The SPDR S&P Oil & Gas Exploration & Production ETF (XOP) had outperformed the S&P 500 by about 89% as of early June. Four weeks later, the fund is underperforming the index by nearly 25%. Spot prices for natural gas are down by about 25%, West Texas Intermediate crude oil is down by more than 14% and copper is down about 24%.

Commodity prices tend to take a beating when the economy slows (or a recession is threatening) because supply outruns demand. That historical trend may not be a good model for what is going on right now, however, according to Wells Fargo Securities’ analysts Nitin Kumar, Hanwen Chang and Rosalie Chen.
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The analysts say that this time is different. The underperformance of U.S. exploration and production (E&P) stocks may have been overdone:

[T]ight inventory levels for both oil and gas, limited foreseeable supply upside, and strong cash flow generation/capital returns make the recent pullback in stocks a ‘buying opportunity’ in our opinion. We also note that our coverage is set to generate ~6.6% quarterly FCF yield in 2Q22 based on actual prices during the quarter. Critically, they could return half or more of that cash to shareholders. This could be a near-term catalyst for investors to refocus on the U.S. E&P sector, in our view.

The analysts’ 6.6% quarterly free cash flow yield implies an annual yield of around 25%. They believe that “based on announced capital return frameworks that include base dividends, variable dividends, and share repurchase plans, we estimate our coverage can return at least ~3.1% of their current market cap to investors in 2Q22 alone.”

With this background, Wells Fargo reiterated its top picks in the E&P industry: Coterra Energy, PDC Energy and Devon Energy. All are rated Overweight by the Wells Fargo analysts. Coterra’s price target of $46 implies an upside potential of 75% based on Friday’s closing price. PDC’s price target of $105 implies an upside potential of nearly 78%, and Devon’s price target of $73 implies upside potential of almost 40%.

Range Resources

Wells Fargo upgraded its rating on Range Resources Corp. (NYSE: RRC) from Equal Weight to Overweight and raised its price target on the stock by 11%, from $44 to $49. Range Resources will begin paying a regular quarterly dividend of $0.08 per share in the second half of this year and already has a $500 million share buyback program. Wells Fargo estimates that the company will generate a free cash flow yield of around 27.6% this year and 15.0% next year, well above the peer group average of 20% in 2022 and 11% in 2023.

Range Resources will report second-quarter results later this month, and consensus estimates call for revenue to rise nearly 390% sequentially and more than double year over year. The stock traded up by about 0.5% late Monday morning, at $25.73 in a 52-week range of $12.37 to $37.44. The stock’s total return for the past 12 months was nearly 52%.

The Wells Fargo analysts also upgraded shares of Southwestern Energy Inc. (NYSE: SWN) from Underweight to Equal Weight and raised the price target by 20% from $10 to $12. The analysts like Southwestern’s recently initiated $1 billion share buyback program that runs through the end of next year and the company’s “long-term ability to participate in LNG export markets through the Haynesville assets acquired over the last 18 months.”

Southwestern is expected to report quarterly results late this month, and consensus estimates call for a sequential decline of about 38.6% and a year-over-year increase of 72.4% in revenue. The stock traded down by about 1.3% late Monday morning, at $25.73 in a 52-week range of $3.81 to $9.87. The stock’s total return for the past 12 months was about 10.8%.

Civitas Resources

Wells Fargo downgraded shares of Civitas Resources Inc. (NYSE: CIVI) from Overweight to Equal Weight and lowered the $69 price target by 3% to $67. The analysts estimate that Civitas has approximately 8 years of inventory in the Denver-Julesburg basin and admit that they prefer larger companies. PDC Energy is a “more compelling opportunity” in the basin and Wells Fargo expects Civitas to “underperform on a relative basis.”

Civitas will report quarterly results in the first week of August, and consensus estimates call for a sequential increase of 10.2% and a year-over-year increase of about 478% in revenue. The stock traded down by about 5.4% late Monday morning, at $47.91 in a 52-week range of $31.74 to $84.76. The stock’s total return for the past 12 months was about 8.7%.

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CNX Resources

The Wells Fargo analysts also downgraded shares of CNX Resources Corp. (NYSE: CNX) from Overweight to Equal Weight, while lifting the price target by 4% from $26 to $27. The analysts base their downgrade on the company’s “conservative approach to hedging — ~85%/73% of [estimated 2022 and 2023] volumes are covered by swaps [which] limits their ability to either (1) accelerate debt reduction, and (2) participate in commodity price upside.” CNX also focuses on share buybacks while Wells Fargo would like to see a base dividend payment.

CNX will report quarterly results later this month, and consensus estimates call for revenue of $431 million, compared with a loss of $913.1 million in the first quarter, primarily the result of “an unrealized loss on commodity derivative instruments of $1,456 million. Included in the earnings for the three months ended March 31, 2021, was an unrealized gain on commodity derivative instruments of $31 million.” CNX reported a loss of $127.2 million in the year-ago quarter. The stock traded down by about 1.2% late Monday morning, at $16.00 in a 52-week range of $10.41 to $24.21. The stock’s total return for the past 12 months was about 25.7%.

Centennial Resource Development

Wells Fargo also downgraded shares of Centennial Resource Development Inc. (NASDAQ: CDEV) from Equal Weight to Underperform and lowered the stock’s price target by 8% from $12 to $11. A recent acquisition has pushed the company’s net debt to EBITDA ratios for this year and next well above peers and “adds a potential overhang for the stock when the transaction is completed and the lock-up period for the private equity sponsor expires.”

Centennial is expected to report quarterly results in early August, and consensus estimates call for a sequential increase of 10% and a year-over-year increase of about 64% in revenue. The stock traded down by about 6.3% late Monday morning, at $5.51 in a 52-week range of $3.90 to $9.70. The stock’s total return for the past 12 months was negative 19.2%.

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