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Are Energy Stocks Ready for a Comeback?

Warren Buffett's recent purchase of Dominion Energy's (NYSE: D) natural gas assets surely managed to stir up some investor interest in the lackluster energy stocks. As always, the legendary investor managed to acquire Dominion assets at an attractive price, thanks to the challenging energy market conditions. But is the deal an indication of attractive valuations of energy stocks in general? And more importantly, is the longer-term outlook for oil and gas indeed positive?

Are energy stocks trading at attractive valuations?

Dominion Energy sold its gas assets at an earnings before interest, taxation, depreciation, and amortization (EBITDA) multiple of around 10 times. That's derived from the company's expected 2020 EBITDA of around $1 billion from the assets and the deal amount of roughly $10 billion. Dominion Energy stated on its recent conference call that it viewed this as an attractive multiple, considering that other publicly traded companies involved in natural gas transmission are currently trading at slightly lower valuations. However, the multiple is, in fact, attractive for Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B). That's because crushed energy stock prices have resulted in cheaper valuations of most of the oil and gas stocks.

KMI EV to EBITDA (Forward) Chart

KMI EV to EBITDA (Forward) data by YCharts

Consider the examples of three midstream stocks with strong fundamentals and diversified businesses: Kinder Morgan (NYSE: KMI), Enterprise Products Partners (NYSE: EPD), and ONEOK (NYSE: OKE). These companies are involved in gas transportation in addition to other midstream operations. As the above graph shows, all three stocks are trading at a lower EBITDA multiple compared to that at the start of the year. Indeed, Buffett managed to acquire Dominion's steady cash-generating gas assets at an attractive price. As economic activity and demand for oil and gas products recover, energy stocks should recover too.

The longer-term outlook for oil and gas

Apart from commodity prices, one of the factors that has pressured oil and gas stocks in recent years is the belief that fossil fuels are eventually going to be replaced by renewable sources of energy. While this could be true, it will take time for this transition to happen. According to the U.S. Energy Information Administration's (EIA's) annual energy outlook, U.S. natural gas production through 2050 is expected to increase in most cases. It projects 1.9% per year growth in dry natural gas production from 2020 to 2025.

Stock market chart with oil rig in the background.

Image source: Getty images.

The EIA expects that higher exports, mainly to developing economies, will partly drive the increase in gas production. Energy demand from developing economies is expected to continue rising for the next several years. Key factors driving this trend are rising population, higher income levels, and improved life expectancies. Basically, natural gas as a source of energy will stay here for years to come.

Having seen coal replaced as an energy source by cheaper, environment-friendly alternatives, investors' fear of natural gas meeting the same fate are not unfounded. However, this will happen only when the new source is cheaper than gas, in addition to being steady and environment friendly. Though some renewable sources are already cost-effective, they may not always be steady and their effectiveness varies geographically. Overall, a combination of all the different sources of energy will be needed to meet the rising global energy demand. Fossil fuels will continue to be a key energy source for the next several years. 

Additionally, areas such as heavy-duty transportation, industrial manufacturing, plastics, and aviation provide oil and gas with avenues of growth not yet penetrated by renewable sources.  

Three stocks offering attractive yields

Beaten-down valuations combined with positive long-term outlook make energy stocks enticing currently. Kinder Morgan, Enterprise Products Partners, and ONEOK are all trading at alluring yields. Despite headwinds, the three companies kept their second-quarter dividends unchanged over the first quarter. 

KMI Dividend Yield Chart

KMI Dividend Yield data by YCharts

As expected, Kinder Morgan's Q2 earnings were negatively impacted by coronavirus. It has also lowered its adjusted EBITDA guidance for 2020 by around 8%. However, despite that, the company is optimistic about being able to raise dividends in the first quarter of 2021. If the demand for oil and gas products continues to recover, this looks achievable.

ONEOK raised funds, both debt and equity, to help it manage during the challenging coronavirus period.  It has already completed a major portion of its 2020 planned capital expenditure, which makes its earnings available for dividend payments.

With a debt-to-EBITDA ratio of around 3.6 times, Enterprise Products Partners is the most conservatively managed of the three stocks. The master limited partnership's  diversified operations and fee-based earnings make it an attractive pick for income investors.

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Rekha Khandelwal has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares) and Kinder Morgan. The Motley Fool recommends Dominion Energy, Inc, Enterprise Products Partners, and ONEOK and recommends the following options: long January 2021 $200 calls on Berkshire Hathaway (B shares), short January 2021 $200 puts on Berkshire Hathaway (B shares), and short September 2020 $200 calls on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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