When I am looking for stocks to buy, I like to focus on significant macroeconomic themes. As such, I have been taking a closer look at the oil and gas sector. There are two penny stocks I would be happy to add to my portfolio, considering the improving outlook for this industry in general.
Penny stocks with potential
With oil prices currently trading at a seven-year high, I think the outlooks for Tullow Oil (LSE: TLW) and its peer, Enquest (LSE: ENQ), are brighter than they have been for years. However, it does not look as if the market holds the same opinion. I think that presents an opportunity.
According to current City projections, Enquest could report net earnings of $156m for 2021, rising to $312m for 2022. Based on these numbers, shares in the business are currently selling at a forward price-to-earnings multiple of 1.6.
Tullow’s valuation is just as attractive. With analysts projecting $260m of net profit for fiscal 2022, the stock is currently selling at a forward P/E of just 5. To put these numbers into perspective, shares in peer BP are currently changing hands at a P/E of 7.
Of course, these two penny stocks are not entirely comparable to the oil giant. They have far more debt and less diversification. This means they are more susceptible to sudden changes in the oil price. If it suddenly slumps 10% or 20%, their outlooks could change overnight. This is the most considerable risk I will have to keep an eye on going forward.
Still, with profits surging, both companies can make a material reduction in their liabilities over the next 12 months.
Unfortunately, they will not be able to capitalise on the current oil price boom immediately.
Undervalued stocks to buy
Both Tullow and Enquest use hedging programmes to protect their bottom lines from oil price volatility. This can reduce losses when prices fall, but it can also cap gains.
Nevertheless, Tullow was forecasting $100m of free cash flow for 2021 in November, even with its hedging programme. Enquest has said that its debt position will remain unchanged during 2021 after acquiring the Golden Eagle area asset, which added 10.5k barrels of oil to the group’s overall production.
So some headwinds will hold these companies back in the short term. However, I project that as 2022 progresses, these businesses will revise their growth and cash generation plans. As they do and begin to stabilise their balance sheets, I think the market will return to these penny stocks.
This change in sentiment could lead to a re-rating of the shares. Although this is far from guaranteed, I do not think it is unreasonable to suggest that both stocks could command a similar valuation to BP as their outlooks improve.
Considering this potential, I would be happy to add both penny stocks to my portfolio today as a way to invest in rising hydrocarbon prices over the next year.
Rupert Hargreaves has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
