Motley Fool Hidden Gems Investing - Energy Investing 101

Episode Date: May 28, 2022

While the broad stock market has been plunged, energy has proven to be a rare safe haven. Warren Buffett has increased his stake in his energy investments by billions over the past year, but this industry runs in cycles. Nick Sciple and Jim Mueller go over the fundamentals of energy investing and discuss: - The complex connection between oil prices and what you pay at the pump - Which legacy energy companies are meaningfully moving to green energy - A 19th-century food processor that has an interesting strategy in renewable diesel Stocks mentioned: BP, XOM, SHEL, CVX, PSX, TPIC, VLO, BEP, TTNDY, DAR Additional resource: https://www.fool.com/investing/stock-market/market-sectors/energy/ Host: Nick Sciple Guest: Jim Mueller Producer: Ricky Mulvey Engineers: Rick Engdahl, Dan Boyd Learn more about your ad choices. Visit megaphone.fm/adchoices

Chris Hill. Renewables, I think, are going to be a long-time feature and a long-time growth trend. But as far as the oil majors go, of course, they've been notorious for denying climate change, and they've even lobbied actively against efforts to mitigate it. But some, I think, are finally seeing the light. But maybe not all of them. I'm Chris Hill, and that was Motley Fool senior analyst Jim Mueller. This year, Warren Buffett has increased his stake in energy investments by billions. Those of us with a little less cash may be wondering if this is a place to start adding. Today, Jim is joined by Nick Seipel to talk about the connection between oil and gas prices,

how major oil companies are investing in renewables, and how investors like us can think about allocation in this very cyclical industry. Nick Sciple In 2020, oil futures plunged into negative territory. However, in 2021, energy was the top-performing sector in the S&P 500 by far, and energy has exceeded that performance so far in 2022. Here's a beginner's guide to investing in energy if you're eyeing those returns, maybe if you're trying to copy Warren Buffett, or if you're looking for a safe haven amid today's market volatility. I'm Nick Sciple here today with Jim Mueller. Jim, how are you doing? Jim Mueller

How are you doing, Nick? I'm glad to be here. Great to be back here with you as well, here on the podcast. Jim, as someone who follows the markets, you talk to our members regularly on The Morning Show. Are you seeing a lot of newfound interest from investors in the energy sector and energy stocks in general? Not really. Actually, most of what I'm hearing is concern about the downdraft in the markets and the holdings. People aren't really paying attention much to the energy sector, That's kind of too bad, I think. As someone who hosted the Industry Focus Energy show for a number of years, I think it's too bad as well. I think there's certainly

some opportunities there in the energy market. I certainly own some energy stocks in my portfolio. But, Jim, when we're talking about the energy sector, and I just quoted those high-flying returns earlier in the intro, what are we really talking about when we're talking about the energy sector? It's traditionally been oil and gas. means drilling and refining and piping and sending oil and gas all over the world and doing what we do with it. We're talking the energy majors, of course, BP, ExxonMobil, Royal Dutch Shell. We're talking pipeline companies like Kinder Morgan and Brookfield Asset Management. We're talking all kinds of things like that. But you're not really

including in the energy sector the renewables. That's where I tend to focus more often than not. Yeah. If you think about renewable companies, if you think about solar panels, traditionally, that's going to be in the tech sector of the S&P 500. But when you hear the energy sector quoted, it's oil and gas companies at the end of the day. Jim mentioned the big integrated oil majors, your Exxons and your Chevrons of the world. Then, if you get more specific into those companies, you usually hear them quoted as the different streams. You think about the streams of a river, you've got upstream, the top of the mountain where the river starts, midstream where it's flowing through the middle of the country, and then downstream

or it ends up in the ocean. In the version of the oil and gas universe, you've got the upstream, which is the exploration and production companies, the folks who are pulling the oil out of the ground. It also includes the service companies who are doing work for those exploration and production companies to actually drill the holes and put the bits in the ground and that sort of thing. Then you've got the midstreams. Those are the pipeline companies that Jim mentioned earlier. Think about companies like Kinder Morgan and One Oak. Those are the ones that actually take it, it comes from the well, it goes into the pipe, and then it goes to the customer. And then you've got the downstream part of the market, which is refining or the pumps, those sorts of things,

the folks that take the oil and gas and turn it into final products. So, whether that's gasoline or jet fuel or fertilizers, those sorts of things, that's the downstream part of the market. Okay, Jim, so we've talked about what oil and gas companies are. Now, let's talk about what drives these businesses. Again, off the top, I talked about this incredible performance we've seen so far this year. That performance has come in line with a huge surge in oil and gas prices, whether it's natural gas hitting multi-year highs, oil peaked out over $130, has since come back. How does those moves and those underlying commodity prices impact those businesses that we've talked about? Well, they certainly impact the stock

stock prices. The stock prices are highly correlated with the price of oil and gas. You'll see companies like Chevron and BP, their stock prices will go up when the price of oil goes up. That's because investors and Wall Street is expecting that as the price goes up, they'll start drilling more, they'll start producing more and start selling more of that oil and therefore their revenues will go up and their earnings and cash flows will go up. And so, that's why the share price rises with the price of oil. Right. So, as I mentioned earlier, those different streams of the oil and gas market, traditionally the ones that are most levered to the oil and gas price are those upstream,

those E&P companies, the ones that are actually touching the commodity at the end of the day. Obviously, they get the full benefit of the increase in price of that commodity. But one of the areas that we've seen, a lot of folks have seen an increase in price, is at the pump. And that's in the downstream part of the market. Even as overall oil prices have declined somewhat from that $130 high I mentioned earlier in early March, the price of gasoline has continued to surge up and up, hitting new records on a daily basis, according to AAA. For the first time, gasoline prices are above $4 a gallon in every state of the nation. Jim, if oil prices are so far off their peaks, why do we see gasoline prices continue to rise?

Well, oil is only a small component of the gas price. There's the refining cost that you have to include. There's the support of the gas station, of course. They have to make a small profit. And then they're always buying and setting their prices based on what they're going to be delivered next. And as those prices stay high, the gas prices, even though the oil price falls, the gasoline price doesn't always fall as quickly. And it's a lot of supply and demand, but it's also a lot of expectations for the future that is what's being priced into that. Yeah, I think that there's a few factors that are kind of coming together to create, if Charlie Munger would say, it's a Lollapalooza effect. So, number one, pandemic ending, we're coming back, returning to traditional travel, those

sorts of things, demand moving up. as well during the pandemic. It's just since 2019, the overall refining capacity in the U.S. is down something like 5% or so. You have a decline in supply in conjunction with an increase in demand. That's a recipe for higher prices. But you throw on top of that what's going on with the Russia and Ukraine war and how that's impacting prices, you're seeing significant increases in demand for U.S. exports of refined products, whether it's gasoline or diesel, those sorts of things. Also, Russia is a big producer of refined products and also a big producer of some of the supplies that go into making some of those products. And that's impacting

the market. And lastly, you see some interrelation as well, in that refineries are very energy intensive beasts. And as energy prices surge in Europe, that makes it more difficult to make refined products there. So, a number of those things coming together to make supply extra contracted than it would have been otherwise. And another thing is the choice of what the refineries are making. I mean, gasoline is made from, I believe, basically the same kind of oil as airplane fuel and jet fuel. And so, there's been a lot of growth in the airplane industry. Flights are coming back. People are traveling more, as you said. And so, the refiners are making a lot more of the jet fuel at the cost of making not as much as the diesel and the gasoline.

That affects the supply of the latter two, which is also helping to push prices up. The short answer to the question is, gasoline and oil are different products, even though we traditionally hear them quoted together, just like how you make cakes from flour. Flour and cakes, there's different markets for those two products. That's what's going on in the gasoline and oil market. We'll see how long it takes to bring new refinery capacity online and or demand to adjust. But until that happens, we're seeing refiners put up record margins and doesn't appear likely to slow down anytime soon. The last thing I would mention as well is, Javier Blas, great follow on Twitter. He's a Bloomberg reporter. Put out

just today on Wednesday. If you look at the refineries in the Gulf of Mexico, they're running at 97.4% of capacity in the last week, which is the highest level it's run for this period of the year in the last 30 years of historical data. For the capacity that we have in place, the refineries are doing the best we can, but there's a misalignment of supply and demand, and you can't go out and print more refineries. It takes time to correct that. And one of the ways that the market corrects that is to raise the price in order to lower demand. Right. So, it's not like flipping on a switch. You can't flip a switch, and all of a sudden, you're producing more oil and sending it to

the refiners, and they're producing more gasoline. It takes a while to drill. It takes a while to restart wells that have been turned off. And it certainly takes a long time to probe what's underneath there and find the correct spots to drill for new wells. And so, unfortunately, the exploration and production companies, the E&Ps, they can't just be told to, oh, start producing next week. No, it doesn't happen that way. It takes a couple of years for that stuff to flow through. Okay, Jim, so we talk about this misalignment in supply and demand, the surge in prices that we've seen in products, as well as in the underlying oil and gas stocks. What would you say to an investor that's looking at some of

those returns today, looking at conditions in the market, and is considering an investment. Do you think about these companies as a dividend play, or do you think about now as maybe a time to lay off the market and look for other places to invest? It could be a good time. If the oil prices stay up and elevated and supply remains constrained, then yeah, the big energy companies could be a decent place to park your money. But if, for instance, the war in Ukraine ends fairly soon, then that could potentially free up a bunch of oil to come back out of Russia, and if the production in the U.S. starts to ramp up and start pushing the price of the oil down, then you might want to pull back from it.

The problem with these companies is that they're cyclical, and counterintuitively, might want to sell them when the P.E. is low and they've got a lot of earnings relative to their price, and then buy them when their P.E. is high, because then that means they have just a little bit of earnings, they're not selling much, and so the expectation is that they'll start to sell more and drive up their earnings again. As dividend plays, yeah, they're often used as sources of dividend income. If things get really bad, they might start cutting their dividend, but that may or may not be in the cards. So, as a dividend play, probably relatively safe, I think.

Yeah. I'll tell you, for myself personally, I own a fair bit of oil and gas stocks in my portfolio. Part of the reasoning behind that is, I think the cycle that we're in will be relatively extended. The last time we saw a big surge up in oil and gas prices, the shale boom was waiting in the wings to really pour a lot of additional supply onto the market. I think today, there's not a shale industry out there to add a bunch of marginal barrels. I think because of the nature of the shale industry, you've seen the cycles at which folks invest in oil and gas become much more short-term because of the short-term turnaround of shale investing. One of the negatives of that is that those long-term projects,

think about offshore, those sorts of things, while it takes a long time and a lot of investment to get them up and running, they produce for a long, long period of time at steady rates of production. We're in this period where the place where dollars are surging in the market can bring on production quickly, but I think that this misalignment in supply and demand is more of a longer-term problem. To truly fix it with marginal new supply, we'll really need some more of these longer-cycle investments to take place. To make that happen, the prices need to remain higher for longer. And so, that's what I think is going to happen. That's how I'm invested. But you have to believe in the cycle being relatively extended to invest today. If

you think you're going to see a whole bunch of shale investments snap back on, like we saw maybe in the latter half of the 2010s, whenever prices move back up, then you're going to get the rug pulled on you. And so, you need to have an opinion about what this cycle looks like. Talking about opinions on the future and looking to the future, one of the areas that I think a of folks are focused on as a potential opportunity is, we're seeing these high energy prices. What opportunity does this create for an energy transition? Jim, I know that's an area that you spend some time on, looking at opportunities in the renewable energy space. One of the areas maybe we wanted to talk about a little bit is what you're seeing from traditional

energy companies in renewable energy. Do you think these companies have a meaningful strategy, or is it more just window dressing to hide the core business, which is oil and gas? I certainly hope it's a lot more than window dressing, because in order to get temperature change and climate change under control, we do need to move away from a lot of the use of fossil fuels as an energy source, because pumping carbon dioxide into the atmosphere is not the way we want to move forward. I'll come back to how the big oil companies are dealing with this, but I just want to put some perspective onto this. We've heard stories of all the growth in solar and wind, and you might think that we're pretty much there, but that's not the case. There's a lot more

investment that needs to be done. And even the big oil majors are beginning to accept that and move towards that. I'll talk about BP in just a moment on that. To put this in perspective of how big the issue is, how much energy the world actually uses, in 2020, the entire global production of energy from solar and wind was enough to supply the energy needs of all the homes in the U.S., Germany, France, Great Britain, and most of Austria. That leaves out the rest of Europe, the rest of North America, and all the rest of the world, Africa, South America, etc., etc., Asia. Let's not forget Asia. And that's just for residential use. But residential use is only a small fraction of the total amount used on the planet, about 7.5%. The rest supplies industry,

agriculture and transportation. Iron and steel production by itself is four times the amount of residential use. So, there's not nearly enough solar and wind and other renewables to supply all that, which is why fossil fuels has remained a major supplier of the world's energy and fairly constant supplier at 80% of the total consumed over the past decade. It hasn't really moved very much. And then there's all kinds of other factors that play into this, such as getting a country to switch. In India, for example, solar electricity is cheaper than coal electricity by a fair amount. But India is not moving that way. It's not going all in. And that's because the profits of a very large industry in India, railroads, depends upon

shipping coal around. And so, if India goes all in on solar, they hurt a major industry in their economy. For the U.S., there's transmitting energy from where it's produced, winds in the Midwest, in solar down in the South to where it's needed all over the country. And getting that electricity moved around the country is pretty difficult because the way our system is set up, states and even local municipalities have a lot of power. And as the energy goes across the state lines, you have to negotiate with different regulatory bodies and maybe even follow different rules. And that throws up a lot of delay and expense into the equation. So renewables, I think, are going to be a long-time feature and a long-time growth trend. But as far as the oil

majors go, of course, they've been notorious for denying climate change has been around for a long time. And they've even lobbied actively against efforts to mitigate it. But some, I think, are finally seeing the light. But maybe not all of them. I found a recent study that was published that looked at data through 2020, and that looked at BP, Shell, ExxonMobil, and Chevron. So, two American and two European majors. And there's only a couple of others that are big. But these are arguably called the four biggest. And while all of them have been saying for years that they're going to be getting into renewables any day now, yada, yada, we're investing this, or we promised to invest that, BP and Shell were the only two that really seemed to be acting on

the promises. Chevron and Exxon say a lot, but don't do very much, at least through 2020. For instance, BP, in 2020, they made some big moves with their new CEO about moving, big announcements, I should say, about moving towards renewable energy. In 2020, they said, by 2030, we want to have 50 gigawatts of renewable energy on our books that we own, and up from just two and a half. So, that's the previous year in 2019. So, that's a 20-fold increase. Well, they just reported their first quarter, and they now have 25 gigawatts. So, they're halfway there. They're actually moving towards that. Another one of their goals, they said they wanted to have 70,000 electric vehicle charging points by, I think, the same

deadline, 2030. They just announced a joint venture with Volkswagen to open 8,000 more by the end of 2024. They're making actual progress and they're getting more into hydrogen production and green hydrogen. Hydrogen production is made from splitting water into hydrogen and oxygen, and it takes energy to do that. And if you're using coal or oil, electricity to do that, you're just transferring the carbon effect from one fuel to another. But if you're using excess solar or excess nuclear power or excess hydro or wind power, all the green energy, the renewable energies, then you get what's called green hydrogen. And then green hydrogen can feed into things like industry. It can be burned to heat during the smelting

of iron ore to make steel. You end up with something called green steel. Cement making requires a lot of heat. If you can grow that more, then you're doing pretty well. BP is definitely moving in that direction and investing serious dollars and making serious moves into that. Of those four, I'd look at BP first. It still benefits, of course, from its oil and gas side. One area that I think is the most interesting for me, if you're talking about traditional oil and gas companies investing in green or renewable fuels, is renewable diesel. You talk about how green hydrogen is where, basically, you make hydrogen, but you make it in a way that is cleaner than has been the traditional

method. Renewable diesel is a similar thing. A lot of people are probably familiar with biodiesel. Renewable diesel and biodiesel are not the same thing. Biodiesel has to be blended with traditional diesel to run in engines, and it also tends to be more corrosive than traditional diesel. Renewable diesel is chemically identical to traditional diesel, except it is made with either used cooking oil, or in some cases, they'll use virgin canola oil or soybean oil, those sorts of products. We'll come back to that later. This renewable diesel area is a sector we've seen tons and tons of investment, or at least announcements in the past couple of years, from large traditional energy companies.

Just a few examples, Kinder Morgan, Marathon Petroleum, Phillips 66, Exxon, Chevron, all of these companies have announced significant plans to build renewable diesel plants. Obviously, one of the big areas we're seeing shortages today, as we talked about earlier, was refined products, and they're very, very acute in the diesel market. There is a serious demand for these types of products. But the company that I find most interesting to invest in renewable Diesel is not an energy company. It doesn't end up in that energy sector that we talked about earlier. It's a company called Darling Ingredients. Darling Ingredients is a company that's been around since the 19th century and is the largest provider of rendering,

recycling, and recovery solutions to the nation's food industry. It's a very exciting business where they process more than 15 million metric tons of the world's available slaughtered animal byproducts, or about 15% of the world's supply. Why is this business interesting? Well, in addition to this business that they have, processing animal byproducts and also collecting used cooking oil, they have a 50-50 joint venture with Valero, which is one of the nation's largest refiners. That 50-50 joint venture is called Diamond Green Diesel. It's the largest producer of renewable diesel in North America. In the year 2022, they're going to produce 750 million gallons of renewable diesel at $1.25 per barrel EBITDA margin. If you look at the

business's valuation today, it's at the low end of its historical range. And at the back end of 2022, they're going to turn on another significant extension of their renewable diesel plants. I mentioned earlier that there's a lot of competing renewable diesel facilities coming online trying to take advantage of some government tax credits to favor these types of fuels. I would argue that there's probably more incentive for the government to pass those tax credits today than there were a couple of years ago, but that's besides the point. A lot of these facilities are going to be fighting for feedstocks to make this renewable diesel, and a lot of these facilities are reliant upon virgin oils, so virgin seed oils

like canola and soybean oil. Well, if you've looked at anything in the price of fertilizer or the price of commodities, those prices are up significantly. There's actually been some pushback on using those types of products for renewable diesel. Where Darling has an advantage, though, is Darling controls something like 40% of the supply of feedstocks in North America that use cooking oil that goes into renewable diesel. They have an advantage in feedstock pricing relative to other folks on the market. They also have been in this business significantly longer than other folks on the market. At the low end of its historical valuation, with arguably

more demand in the future than there is today, and an expansion of their renewable diesel plant coming online, I'm excited about Darling. A couple of other things to mention as well is they've made some investments in Europe where they're processing animal waste and trash waste to produce fertilizer. Obviously, fertilizer is very much in demand, particularly in Europe today. They also have made some investments in the biodigestion business. This is the business where you take trash and you apply some enzymes and that sort of thing and you pull out what's called renewable natural gas, methane, that you can use for power applications. A lot of these businesses that they're in, which is taking trash and

taking the byproducts from that trash and selling it for something useful, those byproducts are more and more useful today than they were yesterday, and it behooves governments more and more to incentivize what they do than it would have a year ago or five years ago. I love that idea. It's a non-traditional way to get into a traditional idea. That's awesome. Okay, Jim, last question. We talked a little bit about how to maybe get some green exposure into traditional energy sectors. If you're looking pure play, green energy, renewable energy, where are you looking and why? You can do this in many different ways. You can look into companies that are pure

plays such as TPI Composites. They build the wind blades that are used in the wind turbines. Their customers build 34% of the onshore global market and 89% of the U.S. onshore market. They're the makers of the blades. That's one way to get into it. Another way to get into it is companies that build the renewable energy power plants, the dams, the solar farms, the wind farms. You might look at a company like Brookfield Renewable, which is part of the big Brookfield Asset Management conglomerate, but is a separate entity within that. Or you can invest indirectly. You don't have to buy just the pure plays. You can look at Tektronik And they sell power tools, okay?

And you've probably heard of their brands, Hoover, Dirt Devil for appliances. But Milwaukee and Ryobi are their big power tool brands. And those are anything from drills to pneumatic cement, whatever the pneumatic cement breaker upper thing. I think you know what I mean. And they're making a lot more of those battery-powered and electrical. And so that is indirectly benefiting the renewable energy by not needing as much oil and gas to run and benefiting for the growth of renewable electricity. So there are several different ways to get into this.

As far as an allocation, it depends on how much you want in your portfolio. I mean, I would probably keep it moderate. it. I certainly would not go all in on these because if you've looked at the prices over the last several months when the Build Back Better program in the United States was being talked about, the prices of a lot of these renewables went up in anticipation of a lot of funding coming through. And then when that didn't pass, their prices went screaming down when the funding didn't go through. So if you go into these, go into them with a long-term mindset. I think this is a multi-year, even a multi-decade trend that these companies can take advantage of. So I would not

go all in on these, but keep them a moderate-sized position, maybe a few percentage points in your portfolio. Jim, thanks for spending this time with me. It's great to be back in podcast world with you. Thanks, Nick. I enjoyed it. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill, thanks for listening, we'll see you tomorrow.