Ask 10 financial experts the best stocks to buy, and you'll get 20 answers. The reality is, there are a lot of great companies out there, and there are also a lot of ways to find them. One method to finding great stocks is to identify a sector that is getting killed -- like oil stocks right now --and then find companies that have had their stocks unfairly punished.
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Here are a two companies that, while they do have some exposure to oil, are much less at risk than Mr. Market is making them out to be right now. Let's take a closer look. Is there hidden value here, or a value trap waiting to spring?
Low-cost natural gas producer with the misleading name
Ultra Petroleum has significantly increased its oil production over the past year, and that is expected to be the case again in 2015. However, oil will only represent about 10% of total production. Although it carries a much higher dollar value, oil will make up about 25% of the company's sales. But the market is acting like it's the other way around:
Don't get me wrong -- Ultra certainly has its share of risks. Debt has gone up significantly:
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It's worth noting that the recent debt increase was tied to a transformative acquisition of significant assets located in the company's most profitable area: the Pinedale play in Wyoming. The company significantly increased its proved reserves by $1.8 billion, increased the percentage of wells that it owns and operates to 82%, and positioned to better operate in a low price environment.
The company has also been relatively successful at hedging its prices. For example, 40% of its fourth-quarter oil production is hedged at an average of $93.19 per barrel. It may not be able to get significantly above-market hedges for Q1 of next year, but this management team has historically been very conservative with hedging and cost management.
Furthermore, the company's oil exposure is quite low-cost:
Source: Ultra Petroleum presentation.
As you can see, even at $60, wells have a payback period of one year. Ultra will be able to weather the current cheap oil environment.
Biggest risk for Ultra
Potentially the biggest risk Ultra faces, is seeing a significant number of producers shift production from oil assets to natural gas. According to T. Boone Pickens, there are around 1,900 rigs operating in the U.S., and 1,500 of them are drilling oil today. If even 100 of them shift to natural gas, it could lead to the same oversupply problem that has killed oil prices over the past six months. I don't think this is a high-probability event, but it shouldn't be ignored.
The hedge doctor
Today's Chesapeake Energy is far removed from the "growth at all costs" wildcatter days under Aubrey McClendon. Just one look at how much the company has deleveraged shows a different approach:
That's a lot of debt reduction, and it's having a real impact on the bottom line. Through the first nine months of 2014, interest expense has been cut in half, saving the company more than $80 million. Not only is the company cutting its debt, but management is also taking a very conservative approach to capturing value for its oil and gas production.
Chesapeake has more exposure to oil than Ultra Petroleum, with 16% of production, and 59% of revenues coming from oil last quarter. It also uses one of the most aggressive hedging programs, and at times, that may have kept the company from getting the highest market price on oil and gas. However, with oil now trading near $60 per barrel, Chesapeake may be more protected on the downside, than any other U.S. producer. CEO Doug Lawler, from the recent earnings call (emphasis mine):
From a hedging perspective, we have relatively significant position of Q1 2015 gas hedges at attractive prices averaging $4.51 per Mcf. We also have had substantial amount of oil at just under $95 a barrel, and we'll continue to look to add both positions should prices justify doing so.
From a recent Chesapeake presentation:
Source: Chesapeake Energy presentation.
In short, Lawler and his team's moves to protect the downside will pay major dividends next quarter.
Nobody knows what could happen in the short term. There's plenty of reason to think that both of these company's stocks could go lower because there is so much uncertainty around oil prices and demand. However, looking out over the next several years, I see two great companies with solid leadership. That leadership has taken very conservative approaches at capital management, and care in positioning these companies with great economics for their oil and gas production.
Combine that with the beating the market has given these stocks this year -- somewhat unfairly based on their business results -- and these could be two of the best beaten-down stocks to buy right now. Just remember: If oil prices stay down for an extended period, it could take some time for the market to catch on. As with any company, measure your investment based on the performance of the business first, and not so much on the stock price movement. If Ultra and Chesapeake keep performing, eventually the market will notice.
The article Best Stocks to Buy: Hidden Value in This Beaten-Down Sector originally appeared on Fool.com.
Jason Hall owns shares of and options for Ultra Petroleum. The Motley Fool recommends and has options on Ultra Petroleum. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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