________________

The global energy sector includes companies that discover, produce, and deliver energy products made from fossil fuels to both retail and commercial customers. Since most individuals and businesses around the world require energy on an ongoing basis, one might assume that these products and services are nondiscretionary in nature. However, the energy sector is highly cyclical, primarily because much of the demand for oil comes from industrial companies, and these businesses are cyclical. Manufacturers, for example, expand production during periods of economic growth, thereby increasing their use of energy products. Conversely, as economic growth slows down, manufacturers produce fewer goods and consume less fuel. In the chemical industry, energy products are often a significant component of the goods being manufactured, including paint and plastic. Other industries that would consume less fuel in weak economic environments include transport and shipping companies as well as airlines. Even consumers cut back on their fuel consumption in a weak economy, driving less for vacations or making fewer trips to the shopping center. The result is a strong correlation between oil consumption and economic growth, whereby a 1% increase in global economic growth translates to an approximately 0.5% increase in oil consumption.

Energy derived from fossil fuels has been linked to climate change and has a history of creating environmental calamities, such as oil spills. While the fossil fuel industry is under social and regulatory pressure to change its ways, an immediate end to the use of fossil fuels would be catastrophic for the world economy. Nevertheless, many companies in the energy sector are striving to operate in an environmentally friendly manner in addition to diversifying operations by allocating capital toward the development of renewable energy projects.

Governments around the world are also investing in renewable energy, further augmenting competition for the energy sector. Renewable energy refers to energy produced through sustainable means such as wind, solar, geothermal, nuclear power, hydroelectricity, and tidal power. Renewable energy is grouped in the utility sector and is discussed in more detail in Chapter 19. The transition from fossil fuels to renewable energy will take considerable time, with the International Energy Agency estimating that oil and gas consumption will continue for another 20–30 years and require significant ongoing investment.

The futures curve for crude oil can be a useful tool for assessing the current state of the energy market. The curve consists of contracted prices for delivery of crude oil today (referred to as the spot price) and at various future points in time (future prices). If the spot price is higher than future prices, the curve is said to be in backwardation. This means that there is strong near-term demand for crude oil, and it is being bid for use. Conversely, if prices are higher in the future, the price curve is said to be in contango. In that case demand for oil today is below what is expected in the future and oil is being bid for storage. In other words, buyers are willing to purchase crude oil today and store it, with the expectation that they can sell it at a higher price sometime in the future. If the futures curve for oil is in backwardation (downward sloping), it is positive for energy companies, boosting near-term demand as well as their profit margins. Examples of both types of futures curve (contango and backwardation) are shown in Figure 12.1.

In this chapter we take a closer look at the six main industry groups within the sector: (1) coal, (2) energy equipment and services, (3) exploration and production, (4) integrated oil and gas, (5) refining and marketing, and (6) storage and transportation.

Coal

The use of coal to produce electricity began in the nineteenth century, and it has been used extensively as a source of heat in homes as well as to power industrial and transportation equipment ever since. Metallurgical coal (used to make steel) is included separately in the mining industry within the materials sector. Thermal coal (coal used to produce heat) has been identified as a major cause of climate change, resulting in reduced demand and a shift toward replacing the use of coal with alternative energy sources. Although some companies are trying to develop more environmentally friendly methods for using coal to generate power, investors should expect continued pressure on the industry. While coal is gradually being eliminated as an energy source, it is still used extensively in countries that have not yet been able to replace all of their coal-fired power plants. China, India, and the United States are the largest producers of coal, but they are also leading the world in renewable energy investment. The relative price of thermal coal to oil and gas is a potential indicator of future demand. In many thermal power plants, both oil and gas are readily available substitutes for coal and if the price gap between them grows materially, demand will shift to the lowest-cost fuel. Since coal is a substitute for oil and gas at the margin, increases in oil and gas prices will eventually lead to a corresponding increase in thermal coal prices. Other economic factors that affect sales and profit growth include GDP and population growth, industrial production levels, and fuel costs (diesel and gasoline), especially in situations where coal must be transported to the final customer. The coal producers listed here generated relatively strong, predictable earnings in recent years while maintaining above-average dividend yields. Key factors for investors to monitor include local coal prices, oil and gas prices, coal production and sales volumes, and production cost trends. Valuation comparisons can be made using measures such as P/E and EV/EBITDA multiples.

Energy Equipment and Services

Businesses in the energy equipment and service industry supply the products and services necessary for the discovery and extraction of fossil fuels both onshore and offshore. This includes well drilling, geological, engineering, and operational services, as well as supplying derricks, turbines, valves, pumps, drills, and pressure control equipment, among many other items essential to the industry. Oil and gas prices have the biggest impact on this industry, as higher prices lead to greater investment in exploration and production by energy producers. Due to their reliance on commodity prices, businesses in this industry are highly cyclical and sensitive to changes in economic growth. The same factors that affect oil and gas producers (discussed next) flow through to the equipment and service providers, usually with a delay of several months. Share price volatility for these companies is relatively high, while the depressed valuations, sales growth, and profitability evidenced in this table are the result of weakness in the energy sector in recent years caused in part by overproduction. These characteristics are likely to recover once demand for equipment and services increases and energy producers become profitable again. In addition to oil and gas prices, it is important to monitor the capital expenditure plans of the world's major energy producers. EBITDA is a widely followed metric for the energy service industry, but investors should also monitor discretionary cash flow, which better accounts for the increase in maintenance costs that occurs as EBITDA grows. Other important metrics that investors should monitor include tangible asset turnover as well as net debt/EBITDA ratios. For equipment and services companies, rig counts, day rates (the dollar amount charged by contract drillers), and day costs are also important. For disposal businesses, injection well volumes can also provide useful information. Commonly used valuation measures for the industry include P/E and EV/EBITDA.

Exploration and Production

Exploration and production companies (commonly referred to as E&P companies or energy producers) are engaged in the discovery and extraction of fossil fuels both on land and at sea. The pandemic-driven price collapse in 2020 marked the start of a new era, one defined by pervasive capital discipline, rising free cash flow, and an emphasis on growing shareholder returns instead of production. Given the impact of fossil fuels on the world's climate, investors should expect continued pressure on the industry from an ESG perspective. That said, most large producers are developing climate-friendly technology, including decarbonizing technology that is synergistic with existing operations such as carbon capture, hydrogen, and biofuels. While the price of oil is primarily decided at the global level, demand for natural gas is highly seasonal and prices are very regional. Companies realize different prices based on the spread to major pricing hubs, also known as differentials. Commodity prices are a function of supply and demand and influence company earnings the most. Natural gas prices are also driven by supply (production) and demand (power generation, heating, weather, industrial activity). FCF yield, or FCF/equity, has become a key valuation metric. FCF/EV is another form of FCF yield and it factors in debt on the balance sheet. EV/EBITDA, debt/EBITDA, dividend yield and reinvestment rates (capex as a percentage of cash flow from operations before working capital) are also important metrics since the industry is capital-intensive. Due to the high variability of earnings over the economic cycle, investors should use the price to net asset value (P/NAV) ratio for valuation comparisons, in addition to P/E and EV/EBITDA.

Integrated Oil and Gas

Integrated oil and gas companies (also referred to as the majors) are essentially energy conglomerates, whose businesses extend from exploration and production, refining, and transportation all the way to downstream operations in which the end products, such as gasoline, are sold to consumers. As mentioned earlier, concerns over climate change have led to an emerging area of energy production, namely renewable energy. The expected time horizon for the transition to renewables is long, however, and the integrated energy companies may be best positioned to lead the transition. European majors have taken a proactive approach to the energy transition, investing more heavily in renewables compared to North American peers that are still more focused on the traditional oil and gas business. Despite this North American majors have tended to trade at a 1.5–2× multiple premium when compared to European peers. Although sales growth has been below average, profits have grown at an above-average rate, suggesting these businesses have successfully expanded their profit margins relative to the market. All of the factors that impact other energy industry segments will affect integrated energy firms, including global GDP growth, industrial production, trade, and travel, all of which help drive oil and gas prices, which are the most critical determinant of sales and earnings growth for the industry. For the integrated companies, crack spreads (refining margins) and chemicals margins also drive earnings, while input costs such as labor, steel, sand, and chemicals drive capex inflation. Commonly used valuation measures for the integrated oil and gas industry include P/E and EV/EBITDA, but a sum of the parts or discounted cash flow analysis may be most appropriate for these businesses since they often operate in multiple areas of the energy sector.

Refining and Marketing

Companies within the refining and marketing industry are tasked with final processing of the various elements found within raw fossil fuels. During the refining process, impurities such as sand, water, sulfur, and carbon dioxide are removed, and the remaining substances, such as oil, natural gas, and natural gas liquids, are separated and processed into final products such as heating oil, gasoline, jet fuel, and lubricants. The products created through the refining process are also used extensively in the chemical industry and to produce the asphalt used to build roads. According to the US Energy Information Administration, “crack spreads are differences between wholesale petroleum product prices and crude oil prices. These spreads are often used to estimate refining margins. Crack spreads are a simple measure based on one or two products produced in a refinery (usually gasoline and distillate fuel). They do not take into consideration all refinery product revenues and exclude refining costs other than the cost of crude oil.”¹ Economic factors that affect the refining industry include GDP growth and the general level of economic activity, industrial production, shipping levels, and travel, which helps drive demand for gasoline and jet fuel. Several refiners listed here also own downstream operations, where they deliver gasoline and other products directly to consumers. Although refiners are influenced by the price of oil and gas, their earnings tend to be more stable than companies engaged in energy exploration and production or that provide energy equipment and services. For refiners, crack spreads (refining margins) and chemical margins also drive earnings. Input costs such as labor, steel, sand, and chemicals impact capital expenditure inflation. Standard valuation measures such as P/E and EV/EBITDA are often used to assess valuations in this industry.

Storage and Transportation

Energy companies engaged in the storage and transportation of energy products (often referred to as “midstreamers”) are comprised primarily of pipeline operators that gather, store, and transport crude oil, natural gas, and fluids between producers and refiners. These businesses also provide a limited amount of treatment and processing where they separate components of the raw commodity through a process called fractionation. Pipelines are used more extensively in large geographic regions where raw fossil fuels must be transported great distances before reaching the refineries needed to convert them into end products. Railroads and trucks compete with pipeline operators to facilitate transportation of energy products. However, these transportation methods tend to be less cost effective and may pose a greater environmental risk. Despite this, it is likely that an increasing amount of fossil fuel will be shipped by rail and road, as it has become exceedingly difficult in many jurisdictions to get approval to upgrade or build new pipelines over environmental concerns and the need to obtain easements through private and public property. Like other industry groups within the energy sector, midstream companies are working toward reducing carbon emissions. Pipeline operators have attractive business models, assuming they can obtain regulatory approval needed for new projects and to effectively maintain their existing networks. Once pipelines are built the cost of maintaining them is low and they are long-lived assets. Pipeline operators are less sensitive to the economic cycle compared to other industries within the energy sector because their contracts are usually take-or-pay, long-term fee for service agreements, or regulatory cost of service, making revenue and earnings stable and predictable regardless of economic conditions. As a result, they generate strong cash flows and can support attractive dividend payouts. Key variables that investors should track include crude production, mainline (pipeline) volumes, refinery throughput, fractionation spreads, prices for oil, gas, and natural gas liquids (NGLs), EBITDA, return on invested capital (ROIC), capital expenditure requirements, leverage (debt/EBITDA), dividend payout ratio, FCF/dividend coverage, and FCF yield. Valuations are most often compared using EV/EBITDA or FCF yield. Contracts are long term and predictable so a discounted cash flow approach (EV/DACF) can also be used for valuation.