Digging for Fossil Fuel Winners

Motley Fool contributors Jason Hall and Tyler Crowe join host Nick Sciple to dive into the energy capital cycle and share a handful of stock picks that could be winners in fossil fuels over the next several years. 

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This video was recorded on Oct. 7, 2021.

Nick Sciple: Welcome to Industry Focus. I'm Nick Sciple with oil approaching $80 a barrel and natural gas at multi-year highs. This week we're taking a look at what that means for oil and gas producers and what investors can do with that information. Joining me to help me do that are my good friends, Jason Hall and Tyler Crowe. Guys, thanks for joining me.

Tyler Crowe: Glad to be here.

Jason Hall: Absolutely. Thanks. From all corners. Well, three corners of the world.

Nick Sciple: We mentioned before we got started on the show Tyler is joining us from Tbilisi. Last time we had him on the podcast he was joining us from Africa. Really the jetsetter journey all over the world. Tyler what can you tell us about where you're at in Eastern Europe and what it's like to be living there for these past couple of weeks?

Tyler Crowe: Well, it's only been two weeks so to say that I have a good feel for the country would be really disingenuous statement. I moved here from, my wife works for State Department, so we tend to move every few years. It's certainly not the Tbilisi that was part of the Soviet Socialist Republic the USSR. It is a thriving city. I look around right now and there's probably about 20 high-rise apartment condos going right around me, so a lot going on.

Nick Sciple: Tyler, bringing us the perspective from across the world. Getting familiar with this part of Eastern Europe, I think one area that you have maybe a little bit more familiar with is what's going on in the oil and gas markets. We're in an interesting time here in that market. How do you like that transition? If you look at oil prices roughly double over the past five years. But if you look at them today, we're roughly flat where we were 10 years ago. Obviously, a lot has happened over the past year. A lot of happened over the past five years, the energy market. If you're trying to put where we're at today in context to just where we've been, how unique is this time and what do you make of where we are now in the cycle?

Tyler Crowe: Well, I'll start here. I think the best way to explain what's happening right now starts about seven years ago, 2014. You can almost think of these in like chunks of seven years because 2007/2008 up to 2014 was this very, very large push. Everybody remember peak oil? Does anybody remember that? Like oil North of $150 and everybody worried we're going to run out. Oil and gas companies just started pouring money into megaproject like these massive projects that were super expensive to build the names of like, anybody remember, [...] and Oregon LNG. These were 20, 30, 40 billion-dollar projects that we're going to hopefully stem the tide of peak oil. Then Shell came around and all of a sudden Shell started producing enormous amounts of oil and gas, and it all came to a precipice in 2014 where a lot of these developments came online with the addition of adding Shell to the mix, and then we had an oversupply. Since that time we've been working down all of those developments since then. Right about 2014, you really started to see those developments come online. Then what was behind it, like the developments from 16, 17, 18, they started to gradually, slowly decline. Investment in the sector since 2014-2015 has been going down. I can't remember which Austin powers movies was, but there was one where like there's a crash scene but it involves a steam roller and it's going two miles an hour. We've been watching this for seven years of just declining spending on exploration, declining spending on development. It's all of a sudden coming to a head. Everyone's realizing now, hey, guess what? Our development bench for the next 5-6 years looks like crap. With demand actually starting to pick back up again, most people aren't 100 percent certain where that next 5-10 years, or we'll call it seven because seven seems to be a pretty good gauge of the oil and gas industry. Where has the next seven years come from?

Jason Hall: The important thing to remember too is if you go back to seven years ago, we weren't talking about electric vehicles, anything like we are today. This was before the Model S was around. There wasn't the Prius, so you have hybrids but full EVs were not even a thing. But if you look at that chart, it's incredible. It's like a rollercoaster, from the beginning of 2010 where it's super high, prices started to peak that summer. Then spent the next two-and-a-half, three years declining before oil prices bottomed in the 20s and early 2016. We went from $115 for the barrel in 2014 during the 20s before stabilizing around $40 or $50 for a year. As much as we're about where we were four or five years ago, the journey between then and now is enormous. I just want to hit on one thing Nick real quick before we keep the show moving here. Tyler, was talking about the investing and the spending in particular one sector that we've seen enormous underspend is an offshore. These are some of the largest assets in the world that we know about. There's some of the largest assets that can produce a lot of oil for a long time. You think about fracking in the Shell plays where you have to spend tons and tons of money every year to keep production up. You have to keep drilling and keep drilling with a lot of these offshore plays. Once you make that initial investment, you can get decades of oil. But those additional investments can take a decade right by themselves. A lot of that spending, a lot of that development is really what undermined a lot of the global supply. It's a big part of the reason that we are where we are now.

Nick Sciple: Tyler, you mentioned we've basically under-invested in oil and gas, turned off incremental investment for the most part going back to 2016, which makes sense. Folks, hey, we're not making money on this, we don't want to throw more good money after bad, so we're going to hold off on investment, but those bills have come due as investment has gone down, demand keeps ticking up. Obviously, 2020 was a special situation. But we're in a scenario where there is under-supply in the market, and to correct that, you want to drill for oil. But we're really seeing some reluctance to bring oil online. You have ESG concerns a lot in Europe, you have Actavis in the US that are really constraining the ability for folks to produce. Where there's tradition folks don't want oil companies to produce, we need oil companies to produce in order to keep pricing in check. What do you do in this world if you're in oil business?

Tyler Crowe: There's the combination that we can just for a shorthand version we call it ESV, but there's also this component we watched for the past, I don't know, 5-6 years, just oil and gas producers in the United States repeatedly shoot themselves in the foot. New York getting incremental price increases that would have allowed them to pay down some debt, clean up the balance sheets, maybe even to return some capital to shareholders, God forbid.

Nick Sciple: They just drill more wells.

Tyler Crowe: Yeah, exactly. Any spare time they can find they would drill more wells.

Jason Hall: That was the answer to every question. Let's just say.

Tyler Crowe: Fortunately, it is starting to look like there is greater capital discipline, in part because bankers aren't giving them money for these development projects. We could call it an ESG concerned, or we could call it, you guys have obliterated billions of dollars in capital for seven years, why is it different this time? With that, a lot of the independent producers, we had some of the smaller players, they are starting to fall off the buying here, all that's really left are the big plant. A lot of the larger players to have either grown through consolidation or the integrated majors who have been getting by on their balance sheet. Whether or not they're going to be able to raise capital either through free cash flow or from the capital markets to get the money for these drilling and development projects is yet to be seen. However, at today's prices, it's hard to not see a company like an ExxonMobil or ConocoPhillips, some of these larger people not making money and generating enough free cash flow to do something, whether that be pay off all the loans for the past seven years, pay the bills, or return capital or start actually increasing investment again for this next cycle, however long it takes.

Nick Sciple: It appears you mentioned these different seven-year periods where we're potentially at the launch of a new cycle. When you look at oil and gas, it is governed by the capital cycle. You need the industry of capital to get conditions good enough to where it actually look attractive to capital again, and we're in the scenario where things are looking attractive. Even the highest break evens we're looking at, low 60s gets you into profitability, now we're pushing 80, so really everybody should be able to make money. Do you think now is the time where given where we are in the cycle, these companies are investable?

Jason Hall: I think it depends. It's the same answer that it's really been for a long time. Because at the end of the day, I think you're probably going to get to that point of the cycle where rationality changes and money gets a little bit free and easier. It's just given a little bit of time, people are going to make their decisions with capital, and there's a scenario where that's probably eventually going to happen again. But if you find companies that have low costs, that have a history of discipline that are smart about how they allocate capital and that have some diversification of the business, I think that can make it really, really interesting. There are a few companies that I think are really interesting right now.

Tyler Crowe: There's also a new dimension here that hasn't really been considered up until 2020s and going into 2030s is up until today. There was little to no reason for any oil company to have a contingency plan for a world without oil. I think that today there needs to be an escape plan. Everyone needs their contingency up saying 15 years, we're talking about the big companies, again, the companies that are making investments that are going to pay off 10-15 years from now or start to dwindle from that time, generally, I think it was CEO of Shell. It was a long time ago. Basically, what they said is with the amount of money that they spend, it's somewhere between 25 to $30 billion a year on capital expenditures with a $300 billion market cap company. What you're basically doing is you're turning over your entire asset base every 10 years. If you think of it in that way, how are they going to turn their asset base from 2021- 2031? I would be shocked to see any company completely ignore some transition, the European majors are leaning harder into it, the Americans, not so much, but I think over the next couple of years, perhaps, some cleaning up the balance sheets and freeing up some capital to do something. I would be very surprised if we didn't see more contingency plans and to what is our life after oil.

Nick Sciple: To be watching out for folks to capitalize on this opportunity to print a whole bunch of cash to then redeploy it into some of these new business lines, which I guess is a good transition for us. If we look out the next, I would say 3-5 years, the cycle looks constructive toward oil.

Tyler Crowe: I think cycle looks great for three to five years. If that's your investment time horizon, if you're looking to hold something beyond that, say like you were looking at some of the things to own for a dividend for 10-15, then you might need to start making some different considerations.

Nick Sciple: Yeah. As you look at this current cycle, let's talk about maybe companies that stand out to you as places to look to potentially invest in this big upswing. I think Goldman Sachs is going for $80-$90 oil by the end of the year, that leaves these companies making quite a bit of money would be on your shortlist of businesses to look at if you wanted to get some exposure to this trend in this cycle as it starts to swing up. Jason?

Jason Hall: Yeah, I will kick us off here. One that's just become more and more interesting to me then a follow-up for a number of years is Diamondback Energy ticker FANG, F-A-N-G. This is a pure-play essentially on the Permian Basin in Texas. Mostly oil they have some gas too but they're really focused on oil. What's really interesting to me about Diamondback is this is a company that's really done an incredible job of developing assets and getting their costs down, and also thinking about a really disciplined capital allocation approach. Their CEO, which advertisers has been there for almost 10 years now, and they've done a great job in terms of costs. This is a company that says they can maintain their dividend if they can realize $35 per barrel oil. That's pretty attractive considering what oil is right now. There's some of their costs the cash costs, I think around $32 a barrel for a lot of their oil. If you're going to invest in any pure-play on E and P exploration and production, you need to focus on their costs, not what you could project oil to sell for. You have to start, where's their baseline? What's the basement? For this company, that's really good. I also like their approach to returning capital to shareholders. The goal is to take 0.5 of free cash flow and either we purchase shares or pay dividend t, do one of those two things. They take the rest of free cash flow and they fill their balance sheet retiring debt. That means the dividend is going to be variable. That means over time, as oil prices move around, they are going to have a variable dividend. I think in this business it's smart to have that model so that you can focus on the health of the business first and not get so caught up in thinking you have to keep a promise of a certain dividend level that you end up hurting the company. I think it's an interesting company, especially over the next five years. Tyler, tell me where I'm wrong.

Tyler Crowe: Well, you're not wrong. I'm a deeply cynical person who has been burned by this industry so much that I view basically any pure independent exploration production company as more or less as a levered bet on oil prices. We can talk about their positioning and what not. But if you really think that oil prices are going to go up over a couple of years, independent EMPs, they're going to rip because that's all they do, they move on oil prices.

Jason Hall: There's a very good chance we're going to see the stock price correlate with oil prices.

Tyler Crowe: Right. The only problem is you're basically trying to be up a soothsayer on what oil prices are going to do for a couple of years from now.

Jason Hall: That's the risk, it really is.

Tyler Crowe: That can go wrong. It's just not my investment style in the oil and gas industry. I've always looked at 10-15 year term pricings, and because of that, the one that attracts me the most right now is Total Energy, the French integrated major. As I was talking about earlier, of all the integrated companies right now I think they have the most practical and forward thinking plan as to what does our company look like 10 years from now, what does our company look like 20 years from now. They are laying a foundation for that.

Jason Hall: It happened for a long time. This is something the company started a year ago.

Tyler Crowe: They actually just put out their capital plan and it was coupled with a sustainability presentation for their annual meeting a couple of weeks ago. One of the things that they had mentioned is over the next 10 years, they envision somewhere between a 20-30 percent decline in oil production, a doubling of their natural gas and LNG production, and a multiples larger business in utilities, electrification, hydrogen production, and making a lot of those growth investments. They are actually allocating significant capital to that right now. I see that as a good way for anybody looking to bet on energy, just being a long-term growth thing, either in renewables, either in natural gas, but they're doing it in a way that it seems like they are going to transition well, and they have an exit plan from the oil business. Despite generating gobs of cash right now, after capital expenditures and after dividend they're break even, it's like $35-37 a barrel. They're generating massive amounts of cash flow right now but they're going to be able to plow into paying down debt, getting the company financially ready for this transition and rewarding shareholders along the way .

Nick Sciple: Yeah, there's been this trend you mentioned with Total. European folks are really ahead of the curve when it comes to transition. What's special about the European market that's really driving that difference in behavior over there?

Tyler Crowe: Probably a larger pressure from the investor base. Because obviously, the more European the centric market, European board of directors things like that. I would push back on all of the European majors doing it because I think Shell and BP got thrust into it more recently and had to take their drastic measures to implement that. You saw BP slash their dividend significantly, Shell slashed their dividend significantly. But one thing that's impressive about Total doing this is they've capped shareholder return pretty much on par and saying we can do this without murdering our shareholders. Go ahead, Jason.

Jason Hall: I was just going to make a 30-second pitch for Phillips 66, in the same vein. This is a company that dividend yield like four-and-a half percent. It's not a producer of oil. They're a buyer so that insulates them from a lot of the price movement. I think there's a lot of future proofing already built into their business too. Their petrochemicals business relies largely on natural gas. There's lots of concerned about the carbon footprint of that and it's so important for things like fertilizers and those materials. But also in their refining business, they're steadily slow, really starting to make a shift to renewables. I think as the market demand for that grows, as the profitability model gets better, they're going to continue to do it. That's one that I really like a lot for the next really 10 years. Go ahead, Nick.

Nick Sciple: Phillips 66 in addition to Diamondback Energy for Jason. What I was going to say, yes, so mine, we have a good diversity here. Jason had a US shale producer and Tyler had a European oil major, and so my company I think is most interesting to me right now is Canadian Natural Resources, which is CNQ. This is a Canadian oil sands producer, a little bit different. I fall in the bucket like Tyler was talking about where I view it as, if I'm investing in oil and gas today, it's a 3-5 year time horizon and I'm looking for this in a levered bet on oil prices. A couple of things I'm thinking about there. Number 1 is, who are the folks that their shareholders are going to let them drill? The European folks, it's hard to drill more, US oil majors were getting attacked by activists. The folks that are really going to be allowed to drill is folks that are small enough to not get activist pressure or folks where it's really I think, systemically important to their economy. I think that's true in Canada. Oil in Canada is really importantly to the economy. Not exactly in the way oil is important to Texas, but it rhymes. It's in a similar boat. I think there's a little bit less pressure there. You also look at the break evens in particular for Canadian National. Yours up $30, I've seen some estimates as low as $23. They were generating positive free cash flow even the past couple of years with difficult conditions in the market. As oil prices move up, it's really incredible leverage they generate from those higher oil prices. You also look at the duration of their assets, oil sands much longer duration, and the quick on, quick off of shale assets, there's some negative to that. It's harder to get these things up and running for oil sands. But once they're running, the upkeep costs are lower and you have longer duration. They've increased dividends for 20 plus straight years and they have a capital allocation framework like Jason had talked about. Once they're going to de-lever until they get down to $15 billion of absolute debt on the balance sheet, and then going forward, they're going to deploy 50 percent of that to the balance sheet and the other half to share repurchases. Currently, they're buying back about one percent of the stock every quarter. I think that can accelerate as they start printing cash with oil prices high. Last thing to mention is if you look at their hedge book, they are unhedged. A lot of these on the oil side, they have some hedges in natural gas. You look at a lot of these small oil producers, you're like, "Hey, they're going to print so much money because of the oil price in the market." Well, not true for all of them, because a lot of them have hedged their oil production significantly at prices in '40s, '50s, '60s, not really benefiting from the upside here. You look at Canadian Natural Resources, they have all those low breakeven conditions but also are unhedged so they get all the benefit of the upside here. Because of some of those macro conditions, also as well as the break evens and the hedge book, I think Canadian Natural Resources stands out to me. But yes, those would be our three picks. One thing to keep in mind, as we mentioned earlier though, is any investment in these oil producers to a certain extent is you're making a bet on what's going to happen in the energy market. One of the unique things about the energy market is there are some national governments that at any particular time could pull the rug out from under you and increase production. As somebody who's investing in this space, how do you think about that scythe that's hanging over your head at anytime, OPEC could decide to turn the taps on full bore and really catch you flat footed? How do you think about allocating cash and forming a thesis as an investor with that hanging over you?

Jason Hall: Tyler, go first.

Tyler Crowe: [laughs] I'm going to be probably in very much the minority here in that I haven't given OPEC, Russia major country decisions or political decisions on oil, a hair of a thought in my investment thesis. Simply because it really depends on your investment time horizon over 3-5 years. You can get wiped out by something like that, but if you start looking at it from a 10-15 year time horizon, all of those things tend to come out in the wash. My view is I tend to ignore it for the simple fact that I just extend my time horizon. For those that are concerned, yeah that's what makes it a levered bet because those are the variables that are going to make you sink or swim.

Jason Hall: Yeah, actually, I largely agree, and I think the key is one of the reasons you don't have to think about it Tyler is you own companies that have competitive advantages and enough diversity in their business that oil prices alone don't drive their cash flows. They have other parts to their businesses. You get into the integrated majors. You own a toll booth business which you still make money whatever oil prices are. Demand affects it, the price is not so much. I think that's important. It's actually one of the reasons I like Phillips 66 is because they are largely detached from prices. But at the end of the day, you have to think about it. I'd say it's a buying opportunity. Sometimes when you see Russia and Saudi went to war late January right before the COVID shutdowns happened, so oil prices were already on the way down because they were flooding the market with oil. Those events can be buying opportunities. If you have great businesses on your watch list, you may be able to add if they're falling oil prices down because of some big macro stuff going on.

Nick Sciple: One thing I think about too is, Tyler mentioned life after oil for some of these energy companies. I mean, these national governments know that too. There are certain incentives in place, whether that's drill as much as you can, to realize as much profit as you can or hold back production so you can maximize price. There's a game theory going on here with these companies. You can try to get in their heads a little bit, but also they take you by surprise. They do things that are even disruptive to their own industry. You mentioned the Russia-Saudi price war. Nobody won that. Everybody was a loser there. Sometimes they're just irrational stuff that will take you by surprise or something you always have to think about.

Tyler Crowe: Or just a bunch of shale execs drilling because they'll annihilate just as much capital as anyone else will.

Jason Hall: There you go. They probably done more harm for use oil investors than OPEC plus has in its entirety.

Nick Sciple: Yeah. For me, if I'm putting together a portfolio, I really wouldn't want this particular factor to get any bigger than about maybe 10 percent or so just because there's so many things that are just not in control of the business itself. That said, lots of upside, potential benefits. If we sustain these higher prices and everybody plays along, we'll see what happens. But as we have updates and things to discuss, we're looking forward to having you guys back on the podcast to break it all down. Until then, thanks for joining me.

Jason Hall: Looking forward to. It was fun. Tyler, it's fun to be back on with you, buddy.

Tyler Crowe: Same here, buddy. Last minute on the way out, just a fun little fact, I saw it on Twitter. An energy equivalent price natural gas in Europe right now, if you were to convert it to oil, is north of $200.

Jason Hall: Two hundred dollars a barrel. Guess what, ladies and gentlemen? US gas producers don't really have access to that market, so it doesn't even really matter. There you go.

Nick Sciple: We could spend another hour talking about substitution effects from natural gas to oil as prices go up, lots of interesting things to get into, but that's a whole another podcast. Thanks, Jason. Thanks, Tyler. We'll break it down next time. Until then, as always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed. Don't buy or sell anything based solely on what you hear. Thanks to Tim Sparks for mixing the show, for Jason Hall and Tyler Crowe. I'm Nick Sciple. Thanks for listening and Fool on!