3 Distinct Futures For The Oil Industry

As the global economy emerges from the pandemic and commodity prices continue on a recovery path, it's becoming increasingly evident that the oil and gas industry is standing on the precipice of something big. Scores of Wall Street punters have issued a generally bullish short-to-mid-term oil outlook despite the formidable headwinds posed by the pandemic. Even the normally conservative IEA has raised its oil price outlook for 2022 despite issuing a lackluster forecast for the remainder of 2020.However, few experts have ventured into prognostications about the long-term oil trajectory. What's in it for Big Oil 5, 10, or 20 years from now? A remarkable reinvention? A long, slow decline? Or perhaps a more abrupt collapse? 

UK-based multinational professional services network Ernst & Young has delved into the subject and offered some pretty interesting insights regarding the long-term oil and gas outlook.

Mitch Fane, EY Americas Energy & Resources Leader, and EY US Oil & Gas Leader, kicks off the analysis by noting that last year was unique among down cycles experienced by the oil and gas industry before culminating into this:

"The higher prices of 2021, and the substantial cost-cutting of last year, have boosted 2021 earnings and illuminated three probable paths for E&Ps moving forward:

• Integrated oil and gas companies seem more likely to use their capital to invest in decarbonization and alternative energies, 

• Many independents will be more likely to reinvest in their core business as oil and gas continues to be needed for decades to come,

• A smaller subset of companies may choose a path toward slow liquidation, returning capital to shareholders instead of investing for the future.

Let's look at how some of these scenarios are playing out.

Clean energy transition

EY says deep-pocketed integrated oil and gas companies are the most likely to invest heavily in renewable energy.

Yet, Big Oil just can't seem to catch a break, with stocks of oil and gas companies that are investing heavily in renewables not necessarily outperforming their brethren with lesser green credentials.

Good case in point is BP (NYSE:BP) and Shell (NYSE:RDS.A), European oil supermajors with some of the largest clean energy commitments, with both stocks underperforming  Europe's oil and gas benchmark STOXX Europe 600 Oil & Gas Index (SXEP).

The big problem here stems from the way the renewable sector operates. 

Green energy requires heavy upfront investments with longer payback periods compared to fossil fuel investments. In fact, green infrastructure is 1.5-3.0x more capital- and labor-intensive than hydrocarbons.

Oil and gas firms are still grappling with the best way to presently use dwindling cash flows; in effect, they are still weighing whether it's worthwhile to at least partially reinvent themselves as renewables businesses while also determining which low-carbon energy markets offer the most attractive future returns.

Most renewable ventures, like solar and wind projects, tend to churn out cash flows akin to annuities for several decades after initial up-front capital expenditure with generally low price risk as opposed to their current models with faster payback but high oil price risk. With the need to generate quick shareholder returns, some fossil fuel companies have actually been scaling back their clean energy investments.

By investing their cash flows in clean energy projects, the oil majors are likely to reap the benefits in the future--but at the expense of today's dividends and buybacks. In other words, it's a bit like the markets want to eat their cake and still have it.

Independent E&P Investments

Interestingly, EY notes that the majority of independent E&P companies are likely to continue investing the majority of their cash flows into their core oil and gas businesses despite the ongoing energy transition.

Independent E&P companies primarily focus on the upstream segment, making them strong winners in a bull market but susceptible to falling oil prices. Not surprisingly, many are outperforming in the current market.

Last year, Houston, Texas-based shale producer ConocoPhillips (NYSE:COP) earned itself accolades after announcing some of the deepest production cuts at a time when many shale companies were reluctant to lower production and relinquish market share. The company lowered its North America output by nearly 500,000 bpd, marking one of the biggest cuts by an American producer. This year, ConocoPhillips has kept drilling activity subdued and also kept a tight lid on capital expenditures.

And those austerity measures are now paying off.

Conoco has become the first large U.S. independent oil producer to resume its share buyback program after suspending it during last year's oil crisis.

Conoco says it has resumed stock buybacks at an annualized rate of $1.5B, and also plans to sell off its Cenovus Energy stake in the current quarter and complete the sales by year-end 2022. Proceeds from the sale--valued at ~$2 billion--will be used to fund share buybacks.

COP stock is rallying again after Bank of America upgraded the shares to Buy from Neutral with a $67 price target, calling the company a "cash machine" with the potential for accelerated returns.

According to BofA analyst Doug Leggate, Conoco looks "poised to accelerate cash returns at an earlier and more significant pace than any 'pure-play' E&P or oil major." 

Leggate COP shares have pulled back to more attractive levels "but with a different macro outlook from when [Brent] oil peaked close to $70."

But best of all, the BofA analyst believes COP is highly exposed to a longer-term oil recovery.

But BofA is not the only Wall Street punter that's gushing about COP.

In a note to clients, Raymond James says the company's stock price is undervaluing the flood of cash the oil and gas company is poised to generate.

That's quite remarkable considering COP shares are up 40.9=5% in the year-to-date.

With WTI price in the high-60s, ConocoPhillips should have little trouble generating copious amounts of free cash flows given the company's cash flow breakeven level of under $30/bbl.

Then we have strong cyclical stocks such as Devon Energy (NYSE:DVN).

A couple of months ago, BofA Analyst Doug Leggate projected that many oil and gas stocks will see significant upside in 2021 if Brent prices are able to rally to $55 per barrel or higher. With Brent prices constantly flirting with $70 per barrel, many shale drillers are now home and dry.

BofA has an overweight rating on the energy sector and has advised investors to focus on Oil companies with the potential to grow their free cash flows through consolidations or other cost reduction measures, naming Devon Energy, Pioneer Natural Resources (NYSE:PXD), and EOG Resources (NYSE:EOG). 

Turns out BofA was right on the money, with DVN stock surging 88.4% YTD thanks to strong earnings and continuing cost discipline, including a variable dividend structure.

Devon has adopted a variable dividend structure, something that has gone down well with Wall Street.

Devon paid an $0.11/share regular dividend and a $0.24/share variable dividend during the last quarter, implying an annualized 5.5% yield. Further, the company has forecast a dividend yield of more than 7% for 2021 if current trends hold, illustrating its commitment to return more capital to shareholders in the form of dividends whenever cash flows permit.

Some Wall Street analysts have pointed to the potential for DVN to sport a dividend yield of as high as 8%.

And there's no shortage of strong natural gas/LNG players in this category.

Antero Resources (NYSE:AR), Southwestern Energy (NYSE:SWN), Cheniere Energy(NYSE:LNG), EQT Corporation (NYSE:EQT), and Range Resources (NYSE:RRC), are all strong picks.