Raymond James' Top Picks for 2023

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From Raymond James' Industry Brief 1-3-2023

E&P outlook: Capital discipline and maximizing free cash flow/shareholder returns remains the focus.

U.S. E&P capital discipline remains the most bullish long-term development for the commodities. Despite all the recent volatility in the oil markets, the U.S. supply outlook is still mostly the same story: E&Ps are not chasing production growth anymore. We know we sound like a broken record, but the public E&P mindset has dramatically changed, and even in the face of higher prices we have seen minimal deviation from maintenance-type programs, with the majority of operators pursuing mid-to-low single digit growth in 2023 and beyond. There have also been recent signs that the private operators have started to lose momentum with activity levels finally weakening some after a two-year, breakneck rise in the private rig count.

Despite the capital discipline, E&Ps were not immune from rising costs with inflationary pressure hitting the group hard early in the year. To be clear, capex budgets moving higher this year were largely not due to a ramp in activity, but instead the prices of steel, sand, labor, and rig contracts (amongst other items) ramped faster than anticipated by nearly every management team we cover. 2023 capex is looking much the same, activity will be mostly flat, but we will be looking at a full year with inflated prices. This, combined with a lower strip ($75/bbl oil vs $95) means we are anticipating a higher reinvestment rate in 2023 (~45%) compared to last year (33%) as shown in the chart below.

Not surprisingly, the unprecedented nature of current E&P capital discipline has resulted in impressive return figures, especially when compared to other sectors. E&Ps not only outperform their Russell 3000 counterparts on a FCF/EV yield basis, but also trade at a steep discount to the Russell 3000 mean (nearly one-third the group average on an EV/EBITDA basis). Meanwhile, leverage, once an obstacle for our coverage, fell below one turn when we exited 2022.

We currently have 12 Strong Buy rated companies within our coverage — 10 of which are traditional E&Ps and two mineral names. Among the large-caps, ConocoPhillips (COP), Devon Energy (DVN), Diamondback Energy (FANG), EOG Resources (EOG), Marathon Oil (MRO), Occidental Petroleum (OXY), and Pioneer Natural Resources (PXD) all offer attractive shareholder return options between dividends and share buybacks as well as strong operational performance. Across SMID-caps, Antero Resources (AR), APA Corp. (APA), and Northern Oil & Gas (NOG), make the list for various reasons. APA has considerable upside potential given its position in Suriname (FID decision expected mid-23) and continues to aggressively repurchase shares (~15% in past 12 months). AR remains our preferred natural gas E&P with advantaged takeaway options and attractive shareholder return program (~15% shares repurchased in past 12 months). Finally, NOG has the fastest growing dividend of any small-cap E&P and an ability to minimize cost inflation relative to their small-cap peers due to their exposure to large operators with their unique business model. On the minerals front, Kimbell Royalty Partners (KRP) offers investors an astounding ~12% anticipated dividend yield this year, while possessing just a ~12% annual base decline rate, the best among all public mineral names. For those looking for more nat gas exposure, Black Stone Minerals (BSM) has an ~11% projected dividend yield.
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AR and NOG are in our Sweet 16
DVN, FANG, EOG, PXD are upstream companies in our High Yield Income Portfolio
KRP and BSM are minerals companies in our High Yield Income Portfolio

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