if the sector continues its rise. In fact, there are a lot of stocks that would be worse buys than either of these majors at current prices. Only relative to the sector, they are no longer mispriced.
Here are a couple which still are significantly mispriced.
Suncor still mispriced
In October 2021, I suggested that Suncor (SU) was "one of the most mispriced equity investments available".
The thesis was quite simple: Energy was well above SU's breakeven prices, the dividend had been doubled, and the company had reached 5-year targets in 1 year, yet the market was not reacting.
I said:
From these levels, it is only normal to expect the stock to increase back to $40 to $50 over the next year or two.
Suncor is totally mispriced.
Certainly, that has been changing since, with Suncor's price going from $25 to $37.
I guess activist hedge fund Elliott has finally caught up (maybe we should suggest they subscribe to the Dividend Freedom Tribe?) and built a sizeable position in Suncor, as they envision 50% upside.
The upside is happening with or without them, by the way. At current oil prices, Suncor is printing $70 per barrel after everything from operating costs to CAPEX to dividends has been covered.
Think about this. At $105 WTI, that is $70 of excess cash which the company has no practical use for. I'm sure they'll think of something either more dividends, or deleveraging, or accelerated Capex.
There are no shortages of things to do with excess cash flow. I'm confident Suncor's management will use this excess cash flow to return more cash to shareholders through buybacks and dividends. The company bought back 6% of its stock last year, in what was incredible timing as the stock traded at all-time lows.
More buybacks should enable the dividend to continue growing, as should multiple years of sustained energy prices.
Consider that the World Bank thinks commodity prices could remain unusually elevated until the end of 2024. That's more than enough time to ensure shareholders get handsomely rewarded.
Yet Suncor's current yield is still above its 10-year median yield of 3.1%.
A return to median yields alone should ensure that investors get a further 18% upside.
We still see SU going to $50.
SU has an upside whether or not Elliott is successful in replacing management. If they do, then they will be able to infuse a new C-suite team with the goal of making the company more dynamic. If they fail, SU's management will likely increase the dividend heavily again, as a reminder that shareholders can still do well despite the bureaucratic management.
SU is still a buy, after increasing nearly 50% from our first signal.
EOG Resources: Further to run
EOG Resources (EOG) is a high-quality US exploration and development company which has been on a tear.
We first recommended members of the Dividend Freedom Tribe buy EOG when it was trading at $50 in January 2021.
Since then investors have received $7.5 worth of dividends, which is equivalent to an 11% annual yield thanks to generous special dividends. That alone was nice.
But the stock increased to $112, which equates to 124% returns. in just about 16 months.
Not bad at all.
EOG historically yielded very little because of its explosive dividend growth.
During the past 5 years, it has yielded a median 1.5% these past 5 years, and a 0.75% yield during these past 10 years.
As the yield has come up, the MAD Chart looks insane, as dividends have continued to increase aggressively but the price has not followed suit.
Therefore it is best to focus on the 5-year MAD Chart to get a reading which actually gives us a reasonable indication of where the stock could be headed over the next few years.
As you can see, a return to median yields would suggest a crazy upside for EOG.
The price could go to $200.
Do I think it is heading there? It depends.
There is no good reason for EOG to yield 2.66%. But going back to a 1.5% yield would need a further leg up in all energy stocks to support this.
In the current market conditions, however, I can easily see EOG trending towards a 2% yield. That suggests a $150 price which would still imply a 30% upside this year.
Just like SU, EOG is a low-cost producer and prints cash at anything above $44 WTI.
With $100+ oil prices, another dividend increase in a couple of quarters seems inevitable.
Given EOG's history of aggressive dividend increases, I expect a 20% to 30% increase this year.
This is easily achievable as the company continues to increase its free cash flow dramatically.
This profitability is not only due to increasing oil prices but also to reducing costs during past years.
All this extra cash has resulted in net debt going down to 0.
EOG has a pristine balance sheet and plenty of room for more upside. The market is not appreciating this company to the full extent of its value.
Conclusion
In an inflationary environment, and amid a commodity crunch, wouldn't you want to own the companies of those who are profiting from it?
If yes, you'll agree that exposure to the energy sector will be well worth it.
Picking the most mispriced assets like SU and EOG could provide investors with outsized returns (again).
One Last Word From Us...
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