After a stellar run during the so-called reopening trade from late 2020, the small-cap sector has turned into a major laggard in 2022. The sector’s popular benchmark, the Russell 2000 Index, has tanked 9.7% in the year-to-date compared with a milder 3.8% decline by the S&P 500 with a cross-section of analysts such as J.P. Morgan warning that this isn't just a stock market correction but a full-bodied bear market.
The small-fry stock trade fizzled by Q2 of 2021 as inflation began to bite into corporate margins and the Federal Reserve Bank became more hawkish.
“Client conversations have recently focused on the dramatic underperformance of the Russell 2000 small-cap index.Small-cap firms generally have weaker balance sheets, lower profit margins, and less market power, all of which make them highly sensitive to economic growth environments,” writes Goldman Sachs’ chief U.S. equity strategist in a client note.
JPM strategist Marko Kolanovic has recommended buying the dip, saying small-caps (NYSEARCA:IWM) and cyclicals (NYSEARCA:XLI) (NYSEARCA:XLE) (NYSEARCA:XLF) (NYSEARCA:XLB) (NYSEARCA:XLY)--offer buying opportunities.
Goldman’s David J. Kostin is less sanguine about small-cap prospects, saying tightening financial conditions, slowing growth, and a flattening yield curve will continue to pressure Russell 2000 returns relative to the S&P 500.
Nevertheless, Kostin has not written off the entire universe of small-caps, and recommends buying small-caps that can demonstrate strong growth, high profit margins, and “undemanding” valuations.
Kostin’s top small-cap picks are: Marathon Digital Holdings (NYSE:MARA); Northern Oil and Gas (NYSE:NOG); Murphy Oil (NYSE:MUR); Riot Blockchain (NASDAQ:RIOT); Federated Hermes (NYSE:FHI); Crocs Inc. (NASDAQ:CROX); Focus Financial Partners (NASDAQ:FOCS); Herc Holdings (NYSE:HRI); Tivity Health (NASDAQ:TVTY), and Sun Country Airlines (NASDAQ:SNCY).
Here are our top small-cap oil and gas picks.
#1. Northern Oil and Gas
Market Cap: 1.8B
YTD Returns: 12.2%
Minnetonka, Minnesota based Northern Oil and Gas Inc. (NYSE:NOG) is an independent energy company that engages in the acquisition, exploration, exploitation, development, and production of crude oil and natural gas properties in the United States.
NOG has a rather unique modus operandi in that it invests in oil producing properties, acting as a financial partner to exploration and production names. The company has more than 6,000 gross producing wells primarily in the Bakken.
NOG stock ever since the company announced that it had agreed in 2020 to acquire its first non-operating interest in the Delaware Basin in a $12M deal. That piece of news would have hardly turned heads if the buyer was an Exxon or a Chevron. The fact that a financial distressed company with more than a billion dollars in long-term debt and a high debt-to-equity ratio made such a bold move still deep in the throes of the crisis means that NOG really believed that an oil price rebound remained firmly in the cards, in which case its latest purchase could end up being a massive bargain. Further, NOG upped its production guidance.
The ongoing oil price rally has vindicated the company’s decision.
Further, NOG’s Marcellus Shale acquisition is expected to return an average 18% FCF yield on the investment, making the shares appear deeply undervalued despite the recent run.
Last year, Northern Oil and Gas announced it acquired Reliance Marcellus LLC’s non-operated interest in Appalachia natural gas assets. According to the company, the acquisition will generate ~$125 million of free cash flow over the next four years with an average 18% FCF yield on the investment.
Healthy cash flows have helped the company hike its dividend 75% to $0.14/share quarterly dividend.
#2. Tamarack Valley Energy Ltd.
Market Cap: $1.6B
YTD Returns: 25.3%
Headquartered in Calgary, Canada, Tamarack Valley Energy Ltd. (OTCPK:TNEYF) is a small oil company that acquires, develops, and produces crude oil, natural gas, and natural gas liquids in the Western Canadian sedimentary basin.
Tamarack Energy primarily holds interests in Alberta Cardium light oil plays in Wilson Creek, Pembina, Alder Flats and Garrington and Lochend areas in Alberta. It also owns Viking light oil resource plays in Redwater in Alberta.
Although Tamarack’s debt has surged after making several accretive acquisitions, it could come down by nearly 50% with the current high level energy prices.
Last year, Tamarack Valley Energy initiated a CAD 0.0083/share monthly dividend, good for 2.8% fwd yield.
#3. Crescent Point Energy Corp.
Market Cap: $3.7B
YTD Returns: 21.5%
Another Calgary-based oil company, Crescent Point Energy Corp. (TSX:CPG)(NYSE:CPG) explores, develops, and produces light and medium crude oil and natural gas reserves in Western Canada and the United States. The company's crude oil and natural gas properties, and related assets are located in the provinces of Saskatchewan, Alberta, British Columbia, and Manitoba.
Crescent Point shares once traded above $45 per share and even paid out a generous dividend, compared to the current $5.15 share price. Unfortunately, the 2014 oil price meltdown left the company battling plunging cash flows and high debt levels that forced the company to heavily trim dividends--and the shares have never fully recovered. Even after this year’s 120% gain, Crescent Point shares are trading 80% below 2014 levels.
Thankfully, the ongoing oil price rally has allowed Crescent Point to start generating healthy cash flows and make several strategic acquisitions. That said, this stock is likely to remain volatile and any setbacks in the near future could send the shares crashing again.
#4. Ring Energy
Market Cap: $278M
YTD Returns: 23.7%
Ring Energy, Inc. (NYSE:REI), is an exploration and production company that engages in the acquisition, exploration, development, and production of oil and natural gas in Texas and New Mexico.
As of December 31, 2020, the company proved reserves consisted of approximately 76.5 million barrels of oil equivalent(BOE) as well as interests in 45,000 net developed acres and another 31,700 net undeveloped acres. Ring Energy, Inc. primarily sells its oil and natural gas production to end users, marketers, and other purchasers.
In April 2020, REI announced that it had entered into a purchase and sale agreement on its Delaware Basin Acreage consisting of approximately 20,000 net acres with a sale price of $31.5 million.
The Company has received a $500,000 non-refundable deposit, and had received $5.5 million in non-refundable deposits, or 17% of the original purchase price by the time the deal fell through in October 2020.
The considerable non-refundable deposits that Ring Energy received painted it in a good light by proving the value of its assets to shareholders. The company is also likely to receive considerably more for the same asset in the future given that oil prices have climbed more than 30% since then.
#5. PDC Energy
Market Cap: $5.8B
YTD Returns: 24.1%
Last year, J.P. Morgan picked seven narratives playing out in oil and gas E&Ps. One of J.P. Morgan's fall "playbook" for oil and gas exploration and production companies are those with the highest potential return of "significant" levels of free cash flow to equity holders--rather than merely using it for reducing debt, as most oil and gas companies have done this year. Indeed, JPM says that since the end of 2020, companies in the firm's coverage group have cut net debt by $9.65 billion through balance sheets of June 30.
PDC Energy (NASDAQ:PDCE) is one such company that has announced cash return strategies beyond normal dividends.
PDC Energy is an independent exploration and production company that produces crude oil, natural gas, and natural gas liquids in the United States. The company's operations are primarily located in the Wattenberg Field in Colorado and the Delaware Basin in Texas. As of December 31, 2020, it owned interests in approximately 3,727 productive gross wells.
JPM also favors PDCE as a top pick because:
"We think that the current price environment remains a 'sweet spot,' with demand gradually recovering from COVID-19 and the OPEC/shale market share war remaining fairly subdued largely driven by public company shale discipline."
By Alex Kimani for Oilprice.com
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