Motley Fool Hidden Gems Investing - Energy Investing 201: Relentless Demand, Uncertain Supply

Episode Date: June 11, 2022

Earth’s population continues to grow and energy needs are struggling to keep up with worldwide demand. Nick Sciple and Jim Gillies dive into the macroeconomic forces creating an energy crunch, where they are finding investment opportunities, and discuss: - The wide-ranging effects of an energy crunch - How a shale boom “incinerated” $700 billion - Ways individual investors could benefit from pension funds leaving oil Additional resource: https://www.fool.com/investing/stock-market/market-sectors/energy/renewable-energy-stocks/ Stocks discussed: OTC:IPFCC, TSX:IPCO, CBRL Host: Nick Sciple Guest: Jim Gillies Producer: Ricky Mulvey Engineer: Dan Boyd Learn more about your ad choices. Visit megaphone.fm/adchoices

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Because we have your number. You know, any money I pay you as a dividend, Nick, is money I'm not reinvesting into my business to drill baby drill, if you will. So it's a prime setup for, I think, a multi-year energy boom. I'm Chris Hill, and that was Jim Gillies, Senior Analyst at Motley Fool Canada. Jim and Nick Seipel are taking another dive into energy investing. It's a cyclical industry, but one that they believe is facing relentless demand with a less certain supply. Today, they're digging into the wide-ranging effects of an energy crunch, how a shale boom incinerated $700 billion, and the ways that individual investors could actually benefit from fewer institutional funds investing in the space.

Off the bat, Jim, there's an energy supply crunch in the market today. Why are we seeing that? What the heck is going on? The world needs a lot of energy. As we come out of the pandemic, as we keep adding people to our global population, as we keep having people wanting, understandably, lifestyles more like what we enjoy in the West, which of course, are inherently higher energy consumptive, we have found ourselves with record worldwide demand. I always try to set the parameters. The world demand for energy, this is not where it's coming from at all, we're not talking commodities yet, but the worldwide demand is about 175,000 terawatt hours per year. To put that into perspective, the average

American household, single-family dwelling, uses between generally about 10,000 and 11,000 kilowatt-hours a year, and a terawatt-hour is a billion kilowatt-hours. What this means is worldwide energy demand would be like powering 16.5 billion average North American-sized homes. It is a massive, massive thing. That's point No. 1. Point No. 2 is that worldwide energy use is continually growing, demand is growing at just under a 2% annual rate for the past three decades. So, we now have this massive demand, we have a rising demand. And the question becomes, where do we get it? How do we fill that bucket, is what I like to call it? And right now, the big three fossil fuels, so oil, gas, because again, we don't care how we fill it,

but we know we need to fill it. The big three fossil fuels are running at just about, just shy of 80% of the share. So, oil, gas and coal are the big three. And it was about 79% in 2019. The problem is, it was about that same percentage 10 years ago, 20 years ago, 30 years ago as well. And so, now there has been a shift more from coal to gas within that, the fossil fuel share, but the overall share of fossil fuels has remained the same. And what this suggests to me is that for all of the talk of the move to renewables, to the expansion of wind, and solar, and geothermal, all of which I think are important and vital to our energy future, they've not yet made a dent really in filling that bucket. Unless we're going to argue about

reducing how big the bucket is, which I don't think we're going to, we now have a very interesting problem to solve. Yeah. So you've talked about this relentless growth in energy demand. You talk about countries around the world, developing countries continuing to develop, continuing to increase standards of living around the world. And of course, that comes with increasing energy demand on a global basis. But if you look back the past five years or so, we've really seen a contraction in capital expenditures going towards new oil and gas exploration. And there's reasons behind that. A lot of investments in the 2010s, particularly in the shale industry, didn't provide economic returns to shareholders. And one of the facts

you can cite to that is 2020, there was a record year in the history of the oil and gas industry for bankruptcies, as a lot of those investments and debts came home to roost. And as a result, when you see a poor performance of your investments, it doesn't encourage investors to put a lot more money into the space. You've seen, since the last peak in 2016, a slowdown in capital expenditure. Obviously, if a slowdown in capital expenditure, you have a slowdown in growth in supply while demand has continued to grow. Then we have this big ramp up in demand coming out of the pandemic. In March, global oil demand was 101% of 2019 levels, so we fully recovered to pre-pandemic demand. We're already expecting a little bit of a supply crunch

as that underinvestment in oil and gas over the past several years came home to roost. Then you throw on top of that the war between Russia and Ukraine and the impact that that's had on Russia's exports of oil and gas and productions of global commodities in general. If you look at food in Ukraine, fertilizers exported from Russia, there's really wide ranging impacts of the shortage beyond just those headline three commodities, Jim. For investors who are trying to think about, okay, gosh, we have this energy shortage, what does this really mean in the real world? Thoughts on that? Boy, we're really painting a happy circumstance here. Let's see if we can get to more of a happy circumstance. But yeah,

no, this is a real problem. Just to go back a little bit, I used to be a real negative on the oil and gas space through much of the 2010s. And my logic was simply this, most of these companies were spending like $1.20 for every buck they pulled out of the ground. They were in constant reserves, growth, go out, buy more oil, do more. They were spending, spending, spending. So, basically, when you're spending $1.20 to raise $1, obviously, you're burning more money than you're making in, but when times are good, because you had $100-plus barrel oil, circa 2014, these companies, look how well we're doing. They also paid a dividend, but of course, they're already, in many cases, cash flow negative. So, the dividend act is a further drain on cash flow,

and they would make it up through continuous equity and continuous debt issues, because we assumed that high commodity prices would be here forever. The milk and honey would never run out. And then, you know, but you, kind of, point out that, well, this is inherently a bet on reserve prices or resource prices remaining high, which you can't control as an E&P company, Exploration and Production, you know, you just don't control them, you know, and so, when you have, it's inherently unknowable and uncontrollable, the future commodity prices. And so, when you do start to get a slowdown, when you aren't able to make money, A bunch of these players, you know, kind of went boom, down 70%, 80% plus, their stock

prices laid waste, you know, dividends slashed, if not eliminated, financing dried up. And the estimates from the U.S. shale boom from the middle part of last decade, early middle part of last decade, the estimates are somewhere between $700 billion to $1 trillion capital raised for the industry to make kind of, well, to make your fine country, you know, supposedly energy independent. I mean, it's more complicated than that. But, you know, somewhere between $700 billion and $1 trillion was incinerated, didn't earn close to its cost of capital. And so, that has made the industry as a whole and the financing side of things as well as as a whole, somewhat reticent to dig in precisely at a time when we arguably need more energy.

It's almost like these companies have got religion. We're going to see if they're going to backslide a little bit, but the financiers have said, hey, the last time we raised money for you, we lost our shirts. Investors have said, we lost our shirts. We want to see free cash flow generation. We want to see you generating money, and we want you sustainably generating money. We want to see some of that coming back to us, the investors, in the form of dividends, share buybacks, maybe deleveraging of the company. We've really got ourselves in a bit of a pickle. I will argue this is probably the most important industry, is where we get our energy, because everything else stops without it. We have an energy industry that is coming

out of the pandemic, as you said, as every industry is, that has this unrelenting demand, that has historically under-invested itself since 2014, 2015. You're earning about seven years because you need continuous capital investment within the industry. We've not done that, the collective we. And now we've got oil prices running, and oh, by the way, there's that present unpleasantness happening in Russia and Ukraine, which again, only exacerbates the problem. And throughout all of this, as some of these energy commodity companies are now being beaten up for having record profits, which again, go back to 2014, 2015, 2016, different story. Their investors are demanding real returns, which is also serving to ... Any

money I pay you as a dividend, Nick, is money I'm not reinvesting into my business to drill baby drill, if you will. It's a prime setup for, I think, a multi-year energy boom. Since we are an investing company, an investing show, that's where I'm now going to look at this. Some of those investments that investors were not realizing return, that were uneconomic relative to the business. If you think about that, that production to a certain extent was subsidizing the market, was keeping energy prices lower than they would have been alternatively. Now, when you have underinvestment in the market, it's arguably putting prices higher than they would have been otherwise. Maybe to go to that line that I like to use, energy is the

prime commodity. Energy is the thing that underlies all other products. It takes energy to produce products, it takes energy to bring products to market. The consumer's ability to afford energy impacts their ability to demand goods in the market. As we've seen previously, when we had some of that economic production essentially subsidizing the market with arguably oil and gas that shouldn't have come out of the ground, that was a boon to economic activity. As those prices increased, it will be a headwind to economic activity. You see that across the board. Diesel prices at record highs, certainly impacting company margins. Gasoline prices, the phrase you hear thrown around is demand

destruction. As prices get higher, individuals are less likely to go drive around and take vacations. The fact that I think is a fun fact to cite is, is Cracker Barrel in their earnings this week cited a slowdown from their over 65 consumers. If you think about the folks who are going to be first hit by these increases in commodity prices, it's the marginal consumer. In a place like North America, it would be folks on fixed income. On a global basis, it would be some of these developing countries that are now bidding for short supplies up against countries like Europe and North America, and that sort of thing. Even outside these core commodities. We talked about a shortage in products like diesel and a shortage in gasoline.

There's other commodities where there are effects as well. You look at plastics and building materials, certainly an impact there. But the big impact that I don't think a lot of people realize is in food production. One of the key inputs to global food production is natural gas, which is used to make ammonia, which is used to make nitrogenous fertilizers. Vaclav Spil, who's a well-regarded scientist, as cited based on some of his research, that without the nitrogen-based fertilizers produced largely from natural gas, it would be impossible to feed, at current levels, nearly half of the world's 8 billion people. When you look at shortages in things like oil and gas, it's not just, okay, you can't drive, you can't go on vacation. At least for folks on

margin, it can impact food demand. Again, the prime commodity, it touches all parts of the economy. When you see prices increasing all across the economy, certainly something consumers are concerned about. When consumers are concerned about something, you see governments concerned about that as well. We've seen some actions from a number of governments trying to stoke demand, trying to solve this problem. Jim, can you tell us about that and what prospects they have for for solving the problem in the near term? I think near term is going to be a problem. I know that your president, I believe, has tapped the Strategic Petroleum Reserve. With all due respect, that is not going to, that's a proverbial drop in the bucket

at our current demand. I know that people said, well, why can't OPEC just pump more? We have seen that OPEC largely is, I believe, in an article you shared with me. Yeah, the Secretary General of OPEC has said this week, said, quote, OPEC is running out of capacity with the exception of two or three members. We are all maxed out. The world needs to come to terms with this brutal fact. It is a global challenge. That's a series of quotes from the Secretary General of OPEC.

And you've seen similar comments from Saudi Arabian leaders as well. There's just not a lot of spare capacity out there. there's not another shale-type boom waiting in the wings. And it takes time to produce these other types of resources. A subject near and dear to both our hearts, I think probably nearer and dearer to yours, is the substitutive effect of nuclear, of bringing on kind of modern-day nuclear power generation to kind of offset from, offset baseload power from primarily gas and coal burning. But it's not like throwing up a Chipotle where we can probably have one built in a couple of months. A new nuclear power, if we do all get religion on bringing nuclear to scale,

it's going to take a decade or more with permitting and building. I grew up in the shadow of a nuclear power plant in Pickering, Ontario, so that might explain a bit. We were never terribly worried about it, but I understand with nuclear comes a whole host of other concerns. And so, with oil and gas, of course, you have oil and gas and coal combustion, you have global climate change, CO2 emissions and what have you. With nuclear, there is the spent fuel that has some environmental implications. I am in the camp that says you deal with the most pressing problem first. I feel the most pressing problem is the climate change aspect of things. That's why I'm a fan of nuclear, but I think you are more versed on nuclear

than I am, I'm just more of a conceptual thing. What do you think in terms of how we can speed track or speed walk the nuclear option forward? Sure. I think in the near term, if look at the primary drivers of electricity demand or primary producers of electricity, natural gas, coal, those types of facilities. Now, there's been lots of drive to replace those facilities or introduce more renewable wind and solar facilities into the market to try to reduce dependence on fossil fuels. The issue with wind and solar is that they're intermittent. They only produce when the wind is blowing and the sun is out. And also, there's issues with overall efficiency on some of those projects. If you want to transition the grid long-term away

from fossil fuels, you need something that can provide baseload power to truly replace one-for-one some of this coal and natural gas production. One of the ways you can do that is with nuclear power. There has been significant nuclear build-outs. Going back to the 60s and 70s, there's certainly technology available, but it's been a politically charged topic for some of the reasons that Jim laid out. But you have seen, as prices have become higher, attitudes change. The European Commission in their clean energy framework earlier this year included nuclear energy as quote-unquote green energy. You've seen Japan reduce its pledge to back off on nuclear power. South Korea's new political leadership has advocated nuclear power

as well. You're seeing increasing political support for some of these types of projects as well. But I don't think it's a one-size-fits-all problem. I think we'll need to see significant increases in solar and wind investment. We'll need to see in the near-term to solve our problems, we'll need more natural gas and oil investment. Even if we transition away from natural gas gas and oil for transportation and for energy use, we'll still need some of those products like plastics and fertilizer that I mentioned earlier. I think there's going to be sustainable demand of these commodities across the board. Regardless, off the top, we let off saying there's an energy crunch, and to solve an energy crunch, you need to invest in new supply. We said

there's lots of different ways we can go about doing that, whether it's nuclear or oil and gas or wind and solar. The question to you, Jim, we said we're an investing show. Where are you most excited to invest or look for opportunities to invest to solve this current energy problem? Sure. Well, what you've just said about the nuclear, Nick, just if I may, it goes back to my bucket analogy. We have a bucket that consumes 175,000 terawatt hours a year. We have a bucket that needs a lot. Again, it does not matter how we fill that bucket, we just know we have to. And so, that's why we've been proponents of fast-tracking nuclear. I'm hopeful that that is on the table, but again, there are some time issues, and the time issues

feed directly into, until we have, say, nuclear spooling up to aid in filling that bucket and remove some of the fossil fuels. Fossil fuels being still almost 80% share and having been for decades, where I am most excited, sounds bad to say the word excited, where I'm most interested in being in this space as an investor is in a bunch of what we're going to call the, I'm going to say two groups. First, the plain vanilla oil and gas E&Ps, which again, I used to loathe with a passion, but as Charlie Munger has been wanting to say, try to destroy a cherished belief at least once a year and it'll help improve your thinking. I have come full 180 on the E&Ps for now, not all of them, but we do have a few that we've

recommended in Hidden Gems Canada. I'll give you one, it's probably my favorite in the space. Bear in mind, it's a small one, because Hidden Gems is a small-cap service. It is a company called International Petroleum. It is jointly listed in Canada on the Toronto Stock Exchange, IPCO, IPCO is its ticker, as well as listed over in Stockholm. It's a pretty standard E&P company. company. The London family has about a 27% stake. They're long-term players in the space, like multi-decades, both in oil and gas and mining. They have, I've already used the term got religion, so we'll do it again. They got religion, I think, faster than some of their compatriots and are very free cash flow focused, very low leverage, and at present oil prices,

operating leverage of the company is stunning. They are in the midst right now of buying back probably about 9% of the stock. They're doing a substantial issuer bid, which is basically a tender offer to buy a large chunk of their stock. I suspect it might be funded by all the cash they're going to generate in this quarter. Chris Hill We said at the top of the show, we've seen this big decline over the past several years in CapEx on energy exploration and production. If you think about how oilfield servicers get paid, they get paid out of that capex budget. If you expect that capex budget needs to increase and increase meaningfully over the next several years to get supply and demand in line, that means

there's more and more cash flowing to those oilfield service businesses. Then lastly, the royalty business, you think about these businesses as silent partners. If more oil and gas comes out of the ground that they own, they make more money. Of course, if oil and gas companies are spending more money to pour more oil and gas out of the ground, which helps the servicers. Guess what? The royalty companies are going to make more money too. The underlying thesis is here, is we think that oil prices are constructive, such that it makes economic sense for oil exploration and production companies to continue investing and that they will continue producing cash in the near term. That's why it's an interesting place to invest in today and why

it wasn't an interesting place to invest in, say, three years ago. These companies are producing meaningful cash, and at least in the near term, as long as this cycle continues to move up, and I think it will be extended for a while because the marginal barrel is the type of barrel that will take a number of years to bring online, then there will be cash for shareholders. To the extent any of that's wrong and there's not cash for shareholders, then maybe we see a repeat of prior cycles. But that's the investment thesis if you're investing in the quote-unquote energy boom today, if you're investing in correcting the quote-unquote energy crunch that's going on today. Jim, final thoughts? Yeah, it's just that we've talked about the

capital cycle, obviously. And I am of the opinion that the capital cycle this time around is probably going to be, and we've talked before about the dangers of saying this time is different. But truthfully, every time is different, maybe good or bad. The other wildcard we really haven't hit yet, but I want to mention, is the companies themselves are somewhat reticent to be investing in the present capital cycle because their investors in the prior cycle got their heads handed to them. They're reticent about giving money without being sure they're going to get something back. But there's also parts of governments and organizations responding to ESG concerns, pressures, what have you. I'm not here to say positive or negative things

about ESG, I'm just saying what I think is reasonably self-evident to say is that when there are forces pushing against owning a certain sector, and there's certainly a great number of institutions, pension funds that will not own energy stocks right now because of their anti-ESG stance, environmental social governance, that is yet another factor in in favor, and it's somewhat counterintuitive, but I think it's another factor in favor of going here, because I like to liken it, it's an imperfect analogy, but I like to liken it to tobacco stocks. There's no one who's unaware that tobacco is awful for you, but yet tobacco stocks have been some of the best performers, multi-decade performers, in part

because people didn't want to own them, and so the people who did own them, they always kept the valuation low because people didn't want to own them and they produced a lot of cash flow and they used their cash flow to pay dividends and buy back stock and the returns for shareholders were excellent. While I do not think that oil and gas is completely free of their cyclicality, unlike tobacco, I don't believe that they're free of it. I think it's going to draw out this particular capital cycle more than we think it's going to, which is why I am still interested in these spaces. But I am watching for signs of, when do we think we are going to be topped out? That's a whole different conversation.

Yeah. It's like tobacco if half the world population couldn't survive if it didn't exist, to go back to what we said earlier about fertilizer. Like I said, the perfect analogy. Yeah. Well, which makes this far more important. again, I'm not making a positive or negative statement about tobacco. I personally find tobacco use disgusting, but I'm saying the returns from those companies have been pretty good. There are reasons for that, and some of those reasons tie back to general loathing and reticence on the part of investors, governments, and what have you, to invest in that spot. to me, there are some similarities, it rhymes with a little bit what's going on with oil and

gas and energy right now. That as an investor, as something of a contrarian investor, that interests me. It's like the old Peter Lynch thing, look for companies with low institutional ownership. For many of these companies, institutional ownership, at least compared to historical norms, is below average. But Jim, that's all the time we have today. Thanks so much for joining me to chat about oil, gas and global commodity markets. Until next time, I'm Nick Sciple, we'll see you later. As always, people on the program may have interest 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.