Energy Earnings Might Fall by 11%. But Here Are Analysts’ 10 Favorite Stocks.

Jan 27, 2023

Energy Earnings Might Fall by 11%

Oil and gas earnings have peaked after two years of stratospheric growth. The good news for stocks is that the top was unusually high, and the slide will most likely be slow.

According to Bank of America, fourth-quarter earnings for oil and gas companies, which begin reporting results this week, will be 11% lower than the third quarter. Chevron CVX (CVX) and Exxon Mobil (XOM), the two largest U.S. companies, are set to report profits on Friday and next Tuesday, respectively. Both are predicted to increase earnings per share by more than 50% yearly but post a decline from third-quarter levels.

However, the top for oil earnings does not have to coincide with the top for stocks. They continue to trade at substantially lower earnings multiples than the rest of the market, showing a widespread distaste for energy firms given their recent underperformance. The typical large-cap energy company trades at 9.9 times the estimated profits for the next year, compared to 18.3 times for the S&P 500. Furthermore, because energy is generally a major contributor to inflation, oil and gas equities tend to thrive during periods of inflation. As a result, equities are an excellent hedge for those who predict inflation to remain high.

Energy stocks increased last year as oil and gas prices rose and corporations continued to cut costs. Their fundamentals were so solid that they frequently gained even when oil prices dropped. "Further potential for the sector now rests much more strongly on rising oil prices," Morgan Stanley analyst Devin McDermott said this year. According to Morgan Stanley, oil prices are expected to climb to $100 per barrel by the third quarter, up from roughly $80 today. Thus, McDermott believes the equities can gain by 20%. Exxon, Suncor (S.U.), Cenovus Energy (CVE), EOG (EOG), Marathon Oil (MRO), and Diamondback Energy (FANG) are among his preferred names for 2023.

When companies start reporting fourth-quarter results, investors will be looking for more information on how much earnings may decline this year and whether corporations can continue to raise dividends and buy back shares. Bank of America analyst Doug Leggate said they believe the upcoming results for U.S. oil companies will be one of the most important in years, as management will provide the first official guidance on capex, growth, and the impact of inflation.

Analysts are most optimistic about refiners since they continue to generate high margins on diesel and other fuel products and have the potential to boost earnings. Exxon, Occidental Petroleum OXY (OXY), APA (APA), refiner Valero (VLO), and Hess (HES) are among his top profit names. With China relaxing Covid rules, U.S. refiners should be able to increase their profits by shipping more fuel overseas.

However, one issue for most energy businesses is that their costs are growing. Oil and gas businesses will have to pay more to produce the same quantity of oil after two years of modest expenditure rise since oil service providers have boosted their pricing. According to Leggate, capital budgets are anticipated to increase by 10% to 20% this year. This will reduce free cash flow and cause some corporations to disclose cash flow decreases.

The threat of lesser free cash flow appears to have slowed momentum in several firms. For example, Devon Energy (DVN) outperformed competitors throughout 2021 and 2022 due to its policy of returning a part of its cash flow to investors in the form of a variable dividend. With cash flow expected to decline next year, the stock's trend has flattened. Only a few firms, notably EOG, Hess, Ovintiv (OVV), Chesapeake Energy (CHK), and EQT ( EQT ), are expected to boost free cash flow in 2023, according to Leggate.

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