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Jefferies, Goldman become energy stock bulls on valuations, free cash flows

Analysts at two major investment banks are newly bullish on U.S. oil and gas stocks after two years of market beatings, saying low stock valuations and a shift in executive incentives from production growth to shareholder returns position the stocks to outperform.

A Goldman Sachs & Co. LLC team reiterated its positive view of oil and gad producers May 16 after finding that 19 of 39 covered companies have incentives for management based either on overall corporate profits or on debt-adjusted per-share production growth, compared to four companies in 2017. "We believe this surge will give investors more confidence in shale discipline and owning [exploration and production] equities," Goldman said in a note.

"This is a clearly positive signal for improved U.S. producer discipline, one of the three D's along with strong global demand and OPEC voluntary/involuntary disruptions that have improved and can further improve oil prices/sentiment," the Goldman analysts said.

Goldman highlighted oil producers EOG Resources Inc., Anadarko Petroleum Corp. and Diamondback Energy Inc., as well as Appalachian shale gas producer Cabot Oil & Gas Corp., while raising the target prices for its exploration and production, or E&P, group 7% on average. "The bulk of our buy-rated E&Ps have projected above-average debt-adjusted growth and cash return on cash invested," Goldman said. "We continue to believe that energy FCF [free cash flow] will be competitive with the S&P 500 after underperformance of 2%-5% the past three years. We also see some corporate returns improvement through 2020, not solely driven by higher oil prices."

The analysts said E&P stocks that screen in the top quartile of debt-adjusted production growth and corporate returns have outperformed the bottom quartile by 146% since 2013.

A team from Jefferies LLC urged clients in a May 15 note to overweight the E&Ps that have started showing some discipline in the face of the temptation to drill away higher crude oil prices, much like the industry did with natural gas.

However, Jefferies' love for energy did not extend to gas producers, according to analyst Mark Lear. Natural gas prices will stay static through 2019 as producers keep drilling in a saturated market to meet pipeline commitments, Lear said, and the relief valve of LNG exports stalls as new liquefaction trains will not come online until after 2019. Adding to the gas producers' dilemma are the volumes of "free" gas coming from Permian Basin shale oil wells, Lear said.

"While natural gas operators have followed oily E&Ps in starting to push the capital discipline message and gas storage currently sits 26% below average levels after a colder than normal April, we expect supply growth to continue throughout 2018 and beyond," Lear said in the note.

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"We see limited upside to strip pricing over the next two years, as 1) LNG export growth will slow until additional trains enter service in mid/late 2019, 2) Mexican export growth is limited due to pipeline constraints downstream, and 3) power demand growth is limited by slowing coal plant retirements," Lear told clients.

Lear's lone shale gas pick is the newly minted Appalachian gas pure play CNX Resources Corp. After selling legacy coal interests to spin off Consol Energy Inc., CNX posted 77% revenue growth in the first quarter when compared to the same period in 2017, a relatively low 2.9x debt/EBITDA ratio, and $250 million left in its $450 million stock buyback plan, according to S&P Global Market Intelligence.

CNX plans to use any excess cash flow to pay down debt to 2.5x debt/EBITDA and fund the buyback plan, executives said on their May 3 earnings conference call.

Jefferies' tune changed for small to mid-cap shale oil producers. "While not factored as much into our initial argument on slowing U.S. volume growth, infrastructure constraints in the Permian will also be a growth limitation as substantial infrastructure adds are not anticipated until 2H19," Lear said. "Pairing strong global oil demand with slowing US growth and tighter global spare capacity with likely reimposition of Iran sanctions paints a very bullish picture for U.S. [small-to-mid-cap] E&P."

Lear singled out Callon Petroleum Co., Oasis Petroleum Inc., PDC Energy Inc. and Synergy Resources Corp., all with solid positions and operations in the Permian.