Oil and gas stocks are outperforming growth stocks by a wide margin this year. Here are three factors driving this trend and what it means for your portfolio.
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Supply crunch
Several years of low oil prices discouraged investment in new production capacity. That’s created a shortfall in supply while demand is rebounding strongly. A barrel of oil is worth well over $100 right now, and that’s creating plenty of cash flow for energy companies.
Much of this excess cash flow is being used to pay down debt and reward shareholders. That means investors can expect healthier balance sheets and handsome dividends by the end of the year.
Consumer spending
Unlike other parts of the economy, oil is essential. This means higher fuel prices are cannibalizing the amount of money an average family would have spent on luxury goods, streaming movies, or clothes. That’s why oil stocks are outpacing discretionary retail and growth stocks.
Valuations
Since oil and gas stocks have been so neglected, their valuations have been severely compressed. Despite the recent surge, some oil stocks trade at single-digit price-to-earnings ratios. Meanwhile, tech valuations were stretched beyond reason. Some stocks were trading at 60 times revenue in 2021. That’s collapsed this year, but the valuations are still not as cheap as the oil sector.
A confluence of these factors makes oil stocks a safe bet for the near term. There are plenty of opportunities in this sector, but here’s a top pick.
Best oil stock to buy
Obscure oil producers like Baytex Energy (TSX:BTE)(NYSE:BTE) should be on your radar this year. The company is an oil and gas exploration specialist based in Western Canada.
Baytex has already benefitted from the oil boom. The stock is up 2,000% from 2020. In the first quarter of 2022, Baytex declared a 78% bump in adjusted funds flow surged to $280 million. Free cash flow was $121 million, or $0.21 per share.
The stock is trading at a price-to-earnings ratio of just two or a price-to-FCF ratio of 7.6. Baytex stock is already cheap but could be cheaper if the price of oil goes higher and stays elevated for longer.
Bottom line
The ongoing energy crisis has created a tremendous tailwind for oil and gas producers. The longer this persists, the higher the cash flows this sector can expect. Much of this excessive cash flow is being used to pay down debt and reward shareholders.
However, some obscure producers like Baytex Energy are going a step further. The company is rewarding shareholders, buying back shares, paying down debt, and also expanding production. If the energy crisis continues, Baytex could have further upside. Keep an eye on it.
