The Stock Market’s New Darling? An Oil Driller

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Hello and welcome to the Barron Streetwise Podcast. I'm Jack Howe. The voice you just heard is Rick Moncrief. He's the CEO of the darling of Wall Street at the moment, the single best-performing stock in the S&P 500 over the past year. It's up 142% and it's called Devon Energy. Doesn't do cloud computing or robocars or artificial intelligence. It drills for oil. There's been a massive shift in stock market leadership, and energy is suddenly out in front. In a moment, we'll hear from Rick and two top Wall Street analysts to try to figure out whether oil stocks have further to run. Listening in is our audio producer Jackson. Hi Jackson.

Hi Jack.

You must be excited to talk about oil stocks this week. I know we've done a lot of cryptocurrency and tech stocks and NFTs and all that edgy, exciting stuff, but now we're going to get in the oil patch and see what's going on. Are you fired up?

I'm jumping out of my seat.

Tell folks about the first stock you ever bought.

It was actually two stocks on the same day. I bought Apple and Kinder Morgan.

You know, they call Kinder Morgan the Apple of oil pipelines.

Really?

No, no one has ever said that. I can guess why you bought Apple. What drew you to Kinder Morgan?

I was watching CNBC and they told me to buy, buy, buy. So I bought 3 shares.

One for each bite. Makes sense. We've talked on this podcast about how value stocks are outperforming ahead of expected interest rate hikes. But value stocks aren't nearly all the same, of course. They're diverse groups of companies that are affected by more than just rates. For example, if airline shares got off to a strong start this year, it might be because they're value stocks, but maybe investors are also hopeful about COVID-19 trends, as worrisome as they appear at the moment. JP Morgan recently wrote about the latest virus wave that it will, quote, likely mark the end of the pandemic as Omicron's lower severity and high transmissibility crowds out more severe variants and leads to broad natural immunity. I don't know whether JPMorgan is right about that, but I hope so. Oil stocks are definitely value stocks even after their recent run. An exchange-traded fund called Energy Select Sector SPDR Fund, ticker XLE, has returned 55% over the past year. But over the past 10 years, on average,— it's returned just 2.6% per year versus more than 15% a year for the S&P 500 index. If you don't count dividends, the energy ETF has lost money. It's still less than half as expensive as the S&P 500 relative to free cash flow. So maybe oil stocks are rebounding because they're cheap, but it also makes sense that a recovering economy and hope over the pandemic suggest higher oil usage ahead. This past week, the International Energy Agency increased its demand growth forecast and said that this year's oil demand is likely to exceed pre-pandemic levels. Similar to JP Morgan, the IEA wrote that a large part of the population will likely have gained COVID-19 immunity through vaccination or infection by the end of the first quarter and that mobility restrictions during the second half of the year could be minimal. Now, demand is one part of the picture. Supply is the other. Oil stockpiles in economically developed countries that are part of the OECD recently hit a 7-year low. Texas crude was $53 a barrel a year ago. Now it's $85. Brent crude has had a similar run. To learn more about what's in store for oil and oil stocks, I spoke with a pair of top Wall Street analysts, starting with Stephen Richardson at Evercore ISI, who covers oil and chemical companies. He says investors expected oil inventories to rebound this year, but that there's been a string of production interruptions. For example, political unrest in Libya, protests in Kazakhstan, sabotage and operational setbacks in Nigeria, and the threat of war between Russia, a major oil producer, and Ukraine, a key energy transit hub. Stephen says many investors took profits on energy near the end of 2021 and entered 2022 with low exposure and have been surprised by the continued strength in oil prices. He also says that oil companies have grown more disciplined on how they spend their money. And put a lot of it towards dividends and stock buybacks, which is winning attention from investors.

Two really dominant things are happening in the sector. One is return on capital employed is rising and it's rising pretty rapidly regardless of $80 or above oil price. But then also there's really an underpinning from a valuation perspective. For the most part, the stocks I cover have a high single digit, if not into the double digits, shareholder yield, just talking about dividend buyback, uh, and what they've committed to do in the near term.

When Stephen says buybacks, he means companies using their cash to repurchase their shares. That shrinks their share count and theoretically should make remaining shares more valuable. If a company has a 3% dividend yield and it's buying 5% of its shares back per year, it has a total shareholder yield of 8%. Stephen says that's an attractive starting point for investors who are uncertain about the stock market's potential for price gains from here. I asked about whether the rise of environmental-themed investing is playing a role in oil prices. Some investors are shunning oil stocks or using their stakes to pressure companies to change their business models. This past week, ExxonMobil announced a goal to reach what's called net zero by 2050. That's where it eliminates or offsets carbon emissions from its operations. The announcement comes after a green investment group succeeded in placing 3 members on Exxon's board last year. Some European oil producers have announced more ambitious goals that call for offsetting not just their own carbon generation, but also the carbon generated by customers who use their products. Stephen says, All of this is having a big effect on market psychology.

To hit net zero, many of the European oil majors, if you look at Shell or BP, they're telling you not only are they not going to enter new geographies in oil and gas, they're not going to sanction new projects, and ultimately they're going to start shrinking their oil and gas business and growing the other parts of their business. So that's a really visible way in which the market can see there's divestment and that there's more constraint going on on the supply side.

So is the getting still good in oil stocks? Stephen says yes. He says the group is priced as though oil were priced at $55 to $60 a barrel, not $85. If the oil price falls, he says, the stocks will likely fall too, but they have high yields from their dividends and stock buybacks that look durable. And as investors grow more confident about those yields, stock volatility could fall, and valuations could rise. I asked about all the new models of electric vehicles that are on the way. When will oil demand peak? Stephen says not soon.

The math is actually pretty simple, right? We've got a billion cars in the car park globally. We sell 90 to 95 million a year. Electric vehicle penetration goes from 4% to 14, 15% by 2025, you know, maybe getting 30% by 2030. So You put all that together, you're saying, oh, by 2030 I could offset 3 to 4 million barrels a day of demand. I mean, the amount of growth that we'll have between now and then in the global economy will outstrip that number.

Okay, let's turn to Doug Leggett, a former petroleum engineer who now heads oil coverage for Bank of America Securities. He says history has repeated itself and put Saudi Arabia back in control of the oil market for now. Back in the 1990s, with the oil price slumping, Saudi Arabia wanted production cuts, but one OPEC member went rogue.

Saudi tried to get everybody around the table to cut production and balance the market. Venezuela agreed, constantly cheated. And eventually in the late 1998, Saudi said, we've had enough of this. And they opened the taps and killed the market. The oil price went from $25 to $9.

From $25 to $9. By 2003, one prominent magazine declared the end of the oil age. 5 years later, the oil price ran up to $147. More recently, the rogue producer from Saudi Arabia's perspective has been U.S. shale drillers, Doug says. Those are companies that have learned how to extract oil from porous rock using a process called hydraulic fracturing or fracking. During the pandemic, which sharply reduced oil demand, Saudi Arabia waited until US shale drillers were forced to cut production and then reduced its own production and brought the market back into balance.

I think Saudi's Machiavellian strategy that worked in 1999 was implemented again in 2020. Has worked, has forced capital discipline on the ENPs. They've taken back control of the oil market, and I think we're in a new world for the investment case.

You heard Doug say ENP. That's short for exploration and production companies like Devon Energy. Doug and I also talked about ESG investing. That stands for environmental, social, and governance, and it includes investors who have stayed away from oil because of concerns over global warming. Doug says that decision is becoming more nuanced.

It's easy to use ESG as a disqualifier for a sector that's not doing well. Why do I need to own this stuff? The investment opportunity is awful and they produce fossil fuels, so I just don't need to own it. And I can create this ESG framework that says fossil fuel bad, everything else good. That's a much harder discussion when the sector's outperforming. It's more of a spectrum than a binary discussion. It's more of a who's improving, whose rate of change, who's making the commitments to improve their emissions. Oh, I can own that.

To Doug's point, many environmental-themed funds have outperformed the stock market for years and have sold investors on the idea of doing well by doing good. But the outperformance has largely come from underweighting oil. The worst-performing sector of the 2010s, and overweighting tech, the best-performing sector. This year, that performance has reversed, and oil leads tech by 23 percentage points, the second-biggest spread ever, and many environmental funds are underperforming. I'm all for these funds, but I wish the pitches for them set realistic expectations by including less about trying to beat the stock market by doing good and more about doing good for its own sake, even if it means missing out on a bit of upside. Doug's point, meanwhile, is that environmental investors who might have once stayed away from oil altogether are now considering ways to differentiate among companies and invest. I asked if there's more upside for the oil sector. He says there's still a long way to go. The oil price comes from looking at futures trading, And futures contracts relate to specific time periods. So by looking at many contracts together, you can get a sense of how investors expect oil prices to change over time. When I say oil is $85 a barrel, that's the front of the curve, the current price. But Doug says that toward the back end of the curve, prices have been about $20 lower. That's relevant for stock valuations because investors price companies according to the cash flows they're likely to collect far into the future, not just the cash they're collecting now. Doug says investors could be underestimating the size of those future cash flows because Saudi Arabia depends heavily on dividends from its state oil company, Saudi Aramco, to fund its government. And it needs a $60 to $80 oil price to make the math work.

Well, if you add $10 to the back end of the curve on a sustainable basis, the sector, we think, has got between 40 and 90% upside. Depending which company you look at.

So which companies should you look at? Doug's top picks are Occidental Petroleum, that's ticker OXY, APA, ticker APA, that's the holding company for Apache, Hess, HES, and ExxonMobil, XOM. Occidental and Apache have a lot of debt, which sounds like a bad thing, but Doug likes that they generate plenty of free cash. And don't have a lot of debt coming due soon and also don't do a lot of hedging, which means they benefit quickly from higher oil prices. Doug says that as the companies pay down debt, they're likely to be rewarded with higher share prices. Like Doug, Stephen at Evercore also likes Occidental. He recently upgraded BP to outperform, in part because the valuation reflects concern over those long-term carbon targets, but not the healthy dividends and stock buybacks in the near term. Stephen also likes ConocoPhillips, that's COP, and Devon Energy, DVN. Let's hear from Devon CEO right after this short break.

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Welcome back, Jackson. How's the oil episode going? Am I holding your interest? You know, there's an exciting turn coming up where I'm going to mention natural gas.

I didn't see that twist coming.

For oil prices and profits to keep from plunging again, you're like the M.

Night Shyamalan of investment podcasts.

For oil prices and profits to keep from plunging again, oil companies will have to keep from going all out on production. So will they? We should probably ask an oil chief about that.

I'm the third generation that's kind of worked in this business, worked on drilling rigs.

That's how I got through— wait a second, you mean you were one of these guys out there actually on the rigs? I've seen that's dangerous work. You were out there doing that?

Oh, absolutely. That's how I got through college.

That's Rick Moncrief. He ran a shell driller called WPX and became CEO of Devon Energy when the two companies merged during a deep industry slump made worse by the pandemic. The company's deposits, particularly in the Permian Basin in West Texas and New Mexico, give it a breakeven price in the low $30 per barrel range. With the current price more than $50 a barrel higher, cash is pouring in. During the third quarter of last year, Devon generated $1.1 billion in free cash flow, up eightfold from the same period the year before and a company record. Fourth quarter results are expected out in mid-February. The sudden surge in cash flow is one reason investors have piled into Devon shares. Another might be its dividend. The yield is difficult to say because Devon last year announced a fixed plus variable dividend, an industry first. Like many companies, it pays a fixed dividend, in its case an amount that, based on the stock's recent price, works out to a yield of just under 1%. The variable dividend is decided each quarter and equals up to 50% of free cash flow. So if I take the most recent fixed plus variable dividend and assume payments will look like that over the next 4 quarters, it works out to a yield of nearly 7%. The downside, I suppose, is that investors don't know exactly how much they'll get, but the upside is that it greatly reduces concerns about future dividend cuts because dividends will fall on their own if free cash flow falls. Ric stressed that his focus is on discipline, whether that means finding ways to contain his company's emissions or going slow on production increases, both of which shareholders are asking for.

As we come back, you know, from recovery mode from the pandemic, demand growth has been very strong. At the same time, we're trying as an industry around the world to balance supply and demand. And so you've seen OPEC+ do, I think, a nice job of bringing barrels back onto the market. At the same time, U.S. producers are being asked by investors to be very disciplined with our spending, and let's make sure we don't get supply and demand out of balance like we have historically.

I asked Rick what sets Devon apart, and he said the quality of his assets, his lean cost structure, and increasingly his balance sheet.

In 2021, we actually paid down $1.3 billion of debt with the additional cash flow that we had. And that was debt that was callable, so it was not due for several years, but we went ahead and just continued to further strengthen the balance sheet. So I think what's different about Devon is, number one, the quality of our assets. Number two, our cost structure, our balance sheet. We're going to be approaching a net debt-to-EBITDA of zero as we exit 2022.

We've been talking about oil, but Devon also produces natural gas. Prices for natural gas have soared in Europe, and Russia is supposed to increase gas supplies to Europe, but tensions over Ukraine have put that in doubt. Natural gas can be liquefied and transported overseas on ships. China recently said that it would increase liquefied natural gas, or LNG, exports to Europe. Rick says he wants to see more LNG exports from the U.S. and that he sees it as a good alternative to dirtier fuels.

Personally speaking, it's a little disappointing in that the U.S. has not been able to build more LNG export facilities to get our natural gas to very, very strong partners of ours in the rest of the world. And that's not only from an economic standpoint, but it's also from a climate perspective. You know, Coal usage around the world is continuing to grow, not shrink in absolute values. On a percentage, it will shrink over time. But, you know, there's no reason that we couldn't be getting U.S.-produced natural gas, more and more of that into the places like Europe, for instance, that you refer to.

The bottom line for investors on oil, I suppose, is that global demand doesn't look likely to fall anytime soon. Barring an economic downturn. And companies sound committed this time around to not chasing every last barrel. Devon has said it will limit production growth to 5% a year. The days of double-digit increases are over, Rick says. He says he thinks the rest of the group will be disciplined too.

I'll just go back to the last 4 or 5 years. Companies like ourselves, we've had some head fakes where commodity prices really rallied only to see too much activity or in the case of an event like the black swan of the pandemic. Those are pretty sobering facts. And so I think that discipline is going to stick. That's what our story is going to be, I can assure you.

Thank you, Rick and Stephen and Doug. And thank all of you for listening and for the lovely reviews you've been leaving on Apple and Spotify. Jackson, here's an actual recent review from Apple. It says, Jackson has won my heart and I only see a wondrous future. I want you to collect yourself and tell us how that makes you feel, but you can only use one word. Tingly. Jackson Cantrell is our producer. Follow me on Twitter. That's @JackHough, H-O-U-G-H. See you next week.

Data is everywhere. When orchestrated properly, it sings. At Morningstar, We analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.