Why this top broker rates Origin Energy Ltd and Santos Ltd a buy

According to reports in the Fairfax Press on Monday, Citibank analysts rate Origin Energy Ltd (ASX: ORG) and Santos Ltd (ASX: STO) as buys based on operations at the companies’ respective liquefied natural gas (LNG) projects.

The upgrade comes as the broker downgrades fellow market heavyweights Woodside Petroleum Limited (ASX: WPL) and Oil Search Limited (ASX: OSH) to neutral and sell respectively.

The rationale for Citibank’s upgrade to Origin and Santos stems from both companies ramping up production at their respective Australia Pacific LNG (APLNG) and Gladstone LNG (GLNG) projects. The bank regards the start-up of these LNG projects as a “further de-risking” to both companies’ cash flows, despite crude oil remaining at or near US$50 a barrel.

With this in mind, is it time to consider purchasing these two stocks?

Where is oil headed?

Crude oil has surged since the start of this year on hopes of an OPEC accord and decreased supply from US suppliers. This has helped lift the S&P/ASX 200 Energy Index (ASX: XEJ) over 25% since its multi-year lows posted at the end of January this year. Part of this rise is credited to a rally in Origin and Santos, which have both added over 50% since January this year.

Of course, history does not have any bearing on future performance and I, for one, believe both Origin and Santos have recovered to a level which implies that the oil price is headed higher.

Citibank’s analysis agrees with me, stating a further recovery in oil price is factored into current stock prices. This means that purchasers of both stocks today are assuming crude oil is either headed higher or will stay at US$50 a barrel from here on out.

Although either outcome is plausible, global growth is unlikely to utilise excess oil supply this year (especially if Iran continues to lift production), meaning the oil price will invariably fluctuate from US$50 in either direction. This could affect Origin and Santos’ share prices positively or negatively in the short term.

Foolish takeaway

Investors should not purchase stocks in an attempt to pick the bottom and sell at the top, as those types of trading strategies are fraught with danger. Neither should they shun or prefer a particular industry based on stock recommendations. A balanced portfolio requires stocks from all industries at fair and reasonable prices – oil is no exception.

Despite facing an uncertain outlook, I am of the view that oil stocks will recover in the long-run, earning them a position in any portfolio. At current prices, I regard both Origin and Santos as fairly valued based on spot crude prices and the outlook.

As such, I would not buy either on the basis of a stockbroker’s upgrade recommendation, preferring to wait for a pullback in price before topping up.

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Motley Fool contributor Rachit Dudhwala owns shares of Origin Energy Limited and Santos Limited. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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