3 Stocks to Watch in Upstream Oil & Gas

By Markets Fool.com

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Source: ConocoPhillips corporate website.

There haven't been many periods in the oil & gas industry as crazy as the ones we have witnessed over the past half dozen years. We've seen the shale boom in the United States take the global oil market by storm and completely change the supply dynamics, which led to the steep drop in oil prices and the decline of the prospects of many upstream oil & gas companies.

While knowing where we have been can be valuable, it won't always tell us where we are going. To do that, you may need to keep a watchful eye on a few select stocks that have a lot riding on the next move. Based on this idea, these three stocks -- EOG Resources , Linn Energy , and Denbury Resources -- have a lot riding on the next couple years, and they could give some clues as to what the market for upstream oil & gas is thinking.

EOG Resources
What makes EOG such a compelling stock to watch in the upstream oil & gas industry is that it does something that almost no other company can seem to replicate: It has generated operational cash flow in excess of its capital expenditures. While some companies in the space have justified their lack of generating excess cash by saying they are focused on growth, EOG has done a pretty commendable job recently in that regard as well. Over the past three years, the company has more than doubled its oil production thanks to its positions in the Eagle Ford, Permain, and Bakken shale formations.

There isn't one single thing EOG has done over the past few years that has allowed it to grow while remaining cash flow positive, but the combined effect of things such as sourcing its own sand for hydraulic fracturing, buying its own rail cars to transport oil, and other similar initiatives have all totaled up to significantly reduce costs per well. In fact, the culmination of these efforts have improved well economics so much that the average rate of return on a well with oil prices in the $60 per barrel range are better than they were just a few years ago, when oil prices were close to $100 per barrel.

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Source: EOG Investor presentation (retrieved June 16, 2015).

If you are interested in knowing when oil prices will become attractive enough to justify an increase in drilling activity, then you should probably watch EOG, because its well economics suggest it will be one of the first ones to turn the taps back on.

Linn Energy
While there are a lot of oil and gas producers out there, very few of them are structured in upstream master limited partnerships like Linn. Linn looks awfully tempting as an investment in the upstream space because it pays out a pretty sizable distribution, but with the commodity cycle where it currently is, it makes those distribution payments awfully difficult.

Historially, Linn has used futures contracts and other derivative instruments to lock in prices for its oil and gas production several years in advance to ensure a certain level of certainty when it comes to budgeting for those hefty payouts to shareholders, but when the commodity cycle hits a low, it doesn't make as much sense to take out those types of contracts.

Source: Linn Energy Investor Presentation.

Linn has been relying on the strength of its previous derivative contracts to get better oil and gas prices, but eventually, those contracts will expire. Unless there is a significant uptick in oil and gas prices in the next couple of years, Linn could find itself in a rather precarious position of needing to pay interest on a pretty large debt load, and hopefully have enough to pay out to shareholders without needing to make another distribution cut like it made to start 2015.

Investing in Linn Energy is a pretty risky endeavor right now, so standing on the sidelines to watch and see what happens over the next couple of quarters is a completely understandable position.

Denbury Resources
Denbury is somewhere between EOG and Linn Energy. On one hand, it has a very disciplined capital allocation approach to oil production like EOG that has allowed it to remain cash flow positive, like EOG. Conversely, it relies heavily on derivative contracts because its production from using enhanced oil recovery with CO2 is planned out years in advance and allows for some clarity when it comes to budgeting for capital expenditures and paying a decent dividend compared to most upstream oil & gas producers.

Source: Denbury Resources Investor Presentation.

This type of oil production is far from the cheapest production source out there, and when the company's derivative contracts roll off, it may lose that cash cushion it has had in recent years. If oil prices were to recover, and Denbury reloaded with some new derivative contracts, it could be a very compelling investment. Without a recovery before some of those derivative contracts expire, though, Denbury could be in for a bit of a cash crunch.

What a Fool believes
For those who may be looking to add some upstream oil & gas to their portfolios, all three of these companies are tempting in their own way: EOG because it's a top-flight producer, Linn because of its very alluring distribution yield, and Denbury because its long-term production goals are rather predictable. While EOG can certainly make money even in today's market to a certain degree, Linn and Denbury are being propped up by some contracts that may not be in place several years from now.

Watching how all three of these upstream oil & gas companies handle the next couple of years, and how the commodity cycle behaves during that period, could give you a serious leg up when investing in this space.

The article 3 Stocks to Watch in Upstream Oil & Gas originally appeared on Fool.com.

Tyler Crowe owns shares of Linn Energy, LLC.You can follow himat Fool.comor on Twitter@TylerCroweFool. The Motley Fool owns shares of Denbury Resources and EOG Resources. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.