With the energy sector handsomely outperforming the broader market this year as oil prices rebounded just as swiftly as they crashed in 2020, some investors feel they missed the bus. That's not necessarily the case because if you delve deeper into energy stocks, especially oil and gas stocks, you'll still be able to find hidden gems that are undervalued and have huge upside potential. Here are two such cheap oil stocks you'll want to look into right away.
Two charts reveal the golden opportunity
Oil and gas companies are making a killing this year thanks to higher oil prices. However, something unusual is happening that we haven't seen in previous oil upcycles.
The oil industry is highly competitive, and when oil prices rise, it's not unusual for some upstream oil and gas companies to aggressively scale up capacity and production to make the most of strong end markets. That eventually pressurizes supply and prices, much to the industry's dismay.
This time around, most oil producers are on the same page and have adopted a common strategy: Limit capital spending and production, and instead use incremental cash flows to strengthen their financial standing and reward shareholders with big dividend raises. The strategy, unsurprisingly, is working remarkably well in favor of oil stocks and their shareholders for two reasons.
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First, with production in the U.S. oil industry flattening, crude oil inventories are depleting although demand remains strong. That's one big reason why oil prices are holding up despite weak economic data from China and why most oil producers have now delivered at least two strong straight quarters. Better yet, demand for oil and gas is expected to rise further as we enter seasonally strong winter months.
Second, higher oil prices have sent free cash flows (FCF) soaring, and companies are doling out big dividend raises, pushing stock prices higher. It's a win-win for shareholders.
Two oil stocks, however, aren't getting much love from the market although they're generating higher free cash flows now than they have in years. Importantly, cash flows at both Marathon Oil (MRO -1.62%) and Enterprise Products Partners (EPD -0.72%) are headed even higher!.
Marathon Oil has already increased its quarterly dividend twice this year, first by 33% in the first quarter and then by 25% in the second quarter. There are three important numbers to keep in mind about Marathon Oil:
- Oil price of $35 per barrel: That's all Marathon Oil needs to generate enough FCF to fund its maintenance capital expenditure while keeping production flat at last year's level.
- 40%: With an oil price of $60 per barrel, Marathon Oil aims to return at least 40% cash from operations, or more than $1 billion, to shareholders annually.
- $4 billion: That's the amount of total, long-term debt Marathon Oil could end 2021 with -- its lowest debt level in nearly a decade.
Marathon Oil's financial fortitude is unmistakable, and it's clearly poised to generate hefty amounts of cash given its low breakeven oil price of $35 per barrel, a good chunk of which should end up in shareholders' pockets. Yet the stock is trading well below its five-year average price-to-cash flow of 5.9 times, making it a great stock to buy.
Enterprise Products Partners too is trading at a price-to-cash flow of just around 7 times versus its five-year average of 10.4 despite soaring cash flows. In fact, if you look at this chart closely, you'll notice how the company's cash flows are at 10-year highs, but the stock is still available for almost half its all-time high price of 2014!
An important metric that reflects the strength of Enterprise Products Partners' cash flows -- and more importantly, their consistency and resilience -- is its distribution coverage ratio, or the number of times the master limited partnership's cash flows can cover its distribution (or dividends) in any given period. The year 2020 was an historically challenging year for the oil industry, yet Enterprise Products Partners generated enough distributable cash flows to cover its distribution 1.6 times.
The trend continues, and that's just one of the reasons why Enterprise Products Partners ranks as one of the best and safest energy dividend stocks right now. The company stores, processes, and transports natural gas, natural gas liquids, and crude oil, so it should have a busy season ahead as winter comes. Its capital expenditures are also expected to taper going forward, which means its cash flows should remain robust and so should its dividend yield.
Right now, Enterprise Products Partners yields a juicy 8%, and it's backed by dividend growth. But the stock has dropped nearly 11% since mid-June even as oil prices remain firm. My recommendation: Buy this top-notch, high-yield dividend stock while it's still cheap.
