The energy sector has been one of the few bright spots in the market in 2022. The Energy Select Sector SPDR ETF (XLE) is up 46% in 2022, meanwhile the S&P 500 is down 6%. But how do we identify energy stocks to buy if we’re concerned about arriving to the party late, and what has driven the strong performance?
First, we had (and continue to have) a cyclical recovery from the pandemic-driven recession. During the pandemic, wells were shut in, and oil & gas companies stopped drilling new wells.
Upstream companies have started to drill new wells, but drilling is still below pre-pandemic levels despite a full recovery in demand.
And drilling activity remains significantly below prior peak levels.
There is a saying in the energy industry that “the best cure for high oil prices, is high oil prices.” This saying is correct, but it might take a lot longer than usual for high oil prices to “cure” the market.
Over the last eight years, the oil and gas industry has been starved of the capex that is required to find new reservoirs of oil and gas. Why? Mainly because of ESG concerns, which have forced oil and gas companies to deemphasize new discoveries in favor of generating positive free cash flow.
As a result, it could take several years of heavy investment before supply of oil and gas can catch up to demand.
Two of my favorite energy stocks to buy are Dorchester Minerals (DMLP) and Epsilon Energy (EPSN).
Dorchester Minerals (DMLP)
One stock in my portfolio that will continue to benefit from higher natural gas and oil prices is Dorchester Minerals (DMLP).
Dorchester Minerals’ stock is up 171% (including dividends) since I originally recommended it to my Cabot Micro-Cap Insider subscribers in October 2020, but I think there’s significant upside ahead.
Dorchester Minerals is an energy royalty company. It doesn’t have to spend any money to drill new wells. It just sits back and collects royalty checks from oil and gas assets that it owns. Despite soaring energy prices, it is still trading below pre-pandemic levels.
Because of Dorchester’s excellent business model, it has a higher EBITDA margin than Facebook (63% vs. 50%).
It is currently trading at 13.4x 2021 EPS, too cheap a multiple for such a high-quality, high-margin, and no-debt business. At its current quarterly dividend, the stock is trading at a yield of 9.7%.
Epsilon Energy (EPSN)
Epsilon Energy (EPSN) is a cheap, debt-free company that is generating gobs of cash and buying back stock. Insiders already own 25% of shares outstanding but are buying stock in the open market. The company has downside protection with a net-cash balance sheet and a valuable midstream business.
The stock has been soaring over the past couple weeks due to rocketing natural gas prices, and I expect strong performance to continue.
Last year, the company produced tremendous free cash flow and will likely do so again this year. Epsilon currently has $27.1MM of cash (16% of its market cap) and no debt. Epsilon recently committed to paying a quarterly dividend of $0.0625 per share starting on March 31. This works out to a 3.4% dividend yield. In addition, the company approved a share repurchase authorization to buy 1.1MM shares, ~5% of shares outstanding.
Dorchester and Epsilon are the best two energy stocks to buy to benefit from the continued strong performance of the energy sector!
Have you shifted more of your portfolio to energy stocks to take advantage of the sector strength?