Oil prices and energy stocks moved higher earlier this week on the news that Saudi Arabia will cut an additional 1 million barrels of oil a day from its production until year-end as part of a deal reached with its OPEC allies. After 2 consecutive years of strong outperformance vs. the broader market, the US energy sector has returned only 4% on a year-to-date basis vs the S&P 500 return of 17%. Late cycle macroeconomic unease around the long-term future of conventional energy have detracted from a constructive sector outlook, in our opinion.
ENERGY TRANSITION IN THE SPOTLIGHT
The global primary energy mix continues to shift away from hydrocarbons in favour of clean energy, notably renewables. While primary energy consumption expanded by a modest 1.1% in 2022, renewables consumption expanded by over 13% with its share of the total energy mix growing to 7.5% during the year. Within renewables, solar power additions accounted for over 70% of total capacity growth in 2022. The IEA estimates that global clean energy investment will exceed $1.7 trillion in 2023 which is over 3x greater than current total global upstream spending.
Despite growing demand for oil (+3.1% in 2022 and a CAGR of 0.9% over the past decade), oil’s share of the global primary energy mix has generally been declining for the better part of 20 years and is now approaching 30% of the total mix (vs. 39% in the early 2000’s). Investor focus on climate change and sustainability initiatives have driven global E&Ps to invest in the clean energy sector as well. Conventional energy companies have dedicated increasing amounts of capital to reduce their carbon footprint while also investing in ‘new energy’ ventures (such as carbon capture solutions, biofuels and hydrogen) which will become part of the solution.
Today, many North American majors have committed in the range of 5% to 10% of their capital budgets toward sustainability initiatives, following in the footsteps of some European peers who now devote over 20% of their annual capital spending toward new energy investments. We expect industry capital devoted to carbon reduction initiatives to increase over time and see this trend ultimately limiting hydrocarbon supply growth going forward.
Source: Company filings, Morgan Stanley Research
CAPITAL DISCIPLINE: THE NEW INDUSTRY REALITY
Against this energy transition backdrop, oil and gas management teams have begun to fundamentally change the way they run their businesses – with little fanfare or recognition. Operating and capital discipline (long demanded by shareholders) have now become fundamental tenets to a more constructive investment backdrop for the industry.
For energy investors, the sector’s newfound capital discipline is perhaps the most consequential shift in mindset. Despite the recovery in commodity prices from the pandemic lows of 2020, producers have remained disciplined and committed to investing capital at levels well below industry cash flows.
Using the US E&P sector as a proxy for the industry – 2021 and 2022 capital investment totaled only 39% and 36% of sector cash flows respectively. Similarly, 2023 capital investment is expected to total only 54% of sector cash flows. This compares to the pre-pandemic 5-year average of 125%.
Source: BMO Capital Markets, Wood Mackenzie
When we consider aggregate global upstream capital spending – the numbers convey a similar story. At $520 billion in 2022 – global exploration & development capital spending was 40% below prior cycle peak levels of 2014 and 4% below 2019 levels (pre-pandemic).
BMO Capital Markets (‘BMO’) expects that inflationary pressures will push global upstream capital investment to $590 billion by 2026, which is only ~ 10% above 2019 levels on a nominal basis in other words industry capital investment adjusted for inflation will remain below pre-pandemic levels over this timeframe. This suggests that capital discipline is expected to remain an important theme going forward. This level of discipline, in addition to the above-noted sustainability initiatives, should also help to keep a lid on unfettered supply growth and could help dampen the commodity price volatility that invariably affects the sector during periods of slower economic growth.
HARVESTING CASH AND CAPITAL RETURNS
A biproduct of industry capital discipline has been the meaningful inflection in free cash flow (FCF) generation witnessed since the end of the pandemic. BMO’s universe of over 100 global producers has seen a nearly 300% increase in free cash flow from the 2020 lows with 2022 FCF levels being 2x greater than those witnessed during the prior commodity cycle peaks of 2007 and 2014.
Source: BMO Capital Markets, Wood Mackenzie
The industry has returned this excess cash to shareholders in the form of dividends and share buybacks. Shareholder yields (the sum of dividends and share buybacks in relation to a company’s total market capitalization) are currently near their highest levels in over a decade. QV strategies hold a number of energy franchises (including Canadian Natural Resources, Imperial Oil, EOG Resources, Chevron and Exxon Mobil) which should continue to deliver attractive shareholder yields – currently expected to be in the range of 5% to 12% over the 2023-2025 timeframe. Debt repayment has also been a notable theme for the industry – with Net Debt-to-EBITDA levels falling to 0.7x from 1.9x in 2019.
UNDEMANDING VALUATION
Despite improved fundamentals, the US energy sector trades at only 7.0x forward cashflow vs. its long-term average of 7.5x. However, relative to the broader market, today’s valuations also remain compelling with the sector trading at only 48% of the S&P 500’s cash flow multiple vs. the long-term average of 61%.
Source: Capital IQ, QV Investors.
