High Return Investments in Oil Potentially Worth the Risk

Needless to say, oil stocks have fallen on hard times. That's just what happens when oil prices unexpectedly do this:

Brent Crude Oil Spot Pricedata byYCharts

That deep sell off in oil prices led to an even deeper sell-off for many oil stocks. In most cases the deeper stock price plunge was due to the fact that those oil companies took on boatloads of debt to grow their oil production in order to profit from triple digit oil prices. As prices plunged that debt acted as a weight to really sinks those stocks. However, the oil stocks that went down the farthest could really bounce back if oil prices rebound.

Here are some sectors within oil that have been hardest hit and therefore potentially offer the highest return for investors not afraid to take on some risk.

The upstream MLPsOne class of oil stocks really hit hard by lower oil prices was upstream MLPs. These companies tend to own mature oil and gas wells and use the cash flow from those wells to pay very generous distributions to investors. However, these companies also tend to take on a lot of debt to acquire additional oil and gas wells since most of their cash flow is sent back to investors via distributions. That debt has proved to be burdensome, sending oil-focused upstream MLPsBreitBurn Energy Partners,Linn Energy, andLegacy Reservesall down by more than 54%, as we see on the following chart.

LINEdata byYCharts

These companies know that investors are worried about their balance sheets, which is why most of them have already taken action to address these concerns. So far this year BreitBurn and Linn have already cut their distribution to investors in order to improve their liquidity. In addition to that both found private market investors to provide them with capital with BreitBurn getting$1 billion in debt and equityto pay down its credit facility while Linn is using private capital tofund drillingandacquisitions. Meanwhile, Legacy Reserves has yet to make any balance sheet moves this year other than the fact that its credit facility was cut by its banks from $950 million to $700 million leaving it with less liquidity to ride out the market cycle. However, the company still has $570 million of liquidity at the moment, so its in decent shape. The bottom line with these MLPs is that they don't have any near-term liquidity issues paving the way for them to surge if oil prices can mount a meaningful rally.

The oil specialistAnother oil stock caught up in the weak oil market isDenbury Resources. The enhance oil recovery specialist has largely followed the oil price down as we see on the chart below.

DNRdata byYCharts

This sell-off is despite the fact that it's fairly well hedged and didn't really overextend itself with debt as others did. The company also plans to keep its debt in check as it was quick to cut its capital spending, which will keep its production flat in 2015 and could enable the company to generate free cash flow if oil prices improve. Moreover, the company is focusing on cutting its costs to improve its margin per barrel of oil. Add it all up and Denbury is an oil stock that has a lot of potential to generate higher returns in the years ahead.

The shale drillersThe last subsector of oil stocks that have high return potential are shale drillers. Like MLPs a lot of these companies used leverage to grow and that leverage has come back to bite them. We see this on the following chart where shale focused drillersLaredo Petroleum,Whiting Petroleum,Oasis Petroleum, andHalcon Resourceshave all been badly beaten down by the weak oil prices.

WTI Crude Oil Spot Pricedata byYCharts

To better position themselves to survive the downturn all four of these companies raised capital early in 2015. All raised equity capital in order to take debt off their balance sheets, which will save them some money on interest and remove some of the weight that had been holding them back. Meanwhile, Laredo and Whiting also raised some debt, which was used to pay down their credit facilities and in Laredo's case also pay down other higher interest debt. By raising capital these companies boosted liquidity to ensure their survival during the downturn in the oil market so all can potentially thrive when conditions improve.

Investor takeawayIf oil prices begin to rebound these oil stocks could really surge. That's partially due to the fact that many sold off much deeper than oil prices. In addition to that many of these stocks have taken actions to improve their financial position, which has reduced their near-term risks and improved their potential to producer stronger future returns.

The article High Return Investments in Oil Potentially Worth the Risk originally appeared on Fool.com.

Matt DiLallo owns shares of Denbury Resources and Linn Energy, LLC. The Motley Fool recommends BreitBurn Energy Partners. The Motley Fool owns shares of Denbury 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.

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