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5 Newly Minted Narrow-Moat Oil and Gas Firms

We think these elite producers have sustainable competitive advantages.

Dave Meats: We recently awarded narrow moat ratings to five of the lowest cost upstream oil and gas producers in our coverage universe. These are Concho Resources, Continental Resources, Diamondback Energy, EOG Resources, and Pioneer Natural Resources. These are the firms we think can sustainably earn their cost of capital.

We believe North American shale is the source of the marginal oil barrel, but not all shale is marginal. The firms we've highlighted enjoy a significant cost advantage because their acreage is located more favorably in areas that typically yield more volumes for each [unit] of capital invested. On average, new wells in these juicy acreage areas deliver more bang for the buck, supporting lower unit costs and thus, stronger margins for the firms in this select group.

After an extended rally, oil prices have reached a level not seen since late 2014, before the global crude downturn really took hold. But this has been mainly driven by near-term supply disruptions, and isn’t sustainable in our view; our midcycle forecast for WTI crude is still $55/bbl. High oil prices did not factor in our moat ratings. Likewise, advanced technical expertise is only a benefit in the short run as innovative techniques that work well can eventually be adopted across the industry. But the acreage itself cannot be replicated, and that's what drives the sustainable competitive advantage behind the moat.

In the past we've argued that the market has failed to separate these elite producers from the peer group, creating upside for investors. For now, robust demand growth and the threat of further supply disruptions has driven oil prices to an unsustainable level, pushing up shares across the upstream segment. Of the moaty firms highlighted, only Concho, Diamondback, and Pioneer currently trade at a discount, and in each case the margin of safety is less than 10% at current prices. Therefore, while these are the best opportunities in the segment right now, we think most investors would be better off waiting for a pullback.

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