Oil Outlook, and an Exxon Upgrade

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At Rystad, we've always been super bullish about US oil production. We're always saying shale is growing, shale is growing, while others are saying it's not possible anymore. We've been right most of the years. So this is the first time that we're saying that actually shale won't grow as much as maybe others think.

Hello and welcome to the Barron StreetWise podcast. I'm Jack Howe, and the voice you just heard, that's Alex Ramos-Peñón. He's the VP of Shell Research at Rystad Energy. Shale as in porous stone, as in the kind that holds oil. In a moment, Alex will tell us about the outlook for oil production and prices and profits for the oil industry. We'll also hear from an analyst who just upgraded ExxonMobil. Listening in is our audio producer Jackson. Hi, Jackson.

Hey, Jack.

I have slotted in about 10 to 15 seconds for pointless small talk. And I understand you recently bought— is it a swimming cap? What do you call it?

Oh yeah, yeah. I was at the store. I bought a swim cap because I joined the YMCA.

Really?

Yeah. It's like, you know how you're talking about streaming, how you have a different streaming service every couple of months?

Yeah.

Which—

that's me for gyms and winter months are the YMCA because, you know, You know, you got the pool, the sauna.

I have so many questions, but I'm sorry, we're out of time for this small talk. Speaking of swimming, ExxonMobil was just upgraded from doggy paddle to breaststroke, or more precisely, from a market perform rating to an outperform rating. That was by TD Cowen. That's a division of TD Securities. TD as in Toronto Dominion, right? Which bought Cowen and Company. This is not the same as TD Ameritrade, which was bought by Schwab. Have I got that right?

Bingo.

Okay, so the case for Exxon has everything to do with free cash flow and generous dividend coverage and a company that's pushing its expenses lower over time, which is going to make that dividend even more secure. We will come to that in a few minutes. Before we get to the details on Exxon, I thought it would be helpful to get a broad overview on what's happening with the oil industry. Where is demand? Where is supply? What's going to happen in the future? Where are prices headed? What does profitability look like for the years ahead? And for that, I wanted to speak with Alex Ramos-Payon. He's the VP of Shell Research at Rystad Energy. Rystad Energy, if you're not familiar, is an independent research company headquartered in Norway. The company collects data from around the world and uses that for forecasting. Its clients include energy companies and the companies that sell to them, also governments and banks. Rystad has traditionally focused on oil and gas but has expanded over the years into renewable energy. We've spoken on this podcast with CEOs of big energy companies who've talked about the industry's newfound discipline on production and spending. Here's Alex.

Things changed a lot in the last few years, right? I think it started right before COVID when all of these oil and gas companies in the US started to move away from growth. That was really their mantra, was let's just grow as fast as we can, right? They would add 2 million barrels a day in a year, I think 2018. And then of course all of this was very unprofitable. Most of the investors got burned. It was really a poor allocation of capital. And then they transition into this so-called capital discipline environment in which the objective is now to generate cash, as it should always have been, which means no need to kind of drill like crazy and just grow production when there's no need for that. It also hurts prices. So we have seen over the last few years operators, oil and gas companies, produce— so still growing their production, but within cash flow. So they're actually generating record high levels of money for their shareholders, which is, right, the purpose of a business. And we are not seeing anymore what we saw a few years ago, which was US shale being, you know, flooding the market with cheap oil.

Alex says that producers will show restraint, but not complacency. They'll still need to increase production just to keep the supply stable.

We have to remember that most of the oil fields across the world, they're declining. That's the nature of things, right? So if you stop investing, I don't know, in an oil field on the Gulf of Mexico or offshore Brazil or wherever you want, production drops. So right now we're roughly producing 100 million barrels of oil per day across the world, which is a massive figure. The US produces about 13 of these. So 13% of the market is very considerable. And if you just stop investing in oil and gas today across the world, this drops at a rate of, say, 20% per year, right? So next year you would be at 80,000 barrels a day. So definitely there is, there is a need to cover that gap. And because a lot of these oil fields are just depleted, you need to see growth from where it's possible in order just to keep the supply stable, right? And growth is possible in the US. In shale particularly. It's possible in Guyana, it's possible in Brazil, it's possible in the Middle East to some extent, but that's about it, right? So you're not going to see huge oil and gas developments popping across the world anymore.

Alex points out the costs for drilling are up. Things you need in large quantities like sand and steel. That's making drilling decisions more difficult in some places. But the producers to watch are the wildcatters or small operators. They face a unique set of decisions. What's behind the US production increase? If, if shale companies are maintaining discipline and they're not blowing out the rig counts, what is it that accounts for this higher production?

There is smaller private companies. They are the ones growing the most. So, you know, the mom and pops— well, maybe it's an exaggeration, right? But, you know, running 1 or 2 or 3 rigs. Smaller companies.

And these companies have not made any promises to Wall Street. They're not on Wall Street's radar, so they're free to do what they want.

That's right, they're free to do what they want, and their business model is to sell out to the bigger oil companies. And if you've been following these earnings, everybody's obsessed right now with the topic of inventory and long-term plans and what are we going to do in 30 years if we can't— so it's all about securing inventory, right? So there were huge acquisitions recently. Exxon acquired Pioneer, for example, two of the largest oil companies in the United States. And their stated objective with this is synergies and whatnot, but in reality, it's securing a large acreage, right, piece of land where they will be able to keep drilling for the next century or so. Because, you know, it's a finite resource. There's still a lot of it, but it will run out if you keep drilling at the current pace. So there's concerns about how far can you go in time and who is going to be relevant 20 years from now. A lot of these small private companies running 3 rigs fueled by private equity, they're not interested in 10 years down the road. They want to prove to the investors that they're sitting on good acreage, that they can grow production fast, that their wells are good, and that therefore this company is valuable. And then these private equity funds need to have an exit strategy. So they will be sold sooner or later. There's very few private oil companies that will be there for the long run. I think Continental is a famous one. You have Newborn Oil Company in New Mexico, Endeavor Natural Resources, and that's about it, right? And then everybody else you probably have never heard about, right? Small companies that don't need to be within their cash flows. That's not their strategy. They can also flare as much as they want. Nobody's going to take their stocks out of the ESG funds because of that.

Flare, meaning if you've got something coming out of the ground that you're not using or selling, you just burn it. And I guess there's pollution, but if they're small enough and no one's paying attention, they don't so much care.

There's pollution in its ways, right? So in the Permian Basin in Texas and New Mexico, people are typically drilling for oil. And when you drill for oil, there comes as a byproduct, there is associated gas, natural gas, methane that comes with it. And it's much easier to transport oil. You just put it in a barrel and ship it, right? You could even truck it if you need. Gas, you can't. You need to have access to a pipeline, compression services, etc. If you don't have gathering lines, if you don't have pipeline takeaway capacity, which is the case in many areas of the Permian, there's nothing you can do with this gas. You can use it on-site to generate power for fracking, for example. Some people have used it to mine Bitcoin and things like that. So all sorts of crazy ideas, because otherwise you just need to You could release it into the atmosphere, but that's a terrible crime from the perspective of greenhouse gas emissions. Venting, it's called. Or you could flare it, which is to set it on fire. And these are the— well, if you've ever flown over an oil field or seen these flares offshore, it's the fire you see coming out of the— literally from the wellbore gas that you're not going to use, so you waste it.

But it's not as bad as if you just let the gas release into the air.

Correct, correct. Typically you need a permit for this. The state of Texas approves automatically every permit that's submitted, so it's kind of a joke. New Mexico is much more strict and Colorado is as well. And so it depends on the state, but the industry has become really good at reducing their flaring because people started to look. This is public data. There's satellites running around that measure this stuff. Investors pay attention and a company that's not taking care of this will will be severely punished by their investors nowadays. In the last few years, it's become a theme. By the way, these majors tend to be among the best when it comes to these ESG metrics. That's their bread and butter. So they flare zero mostly, which means that even if they wanted to grow production, it would be very hard to do that without increasing these emissions. Because unless you come up with a marvelous plan that will capture all of the gas, typically it's very hard. When the oil comes out at high pressure early on, on the well's lifetime, you can't deal with that gas. So there will always be a little bit of flaring, especially when you're growing production. Now this year, these ESG stories have been a little bit kind of in the backseat. No one is really talking too much about it, right? Every earnings season, there's a new kind of point of obsession, right? So right now it's this inventory stuff I mentioned. A year ago it was capital discipline, capital discipline, return shareholders, buybacks. 6 quarters ago, it was flaring, flaring, flaring. And, you know, it will change, right? So I don't know what will be the next quarters. Maybe it would be water management. Where are you throwing this water? Seismicity and whatnot, right?

So it sounds like TikTok or something, like something becomes trendy for a little while and then it flies away and they focus on something else.

Exactly.

I asked Alex about geopolitics and war and how that might affect the oil price. He says that global conflicts can create supply disruptions in the short term, maybe even demand disruption, and they can move the oil price for weeks or even months, but typically there's not long-lasting consequences for oil. The bottom line, Alex says, is that there will probably be too much oil, not too little in the near term, but the companies most likely will remain plenty profitable.

So the market will probably be oversupplied. Or has the potential to be oversupplied in the near future. We have to remember that the Middle East, the producers in Saudi Arabia and their friends, they have a lot of spare capacity. It will be very cheap for them to open up the taps if necessary. And the US is still growing, right? Just last year, 2023, we still don't have full year official numbers, but oil production grew by almost a million barrels a day. So from 12 to 13 on average, which is huge, right? And nobody— well, I guess we saw it coming, but a lot of commentators and experts believed it was impossible because the rig count was declining and because, you know, depletion of the reservoirs and whatnot. So yes, these companies will remain profitable as long as oil prices stay you know, above $60. But if that drops, or if there's suddenly a huge push for electrification and a drop in demand for oil, then the US is probably going to be one of the first places that gets affected by this, right? Because it's— another term that you might have heard is that, you know, the elasticity of supply as a function of price, right? So if price increased to $200 tomorrow, 5 years ago, US shale would grow immediately, right? It would take 4 or 5 months to react.

I'll be out in my backyard digging, looking for— I don't know if you can get oil that way, but I might be trying at $200 a barrel.

Exactly. And everybody would be. But today that's not the case anymore.

One last thing. Just because producers are doing a better job of keeping production stable, it doesn't mean there won't be surprises or volatility. Here's Alex.

It's interesting to see that there's a bit less volatility. There's a bit less, you know, kind of crazy decisions of this kind. But if history teaches us anything, it's that oil price will remain volatile, right? So I mean, I don't think we would be fooling ourselves if we think, oh, now, you know, it's all going to be smooth rides. Of course not. There's going to be a lot of unforeseen things down the road.

Thank you, Alex. And coming up, we'll hear from Jason Gabelman at TD Cowen about the case for ExxonMobil stock. And its big juicy dividend. But first, let's take a quick break if there's no other pressing business. Jackson, anything with this swim cap? Was it just the cap or did you go— did you get nose plugs?

What did—

anything else with that?

Yeah, I think earplugs are my next purchase.

You're eyeing them or earring them, as it were. Back right after this break.

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Welcome back. ExxonMobil, ticker XOM, has been a good stock over the past 3 years. You've made 143% on the shares as a total return versus 32% for the S&P 500. And it's been a bad stock over the past year. You've lost money, about 8%, on Exxon while you would have made 23% in the S&P 500. Over the past 10 years, bad. Over the past 20 years, also bad. You get the idea here. Mostly bad, but for a brief while there, pretty darn good. And now here, TD Cowen analyst Jason Gabelman has upgraded the shares to outperform from market perform. He has a price target of $115. The stock was recently around $100, so that's 15% upside he sees on the price. There's also a dividend yield almost 4%, 3.8%. That would make for a nice total return. I checked in recently with Jason to hear his case. I gather that the case starts with this idea that we've had some strong years for energy prices it might not be quite that strong going forward. And so now you're looking for companies that can be more resilient. Is that the idea?

Yeah, that's exactly it. You know, oil prices, refining margins, and global natural gas prices out of COVID were all extremely strong, and it's unlikely that that's going to continue moving forward. We actually are forecasting an oversupply of oil from 2025, refining margins moving below mid-cycle levels, and global natural gas prices falling as well due to oversupply from 2025. And so I think where investors need to look are at energy companies that are more defensive, where there's underlying cash flow growth to offset the headwinds from lower commodity prices, and companies that can maintain their distributions either due to balance sheet strength and/or that growing cash flow growth.

And when you talk about energy prices falling, you're not saying falling off a cliff. I think I saw where you were contemplating sort of $65 a barrel, you know, in the years ahead, that kind of area, which these energy companies can still make good profits at that price. Yes.

Yeah, sure. They've taken a lot of costs out of the system really since the 2014 downturn. Companies have really tighten the belt. The oil price they need to cover dividends with organic cash flows has fallen from early Shell times to now by— you're talking $20 a barrel. So the whole industry is a lot more resilient. But at this point, that's priced into the stock.

And that is a big part of the case on Exxon. There's a good dividend yield here, almost 4%. I think I saw 3.8%. And you talk about the breakeven price for funding the dividend and how they are pushing that lower. How do they compare with their rivals on that? And what do you see happening in the years ahead?

So to be clear, we're not necessarily saying their competitors have risk of their dividend being cut. We don't think that's an issue. But companies are also buying back a lot of stock as well. Exxon's buying back $20 billion a year. After the acquisition with Pioneer closes, Chevron's also going to be buying back $20 billion a year. We think Exxon can maintain that for an indefinite amount of time into the future, whereas that's at risk for Chevron given some of the headwinds that they'll see in the upcoming years.

I was a little stunned by some of the numbers here about the cash flow growth that Exxon wants to achieve. And you say in your note that, you know, it has these targets. You're a little short of those targets in your forecast. You don't think it'll quite reach the targets it wants to, but it's still— we're talking about tens of billions of dollars. And it makes me think, boy, if a company could just, you know, snap its fingers and make tens of billions of dollars more each year, why didn't it do that sooner? Like, what is it doing to make all this extra money? And why does it now have the ability or the conviction to do it?

This was a strategy laid out by Darren Woods when he took over. He said, we're going to continue to invest in low-cost upstream resources and continue to strengthen our downstream footprint.

For the benefit of people who might listen to this and they don't know what upstream or downstream means.

Yes. So upstream is the part of the value chain in oil where you produce oil, and downstream is where you refine it from what comes out of the ground into what you use every day in your cars. And Darren Woods was very intentional in setting out this countercyclical growth strategy. Which is investing in assets that are going to earn a lot of money across a wide range of commodity price environments. And that takes time. It would've taken time without COVID. It's taken longer because some of the projects have gotten delayed, but they're finally starting to come online. Guyana's probably the top example that comes to mind. Exxon found a lot of oil there, started up one production facility right before COVID and now they're at a period where they will have multiple facilities come online in sequential years, which will be a lot of earnings growth over the next few years. You know, where they got to kind of $4 billion of cash flow from this asset 2027. That's annual cash flow growth, $4 billion. So that's a pretty big number. And that's the type of projects that they're doing that, you know, you need to invest a lot. Initially to get the oil out, and then you get into this harvest period.

And that's an example of the upstream investments they've made. What about downstream?

Yeah. So in downstream, what they've done is strengthen the resilience of the businesses and invest in projects in their portfolios that enable them to generate higher margins. So for example, taking low-quality crude feedstock that's discounted versus higher-quality feedstock and upgrading it into gasoline or diesel.

I saw in your report that you talked about the number of cases where they were— I don't know if you call it co-locating, like you've got a refining plant where you're making, you know, fuel products and you pair that with a chemical facility where you're making, you know, what kind of chemicals would we be talking about? Are we talking about like agricultural chemicals, fertilizers, or What kinds of things?

Plastics, mostly plastics.

Plastics.

Yeah. Ethylene and polyethylene, which goes into things like water bottles and everyday items.

Those are some of my favorites. Polyethylene and what's the— polypropylene.

Yep. Yep.

Yeah, I can never decide which one I like more. So by putting those facilities together, does that make them more efficient or save a bit of money or make for better profitability? Do I have that right?

Yeah. So it does a couple of things. It gives you optionality on the refining side where You know, some days it maybe makes more sense to send a little more from the oil refinery to the chemicals plant. Some days it makes more sense to take that product out of the oil refinery and have it go into something else. And it also reduces the cost of the feedstock into the chemicals plant because you're not going out and buying it in the market. It's right there and you know what that cost is going to be. So it does certainly make them more resilient and they've been intentional in reducing their refineries that don't have that setup where the chemicals plant and the refineries are right next to one another.

And there's some cost cutting going on here, and there are— there's also some investments in, um, clean energy. And when people think about clean energy investing, they don't immediately think of sort of lush cash flows, uh, coming, coming forth right away. Maybe they think that's something down the road, but this sounds like, um, Exxon is pushing in a profitable direction here. What are they doing on the clean energy front, and, um, what kind of money do you think they stand to make there?

Flush may be a strong word. Um, I would say modest in the upcoming years, but they're investing in 3 areas where they think they have a core expertise in from just their legacy operations: in carbon capture, in production of hydrogen, mainly blue hydrogen, so hydrogen that comes from natural gas that's low in carbon intensity, and then by biofuels. And they have a biofuels plant coming online in 2025 that should earn money. And then medium term, they're going to build out a carbon capture business. And they recently bought another EMP company called Denbury, which had a carbon dioxide pipeline that flows right by all of their plants in the US Gulf Coast. So it makes it easier for them to capture the carbon that's coming out of their plants and getting it on a pipeline to a place to put it into the ground. And that's profitable because of the credits that the current administration passed under the Inflation Reduction Act. So that has kind of supercharged interest in this business and makes profitability, I think, more visible to investors. That doesn't mean billions of dollars overnight, but that means maybe a few hundred million dollars in a few years. And then the last thing they're doing is looking for lithium as well. So this was the most recent development where they're using similar, uh, technology and expertise they have from drilling for oil. It's good geological understanding and drilling, and they're doing that in the lithium space. Still small and early days, But these are businesses that if they can get them right, can be, you know, in the 2030s, a driver of growth for this company.

The case you make on the stock, you can tell me if I have this right. You have a price target of $115. Last I looked at the stock, that implied about 15% upside on the price. You add your dividend to that. You pointed out about the free cash flow that this is going to be a company trading at an 8% free cash flow yield, whereas pre-COVID, maybe, maybe a 6% or lower yield was more typical. So that's, that's where you get that, that sort of price upside that would get it back to its closer to its historical free cash yield. And this upgrade on Exxon came out about the same time as a downgrade, and that one was on Chevron. And that went just the opposite from an outperform rating to a market perform. What has you bringing your expectations on Chevron down a little bit?

Yeah, so, you know, we like Chevron over the long term if you're looking at a stock to own for 5+ years. But I think the next couple of years are going to be a bit challenging for a few reasons. One, two of their marquee assets have had execution issues. They have a large position in the Permian similar to Exxon. And they also have a large project in Kazakhstan called TCO. And the Permian wells that they brought online have been disappointing so far in 2023 after many years of strong operations there. And we're fearful that those wells will continue to disappoint, and that is a key asset for them. The other part of this is in Kazakhstan. They've been investing since 2017, I think it was, maybe even earlier, in a growth project. It's the largest growth project in their portfolio, and when it's done, it's going to add $5 billion of cash flow, which is about 25% of their cash flow when that project is done. The issue is, is that they've run into a lot of delays and execution issues with the project, and the project isn't starting up until middle of 2025. So we think we have to wait until we get closer to that startup period for that project to be really de-risked for investors to really like the name more.

Thank you, Jason and Alex, and thank all of you for listening. Jackson Aquaman Cantrell is our producer. If you have a question, send it in. You can record it on the voice memo app on your phone and you can email it to jack.hough@jackhowe.com. Barons.com. Subscribe to the podcast on Apple, Spotify, wherever you listen to podcasts. If you listen on Apple, you can write us a review. You know you've been wanting to search your feelings. Thanks and see you next week.

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