‘It’s pretty clear that the market wants to see this industry return capital to shareholders.’
David Harrell: Hi, I’m David Harrell, editor of Morningstar DividendInvestor newsletter. I’m joined today by Dave Meats, who is Morningstar’s director of equity research for energy and utilities. Dave, thanks for being here.
David Meats: Always happy to be here.
Harrell: And can you just give us a little overview of your role and the team of analysts that you oversee?
Meats: Yeah, absolutely. So I’m the director of the energy and resources team. So that includes coverage of global oil and gas stocks and also the U.S. electric power sector. And then I personally cover stocks as well, as part of that, I focus on the U.S. exploration and production, or E&P, sector. So that’s mainly shale-based crude oil and natural gas producers.
Harrell: Perfect. Now, energy is obviously a very topical sector right now. As you know, the Morningstar energy sector was up more than 55% on a total return basis last year, and oil prices are up about 50% over the past year, and even in 2022, we’ve seen the index up close to 20%. But obviously, it’s moved downward over the past week. Now, you mentioned the companies you cover. I know that several of them reported earnings recently. And I just want to hear what your take was–any trends that you’ve seen among fourth-quarter earnings, as well as your overall outlook for the sector on a valuation basis and your outlook for commodity prices.
Meats: Let’s start with the bigger picture, then. When you look at oil and natural gas prices right now, I’d say both are quite elevated. We have oil closing in on $100 a barrel and natural gas prices in the U.S. well above our 3.30 per 1,000 cubic foot midcycle price estimate as well. So, we would say definitely prices both elevated and I think aspect of that is going to be geopolitical risk. You know, some of that is what’s going on in Ukraine and Russia right now. But other geopolitical issues around the world. And a lot of it is fundamental to supply and demand constraints. So on the natural gas side, just as an example, recently we’ve seen slower wind speeds in Europe, which affects wind power generation, and also tightening carbon regulations over there, which makes natural gas demand more favorable. Natural gas, it’s fossil fuel, but if the alternative is coal, then it’s still a lower carbon alternative.
So, putting all these things together, we’re seeing rising natural gas demand, particularly in Europe, and European prices have been spiking. But that also knocks on to the U.S. now that the U.S. is a significant natural gas exporter via LNG. So there’s higher demand for U.S. LNG, and that falls back on higher U.S. natural gas prices as well. So, U.S. natural gas well above the 3.30 midcycle. And global oil prices or midcycle for WTI crude is $55 a barrel. And we’re obviously well above that. And then, I guess, thinking about the drivers on the oil side, I talked about natural gas a little more, but on the oil side, we’re seeing a very fast recovery in demand after the emergence from the brunt of the pandemic, but the recovery on the supply side has been a lot slower. And that slow recovery is caused by a couple of factors.
The first one is OPEC. They have this plan to very gradually unwind the production goals they put in place during the pandemic by 400,000 barrels a day per month. And even though we’re seeing higher prices, they don’t really have any incentive to accelerate that schedule. OPEC clearly benefits from higher crude prices, and they’re kind of happy with the status quo there.
And the other driver of the slow supply recovery is in the United States and in the shale patch, in particular, where companies are now showing a newfound embrace of capital discipline. And the industry has been criticized for its lack of capital discipline in the past. Ever since the shale revolution began, companies would spend more than their cash flow, they would lean on their balance sheets, use bank debt, and even equity issuances to fund their operations and chase double-digit production growth rates. And all of that made a big difference to global oil markets. The cost of oil came down from over $100 a barrel in 2014 to into the 50s and it’s been oscillating around our midcycle level of $55 ever since then.
So we’ve had this recent trend for capital discipline where the producers have learned that the shareholders don’t want production growth at any cost. What they want is slow and steady production growth, maybe low single digits with a focus on free cash flows, focus on returns to shareholders, rather than just purely production growth. And that’s definitely shown up in the fourth quarter to tie this back to your question. All of the companies are talking about capital discipline, the trend, very few companies are willing to increase their capital budget significantly. It’s more about keeping production at maintenance levels or perhaps increasing 1% or 2% year-on-year. The very gradual production growth coupled with lots of free cash flow is a big windfall with commodity prices being where they are, and all that’s generating a huge surge in cash which these companies are redistributing to shareholders. So that’s one of the big trends.
And then the other one is cost inflation. The industry is certainly not immune from that. Lots of these companies are seeing costs increasing mainly through steel costs, which is a big component of drilling. Also labor, fuel costs, and chemical costs for the fracking process as well. So the cost inflation pushing the cost of drilling up by about 10% year-on-year, it looks like from the companies that have reported so far. But as you say, in general, not only are the commodity prices up in the last six to 12 months, but so are the stocks, and as a result, you’d argue that the good news is mainly baked in from a valuation perspective. Most of our coverage is 3 stars or below at present.
Harrell: Got it. And getting back to the commodity prices: We had an email discussion a couple of weeks back. And you know, obviously the energy sector as a whole is not homogenous, and within it, you have different industries that have varying levels of sensitivity to commodity prices. Could you elaborate on that a little?
Meats: Yeah, absolutely. So the companies that I follow, the E&P companies, they’re the ones that extract and sell the commodity. So, they’re selling the commodity price, it’s pretty clear if the commodity goes up, and so does their revenue. And that makes them very sensitive to those commodity prices. But if you look at the other segments in the industry–midstream would be an example–that’s mainly the pipeline operators that are responsible for transporting the crude from the well site of the refinery. And those midstream pipeline operators take tolls for shipping. So the revenue there is based on the volume, not on the commodity price. So commodity price goes up in the short run, not much impact on the volume. They’re not immune to commodity prices, because the longer the commodity prices are high or low, the more likely it is that the E&Ps will ship more or less, but they’re a little set back from the exposure to commodities directly.
And then if you think about the oil-services industry: Their business model involves supporting the E&P companies in the drilling process. And the capital that the E&P spend on drilling, that’s the revenue for the oil-field services companies. So if you have very high oil prices for a very long period of time, then eventually the E&P companies will change their capital habits. If oil price is very high, they’ll increase their capital and vice versa. So oilfield service revenues are sensitive to commodity prices, but it’s a second derivative, and it takes time to really manifest.
And then I guess the last portion of the industry to consider is the refiners. The refiners will see higher crude prices as higher input costs, because they effectively buy crude and turn it into petroleum products. So they will make a profit based on the spread between the crude price and the petroleum product price. So higher crude prices will be higher input cost for them, but they’re able to pass that through, the petroleum product prices will increase as well. So they’re not as sensitive to commodity prices. So big range, but the most sensitive is going to be the E&Ps.
Harrell: That’s the reason we’re starting to see this trend in the E&P companies toward variable dividends–because of that sensitivity to commodity prices, correct?
Meats: Yeah, I think that’s true. If you’re the CFO of an E&P company, then you have a problem because you know the shareholders want to see return of capital. But if you raise up the fixed dividend to provide that return, oil prices being very cyclical–sooner or later, you’re going to find yourself in a downcycle and in that downcycle your operating cash flow probably isn’t going to be sufficient to fund that fixed dividend. And that’s an awkward situation. You can either cut your dividend, which sends a really unpleasant signal to the market, or you can lean on the balance sheet if your leverage allows it, if you have the liquidity, or you can rely on the capital markets. And really none of those things is ideal. But then the converse situation is to have a low fixed dividend and not take that risk, but then the market will perceive your income potential as lower.
So, what these companies are trying to do is find a happy medium, so some are doing that by special dividends: When you have the cash flow every now and again announce a surprise one-off payment to the market. The downside there is it’s not very predictable or transparent. So, it’s questionable whether the market really gives them any credit for doing that. And the other solution is to pay a variable dividend, which involves paying a fixed percentage of your cash flow every quarter, so oil prices are high, you got lots of cash flow, so the percentage of that will be higher, the variable payout to the shareholders will be higher. But then in the lean times when commodity prices are lower, you have lower cash flow so, as you’re only paying a smaller percentage of that, you’re automatically reducing your payout and protecting your balance sheet during the downcycle.
Harrell: And you think that this approach actually makes sense for the E&P industry as a whole, correct?
Meats: I do. It’s pretty clear that the market wants to see this industry return capital to shareholders. I kind of see it as an analogy to the big tobacco industry in the late ’90s, after the the master settlement agreement where these companies were saying, "OK, we’re in a sin industry, and we’re facing a long-term secular decline for our product, but by being disciplined with our capital allocation, we’re able to generate substantial cash flows in spite of that long-term secular decline." And the value proposition is clearly no longer growth if you have a long-term secular decline, but the income component can be significant if those companies are capable of generating the cash flow. I think the oil companies are trying to go the same way. They have this problem of trying to figure out–how do we show that we have the potential to return significant cash to shareholders but not run into difficult times during the commodity downcycles. I think the variable dividend mechanism makes a ton of sense.
Harrell: Got it. And certainly from income-focused shareholders it means, like you said, without it, the dividend rate would probably be low, to be conservative. So this way, they’re getting more dividend dollars than they would otherwise without that variable component.
Meats: Yeah, absolutely.
Harrell: Are there any names that you’d highlight right now within the sector from either a current yield standpoint or based on their potential for dividend growth?
Meats: Yeah, I was scratching my head over this. I mentioned that the valuations in this sector have kind of followed the commodity prices. So we don’t think the sector is particularly cheap. Most of our names are rated 3 stars and below. But I will highlight three stocks that are kind of similar, and then one that’s a little bit different. So first of all: Pioneer (PXD), Devon (DVN), and Coterra (CTRA). All have fairly similar strategies: They pay a fixed base dividend with a yield about 1% to 2%, typically, based on current prices, and then on top of that, they will layer in a variable component, which has an incremental yield of about 3% to 5%. So in total, these companies at current oil prices are yielding 5% to 7%, more or less. And all of them are in the ballpark of 3-star territory. So all of them, more or less, fairly valued. We don’t see substantial opportunity for capital appreciation, but the 5% to 7% total dividend is attractive for income investors, of course.
And then the last opportunity I would point out–a little bit different–is Occidental Petroleum. (OXY) is the ticker. OXY hasn’t been able to jump on the same bandwagon as the other E&P companies and start paying generous dividends yet. And that’s because they made a big acquisition back in late 2018, I think it was, when it purchased Anadarko Petroleum for $60 billion–big acquisition. So that stretched out the balance sheet, and OXY has been using the windfall from higher commodity prices recently to delever, whereas its peers have been able to use those free cash flows for capital returns. So OXY hasn’t joined the party yet. But if you fast-forward a few years down the line, if you look at a discretionary cash flow yield, you can’t look at a dividend yield because OXY is not paying a dividend. But if you look at the cash flow yield a few years down the line, that’s a proxy for the ability to pay a dividend eventually in the future. And OXY’s free cash yield is about 19% currently compared to an average of 8% for the three companies that I outlined previously. So basically double the potential firepower for returning cash to shareholders, eventually, once they’ve cleared their leverage hurdles, which they’re well on the way to doing. The balance sheet is already looking in pretty good shape compared to how it was six or 12 months ago. So I think this is one–it’s a stock that’s being kind of left for dead a little bit by the market, not really appreciating its potential to pay out those dividends. Eventually investors are really focused, it seems like, on what the stocks can do right now, and I think that’s a bit shortsighted. I think long-term investors would be better served looking at OXY. It has the potential to pay the same dividends that the other stocks are paying, maybe even better, but in addition to that, unlike the others, it’s a little more than 20% undervalued at the current price as well.
Harrell: One last thing I want to circle back to: the Ukraine situation. And your oil market outlook for February, you wrote that, despite what’s going on there that we’re unlikely to see any real shock to the global oil market? Can you explain that?
Meats: Yeah, I guess I’d clarify, at least we don’t think there’ll be a fundamental shock–so in terms of a reduction in supply or a spike in demand. That’s not to say that prices can’t get out of whack temporarily. We’re already seeing that–price is closing in on $100 a barrel. A lot of that is geopolitical risk, like I mentioned, I don’t think there’s really any justification from a supply/demand perspective for $100 oil. So a lot of that is kind of a fear premium. It’s a risk premium. And if you actually look at the fundamentals, what can this do to supply? Well, bear in mind that fossil fuel exports from Russia make about 40% of GDP. So, that’s really significant for Russia. And then think about the three scenarios where a fundamental supply shock can happen.
The first one is direct military action. So that could be a sabotaged pipeline or something that gets destroyed in conflict. And that’s one way, but in terms of crude oil, the amount of crude oil that passes through Ukraine on the southern leg of the Friendship Pipeline is about 250,000 barrels a day, which is a small fraction of global supply and not really enough to make a huge difference fundamentally.
But then the other two ways you could get a shock out of this: One way is Russia turns around and applies an embargo and says, "OK, we don’t want to sell our crude to the West because of the sanctions" or because of whatever else. So that would kind of follow what Saudi Arabia did in 1973, the oil crisis then. But the big difference here, given how dependent Russia is on its fossil fuel exports, it would really be cutting off its nose to spite its face, it would be very difficult economically to tolerate that lost revenue. It would be a very painful sacrifice for Russia to make and one that I don’t think it wants to make.
And then on the other hand, you could have the West, effectively saying, "Well, we’re going to sanction Russian oil," which is exactly what they’re doing to Iran, right now. Iran is virtually unable to export any of the crude that it produces. And that’s resulted in a pretty durable supply haircut of about 1.5 million barrels a day since those sanctions were enacted. But the scale here is more than 5 times that. Russia supplies about 10% of the global market–10 million barrels a day–and it exports about half of that. So we’re talking about a 5 million barrel per day loss of supply if the U.S. or other Western countries were to apply those sanctions directly to Russian oil. And the impact of that would be extremely significant on crude prices. You’d have rocketing crude prices, $100 a barrel, at the least there already, but maybe $100, $150 a barrel, $200 a barrel, it would be extremely unpalatable. And would almost immediately cause a huge global recession, more than likely, with that level of increase. Any change in crude prices, generally a regressive tax, because it disproportionately impacts the poor for whom fuel costs are a bigger proportion of their periodic expenses. So it would be extremely difficult; it would cause a lot of hardship across the world. And the impact of businesses as well would be severe, overall really hurting GDP. So that’s not a very good solution either.
So really, neither Russia nor the West can afford to do anything to jeopardize that Russia supply. So I don’t think from a fundamental perspective, you’re going to see any changes, but there’s a lot of fear, there’s a lot of uncertainty, and that’s why we’re seeing prices surge in the short run. So we’ll have to wait and see what happens, but unless the volume of barrels that is leaving Russia and going on to the world market, unless that significantly changes, then I don’t think that you have a durable impact on marginal cost and therefore on crude prices in the long run.
Harrell: Some short-term volatility that we’re seeing now, but perhaps not any change in the long-term supply.
Meats: Yeah, to get that change in long-term supply, either Russia would have to be willing to say, "OK, we’re going to give up that revenue because so much as it hurts us, we want to hurt you even more." And that’s one scenario. The other scenario is the opposite, then the West would have to say, "OK, we’re willing to tolerate economic hardship. We know this is going to really hurt us. But we’re willing to do it because we know it’s going to hurt you more." So, it’s kind of a game of chicken there. But I don’t think that either one of those sides is going to make that sacrifice. I think you’ll see sanctions going around that, and I don’t think that a repeat of the 1973 oil embargo is on the cards in this particular situation.
Harrell: Well, thanks, Dave, for sharing your insight. Appreciate having you here.
Meats: Of course, happy to help.
David Harrell does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.
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