Where Oil Price Bulls Should Be Looking

In today's low priced oil climate, there is a lot of opportunity in many parts of the O&G market. This opportunity has led to a rush of cash from venture capitalists, private equity funds, and smart money across the investing world. But for oil price bulls, two areas of the industry are particularly depressed, and thus, more interesting; offshore drillers and shale exploration and production companies.

On the offshore drilling side, there has been tremendous growth in the rig count across the space over the last few years. This capacity eventually outgrew demand, and day rates in the market started to soften last year. Since that time, companies have begun stacking rigs, delaying new ones, and looking for any opportunity to keep their utilization levels up. Executives across the space expect a pretty weak 2015, but many hope that the business will start to stabilize in 2016.

There is no question then that the offshore market is a very tough one right now, but stock prices have largely reflected that reality. And that has led to some real bargains. Perhaps one of the worst-hit stocks in the space, Paragon Offshore, was spun-off from Noble Corporation last summer at a price of $12 a share. Today Paragon trades at between $1 and $2 per share, despite having beaten estimates on earnings (Q1 Earnings Per Share (EPS) of $0.47) and revenue ($430 million) according to its latest announcement last month.

At these levels, Paragon is essentially a call option on the price of oil. If prices rise to $75 or $80 by the end of the year, and the market starts to stabilize, Paragon will triple or quadruple in value. If that scenario does materialize, the downside is limited. The company is generating cash, so even though the market is treating the company as if it is about to be bankrupt, that's not a likely scenario, unless conditions get a lot worse. Further, with short interest on the company at 36% on a fairly small float, there is not much room for more shorts to pile on, and even a small improvement in the macro-environment could lead the stock to rip higher.

Among major offshore driller, Noble Corporation looks like the best opportunity. Even if the current environment continues, Noble should earn ~$2.30 and $0.95 a share next year in adjusted EPS. Operating cash flow per share will likely be around $5.50 this year and $4.25 next year. All against a stock that is trading for ~$17 a share. 17x trough earnings is not bad and compares very favorably to most peers. When the next up-cycle begins, the company should see EPS of around $5 a share which would easily support a valuation around $75. At this point, the market is so pessimistic about the industry that no one is willing to hold stocks that could carry 5X returns within two to three years. With a debt-to-capitalization ratio of 40%, almost every other offshore driller would likely go bust before Noble did.

While it may take some time for the offshore market to stabilize, it will eventually. The offshore sector is typically slow to respond to changes, in part due to the built in stability of contracts in the space, but that same stability can provide investors with peace of mind.

On the other side of the coin, onshore shale producers are also struggling with the global supply glut. Unconventional production has been the driving force behind the explosive increases in US petroleum supply over the last few years. The EIA is projecting that oil prices will only average $79 in 2020, largely as a result of peaking oil demand, and continued abundant supply. That said, it's worth remembering that most research groups, including the EIA, couldn't forecast their way out of a paper bag. Just last year, the EIA was calling for oil prices in 2020 of $109 a barrel.

Two firms that stand out in the shale space as good buys at current levels are Ultra Petroleum Corp (UPL) and Devon Energy (DVN). Ultra carries a very high debt load, but last fall the company made a deal with Royal Dutch Shell trading UPL's natural gas Marcellus acreage for acreage in Pinedale, Wyoming. The Pinedale acreage has huge natural gas reserves with a long reserve life and slow decline rates. The market was too worked up over the collapse in oil prices to realize the significance of the deal, but the trade should benefit UPL over the long-run. Moreover, UPL has made significant cost cuts which should bring the company back to generating positive free cash flow this year. The company's focus on natural gas also helps to insulate it from some of the oil price volatility.

With Devon Energy, investors avoid the risks associated with many of the E&P players that are overly tied to one particular basin. The company has excellent assets in Eagle Ford, Meramac, and Bone Spring. The firm's Permian plays should have a shelf-life in the decades, and Devon's midstream MLP EnLink gives it some business diversification. The benefits of the stock have not been totally lost on investors, and Devon has not seen quite as big a decline as some other names in the space. Nonetheless, as a best-of-breed player in the space, Devon should see substantial upside from efficiency improvements over the next year regardless of what happens to oil prices.