Oil stocks are on fire this year. The average one in the S&P Oil & Gas Exploration & Production EFT (an ETF that holds 50 oil and gas producers) is up more than 30% year-to-date. Oil stocks are up even more over the past year as they've skyrocketed off their pandemic-induced bottom in March 2020.  

However, if we go out a bit further, it's a different story. Oil stocks are down nearly 20% since the start of 2020 and almost 50% over the past year. That makes it seem like the market might have undervalued oil stocks relative to the current oil price. Here's a look at whether the oil industry is ripe with opportunity for value investors or a value trap.

Oil pumps with money in the background.

Image source: Getty Images.

Why oil stocks might be significantly undervalued

Oil stocks are some of the most challenging companies for investors to determine an intrinsic value because volatile oil prices play a starting role in any valuation calculation. Thus, an oil company's valuation ebbs and flows with oil prices. As such, with oil prices rising this year -- crude is currently up more than 20% this year to around $60 a barrel -- the value of oil and gas assets has improved.  

The million-dollar question value investors must decide is what oil price to use in determining the value of an oil stock since that impacts the amount of money they can earn from producing oil. For example, oil companies like Devon Energy (NYSE:DVN) provide their investors with a range of free cash flow projections at different oil prices, given crude oil's volatility over the past year. The company notes that if oil averages $40 a barrel this year, it would produce around $750 million in free cash flow. That number would rise to about $1.5 billion at $50 oil and close to $2 billion at $60 oil. Devon Energy currently trades at a market cap of around $14.7 billion. That price point implies valuations of about 20 times free cash flow at $40 oil, 10 times at $50 oil, and approximately seven times at the current price near $60 a barrel. 

If an investor believes that oil can remain at or above $60 a barrel, Devon Energy looks like it might be undervalued at around seven times free cash flow.

Other oil stocks strongly believe that the market isn't giving them full credit for their assets' underlying value. That's leading them to launch share repurchase programs. For example, ConocoPhillips (NYSE:COP) plans to repurchase $1.5 billion of its stock this year, a 50% increase from its repurchase level in the fourth quarter of 2020. ConocoPhillips believes that share repurchases are an ideal way to return value to its investors. Big oil giant BP (NYSE:BP) might join it in repurchasing stock in a sign it sees value in its shares. 

A barrel spilling oil on dollars.

Image source: Getty Images.

Why oil stocks could be a major value trap

Value investors can easily make the case that some oil stocks look significantly undervalued at the moment, given that crude oil is currently around $60 a barrel. However, oil prices can change on a dime. It's already well off its peak near $68 a barrel from early March due to rising COVID-19 cases worldwide and OPEC's decision to bring back some supply starting next month. If case counts keep rising (which would likely trigger additional government restrictions on travel) and OPEC brings back its output too quickly, oil prices could tumble. It's not a stretch to think crude could fall back into the $40s, which would make an oil stock like Devon go from seeming undervalued at the current price to significantly overvalued.  

Another factor that value investors need to figure into their equation is the long-term headwinds facing the oil market. The global economy is accelerating its shift toward lower-carbon energy sources like renewable energy. On top of that increasing competition, energy companies in the U.S. might lose more than $35 billion of fossil fuel tax subsidies and could eventually have to pay a carbon tax. These factors and a drive to deliver net-zero oil could increase the costs of producing oil to the point where prices need to rise significantly in the future to make oil profitable even as demand wanes. This uncertain future led BP to shift its investment strategy from fossil fuels to renewable energy.  

Undervalued is a relative term

At $60 oil, many oil stocks certainly seem undervalued relative to the free cash flow they can produce at that oil price. However, that oil price point isn't on solid ground, leaving the risk that oil stocks could go from undervalued to overvalued at their current stock prices in no time. On top of that, the sector faces several headwinds that could keep a lid on valuations even if oil prices continue rising. Value investors therefore need a firm conviction that $60-plud oil is here to stay to declare oil stocks as undervalued these days.

 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.