The commodity cycle is in full steam ahead mode, with one of the biggest markets (oil) taking the spotlight. Now that the Saudis have reiterated their commitment for OPEC to implement production cuts next year, which is a development that analysts at Goldman Sachs (NYSE: GS) are counting on to be proven right on their $100 a barrel targets.
Russia's Putin has also joined the campaign to support the production cuts; whether this is a power move to affect the U.S. is up to speculation. What this means for you, however, is that the lack of domestic production in American oil is leaving a profit bottleneck to flow into a select pocket of the oil sector.
As oil prices go lower below $73.0 a barrel once again, demand is set to be stimulated, given lower transportation and fuel costs worldwide. Since production in America is lackluster, that only leaves the bulk of activity to transport and logistics stocks like USA Compression Partners (NYSE: USAC), EnLink Midstream (NYSE: ENLC), and Baker Hughes (NASDAQ: BKR).
The market's advice
The world of oil stocks is massive, with players all over the spectrum, from exploration and production to pipelines and field services. It is key for you to spread these out to understand where the market is expecting to see increased profits so that you can prepare yourself by allocating with 'smart money.'
Decoding the market can be a mind-boggling task at times. To keep it simple, the advice is to focus on the forward price-to-earnings ratio. You see, markets will slap a value on the expected next twelve months of earnings for a stock; the higher the multiple, the higher the upside expected.
Taken as an average, the oil and gas sector is trading at an 11.3x multiple, a benchmark against which to compare the list of potential suspects. Now, before those value investors in the audience begin to cross their arms, remember: these are not multi-year investments.
Over the long-term, the price you pay matters more than anything, but in today's uncertain oil situation, you just have to make sure to back the right horse until the skies clear out. So, which is the right horse, and is there more than one?
Taking USA Compression's 40.8x forward P/E, which represents a 260.0% premium to the sector's valuation, you can begin to guess where the market expects there to be outsized upside potential. What on Earth could justify anyone paying a 260.0% premium? Great question.
Spot the winners
Earnings per share are expected to grow by an average of 28.4% in the next twelve months for the sector, which is commanding the average forward P/E of 11.3x. So, what type of growth can you expect from USA Compression to forget its obscene valuation?
How is 100.0%? Because that's what analysts are predicting today. Doubling earnings in a typical environment where everything else is the same can lead to a doubling of the price of a stock, which is why a consensus $22.0 price target for the stock seems too conservative.
If you are looking for other candidates who are commanding better treatment from analyst ratings, then EnLink and Baker Hughes may be a better fit for you; here's why:
EnLink is also trading at a premium to the sector; a 22.4x is almost a 100.0% premium to the average sector valuation. To justify this premium, again, you must make sure that there is some EPS growth to be had; in this case, there is, at 25.0%.
Based on the premium valuation and a decently high rate of earnings growth, analysts are placing a $14.0 price target on the stock, representing a 4.8% upside from today's prices.
How is Baker Hughes doing in this beauty pageant? With a 16.1x forward P/E, a premium of 42.3% secures its spot in the competition. Analysts are happy to predict an EPS advance of 30.6% for the next twelve months, which is also above the industry average.
These statistics conclude in a price target of $39.6 for the stock, meaning it needs to rally by 20.6% to meet it. So, here's the protein of the situation:
For USA Compression, you would bet on analysts upgrading the stock, which may come after/if it proves it can double EPS as the market expects. EnLink seems to be the steadier trade, with reasonable growth and premium value. In contrast, Baker Hughes is the middle ground for premium growth, which analysts have already accepted in their ratings.
Pick your poison, and remember that when Goldman thinks oil can go to $100, that's a very reasonable risk to consider in your portfolio.
