There’s an old saying on Wall Street that investors should look to the income statement for upside and the balance sheet for downside protection. But for mining and energy stocks, this axiom has been spun on its head. Income-statement metrics are forcing many of these stocks down, but their balance sheets point to the way to vigorous upside (while that downside protection also remains in place).

You can find no greater example of this than copper and gold miner Freeport McMoran (NYSE: FCX). Copper prices have fallen from around $4.50 a pound in early 2011 to a recent $3.60, dampening the company’s profit prospects. Adding insult, the company is temporarily seeing reduced output at a key Indonesian mine on the heels of work stoppages. Lastly, concerns continue to fester that China’s insatiable appetite for copper is set to slow down. Add it up, and you have a pretty dismal stock chart…

 
To be sure, this stock may look attractive at less than eight times trailing profits and less than four times trailing EBITDA, but Freeport McMoran’s earnings per share (EPS) is expected to slump about 15% this year to about $4.15 a share. And investors simply shun stocks that are posting falling profits.

But such an environment is precisely where you find value. Freeport McMoran is becoming a deep-value stock if you measure the company’s stock against the unlocked value in its various copper and gold mines.  Let me explain…

As mining engineers will tell you, it’s highly unlikely that we’ll soon hear about a brand new mining opportunity anywhere in the world. Any region that contains vast stores of copper, gold or other minerals has already been identified and exploited. So Freeport should benefit in the years to come from finite industry supply and stable to rising demand. Simply based on current dynamics, Goldman Sachs says Freeport McMoran’s mines are worth $50 a share. That’s more than 25% above current levels.

Values across the board
You can apply this same logic to many other mining firms. Take gold-mining stocks as an example. They’ve been steadily falling in value, even as the value of gold has remained fairly steady. As I noted in this article, a number of gold-mining stocks now trade well below analysts’ price targets.  These stocks actually trade above net asset value (NAV), but that’s only because the calculation involves historical purchase prices of mines and not the value of untapped gold that is waiting to be harvested. On that basis, analysts see solid potential upside for this beaten-down group.

The oil and gas conundrum
Trying to find verifiable bargains in the energy sector is a bit trickier. Natural gas prices have been plunging and production is becoming uneconomical for many players. Yet many of these same firms also have significant exposure to crude oil, which has seen more robust pricing. In light of the uncertainty regarding gas pricing right now, it only pays to look at oil-focused companies (which have a greater reliance on oil production than gas production) in the context of their underlying NAV.

What’s a good baseline assumption for oil prices when calculating NAVs? Well, conveniently enough, investing firm Jefferies Group has just issued an updated oil price forecast and updated NAV assumptions for many of the oil companies that the firm follows.

For the past few years, Jefferies had assumed that Brent Crude Oil (which reflects the spot market value in Europe) would settle in at $85 a barrel in 2013. This figure has now been bumped to $100. Their targets for West Texas Intermediate Crude (WTI), which is the basis for U.S. pricing and is often at hefty discount to Brent Crude, is now higher: Jefferies sees WTI at $90 a barrel in 2013 and $95 a barrel by 2014 or 2015.

Key positive and negative factors behind this updated view:

• Chinese oil imports will likely slow, because domestic natural gas production is rising at a 20% annual pace and substituting oil at some power plants.

• OPEC is showing more discipline, and will “defend” oil by cutting output if Brent falls below $100.

• Rising production costs are making certain energy fields economically unfeasible when oil falls much below $100 a barrel, creating a supply cut trigger.

With higher targets for oil prices in the coming years, the analysts at Jefferies have also been kind enough to reconsider their previous target prices, so the following oil stocks now have solid upside, according to the firm.


My personal favorite NAV play remains Marathon Oil (NYSE: MRO), which is a member of my $100,000 Real-Money Portfolio. The company has a range of assets in the United States and abroad. Merrill Lynch pegs the NAV for Marathon Oil at $56 a share, nearly double the current price. Shares have weakened recently on slipping energy prices, but coming quarters should start to show the results of the company’s large capital spending program, which should steadily boost output of oil and gas over the next few years.

Risks to Consider: China is still a driving force in the commodities markets, and although recent economic data suggest that economy is doing OK, a hard landing would bring down demand and commodity pricing.

Action to Take –> These companies have spent considerable sums acquiring and developing their assets. On occasion, investors tend to overlook the value of these investments and sell off stocks based on near-term cash flow trends. These are the times when asset-focused investors tend to come in and scoop up bargains. Any of the stocks I mention here are good candidates to consider buying based on that premise.

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