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Dividend-Stock Deep Dive: Energy Ideas

'It's pretty clear that the market wants to see this industry return capital to shareholders.'

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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. 

David Harrell does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.