Crude oil prices fell over 5% on Wednesday following a seemingly bearish report on U.S. crude oil inventories. I view this sell-off as mostly emotional, for reasons I explain below. I view emotional sell-offs as buying opportunities for good companies. The underlying fundamentals haven’t changed, but the share price has become more compelling. If, for instance, you have kicked yourself for missing EOG Resources (NYSE: EOG) at $95 a share, today provided another opportunity to pick it up at that price.

Why do I think this sell-off is emotional? It was triggered by the latest Weekly Petroleum Status Report from the Energy Information Administration. Crude oil inventories in the U.S. rose by 8.2 million barrels over the previous week to a record high. High crude oil inventories are certainly not bullish, but a little context is in order. This is refinery maintenance season, when some refineries stop or reduce operations for repairs. This reduces demand for crude but at the same time draws down fuel stockpiles.

In fact, the latest report showed finished product inventories were down across the board. Gasoline inventories, for instance, fell by 6.6 million barrels. Distillate fuel inventories fell by another 2.7 million barrels. Netting the overall change in inventories — of crude oil and finished products — total commercial inventories actually decreased by 2.4 million barrels.

Further, the U.S. isn’t the entire world. Global inventories are declining. This is being helped by the fact that the U.S. continues to import 8.2 million barrels per day (bpd) of crude. You read that correctly; the amount of the crude oil inventory build amounts to a single day of U.S. crude oil imports. Imports this week were actually 100,000 bpd higher than a year ago, while refinery production was 400,000 bpd lower. Refinery utilization this turnaround season is at the lowest level since 2013, which indicates to me that some refiners had been delaying maintenance to take advantage of good margins. But utilization will be more than one million bpd higher in a couple of months than it is now.

A common misperception in the market is that high inventories are the result of surging U.S. crude oil production, which necessarily must push prices back down. Domestic crude output has in fact risen in recent weeks, but is still down over the last year. The far larger culprits in the inventory build were the 57 million barrels of oil imported for the week (nearly a million barrels more than a year ago), and the 400,000 bpd decline in demand from refineries in maintenance.

So this is an opportunity to pick up quality oil stocks at what I believe will be a temporary discount. Which ones? I mentioned our #10 Best Buy EOG Resources above, which is the highest ranked oil producer on the list. As I noted in a recent Energy Letter, EOG recently reported earnings that beat analysts’ earnings expectations, while growing free cash flow (FCF) for the fifth straight year.

Screening for FCF Champs

I decided to look at other oil and gas companies that have managed to increase FCF consistently in recent years, using the proprietary stock screen I developed for The Energy Strategist. This screening tool is Excel-based, and extracts data from the subscription-only S&P Global Market Intelligence database. The tool was specially developed for energy companies.  

I screened for U.S.- and Canadian-based publicly traded companies that reported oil or gas reserves at the end of 2016. There were 303 meeting this criteria. I next checked to see how many increased FCF from 2015 to 2016. That left 145 companies led by ExxonMobil (NYSE: XOM) and Chevron (NYSE: CVX), each of which reported an annual improvement of over $9 billion.

However, both of those companies had huge FCF deficits the previous year, so when I demanded two straight years of improving FCF, they dropped off the list, which shrank to 86 stocks. Requiring three straight years of improving FCF whittled the list down to this dozen:

• EV – Enterprise value in millions of U.S. dollars, as of March 8
• EBITDA – Earnings before interest, tax, depreciation and amortization, in millions for the trailing 12 months (TTM)
• FCF – Levered free cash flow, in millions
• Debt – Net debt at the end of the most recent fiscal quarter
• 1 Yr Ret – Total shareholder return, including dividends, over the past 12 months   

In addition to EOG, CONSOL Energy (NYSE: CNX) and Continental Resources (NYSE: CLR) are both portfolio Buys at current prices.

A portfolio of these 12 stocks would have done quite well over the past year, primarily because Resolute Energy (NYSE: REN) turned into a 10-bagger. But even if we remove that one as an outlier, the average for the rest of the group was 37%, and that’s including the outlier in the opposite direction with an 80% loss.

Of those listed, EOG is the company best-positioned to survive and even grow in the current $50 oil climate. For the record, only two companies of the 303 I started with for this screen managed to increase FCF for five straight years: EOG Resources and Southwestern Energy (NYSE: SWN). But Southwestern is primarily a gas producer and is significantly more leveraged than EOG.

I was initially surprised to see Chesapeake Energy (NYSE: CHK) on the list, since it hasn’t exactly been in the best fiscal shape in recent years. But notice that even though Chesapeake’s cash flow has improved for three straight years it remains more than $1.5 billion in the red for the past year. Further, the company remains endangered by its high debt load.   

Conclusions

Inventory levels are indeed high in the U.S. I can’t advise you not to worry, because psychology plays a big role in the market. Breaking below $50/bbl might scare up more sellers and put further downward pressure on prices. But what I can tell you is that fundamentally, supply and demand have balanced. The global inventory picture is improving, which is bullish for oil prices in the longer run. Yes, U.S. inventories are high, but that’s largely because we continue to import lots of overseas crude.