Summary
- In this article, I start with an in-depth discussion of energy fundamentals, explaining why I expect oil prices to remain elevated on a long-term basis.
- Based on that context, I present my favorite energy investments, including upstream, midstream, and downstream.
- I have invested in most of these companies and look forward to buying more exposure on stock price weakness in the months ahead.
Introduction
Recently, I wrote an article titled " The Oil Giant's Bet On The Super Cycle: Exxon Mobil And BP" where I explained my bullish perspective on long-term energy prices. Using the earnings of BP and Exxon Mobil as a basis, I delved into the strategies of these industry giants in dealing with the current energy situation. The oil price super-cycle continues to be a fascinating topic, as subdued oil production growth collides with consistent growth in demand, creating ample opportunities in the energy sector.
In this article, I aim to further explore this super cycle and my continued investment in the energy sector, despite having a substantial portfolio in this sector. Additionally, in response to numerous inquiries from readers, I will be presenting my top picks in various energy industries.
From upstream (oil drilling), midstream (transportation), downstream (refining), and support industries such as equipment and services providers, I will be sharing my top picks in each category. I am eager to share my insights and start a productive discussion.
So, let's get started!
Why I'm Bullish On Oil
A chart-filled explanation of my bullish stance on oil and its drillers
As I wrote in my most recent article, my optimistic outlook on oil prices has always centered around production. After all, I believe that demand isn't slowing down. According to McKinsey's projections, demand for oil is expected to continually increase and surpass 100 million barrels per day. There are numerous other models that indicate this sustained growth in demand. The only exception to this is net-zero models, which have been shown to be unreliable in 2022.
McKinsey & Company
In light of these developments, it's a big problem that the world is transitioning toward green energy. Green energy itself isn't a bad idea. However, the fact that it's a forced trend is what makes these things so tricky.
Governments are stimulating renewable energy, funded activists are gluing themselves to streets to force an end to oil production, and major insurance companies are slowly exiting the industry.
This is the short version, but I think everyone knows what I'm saying. It's a hostile environment for oil and gas producers. They know that if oil prices are to implode again, they cannot count on any support.
Hence, producers (in general) refrain from growing production as fast as they are technically capable of. After all, by keeping supply low, producers can avoid massive supply/demand imbalances that crush the price of oil. We witnessed it in 2015 and 2020.
Essentially, the oil industry spent $305 billion on oil production in 2021. That number might seem a bit outdated, but not a lot has changed since then, as I will show you in this article.
The International Energy Agency estimates that spending of at least $466 billion in annual spending from 2022 to 2030 is needed to meet the world's oil needs - based on current climate pledges.
Bloomberg
Even if big oil were to follow net zero pledges, it would have to grow spending by 25% from current levels until 2030!
These numbers perfectly show how dire the situation has become.
In preparation for this article, I did a Twitter thread the other day, which highlighted the shift in spending.
To start, I'd like to share an updated chart that displays capital expenditures within the oil and gas industry. Since the commodity peak in 2011, investments in the industry have experienced a steady decline. The sharp decline in energy prices caused CapEx to plummet in 2016, and despite a slight recovery, a new low was reached in 2020 as oil prices plummeted again. Although spending in 2021 and 2022 has increased, it has only partially recovered, and there are no significant expectations of improvement in 2023.
Bloomberg (Via Twitter (@DisruptorStocks))
Furthermore, it's worth noting that many companies are currently spending more on shareholder distributions than CapEx. Since 2022, investments in production growth have been outweighed by dividends and buybacks. This trend may continue as companies are generating significant excess free cash flow, which could lead to further increases in buybacks and dividends even without an increase in oil prices.
One of the reasons why companies might choose to prioritize buybacks and dividends is to preserve their high-quality inventory, particularly smaller producers who may risk running out of such inventory. This can lead to increased production costs, making it more financially sensible for companies to prioritize generating shareholder value rather than boosting production.
For instance, in the Permian Basin, one of the most robust basins in the US, production growth has slowed down despite an increase in the number of drilled wells. Most major producers in the basin have reported relatively flat growth rates, suggesting that peak production growth has already been achieved in the Texas region. Please note that there is a typo in the chart below, which reads "Periman."
Twitter (@SRSrocco Report)
Investments are so low that Baker Hughes came out saying that it will require years of investment growth to meet forecasted future demand.
[...] we maintain a positive outlook for the energy sector, given supply shortages appear likely to persist...global spare capacity for oil and gas has deteriorated and will likely require years of investment growth to meet forecasted future demand.
Needless to say, this is in line with what we discussed at the start of this article and in almost every oil-focused article since 2020.
It's also further backed by the following chart, which shows the number of projects (measured by their oil volumes) that have passed the final investment decision. In 2022, projects that were approved accounted for 12.7 billion barrels of future oil production. That may sound like a lot, but it's the lowest in 20 years and just barely above 2020 levels.
Rystad Energy, Morgan Stanley
Hence, despite the rising probability of a recession this year, oil prices remain extremely strong, with Brent trading north of $86.
TradingView (ICE Brent)
It is possible that oil prices may experience a short-term decline. Nevertheless, it is my anticipation that oil prices will sustain strength over the long term and increase to a minimum of $100 upon the resurgence of economic demand.
Despite the potential acceleration of electric vehicle adoption, there is no indication of a decrease in long-term oil demand. Moreover, the slow growth of oil supply renders it incapable of matching demand. It is improbable for oil supply to accelerate without significant changes in Western nations' energy transition approach. This shift must acknowledge that a feasible energy transition is unattainable without affordable fossil fuels.
With all of this said, let me show you my favorite energy picks.
About The Picks
Based on our theoretical discussion of oil fundamentals, the majority of my recommended companies will prioritize profitability and shareholder distributions in a scenario where oil prices remain elevated over a prolonged period. However, as stated in the introduction, I will also offer investment suggestions in other energy industries, such as downstream refining, midstream, support/equipment, and others.
Eland Cables
Given that this article covers more than 2-3 companies, it is challenging to allocate the appropriate attention to each company. To address this, I will provide links to enable you to conduct your due diligence in case you are interested in a particular company.
The primary objective is to provide a brief summary of why certain companies appeal to me and how they could potentially benefit you.
I did not include my largest energy holdings Exxon Mobil ( XOM ) and Chevron ( CVX ), as they are a combination of upstream and downstream. I went with pure-play stocks in this article.
In addition, I will not cover every stock that I favor in the energy sector as this would lead to an excessively long article. However, I plan to highlight further opportunities in the coming months, providing a chance to explore a broader range of investment options.
So, don't hold back if you have any requests for future energy articles!
Devon Energy ( DVN ) - Exploration & Production
- Low breakeven prices
- Healthy balance sheet
- A focus on dividends
FINVIZ
Devon Energy is a major onshore oil producer in the United States. With a market cap of $39 billion, the company has major assets in the Delaware basin, where it produces more than 420 thousand barrels of oil equivalent per day. Total oil production is close to 650 thousand barrels of OE per day. Roughly half of this consists of oil.
Devon Energy
The company's breakeven point is close to $30 WTI, which provides the company with high free cash flow - even at subdued oil prices. Thanks to its investment-grade balance sheet with a net debt ratio of less than 0.5x EBITDAX, the company does not need to prioritize balance sheet health over financial stability. The same goes for its hedges. In 2022, just 20% of production was hedged, which means that higher oil prices translate to higher average selling prices.
At $80 WTI, the company estimates to have a 9-10% free cash flow yield.
Devon Energy
Management has a very shareholder-friendly approach, as it aims to distribute up to 50% of excess free cash flow through dividends, on top of a $0.18 per share quarterly dividend.
On November 1, the company announced a $1.35 per share quarterly dividend. This is 12.9% below its prior payment as a result of lower oil prices. However, it still translates to a 7% yield, which is what investors can expect with oil prices at current levels.
If oil makes its way up to $100 and beyond, the dividend will likely be in double-digit territory.
Beyond that, the company repurchases shares.
However, buybacks are rather subdued, as the number of diluted shares outstanding has dropped by just 1% over the past 12 months.
For more info, I recommend this article .
Marathon Oil ( MRO ) - Exploration & Production
- Low breakeven prices
- Healthy balance sheet
- A focus on buybacks
FINVIZ
While I'm painting with a broad brush, MRO is somewhat similar to DVN, except that it focuses on buybacks instead of dividends.
With a market cap of $16 billion, Marathon produces close to 350 thousand barrels of OE per day.
The company generates breakeven free cash flow at $35 WTI and reinvests roughly a quarter of its free cash flow. At prices above $60 WTI, management aims to return at least 40% of its cash from operations to investors. Long-term production growth is expected to be 5%.
After achieving its leverage target in 3Q21, the company has distributed $3.6 billion in capital to shareholders. $3.4 billion of this went towards share repurchases, lowering the share count by 20%. Its dividend yield is below 2%.
For more info, I recommend this article .
Pioneer Natural Resources ( PXD ) - Exploration & Production
- Low breakeven prices
- Healthy balance sheet
- Buybacks & Dividends
FINVIZ
Pioneer, based in Texas, is a company that offers the best of both worlds: buybacks and dividends. As one of the largest onshore producers in the United States, with a market cap of $52 billion, it produced around 660 thousand barrels of OE per day in 3Q22, including 350 thousand barrels of oil. With over 20 years' worth of high-quality inventory in the Midland Basin, Pioneer has a breakeven cash flow in the $30s WTI range, just like the stocks we discussed earlier.
What sets Pioneer apart is its decision not to hedge production. Its net leverage ratio is below 0.4x EBITDA, which means it doesn't have to focus on the health of its balance sheet. Besides, the company's commitment to distributing most of its cash to shareholders is impressive. Not only does it have a base dividend, but it also has a variable dividend of up to 75% of free cash flow, and share buybacks to take care of the remaining free cash flow.
Scott Sheffield, Pioneer's CEO, is one of the industry's finest, and I believe the company's pledge to reward its shareholders is admirable. At $100 WTI, investors can technically enjoy a dividend yield of 12%, and even at $80 WTI, that figure remains above 8%.
Pioneer Natural Resources
For more info, I recommend this article .
With that said, my next pick operates in a different industry.
Helmerich & Payne ( HP ) - Equipment/Services
- Top-tier equipment
- New growth opportunities
FINVIZ
The last time Helmerich & Payne shares did really well was between 2012 and 2014. Back then, the US shale boom had its best years, which required a ton of new equipment. In an environment of subdued production growth, I prefer drillers over equipment providers. However, if you want exposure in this segment, HP is the way to go.
Helmerich & Payne's innovative drilling technology and highly skilled workforce have helped the company maintain a leading position in the drilling industry. In recent years, the company has also expanded into adjacent industries such as data analytics and automation, which have the potential to further enhance the efficiency and cost-effectiveness of their drilling operations.
Based in Tulsa-OK, the company provides FlexRigs. This technology allows companies to boost output with subdued maintenance needs. The economic life of such a rig is 30 years. Now, the company is increasingly focusing on international production growth, which should offer attractive growth opportunities for its advanced portfolio.
Helmerich & Payne
As of November 16, the company has utilized 72% of its rigs.
Like the oil drillers we discussed, HP has a flexible dividend of 50% of its excess free cash flow.
The current dividend yield is 2.2%, which is not extremely attractive.
That said, the stock has outperformed the energy ETF ( XLE ) over the past 12 months, including its two major peers in the United States.
For investors seeking exposure to equipment plays in the oil and gas industry, Helmerich & Payne stands out as my top pick. While my preference remains with upstream companies, such as MRO, DVN, and PXD, HP's innovative drilling technology, and expansion into adjacent industries, make it a compelling choice for those interested in equipment providers.
For more info, I recommend this article .
Enbridge Inc. ( ENB ) - Midstream
- A top-tier pipeline and infrastructure network
- A healthy balance sheet and client base
- A high dividend
FINVIZ
What comes after upstream? Right, midstream.
Without the transportation of oil and gas, oil production isn't possible.
Enbridge is a Canadian-based midstream operator. The company is not a master limited partnership, which means it pays taxes like a "normal" company, to put it bluntly.
After covering the stock in a separate article recently, I have fallen in love with this company. While I haven't added it yet, it's the perfect fit for my portfolio.
With a market cap of $82.2 billion in New York, this Canadian-based player has a major network of pipelines.
The company has a massive footprint connecting all major energy hubs in Canada and the United States. It has close to 18,000 miles of liquids pipeline, 76,500 miles of natural gas pipeline, huge storage facilities, and diversified assets in renewable sources like wind and solar.
Enbridge Inc.
The biggest part of its cash is generated in pipelines for liquids and gas transmission with incentive tolling and take-or-pay contracts. Moreover, 95% of the company's customers have investment-grade balance sheets, this beats most peers. ENB itself has a BBB+ balance sheet, which is one step below the A-range.
Enbridge Inc.
Moreover, in the LNG (liquid natural gas) space, the company could end up servicing 30% of North American exports with its infrastructure.
We serve four plants in the Gulf Coast soon to be five and we make up 20% of US LNG exports through our pipes. We've also secured [precedent] ("PH") agreements with two more LNG facilities that are pending FID. That's Rio Grande and Texas LNG and there could be more after that. If those do go ahead, we could see our LNG export market share rise to 30% or above.
On top of that, the company is expected to start operations at its own Woodfibre LNG terminal in 2027, which has a capacity of 2.1 million tons per year. ENB owns 30% of this project.
Enbridge Inc.
The company has a 6.5% dividend yield, which is extremely attractive.
Even better, the average annual dividend growth rate of the past five years is 6.4%.
For more info, I recommend this article .
Valero Energy ( VLO ) - Refining (Downstream)
- Healthy balance sheet
- Strong demand
- High margins
- Satisfying dividend
- Outperforming share price
FINVIZ
I bought Valero in 2020, as the pandemic had done a number on refinery stocks.
Valero is a refinery company. If you're new to this, it's essentially a company that turns crude oil into finished products like gasoline, diesel, kerosene, and heavier products used in the construction of roads.
The company produces most of its products on the Gulf Coast, where it operates major refineries and two plants where it produces renewable diesel in a Joint Venture. In the US Midwest, it produces ethanol.
Valero Energy
In 4Q22, the company generated $41.8 billion in revenue, which was $1.57 billion below estimates, yet 16.3% higher compared to the prior-year quarter. Adjusted earnings per share came in at $8.45, which was $1.23 higher than expected.
In its refining segment, the company reported $4.3 billion worth of operating income. In 4Q21, that number was $1.3 billion. Refining throughput averaged 3.0 million barrels per day.
According to the company :
Our refineries operated at a 97 percent capacity utilization rate in the fourth quarter, which is the highest utilization rate for our system since 2018," said Joe Gorder, Valero's Chairman, and Chief Executive Officer, "I am also proud to report that 2022 was Valero's best year ever for combined employee and contractor safety, which is a testament to our long-standing commitment to safe, reliable and environmentally responsible operations."
The company currently benefits from several tailwinds.
- Very tight global supply due to refinery shutdowns after the pandemic started. After Exxon's Beaumont expansion, all new refinery projects are outside of western nations.
- Meanwhile, demand is rebounding (similar to crude oil, in general).
- Europe's energy crisis requires higher imports of refined products, as Russian oil is being sanctioned. This benefits VLO tremendously.
- Thanks to these benefits, the company has reduced its net debt below pre-pandemic levels.
The good news is that while margins are expected to ease a bit (the market isn't staying this tight forever), Valero remains very upbeat about its future:
Looking ahead, we expect low product inventories and continued increase in product demand to support margins, particularly for US coastal refiners that have crude oil supply and natural gas advantages relative to global refineries. And we continue to see large discounts for heavy sour crude oils and fuel oils that we can process in our system.
Moreover, the company has a 2.9% dividend yield. That's not a lot, but dividend growth is expected to pick up, thanks to rapidly accelerating free cash flow growth.
TIKR.com
Over the past ten years, the company has hiked its dividend by 410% and bought back 31% of its shares outstanding.
For more info, I recommend this article .
Takeaway
This article began with an exploration of oil and gas fundamentals, and I highlighted my perspective that a slow supply growth trajectory will propel oil prices upward over the long term.
The second part of this piece delved into some of my preferred energy investment options, encompassing upstream, midstream, downstream, and services/equipment industries. Many of these companies are currently held within my dividend/trading portfolio, and I will continue to present additional investment opportunities in the coming months.
I welcome any questions, feedback, or suggestions for future articles that are focused on energy in the comments section.
I look forward to engaging in another enriching discussion!
For further details see:
My Top Plays For The Energy Crisis