2 Cheap Energy Stocks With Big Upside

Chad Tracy's picture

Thursday, May 9, 2013 - 1:00pm

by Chad Tracy

With the market hitting record highs, value investors are having a tough time searching for bargains.

Don't get me wrong, I'm as pleased as anyone to see green numbers flashing when I check my trading account.

But as price-to-earning (P/E) multiples rise, so does risk. And I've become much more cautious in the past few months about making new investments.

I've been on the hunt for the bargain stocks Wall Street has overlooked. And today I've found two companies in the energy sector that remain undervalued compared to their peers and the market as a whole.

As regular StreetAuthority readers know, the energy boom currently underway in the United States presents a huge opportunity for investors.

New drilling and hydraulic fracturing (or fracking) technology have given energy companies access to enormous oil and natural gas deposits that were previously out of reach.

StreetAuthority's energy and resources expert Nathan Slaughter has been covering this story for years in his Junior Resource Advisor and Scarcity and Real Wealth newsletters.

The two companies I've come across, Apache Corp. (NYSE: APA) and Devon Energy (NYSE: DVN), are involved in the exploration, development and production of natural gas, oil and natural gas liquids.

And right now, both are selling for cheap. In fact, Devon hasn't been this cheap since (briefly) in 2011. Apache hasn't been this cheap since 2008.

Not only are the stock prices low on a historical basis, the P/E and price-to-book (P/B) ratios for both companies are low in relation to their peers.

Devon is currently trading at 11 times forward earnings per share; Apache trades at just 8 times forward earnings. Devon's current P/B ratio sits at 1.2, while Apache trades at a P/B ratio of 1.

These numbers are a bargain in relation to competitors. For example, EOG Resources (NYSE: EOG) currently trades at a P/E of almost 19 and a P/B of 2.6.

Now, just because a stock is trading for cheap doesn't always make it a good buy. Sometimes a stock price is down in the dregs for good reason, and investors would be wise to leave it alone.

But I think this situation is different.

The profitability of both companies has suffered not because of management issues or drastic declines in production. Instead, it's been caused something beyond their control -- namely, the low price of natural gas. This has reduced profitability in the short term and kept share prices low.

But the long-term outlook is a different story...

Let's start with Devon.

Devon has a healthy balance sheet after recently unloading less profitable assets (notably offshore and overseas holdings). This should allow the company to better focus on its core domestic assets and help it weather any future declines in energy prices.

Devon currently owns 1.3 million acres and 2,600 producing wells in the Permian Basin in West Texas. This region is home to the well-known Spraberry Field, where 10 billion barrels have been recovered since drilling began in the 1950s.

Devon has recently reported impressive test results inside a Permian Basin area known as the Cline Shale. Devon's wells show that the formation contains 3.6 million recoverable barrels of oil per square mile. As the Cline covers about 9,800 square miles, this works out to estimated reserves in excess of 30 billion barrels.

These reserves could easily eclipse the Bakken (4.3 billion barrels, according to conservative government estimates) and the Eagle Ford (3 billion barrels). Devon's total proven reserves stand at 3 billion barrels of oil equivalent.

In contrast to Devon's relatively stable balance sheet (especially for an energy exploration and development company), Apache is in the red, thanks to $18 billion in recent acquisitions.

These deals include a $4 billion merger with Mariner Energy and $11 billion in asset purchases from BP (NYSE: BP) and Exxon Mobil (NYSE: XOM).

While this might be a red flag for some companies, Apache has a history of making profitable acquisitions. Big purchases in the past, such as a North Sea position in 2011 and a Gulf of Mexico deepwater acquisition in 2010, have proved profitable for the firm.

Should these new acquisitions also prove successful, this could be a great time to purchase shares while the stock price is still cheap and before these new assets begin production.

Another contrast between the two companies is Apache's presence overseas.

Apache's domestic assets account for about 40% of its production and close to half of its reserves, but it is also a major international player, especially in Egypt, Australia, Argentina and the U.K. region of the North Sea.

Egypt is home to Apache's largest overseas position and accounts for about 20% of the firm's production. This area is prone to political unrest, and the company's large stake in the region makes it a more speculative play.

Risks to Consider: Energy exploration and development companies are, by their nature, riskier investments. Should the price of oil and/or natural gas remain depressed, it will continue to have a negative effect on profitability.

Action to Take --> For investors willing to shoulder the risk, I believe both stocks are worth the investment at today's prices. However, be sure to maintain your stop-losses and to position speculative investments as a smaller portion of your overall portfolio.

P.S. -- If you've been looking to add resource stocks to your portfolio, now may be the time. The global trend for commodities is rising demand coupled with shrinking supplies. That's why we've seen soaring prices for years... and it means short-term sell-offs can be rare buying opportunities. To learn more about Scarcity & Real Wealth, which focuses solely on the market's best resource investments, visit this link.

Chad Tracy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of DVN in one or more of its “real money” portfolios.