Oil has rallied past $50 per barrel with the first production cut by OPEC in eight years. Considering various factors that will be discussed, I believe the energy sector will maintain upside momentum through 2017. I will also discuss selected names in the broad energy sector that are likely to outperform in the next 12 months.
To put things into perspective, I want to start the discussion with a chart from the blog of Frank Holmes. The chart below shows the trend of oil prices in the last three instances of production cuts by OPEC.
It is important to note that in all three instances, oil prices have rallied for at least two years following the cut in production. In my view, the same trend is likely with oil moving higher from oversold levels.
Besides the point that oil has historically moved higher after a production cut, there is a steady increase in demand from emerging markets where per capita consumption of oil is lower compared to developed markets. This will ensure that the demand-supply gap narrows and oil remains bullish.
It is also worth mentioning that the dollar is at multi-year highs and I believe that the currency is overbought in the near term. With some correction likely in the dollar, oil will see more upside support on relatively weaker currency.
With these key factors in consideration, oil has potential upside of 20% to 25% in 2017. This implies that oil and gas exploration stocks might continue to do well. I also believe the energy sector is positioned to outperform the broad markets and several other sectors in 2017. Therefore, considerable exposure can be considered and the following stocks look attractive.
Parsley Energy (PE, Financial)
This oil and gas exploration stock has seen a stellar rally in 2016. The stock is already higher by 94% for the year. However, the upside will sustain in 2017 and it would not be surprising if Parsley Energy is among the stocks providing the best returns for the coming year. The company has robust financial flexibility, quality assets, deep drilling inventory and the company has been doing exceedingly well on the inorganic growth front. I expect core asset acquisitions to continue in the next 12 months that will provide stock upside catalysts besides the strong production growth on the organic front. Parsley Energy has diluted equity on a regular basis, but I do not see that as a concern because attractive acquisitions more than offset the dilution impact.
Diamond Offshore (DO, Financial)
As oil trends higher, it is a good time to buy beaten down names in the offshore drilling sector. Diamond Offshore is likely to be a performer in 2017 with a front-end loaded order backlog, no speculative rigs for delivery, smooth debt servicing and potential decline in debt through free cash flows. While the recovery in the offshore industry is likely to be slow, I expect the second half of 2017 to be good for offshore drillers in terms of order inflow. Diamond Offshore is undervalued and new rig contracts can send the stock higher.
Vanguard Energy ETF (VDE, Financial)
For investors considering exposure to the broad energy sector, the Vanguard Energy ETF provides an excellent opportunity for robust returns in 2017. The ETF has 37.8% exposure to integrated oil and gas companies, 28.5% exposure to oil and gas exploration stocks and 15.7% exposure to oil and gas equipment services, among others. In the last year, the ETF has returned 18.5%. It would not be surprising if the ETF trends higher by another 15% to 20% in 2017.
In conclusion, oil prices have started moving higher after a sustained period of depression and I believe the positive momentum will continue through 2017. Oil and gas stocks have surged from oversold levels, but valuations still remain attractive. Even from a three-to-five-year perspective, the sector is worth considering.
Disclosure: No positions in the stocks/ETF discussed.
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