Energy stocks were among the hardest-hit victims of the summer selloff. Investors will long remember oil’s drop from over USD150 to less than USD30 a barrel in just a few months. And as worries about a new credit crunch/recession surfaced, many moved quickly to lighten up on the sector.

Both November “High Yield of the Month” stocks were caught up in selling. After trading in the mid-20s the first half of the year, Penn West fell as far as USD12.45 per share on Oct. 4. Newalta also hit a low that day, slipping to USD9.40 from a mid-summer trading range of USD12 to USD13.

Both have bounced back since, with Newalta nearing USD12 this week and Penn West revisiting the USD18 to USD19 level. Both, however, remain extremely cheap. Penn West sells for roughly 60 cents per dollar of proven oil and gas assets in the ground. Newalta, meanwhile, trades for barely book value and just 89 percent of sales.

Most important, nothing has happened this year to dim the growth prospects of either company. Rather, their current low prices are due to overstated risks related to macroeconomic fears, which management has largely prepared against. That means powerful upside when confidence returns to the market and little real downside risk so long as it’s absent.

Newalta Corp’s robust third-quarter earnings are a stark contrast to the ups and downs of its share price the past few months. Revenue surged 25 percent from year-earlier levels, while gross profit as a percentage of sales rose from 24 to 25 percent. Headline earnings per share doubled. More important, funds from operations–the account from which dividends are paid–soared 57 percent. And the company doubled capital spending on growth, setting the stage for even better returns in 2012 and beyond.

Newalta’s current strong growth is the result of its multi-year strategy to expand industrial and oilfield waste cleanup and recycling operations across Canada. Management even continued to follow that strategy despite a drop in its share price to barely USD2, when it converted to a corporation at the worst of the credit crunch/recession of 2008-09.

As a result Newalta is now the premier Canadian pure play in cleanup and recycling of industrial and oilfield waste. That includes the oil sands, where the company has entered an exclusive contract to clean up sites and recycle waste for the Syncrude partnership. Operated by the Canadian unit of Exxon Mobil (NYSE: XOM), Syncrude has plans for aggressive expansion in coming years. And Newalta’s three-year contract to process mature tailings near Fort McMurray, Alberta, has put it in prime position to grow along with Syncrude.

Newalta’s customers today range from refining and petrochemical companies to miners and a range of heavy industry. These are fundamentally dirty businesses that have a constant need to dispose of waste safely, particularly as environmental regulations tighten. And the larger the company has grown, the greater its ability has become to compete for contracts with major players like Syncrude.

New contracts boost fee income and provide waste for the company to recycle into saleable products, such as fuel oil. Higher prices for recycled products contributed about 10 percent of third-quarter earnings growth.

The other side of the coin is that heavy industry and energy producers operate in cyclical businesses that are affected by the pace of global economic growth. As a result the sharp contraction of 2008-09 hit Newalta’s business hard, particularly the operations and facilities servicing the energy industry, as its customers pulled back on activities in the face of falling oil and gas prices.

Newalta’s saving grace during that time was management’s tight controls on operating costs, particularly on where it spent its capital. That remains a constant discipline with every new investment decision. And it’s paid off with a robust 15 percent return on capital this year, up sharply from last year’s 12 percent.

Looking ahead, management is squarely focused on growth via a pipeline of organic growth projects, which basically expand capability in areas where the company already operates. That includes lead acid recycling and sales serving eastern Canada’s industrial base, cleaning up and recycling waste from directional drilling of oil and gas and growth of oil sands activity.

Management anticipates return on capital will rise to 18 percent by the end of 2011, with a rising number of onsite services contracts powering similar gains in 2012. And more than 90 percent of earnings will come from fee-based activity, limiting exposure to ups and down of commodity prices.

There is a CAD115 million convertible bond that matures Nov. 30, 2012. The security currently trades at about twice conversion value in stock, meaning the company will likely have to roll over the full amount.

Happily, the company also has a CAD200 million credit facility on which it’s currently only about a quarter drawn. That facility matures Dec. 17, 2013, so the company could pay off the convertible without accessing capital markets in a worst-case.

In addition, Newalta generated CAD97.4 million in funds from operations in the first nine months of 2011. That covered capital spending plus dividends by a 1.17-to-1 margin, meaning the company has ability to fund at least a portion of maturing obligations from cash flow as well.

Newalta shares currently trade for barely a third their all-time high, set Oct. 20, 2006. That was, of course, just days before Canadian Finance Minister Jim Flaherty announced his infamous tax on trusts.

The company, however, is arguably far more valuable now as a corporation than it was then as an income trust. And as it continues to grow its business going forward, it will only become more valuable, potentially as a takeover target.

That kind of value ultimately means very real upside. And it’s why I’ve stuck with this stock over the years, even though it pays the lowest yield in the CE Portfolio (2.6 percent). That payout was boosted 23 percent in July, and it’s headed a lot higher in coming quarters.

But the real appeal of this one is potential for explosive capital gains. And for patient investors with that objective, there are few better bargains now. Buy Newalta Corp up to USD15 if you haven’t yet.

Deep value and the accompanying potential for big-time capital gains is also my primary reason for sticking with Penn West Petroleum, despite a disappointing stock price performance over the years I’ve had it in the Aggressive Holdings. As I’ve pointed out before, my view is today’s low valuation is mainly due to management’s tin ear regarding its shareholders.

The company converted to an income trust in mid-2005 and was wildly successful for several years using a high stock price to buy up a wealth of oil and gas properties. Management, however, seemed to lose its way as trust taxation approached.

Even as Crescent Point Energy Corp (TSX: CPG, OTC: CSCTF) was able to score huge share price gains by declaring its intention to maintain its dividend as a corporation, Penn West executives began making it known they intended to convert to a “growth” company. That, in turn, led to speculation management would gut the dividend, which turned the stock into a chronic underperformer.

As it turned out Penn West’s cut wasn’t as bad as some. But management’s decision to try to fund property development with savings from its dividend fell flat with shareholders. And, despite generally bullish Bay Street sentiment–12 “buys,” two “holds” and no “sells” as of Nov. 3–institutional buyers haven’t picked up the slack.

The result is a company with arguably the best assets in Canada that despite rallying in October still trades at little more than half the assessed value of what it has in the ground. And while all oil and gas producers depend heavily on energy prices, management’s financial policies are so conservative there’s virtually no risk to the dividend, barring yet another decision to tighten those policies.

That, of course, could never be ruled out with former CEO William Andrew, who still retains the “Vice Chairman” title. But with new blood now running day-to-day operations and given strong third-quarter results, that’s highly unlikely.

Funds from operations per share rose 25.4 percent from last year’s tally, resulting in a payout ratio of just 37 percent. That was 12 percent below second quarter funds from operations, due to a drop in realized selling prices for oil. But more important, the company was able to regain its footing in production.

Average daily output of 161,323 barrels of oil equivalent was back on track with guidance and a solid improvement on the second quarter’s 156,107.

The company has now resolved the problems it experienced in the first half of the year due to fire and floods and second half output projections remain unchanged at 163,000 to 167,000 barrels of oil equivalent per day (boe/d).

Equally important, the company’s expansion plans are back on track. Exit 2011 production is expected to hit 174,000 to 177,000 boe/d, ensuring further gains in 2012. Capital spending for 2011 is still anticipated to be between CAD1.4 billion and CAD1.5 billion, as the company deploys 20 to 25 drilling rigs through 2012 breakup season. And management plans to spend an additional CAD1.6 billion to CAD1.7 billion in 2012, to bring average production up to 174,000 to 178,000, from this year’s challenged 162,000 to 164,000 average.

How profitable that increased output will be depends to a large extent on a major factor beyond Penn West’s control, mainly what happens to energy prices, particularly oil. The current spending plan is designed to bring light oil to 51 percent of total output from a current 39 percent and total liquids production to 66 percent from 57 percent. That’s part of an overall plan to lift output 7 to 9 percent a year going forward. The company has leading positions in four of Canada’s five largest light-oil producing regions.

The company currently has hedged roughly 60,000 boe/d of 2012 liquids production between USD75.58 and USD102.28 per barrel. It’s also locked in prices of CAD4.30 per thousand cubic feet for over 8,000 boe/d of natural gas. That’s enough to protect 60 percent of forecast 2012 revenues, an extraordinarily conservative position. And those locked-in prices are on average well above realized third-quarter selling prices.

Penn West has also left little to chance on the balance sheet front. Last month it raised its bank facility by CAD500 million to a limit of CAD2.75 billion with a maturity date of Jun. 26, 2015.

That’s enough liquidity to cover pretty much anything, even as the company continues to enjoy favorable access to credit markets; an offering on Oct. 31 locked in CAD135 million for 8.1 years at a fixed interest rate of just 4.49 percent, with a close Nov. 30. And management has also targeted CAD400 million in potential sales of non-core assets, further limiting the need to access capital markets.

You won’t see it in the stock price now. But the bottom line is Penn West–once the largest oil and gas producer income trust–appears to be getting its mojo back. And sooner or later, that’s going to show up in some monster gains from the current price level.

Some years of experience with this company and its stock make it pretty clear owning it will take patience. And it’s understandable if those who’ve owned it in the past won’t want jump in again.

But for those whose believe value ultimately wins out, there are few stocks with more to offer than Penn West Petroleum, a buy up to USD25 for those who don’t already own it.

What can go wrong at Newalta and Penn West? You don’t have to look any further back than this summer’s drop in their common stocks. Both are considered highly leveraged to the economy, despite the operating and balance sheet strengths I’ve inventoried above. If oil and gas prices should come down on economic worries, their share prices are likely to come down with them. A real 2008-style collapse in energy prices would also most surely crimp profits, though as I’ve pointed out management of both companies has done much to prepare against potential damage.

In any case, both companies not only survived the wreck of 2008-09 but remained solid as businesses. That’s about the best possible testament that they have what it takes to weather anything that might happen in the next few months with their long-term value undiminished. Patient investors can hold with confidence that any near-term damage will be more than made up when macro conditions improve.

For more information on these companies, go to How They Rate and click on their names to go directly to their websites. Penn West is tracked under Oil and Gas, while Newalta is covered under Energy Services. Click on their US symbols to see all previous writeups in Canadian Edge and CE Weekly. Click on the Toronto Stock Exchange (TSX) symbol to go to their Google Finance pages for a wealth of information, ranging from news releases to price charts.

Penn West is the larger of the pair, with a market capitalization of USD8.45 billion. Newalta is smaller at CAD588 million. Both stocks trade with good volume on their home market, the TSX. Penn West trades on the New York Stock Exchange (NYSE) in the US, while Newalta also trades in good volume under the US over-the-counter (OTC) symbol NWLTF.

As is the case with all stocks in the Canadian Edge coverage universe, you get the same ownership whether you buy in the US or Canada. These stocks are priced in and pay dividend in Canadian dollars. Appreciation in the loonie will raise dividends as well as the value of your shares.

Dividends of both companies are 100 percent qualified for US income tax purposes. Both are Canadian corporations, so dividends paid into a US IRA aren’t subject to 15 percent Canadian withholding tax. Dividends paid to non-IRA accounts will be withheld 15 percent from US investor accounts but can be recovered as a credit by filing a Form 1116 with your US income taxes. The amount of recovery allowed per year depends on your own tax situation. Canadian investors may be able to defer some of their tax burden as a return of capital.