With a deep-seated bearishness pervading the energy sector, it’s hard to discuss even favored E&Ps without acknowledging some of the industry conditions that have left energy trailing most sectors of the broader market. As of early June, energy’s weighting in the S&P 500 Index had dropped to a mere 5.9%. This compares to a string of double-digit years from 2007 to 2013 and a peak of 16.2% in June of 2008.

To rub salt in the wounds, while the S&P 500 Index has enjoyed a gain of around 9% through the first five months of the year, many energy stocks are down hard—in some cases by 20% to 30% or more. So what has made energy so perilous for investors? And what names in mid-cap energy—which have generally fallen further than their large-cap peers—are viewed as diamonds in the surrounding rubble?

Oil & Gas Investor asked analysts in the Houston energy hub for mid-cap names that will outperform.

Matt Portillo, managing director of E&P research with Tudor, Pickering, Holt & Co. (TPH), chose Parsley Energy Inc. (NYSE: PE) as a top pick. Subash Chandra, managing director covering the E&P sector for Guggenheim Securities LLC, favored WPX Energy Inc. (NYSE: WPX) as a name that has consistently outperformed since Rick Muncrief was appointed CEO in 2014.

But back to the big picture: What key factors have caused investors to spurn energy of late?

One dynamic has been a “structural shift” in investors’ long-term view of oil prices, according to Portillo. With improvements in well productivity leading to greater capital efficiency, most of the industry’s business models “work quite well in a $50 to $55 oil price environment,” he said. And, with many E&Ps able to roll out high-graded inventories stretching out four to five years, or more, the investment community is increasingly viewing $50 to $55 as the marginal price.

Longer term, investors expect that oil prices may move up to $55 to $60, Portillo noted. However, for the near term, they anticipate oil prices being “range-bound” at $50 to $55, potentially pressuring E&P stocks lower before new buyers are willing to come into the market.

“That sets the commodity price at which investors are willing to buy equities,” said Portillo. “Therefore, a lot of energy stocks need to discount something below that $50 to $55 range to make them attractive for investors to own.”

At $50 to $55, TPH has seen growing interest in energy on the part of value investors, but even so, “I don’t sense there’s a rush to get involved in the space given the sheer level of supply growth that is on the horizon,” Portillo observed. Comparing exit-2017 output to the exit-2016 level, TPH models U.S. crude production growing by 800,000 to 900,00 bbl/d, a level that is set to outstrip demand growth.

“From a macro viewpoint, the real fear is rolling into 2018,” said Portillo. “In the context of 1 million barrels per day of demand growth, the U.S. can grow by closer to 1.2 million per day in a $50 to $55 world, which doesn’t leave a lot of room for OPEC to reverse its cuts. It would necessitate another year of OPEC holding back on the production side and require declines in certain non-OPEC countries’ output to help offset the U.S. production growth.”

Moderating growth

TPH’s investor feedback includes the view that the U.S. should “moderate” its growth, said Portillo, adding that this would help calm fears about “unconstrained growth” coming from the U.S.

“The price point at which E&Ps begin to decelerate is pretty clear,” he said. “If oil prices stay near $45, or lower, for a quarter or two, I would expect to see E&Ps start to cut back on their capital budgets, and hopefully that would begin to revise lower expectations for 2018 supply. Investors are watching and waiting for E&Ps to scale back production, which would set up a fundamentally healthier 2018.”

The $45 mark for oil can have a significant impact on E&Ps’ balance sheets, because below that price level, “you generally start to see leverage metrics rising on a net debt-to-EBITDA basis,” Portillo noted. “Companies can’t really sustain themselves for an extended period of time, and management teams in this space likely start looking to revise capital budgets lower.”

Coming into 2017, TPH expected that E&Ps would set capex levels closer to cash flow, having had to raise billions of dollars in 2016 mainly to shore up balance sheets, Portillo recalled.

“But, that playbook has been thrown out and replaced by the 2014 playbook,” he said, “which was to outspend for multiple years and hope that commodity prices early on allow you to get your growth rates up such that you can grow organically into your leverage metrics over time. Obviously, that was met by some pretty disastrous results in 2014.”

Sorting companies by market capitalization, TPH data indicate varying levels of outspend by the E&Ps covered. While large-cap names plan to spend mainly within cash flow, the mid- and small-cap names under coverage have budgeted outspends of, respectively, 20% to 30% and over 50%. In particular for small caps, this has thinned the ranks of investors willing to consider taking a position.

“In small caps, there’s more willingness to take risk on a cash flow-to-capex perspective in hopes of growing organically into their leverage metric. But, it puts more risk into the system,” said Portillo.

“What we’ve noticed is that, as investors have become more bearish on the commodity over time, they’re continuing to high grade and migrate to the mid- and large-cap companies, because there’s typically less financial risk to their budgets. And, frankly, if you think crude is going to rally $10 to $15 per barrel from here, those large-cap E&Ps will still outperform the broader indices.”

Relative performance prioritized

Investors are inclined to prioritize relative performance over absolute upside in the current market conditions, Portillo added. “The perception is that, with a lot of the names down 30% to 40% year-to-date, you can buy a high-quality large-cap or mid-cap name whose management is spending closer to cash flow, and potentially make 30% or 40% when crude prices eventually make that turn.”

What factors make Parsley a mid-cap favorite?

As of its June 12 closing price of $27.85, Parsley offered more than 60% upside to a net asset value-based target price of $46 per share, based on a price deck of $65 and $3 per thousand cubic feet (Mcf). At a lower oil price assumption of $55, TPH’s NAV (Navistar International) price target calculates at roughly $36, still offering close to 30% upside. In addition, Parsley is one of only a few stocks that is discounting an oil price of below $48

In addition to valuation, Parsley’s full complement of attractive attributes gives it shine.

“Given the sell-off year-to-date, Parsley is one of the most attractive names in our coverage universe,” Portillo said. “The company combines a high-quality asset base, offering leverage to both the Midland and Delaware basins, with an extremely good job by management on the execution front. It is one of the lowest cost producers in the U.S., with some of the highest margins, given the reductions they’ve made in lease operating expense. And they can boast some of the highest growth rates.”

Parsley’s growth has certainly been remarkable: Over its 12 quarters as a public company, it has increased its production at a compound quarterly growth rate of 16%. Moreover, Portillo believes output for 2017 and 2018 is biased higher than consensus estimates. From a 2016 base of 38,300 barrels of oil equivalent per day (boe/d), the TPH analyst forecasts output expanding over 80% and 60%, respectively, to 72,000 and 118,000 boe/d as compared to Wall Street estimates of 67,000 and 108,000 boe/d.

Strong production growth through 2020 compresses Parsley’s valuation on an Enterprise Value-to-EBITDA (EV-to-EBITDA) basis. On 2020 EBITDA, assuming $55/bbl and $3/Mcf, Parsley trades at just a 4.0 multiple of estimated 2020 EBITDA, according to TPH. In addition, the company is projected to become free-cash-flow positive in 2019 and to “generate fairly significant free cash flow” in 2020.

Portillo described Parsley’s balance sheet as “pristine,” with more than $1.6 billion in pro forma liquidity, no debt maturing until 2024 and a B1 rating from Moody’s. In addition, the company has hedges on over 80% of consensus production for the back half of 2017, “plus substantial protection in place for 2018,” according to its investor presentation.

Impressive Wolfcamp ‘C’ well

In addition to its existing inventory of more than 8,000 net locations, Parsley has impressed investors with news of successfully tested incremental horizons and acreage. With the release of its first-quarter earnings, the company announced its first test of a Wolfcamp “C” well, which was outpacing its 1-MMboe type curve by 95%. The well reached a peak 30-day rate of 3,135 boe/d.

“It’s early in the life cycle of the play and its delineation, but that is one of the most productive wells drilled in the Midland Basin to date. It was a bit of an eye-opener for industry participants and investors alike. Not only was the rate on a boe basis quite high, but, more importantly, the oil cut was very prolific, and therefore, the economics exceed anything else being drilled in the portfolio.”

Subject to successful delineation, the Wolfcamp C is expected to capture a bigger portion of Parsley’s budget going forward. But, Parsley has no short of opportunities. It has a base approaching 3,000 net locations in the Wolfcamp A and B and has reported improving results from lower Spraberry wells on acreage acquired from Double Eagle Energy Permian LLC. In addition, Portillo pointed to prospects of expanding resource potential from offset operators proving up Jo Mill and Clearfork horizons.

“I think you’ll hear more about upside potential from the Jo Mill and Clearfork horizons, which may be delineated by industry peers in the back half of this year,” he said. “And, in 2018, we think the Bone Spring may become a bigger opportunity set in regard to acreage positions in Pecos and Reeves counties, [Texas], in the Delaware Basin. So, there are incremental resource catalysts on the horizon that we think are not being appropriately priced into the equity today.”

Natural gas parallels?

Guggenheim’s Chandra ascribed investors’ near-term lack of interest in energy to several factors, but principally to parallels with natural gas and the erosion of gas pricing power in an oversupplied market.

“Oil investors are at some level concerned that this may be the gas market all over again,” Chandra observed. “They’re concerned that there’s a plentiful supply, and the price never fully recovers. That’s what I think is hurting investment in the space.”

Chandra recalled how over a period of years, natural gas sentiment went from an expectation that pricing would rebound to $4 to $6/Mcf to a realization that prices would trade in a range of $3 to $4 and then $2 to $3.50.

“That was the erosion in natural gas sentiment,” he said. “It took several years to happen, but, gradually, the floor on pricing got lower, and the ceiling got lower.”

For individual stocks, the perception of much looser natural gas supply has meant the market is not willing to pay for gas that is being developed more than a few years out, according to Chandra.

“If you’re in a supply deficit market, you’re willing to pay a lot for your future probable reserves,” he commented. “But we’re not in a supply deficit market for gas. When you’re saturated with supply, that future reserve value is worth almost zero.

“It’s like saying, ‘How’s that Devonian gas well doing in the Marcellus, and how’s that Upper Devonian well next to it?’ We used to pay a lot of attention to those wells. What do we say now? Who cares! The Marcellus is oversupplied. You don’t care from which zone you’re oversupplied; it’s just oversupplied.”

Chandra noted some interest in energy from value investors, but said otherwise there’s “a pretty large degree of nonparticipation among investors.” To attract interest, “you’d rather have a market where supply is more constrained, where demand is surprising to the upside.”

Meeting targets

Against such a backdrop of commodity skepticism, Chandra favors WPX Energy, based in Tulsa, Okla. The Guggenheim analyst’s target price for the stock is $16 per share, which offers potential upside of 60% from its June 12 closing price of $9.94. The target is based on a net asset value using long-term commodity assumptions of $60/bbl for oil and $3.40/Mcf for gas.

Chandra initiated on the stock at around $4 per share, after oil prices had collapsed, but a recovery was underway. Earlier, WPX had purchased RKI Exploration & Production LLC, gaining a base of 92,000 net acres in the Delaware but also the need to divest $800 million to $1 billion of assets by year-end 2016 to pay for the acquisition.

“My premise on the stock was that it offered [Rick] Muncrief’s leadership coupled with a core asset in the Delaware Basin,” said Chandra. “The Stateline asset in the Delaware was very appealing to us. WPX was able to buy it before the huge Powerball game began. They had a head start, and they had ways to fund it by selling off noncore assets.”

While critics argued WPX was too levered—or would generate too little cash flow after selling assets—the WPX management team was able to execute on the plan.

“They put out a vision. It was cogent. It was specific. But more important, they delivered on it every 90 days,” said Chandra. “The constant message was: Get it done. Every 90 days there was a big check mark against one of the deliverables. They really did earn the loyalty of the Street.”

In addition, while several Permian E&Ps could speak knowledgeably about the Midland Basin, the role of spokesman for the Delaware was one naturally assumed by Muncrief given WPX’s early entry. Even if investors didn’t have a position in WPX, they would still want to know what its management was thinking in terms of best practices in a difficult time, according to Chandra.

In mid-June, WPX again met targets by making an earlier-than-expected announcement of a midstream joint venture (JV) with Howard Energy Partners. Under the terms of the JV, valued at $863 million, WPX will receive $300 million in cash, as well as a $132 million carry, and will retain 50% ownership.

Chandra noted that the $300 million in cash proceeds were above Street expectations of around $200 million and should fund WPX’s cash-flow deficit for the balance of 2017. On closing, proceeds from the agreement—akin to a “pre-funding” of investments that allows WPX to retain 50%—should lower by half a turn the company’s year-end 2017 net debt-to-EBITDA, reducing it to 4.5x, he said.

Assets covered under the JV include a 125,000-bbl/d crude gathering system and a 400-MMcfe/d gas processing facility. The crude gathering system began operating at roughly 50% of capacity in late 2016 and is due for completion in the first half of 2018. The first of two trains in the gas processing facility is expected to be in service in the same time frame, with the second train planned to be online by mid-2019.

WPX retains 100% ownership of certain midstream assets that are not part of the JV agreement. These assets, according to Chandra, are worth “at least $500 million, the value ascribed to them at the time of the RKI acquisition” over two years earlier.

Guggenheim models WPX’s full-year 2017 production at 108,600 boe/d, up 28% from 2016, and just over the midpoint of guidance. For next year, it estimates a further jump in output of 49% to 161,900 boe/d. The full-year 2017 production guidance could prove conservative, according to Chandra, in light of outperformance of wells drilled on acreage acquired from Panther Energy Co. earlier this year.

In its first-quarter results, WPX announced three 1-mile lateral wells in the Wolfcamp A interval that were drilled on Panther Energy acreage and were tracking above a type curve of 1 MMbbl. It subsequently drilled its first 2-mile lateral well, reportedly with somewhat lower initial rates, but this reflected a period of controlled flowback while waiting on infrastructure, Chandra said.

“The only pushback on Panther from investors is that the acreage is not that contiguous,” he said. “And, what they’re doing is trading acreage in and out to make it contiguous. The other aspect to remember is that the contiguous acreage is really expensive.”

Guggenheim currently estimates that WPX will start generating free cash flow in the fourth quarter of 2018. This assumes a $50 oil price, which obviously could change. If cash flow comes in at a lower level than estimated, WPX might adjust by “reducing capex without lowering the growth rate that much by drilling longer lateral wells,” according to Chandra.

With much of its focus on the Delaware, would WPX consider selling its Williston or San Juan assets?

“WPX is a three-basin company that probably settles on being a two-basin company,” said Chandra. “It would reduce their debt, and I think they would hold on to the Williston.”

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