2 Stocks to Avoid (and 1 to Buy)

By Matthew DiLallo Markets Fool.com

Oil has bounced around the $50 a barrel range for most of the past several months. However, for EP Energy (NYSE: EPE) and Unit Corporation (NYSE: UNT), that oil price just isn't high enough to fuel a recovery in their production. Because of that, investors are better off avoiding those two oil stocks. Instead, a much better option isEncana (NYSE: ECA), which is thriving right now and should continue to do so even if oil remains where it is for the next several years.

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Another down year

Oil and gas driller EP Energy recently released its 2017 guidance. While the company expects to boost capital spending from $488 million last year up to a range of $630 million to $730 million this year, that's still not enough money to reverse the company's production decline. In fact, after falling 20% last year thanks to underinvestment and asset sales, EP Energy anticipates that production will slip another 10.4% this year at the midpoint of its guidance.

Image source: Getty Images.

One of the reasons EP Energy can't grow this year is because of the amount of debt on its balance sheet. While it cut debt by $1 billion last year, EP Energy still had $3.9 billion outstanding, which is a substantial amount for a $4.9 billion company. One of the problems with that debt load is that an outsized portion of the company's cash flow is going toward interest payments instead of capex. Meanwhile, the company's other problem is that many of its drilling locations don't offer the same return profile that other drillers can earn in the current market environment. For example, its largest supply of its locations only delivers pre-tax internal rates of return in the 22% to 30% range at $55 oil and $3 natural gas, which is well below what rivals can earn at those prices.

Still not enough to turn things around

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Unit Corp, on theother hand, is a bit unique in the energy sector because it not only owns oil and gas producing assets, but it also controls contract drilling and midstream subsidiaries. While this diversification should help lower costs and improve returns, it has proven to be a drag on the company since low oil and gas prices have hurt profitability across all three of its operating segments.

Those problems aren't expected to go away in 2017. That's evident by the fact that despite a 32% increase in capex this year, Unit Corp still won't invest enough capital to reverse its production decline. Instead, production should fall another 5% to 8% this year, which is on top of last year's 13.5% decline. One of the culprits is the fact that while the company will spend $227 million on capex this year, only $188 million will go toward oil and gas drilling. The rest will go to its other two segments, suggesting Unit's diversification is a drag on its ability to grow output by diverting precious financial resources elsewhere.

Another thing holding back Unit's ability to invest more capital is its balance sheet, which, like EP Energy, still has too much debt. While the company did pay off $118.1 million last year, bringing net debt down to $800.9 million, that's too much for a $1.9 billion company in the current market environment, which is why it has junk-rated credit.

Image source: Getty Images.

Ramping up

Contrast those two forecasts with what Encana has in store for 2017 and beyond. The Canadian oil and gas driller expects to increase its liquids production 40% this year while boosting output from its core assets by 20%. Further, the company can achieve that growth by funding its capital budget with cash flow and cash on hand. Meanwhile, the company expects to deliver total companywide production growth of 60% through 2021 while living completely within cash flow starting next year, as long as oil averages $55 per barrel.

Driving Encana's ability to grow in the current environment is its strong investment-grade balance sheet and a vast supply of premium wells, which are those it defines as achieving a minimum 35% after-tax rate of return at $50 oil and $3 natural gas. The company built those resources by completing several transactions over the past few years as it repositioned its portfolio. Not only did the company acquire several growth-focused assets, but it unloaded a boatload of low-margin non-core assets and completed several equity issuances to shore up its balance sheet and give it the cash to reaccelerate growth this year. Because of that, the company has a powerful combination of resources that should fuel robust shareholder returns over the next few years even if oil prices don't budge.

Investor takeaway

EP Energy and Unit Corp just don't have the resources to thrive in the current market environment. Instead, both companies expect to take another step backward this year. That's why investors should avoid these stocks and instead consider buying Encana, which has a fortified balance sheet and top-tier drilling inventory that should allow it to thrive even if oil continues meandering along.

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Matt DiLallo has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.