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2 Energy Companies That Can Weather the Storm

The durable competitive advantages of undervalued Continental Resources and Cabot Oil & Gas should drive strong returns on capital over the long term.

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David Meats: Morningstar's energy team has awarded narrow moat ratings to several firms in the beleaguered exploration-and-production segment. It might seem counterintuitive to maintain these moat ratings given that oil and natural gas prices are stuck at once-in-a-generation lows. But moat ratings are not cyclical. Severe commodity-price headwinds do not preclude best-in-class operators from earning moat ratings if they can still generate significant value in the long run. Therefore, our midcycle price forecast plays a much bigger role in our moat analysis than current prices do.

Right now, we estimate that the marginal cost of supply is around $64 per barrel for WTI and $4 per thousand cubic feet for natural gas. At these levels, we believe a handful of elite E&P firms are more likely than not to generate sustainable excess returns on capital for at least 10 years, satisfying the requirement for a narrow moat rating.

Moats are durable competitive advantages that facilitate excess returns. The main source of these moats in the oil and gas arena is the cost advantage associated with each firm's acreage holdings. Firms drilling in areas where the cost of development and production is relatively attractive can enjoy stronger margins. And if there is enough low-cost acreage to support several years of drilling, then this margin advantage is potentially sustainable, driving moat.

We think the E&P firm with the strongest moat is Diamondback Energy (FANG), which operates in one of the most lucrative portions of Texas' Permian Basin. However, the market seems aware of this firm's high-quality resource base, and so the stock doesn't look cheap.

Two narrow-moat-rated stocks that do look undervalued are Continental Resources (CLR), which is an oil producer in North Dakota and Oklahoma, and Cabot Oil & Gas (COG), which is focused on natural gas production in Pennsylvania. These firms have adequate financial health, although their leverage could still trend higher in 2016. But both have a comfortable liquidity reserve to help them manage the downturn, and both have very high-quality assets that should drive strong returns on capital for extended periods if cycle price forecasts are accurate. 

Dave Meats does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.