Future Of Energy: The Big Picture - Part I

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Includes: SPY, TSLA, XLE, XOM
by: Mark Bern, CFA

Summary

Overview of factors involved in determining energy prices.

How the various factors influence supply and demaind.

Major shifts coming in the energy sector.

A low risk, long-term investment in energy.

Introduction

This is the initial installment of a series I will be writing (at least once weekly until completed) to provide readers with a better understanding of what is coming in the energy sector and how investors can identify the lower risk stocks for long-term dividend income and potential appreciation. Not all of the stocks that will be covered in this series will be rated as an immediate buy but target prices will be provided for each company under various conditions.

The focus of this series will slant more towards identifying as many factors as possible that influence the prices of energy inputs, the long-term trends that seem apparent to me, and how we might be able to "connect the dots" to gain a better understanding of what price levels to expect over the short, intermediate and long term. I have written a similar series that was popular and wanted to drill down deeper into the sector for those who have an interest. Part I of that earlier series was primarily a review of the history of energy prices that many found helpful. Since the history has already been written I will not rehash that aspect, even though it is a very important understanding of which investors should be aware.

The other two parts of the earlier series were about what I expected of pricing for the intermediate and longer term. This series is meant to be an update to those expectations based upon the additional knowledge and experience accumulated since mid-2015, when the original series was published. I also wanted to provide more detail on my reasoning in terms of the factors.

Factors involved in determining (or influencing) prices in energy

The list in this section may seem exhaustive but is, by no means, complete. These are, to my knowledge, the most important factors that affect the pricing mechanisms of energy resources.

Supply and demand are, obviously the biggest factors that influence prices of nearly all things in a marketplace. But both of these factors are influenced by many other lesser factors. Such things as substitutes, often one energy resource for another, can impact demand in the short term and supply on a longer term basis. Examples are the use of ethanol as an additive in blending gasoline; coal, natural gas, crude products, hydroelectric, geothermal, wind, solar, methane (gas emitted from decaying garbage) and uranium are all used to generate electricity. Electric and hybrid vehicles use battery power to either replace or reduce use of gasoline. Fuel cells are still under development to power vehicles and generate electricity. More alternatives are in the early stages of exploration and development.

Government regulations that place requirements on specific industries within the energy sector, such as electric power generation, autos, renewable energies, and mining have direct impacts on energy consumption, the cost to produce energy and what energy resources are used (among other things). Also, some government regulations have indirect influences on demand and supply of energy. Environmental regulations governing pollutants affect costs of producers that are then passed on to consumers in multiple industries.

Of course, shale oil and gas production has created a new wrinkle in the evolution of energy availability. So much for peak oil! The once high cost of producing oil or gas from shale deposits are coming down at an incredible rate making shale far more competitive than it was once thought possible. New technologies are being created almost constantly to drive down costs in exploration, drilling and production. These advances do not only apply to shale fields but some will enhance conventional E&P (exploration and production) efforts as well.

Pricing itself can have a significant impact on either demand or supply. As we should all recall, when the price of oil dropped by 75 percent from June 2014 ($107.08) to January 2016 ($26.55) U.S. oil production, primarily in the shale fields, fell by more than 1.1 million barrels per day (see chart below). Likewise, when an imbalance in supply and demand occurs the price will adjust to bring the two components back into balance over time.

Source: Macrotrends.net

The drop in the price oil from its high in July 2008 ($145) to a low in December 2008 ($30) of 79 percent was even more dramatic and occurred over a much shorter time frame. This was the result of fear that was born out of a recession. It was temporary, but very painful for those invested in many energy stocks. Hopefully, investors understand that prices in this sector are very volatile.

Then there is the Paris Climate Accord that will likely have far-reaching implications for energy pricing over the very long term. This agreement, by extension, will create more innovation in the field to conserve energy, reduce the use of fossil fuels, and develop more renewable energy. This is not an argument in favor or against the accord. I merely include it because it is relevant to this analysis.

Technology was mentioned above, but referred primarily to that which directly impacts the energy industry in terms of production and cost. But, of course, there are (and will continue to be) innovative technologies being created to reduce usage of, to store, and to replace different current sources of energy. Other technologies may actually increase the use of energy. But reductions will more than likely outpace increases. Battery storage technology on a massive scale will eventually make renewable sources of energy more efficient and dependable sources for the electric grid. It will also enable large facilities to move almost entirely off the grid to produce electricity independent of utility company electricity generation. A good example of this becoming a reality is the newly planned data center by Apple (NASDAQ:AAPL) being built in Denmark. Completion is projected for 2019 and the facility will be powered 100 percent by renewable energy. This provides a good segue to the changes that are coming in energy.

Major shifts coming in the energy sector

I should mention at this point that this initial article is merely an overview and that I plan to delve deeper into each area within later installments of the series.

There was a time, not long ago, when OPEC (Organization of Petroleum Exporting Countries) was the recognized swing supplier of oil for the world. It was positioned (especially Saudi Arabia) with the only real excess production capability and able to influence the price of oil in a significant way by adjusting its aggregate production. There was a lot of cheating on quotas by some members but, by and large, the organization held sway over global pricing. That has changed somewhat and will change further as the cost of shale E&P operators continues to fall.

There was also a time, not long ago, when the major oil companies were focused upon finding the formations with the potential to produce huge amounts of oil over a very long time. These were called the conventional wells and most were either on land or in relatively shallow coastal waters. Then, as these mega deposits became more difficult to find and the easy (and low cost) fields were becoming saturated, the majors began moving into deeper and deeper ocean waters. This has been going on for some time but, because it requires extremely large investments and development times spanning several years (not to mention the risk of hitting a dry hole), many such projects that were in the early stages got shut down because of the oil glut caused by both OPEC and U.S. shale production.

It sort of reminded me of my teenage years growing up in the Midwest when all the gas stations in an area would compete for business by lower the price per gallon. These were called "gas wars" and were very welcome by the locals and travelers alike. I recall making a trip from my home state of Nebraska to the Canadian border of Minnesota and never paying above 19.9 cents a gallon. The gas wars of old ended up with some of the weaker gas stations closing down and those with stronger financial footings taking market share, thus ending up more profitable when the war ended.

The most recent gas war was essentially between OPEC (again, mainly Saudi Arabia) and U.S. shale producers. At first it seemed like OPEC would win as more than 100 U.S. shale E&P companies filed for bankruptcy. But then something strange happened on the way to the forum. A few shale producers cut costs by using technology to assist in finding, drilling and producing more oil for much lower investments. Again, I will go deeper into this evolution later in the series with more specifics on the technologies and the results. Suffice it to say that some companies have cut drilling time by half or more and increased production from each well drilled by a significant amount. In 2015 the average cost of producing a barrel of oil from shale was estimated at about $60 per barrel (some companies in some fields were well below and others well above). By contrast, today several companies can achieve a reasonable profit margin with the price of oil above $45. From breakeven at $60 to profitable at $45 is a remarkable improvement; and the improvements are still coming. Breakeven in some fields in close to $25 per barrel and will ultimately drop below $20 with future improvements to technology.

Then there is solar power, which has recently come down in cost (on a grid-scale project) to near parity with gas and coal. Of course, there is still the problems of what to do at night or when thick layers of dense clouds block much of the beneficial rays from the sun. Solar panels still generate electricity on cloudy and rainy days but are generally less efficient in such conditions. There is also the problem of storage of electricity during peak sunny periods for use during evening hours when usage generally peaks. But this, too, will be solved eventually and open the doors to stronger adoption of solar electricity generation.

At least, that is the vision of folks like Elon Musk. He expects to create a battery storage system for homes and businesses that will make solar more efficient. Of course, his company's huge investment in the current battery technology may become obsolete with the discovery of a better battery but that does not change the future for consumers, only investors in Tesla (TSLA). This is not intended to be a prediction of the downfall of Tesla, only a reminder of what could potential go wrong and the risk inherent to the significant investment already committed. It could turn out just fine but there is always risk of obsolescence in advanced (and advancing) technologies, especially when there are hundreds of $billions of potential revenues at stake.

Wind power has made great strides in recent years as well, with the cost coming down and large scale generation coming on line. As regulators consider allowing higher speeds of rotor rotation the efficiency of electricity generation via wind turbines may take another leap forward. That, in turn, could lead to additional expansion of wind turbines covering larger swaths of land and seas, replacing or supplementing traditional electricity generation using fossil fuels.

More efficient cars, trucks, buses, planes, ships and trains are always being planned and developed. More vehicles may no longer translate automatically to higher demand for fossil fuels. Traffic monitoring and apps that can be used to divert drivers away from potential bottlenecks will reduce fuel consumption by daily commuters. Autonomous cars should, in theory, also reduce fuel consumption overall.

There is, of course the other side of the equation. Millions more drivers will buy autos as the middle class expands in emerging economies around the globe. As population grows aggregate consumption of everything increases and energy is used to produce more than just electricity. Electricity is used to manufacture almost everything. So, more electricity generation capacity will also be needed. These are the primary factors that have been used historically to forecast energy demand and this method has been relatively accurate over the long run. However, many of the factors and changes mentioned in the preceding paragraphs were either insignificant or irrelevant due to lack of scale to have any meaningful impact on the forecasts. Today, and looking into the future, that is all changing. The old forecasting models will no longer work without substantial improvements to include the more relevant changes that are here and those yet to come.

A low-risk, long-term investment in energy

Because of the volatility in prices it is difficult to imagine any investment in energy as being low-risk. Any stock bought today, whether in energy or otherwise, has a relatively high risk of falling below the purchase price at some time in the future. But over time, there is appreciation potential in energy stocks if (and this is an important IF) an investor is patient and buys on dips or (preferably) crashes experienced by the industry. But there are several important aspects of energy investing, from my perspective, which investors need to keep in mind besides getting in at a good price.

The first is consistency and quality of management; second is the strength of its balance sheet and assets; third is the dividend, how much it rises consistently and the payout ratio relative to the industry average; fourth is how well the company is positioned to adapt to a changing environment; and fifth is how well the stock holds up during times of great stress, as in during recessions or global supply gluts.

Only if a company grades well in all of the above factors does it imply low, long term risk. Energy will always be a necessity for mankind and its form or source of it will evolve slowly over the coming decades. The best run companies will adapt and remain/become leaders in energy production in the future regardless of how dependent we are on fossil fuels. We are moving from a period of nearly complete dependence to a period (at sometime in the future) of declining dependence on fossil fuels. I will attempt to establish the level of probability and time frame of that transition later in the series.

There are few companies that I can check all the boxes for the aspects listed above. Let us take a look at one that stands out for its resilience that I believe is well positioned to evolve and thrive. Exxon Mobil (XOM) has been around for 135 years, far longer than I have. Management has guided the company through multiple crashes in commodity prices (most notably oil) and kept the free cash flow positive, even during the last two dramatic free falls. Many companies in this industry posted negative free cash flow in both instances.

It has a credit rating equal to that of the U.S. government and a strong balance sheet. Only two U.S. companies still have a better credit rating of AAA from Standard and Poor's, Microsoft (MSFT) and Johnson & Johnson (JNJ).

The dividend now yields 3.84 percent and has risen for 34 consecutive years. The rate of increase has decreased to 2.7 percent in each of the last two years, but at least it is above the rate of inflation. The compound annual rate of increase over five years has been 10.4 percent; ten years, 9.2 percent; 20 years, 6.8 percent; 30 years, 6.5 percent; and 40 years, 7.2 percent. I cannot tell with certainty what the future rate of increases will be but suspect that, over the very long term, it will get back to around five percent. Considering that the yield is already higher than most dividend-paying companies, the lower rate of increase may still put more money in a retirees pocket for some time to come. The payout ratio is currently above 100 percent and is a concern, but higher crude oil prices and cost cutting after posting two consecutive down years in 2015 and 2016 will bring that ratio down dramatically as the year progresses.

XOM is an integrated major energy company, not just an oil company. The company explores for and produces oil and natural gas on six continents. It operates through three segments: Upstream, Downstream, and Chemicals. The E&P operations make up the upstream segment. The downstream segment primarily includes transport (collection, shipping and pipelines) refineries, storage and terminal operations. What the Chemicals segment does should be obvious. The advantage of integration is that when one portion of the business is suffering another may benefit. When the price of oil and gas fall both the refineries and chemicals segments experience lower input costs. The transport business is not reliant on prices but throughput, so as volumes increases over time its revenues and margins tend to increase accordingly. When there is a glut of oil the storage and terminal operations do better even as the upstream segment is hurt by lower prices. Integration also allows the company to control costs better. When the industry is booming, owning all the pieces allows the company to restrain the costs that other, smaller companies must purchase through contracts and ever-increasing prices. There are disadvantages due to restraints on downsizing during recessionary periods but those are primarily offset by the benefits over time.

XOM is well positioned to adapt to future demands and has the financial wherewithal to make acquisitions in order to move into new areas if the times so demand of it. The company could easily afford to make a large purchase in solar, wind or any other areas where profitability becomes more enticing than its current core endeavors. The company is currently planning to build multiple petrochemical facilities in the U.S. to take advantage of the low input costs of feedstocks available for the foreseeable future.

The stock is more resilient than the broader market taken as a whole during recessions. The stock fell by 39 percent during the financial crisis of 2008-09 compared to 52 percent for the S&P 500 (SPY). The XOM ride has been far more volatile since then but it did bounce back strongly. Then the price of oil rocketed higher once again and XOM hit new highs. That is not very likely in the near term, but the stock is resilient and, because of the quality of the balance sheet and excellent dividend history, falls less during times of overall market stress.

Then when the price of oil collapsed again from 2014 into 2016, XOM stock fell in price (27 percent) less than the Energy Select Sector SPDR ETF (XLE), which dropped by 43 percent. It also rebounded more strongly in the aftermath.

As many of my readers know I rely heavily on the Friedrich algorithm when analyzing equities. I will provide the Friedrich data file for XOM in another article where I plan to compare it to Chevron (CVX) in the near future. In addition to the Friedrich algorithm, I rely on a tool that I find to be very useful in verifying our work. The Forensic Accounting Stock Tracker (FAST Model) helps identify companies that may be resorting to more financial tricks to make analyst estimates. The model helps pinpoint where management might be aggressive with revenue recognition, cash flows, the balance sheet, and also takes into account valuation and other metrics. Here is an example of the FAST Models results for XOM:

Source: forensicstocks.com

As you can see, there are no signs of problems on fraud, accounting manipulation or potential bankruptcy with this company. That is like a breath of fresh air in the current atmosphere where companies everywhere are doing everything possible to make earnings look better than reality to support overvalued stock prices.

All of this is not to say that I believe XOM to be selling at a bargain presently. But, simply stated, I do feel that XOM, despite all the volatility, can produce good, rising stream of dividend income with less future risk that most of the energy sector. It is highly unlikely to go bankrupt and, if an investor is patient enough to find a good entry price, mine being below $75 per share, I believe it can provide long-term appreciation potential in addition. The current P/E (price to earnings ratio) is higher than normal but I expect it to come down for the same reasons I listed earlier related to the payout ratio. This is not a growth stock, but one that a retiree might consider for a reliable income that beats bonds and is likely to stay ahead of inflation regardless of how the energy market evolves.

If you have any questions, please feel free to ask them in the comment section below and don't forget to hit the "Follow" button next to my name at the top of this article. I hope that readers will stick with the series as I do my utmost to peel the onion that is the future of energy. There is a lot more detail underlying the preview you just read.

For those who would like to learn more about my investment philosophy, please consider reading "How I Created My Own Portfolio Over a Lifetime."

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: DISCLAIMER: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from our research. Factual material is obtained from sources believed to be reliable, but the poster is not responsible for any errors or omissions, or for the results of actions taken based on information contained herein. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.

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