A Diamondback Energy oil rig in Midland, Texas.
Callaghan O’Hare/Bloomberg
With oil prices rising and falling dramatically, it can be hard to get a handle on oil stocks. One strategy: Buy only the most and least volatile ones.
That might seem like a strange way to bet on a very volatile energy market. Oil prices surged 45%, to $130 a barrel, on March 6 from $89 on Feb. 10, the day before U.S. National Security Advisor Jake Sullivan said Russia would attack Ukraine—but they tumbled 27%, to $95, before jumping back to $103. That drop sent oil stocks for a spin, too, with the Energy Select Sector SPDR exchange-traded fund (ticker: XLE) falling as much as 7% since then before rebounding. Oil stocks have a lot to gain if crude prices can bounce back, and a lot to lose if they keep dropping.
That’s where a “beta barbell” strategy comes in. Beta is the term used to measure the volatility of one asset relative to another, and Goldman Sachs analyst Neil Mehta suggests buying the energy stocks with the highest and lowest betas, and ignoring everything in between. The idea: If oil prices rise, the high-beta stocks will outperform, providing a big boost to a portfolio. But if the price of crude falls, the lower-beta socks will provide some ballast and cushion the drop.
“Given the highly volatile commodity price environment, we continue to recommend a beta barbell strategy, and prefer companies where we see dislocations on valuation relative to asset quality and where higher FCF from the current upcycle can drive greater capital returns relative to consensus expectations,” Mehta wrote. He prefers Pioneer Natural Resources (PXD) and Diamondback Energy (FANG) for low beta, and Ovintiv (OVV) and Antero Resources (AR) for the riskier part of the portfolio.
Dow Jones Market Data Group screened for the companies that moved the most and least when oil prices rose or fell 1% during the past year. Kosmos Energy (KOS) was among the most volatile stocks, moving an average of 0.8% every time oil prices moved 1% or more. That makes sense: Kosmos has more debt than its market cap, making it particularly susceptible to changes in oil prices.
Kosmos is risky, but that doesn’t make it a bad bet. Earnings estimates for the company have shot up 26% since Feb. 28, according to FactSet, but they could rise even more. Consider: Sales estimates should rise about 36% if crude returns to its recent highs—and since oil companies have a lot of fixed costs, profit estimates should outpace that increase. Should oil stand at $130, Kosmos “earnings would go up more than 40%” says Panmure Gordon analyst Ashley Kelty. Already, the stock has risen 12% from its low point during oil’s recent swoon. If oil can retake $130 a barrel, “I would expect more upside,” he says.
ConocoPhillips (COP) would make a good choice for the lower-risk part of the portfolio. It moves an average of just 0.4% when oil moves 1% or more, thanks in part to a debt burden that is less than 10% of its enterprise value. Plus, its earnings estimates have risen 18% since the end of February. “Probably a bunch of other earnings revisions are coming,” says KeyBanc analyst Leo Mariani.
That’s less exciting than Kosmos, but the downside risk is much lower too. If oil falls to its pre-Russian invasion level, so would ConocoPhillips stock, he says. That would mean a loss of just 7%, whereas Kosmos’ pre-Russian invasion level is 33% below its current price.
Low risk? High risk? We’ll take a helping of each.
Write to Jacob Sonenshine at [email protected]
