These 2 Stocks Win Every Time An Energy Trade Is Made

Joseph Hogue's picture

Thursday, January 8, 2015 - 1:30pm

by Joseph Hogue

 

After falling for six straight months, oil prices are still in search of a bottom. A greater than 50% plunge over the past year is the second-largest annual decline on record.

 

Sector share prices have followed suit. The SPDR S&P Oil & Gas Exploration & Production ETF (NYSEMKT: XOP), for example, is down more than 40% from its 52-week high.

 

Considering previously planned production increases are still boosting the supply of oil, investors are left to wonder when the bleeding will stop.
 

 

The sell-off has been especially pronounced over the past two months, leading to a huge spike in volatility. The OVX index, a measure of West Texas Intermediate Crude's (WTI) implied volatility, has spiked sharply and is now at its highest level since 2012 despite relative calm in the VIX volatility gauge for equities.

 

 

And with more oil supply coming in the near-term (thanks to nearly $300 billion in energy exploration spending in the U.S. alone last year), few expect a quick rebound in prices or a drop in volatility. The tug-of-war between long-tem optimism and shorter-term realities is driving uncertainty. An elevated OVX index will mean high premiums for energy options and will make it relatively expensive to hedge your energy exposure.

 

To be sure, the sector share prices now look like value plays. The Energy Select Sector SPDR ETF (NYSE: XLE) has fallen to less than 13 times trailing earnings, a sharp discount to the 18.6 trailing multiple valuation on the stocks in the S&P 500.

 

But there is one trade in the energy space that is already paying off and will likely continue to outperform no matter where energy prices go. A pair of companies actually thrive on renewed volatility in energy prices, on both the financial side and the corporate side of the industry.

 

Two Winning Ways To Play Energy Ahead Of A Bottom

I have been following the major energy exchanges for quite some time. In January 2013, I recommended  buying shares of the futures exchange CME Group, Inc. (Nasdaq: CME).  Since then, it has beaten the market with a 68% return.

 

Even after stellar returns over the last two years, CME and another exchange, Intercontinental Exchange, Inc. (NYSE: ICE), are well-positioned to profit, as they solve a huge problem for energy users, producers and investors.

 

For producers, these exchanges offer liquidity and locked-in prices to hedge their supply against further weakness.

 

For energy users, especially large-scale transportation companies, the exchanges offer the ability to hedge their demand by locking in prices at multi-year lows.

For investors, energy futures contracts are some of the most liquid available and offer the potential for huge gains on big price swings.

 

As long as uncertainty in the energy market prevails -- and it’s likely to be one of the biggest themes for 2015 -- these two companies will profit.

 

CME Group is the world’s largest futures exchange, a combination of the Chicago Mercantile Exchange and CBOT Holdings. Volatility will drive trading and risk management in futures products, which account for 86% of revenue. Shares trade relatively high at 10.5 times sales, but only slightly above the average.

 

The exchange has a 2.1% yield and paid out 30% of earnings before interest, taxes, depreciation and amortization in 2013 as dividends. This is just under the 35% average ratio over the past five years. The company has more than $1 billion in cash on the balance sheet, which is a strong sign that the dividend payout is sustainable.

 

Sales could rise roughly 10% in 2015, to $3.45 billion, on increased trading. I look for shares to rise from a recent $89 to my target of $107 per share -- a 20% upside. Beyond the outlook for higher sales, there is a good chance that the higher cash flow will lead to a strong boost in the dividend payout.

 

Intercontinental Exchange is a fully electronic marketplace for over-the-counter trading and exchange products in the energy and commodities space. Primary products include futures contracts for oil and natural gas. Transaction fees on trading (78% of revenue) should increase significantly as companies seek to hedge further weakness or lock-in oil prices for their operations. 

 

The dividend yield of 1.2% isn’t very attractive until you consider that the company also returned $540 million to shareholders over the past year through a share repurchase program. Intercontinental Exchange has been aggressively reducing debt, paying off $2.9 billion over the past four quarters and could significantly boost investor cash return over the next couple of years.

 

Shares trade for 8.4 times sales with revenue of $3.38 billion expected in 2015. My target price is $264 per share -- roughly 20% upside.

 

Shares of both companies are up more than 20% since September so the market is already following the story, but fourth quarter revenue is likely to be higher than current consensus forecasts. Since the companies are largely an intermediary, profitability is extremely high with a net profit margin of 34% at CME and 18% at ICE. 2015 should be a very good year for sales growth as energy prices will likely remain volatile on high production and growing demand.

 

Risks To Consider: Both stocks have rallied over the past month and are trading around 52-week highs. Shares may be volatile through January, but should get a boost on fourth quarter earnings in early February.

 

Action To Take --> While long-term opportunities in the energy space are starting to present themselves, price weakness and volatility in 2015 could keep investors on edge. Hedge your exposure in energy with two companies that will benefit from increased volatility and trading.

 

If oil, natural resources or commodities are what interests you, look no further than StreetAuthority's Scarcity & Real Wealth. Our resident natural resources expert Dave Forest has more than a decade's experience as a trained geologist and analyst. His industry insight allows him to read the markets and provide the most timely, potentially lucrative advice for everything from oil and gold to molybdenum. To gain access to Dave's latest research, click here.

 

 

 

 

 

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