What Energy Investors Need to Know

In this podcast, Motley Fool analysts 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.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on May 28, 2022.

Jim Mueller: [MUSIC] Renewables, I think are going to be a long time feature and a long-term 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 average to mitigate it. But some I think are finally seeing the light, but maybe not all of them. 

Chris Hill: 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 Sciple 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. [MUSIC]

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 the 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 you doing?

Jim Mueller: How are you doing, Nick, I'm glad to be here.

Nick Sciple: 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?

Jim Mueller: 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 and that's too bad I think.

Nick Sciple: As someone who hosted the Industry Focus Energy show for a number of years, I think it's too bad as well, and 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 talk about the energy sector?

Jim Mueller: It's traditionally been oil and gas. That 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 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 things like that. You're not really including in energy sector the renewables and that's where I tend to focus more often than not.

Nick Sciple: 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 and 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 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 where it ends up in the ocean.

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 energy, exploration and production companies to actually drill the holes and put the bits in the ground and that thing. Then you've got the midstreams, those are the pipeline companies that Jim mentioned earlier, think about companies like Kinder Morgan and ONEOK. 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.

Then you've got the downstream part of the market which is refining or the pumps, those things. The folks that take the oil and gas and turn it into final products. Whether that's gasoline or jet-fuel or fertilizers, those things. That's the downstream part of the market. 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 and that performance has come in line with a huge surge in oil and gas prices, whether it's natural grass-hitting, multi-year highs, oil peaked out over 130 dollars has since come back. How does those moves in those underlying commodity prices impact those businesses that we've talked about?

Jim Mueller: They certainly impact the 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 then start selling more of that oil and therefore their revenues will go up and their earnings and cash flows will go up. That's why their share price rises with the price of oil.

Nick Sciple: 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, or 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 hitting new records on a daily basis according to AAA. For the first time, gasoline prices are above four dollars 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?

Jim Mueller: 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. Then they are always buying and selling their prices based on what they're going to be delivered next and as those prices stay high, and the gas prices, even though the oil price falls, the gasoline price doesn't always fall as quickly. 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.

Nick Sciple: Yeah, I think there's a few factors that are coming together to create that Charlie Munger would say it's a lollapalooza effect. Number 1, pandemic ending, we're coming back, returning to traditional travel. Those things demand moving up, as well during the pandemic, just since 2019 the overall refining capacity in the US is down something like five percent 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 are seeing significant increases in demand for US exports of refined products whether it's gasoline or diesel, those things. Also, Russia has a big producer of refined products and also a big producer of some of the suppliers that go into making some of those products and that's impacting the market. Lastly, you see some interrelation as well and that refineries are very energy-intensive beasts. As energy prices surge in Europe, that makes it more difficult to make refined products there. A number of those things coming together to make supply extra contracted than it would've been otherwise.

Jim Mueller: Another thing is the choice of what the refineries are making. I mean, gasoline is made from, I believe, basically the same oil as airplane fuel and jet fuel. There's been a lot of growth in the airplane industry. Flights are coming back, people are traveling more as you said. So the refineries 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.

Nick Sciple: Yeah. 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, so Javier Blas, great follower 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 percent 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 plant 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.

Jim Mueller: Right. 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 refineries and then 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. Unfortunately, the exploration and production companies; the ENPs, they can't just be told, "Oh, start producing next week." No, it doesn't happen that way. It takes a couple of years for that stuff to flow through.

Nick Sciple: Okay. Jim, so we talked about this misalignment in supply and demand and 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?

Jim Mueller: 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. If the production in the US 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 are cyclical, and counter-intuitively, you might want to sell them when their PE is low and they've got a lot of earnings relative to their price, and then buy them when their PE is high because then that means there you have just a little bit of earnings, they are not selling much, and so the expectation is that they'll start to sell more and drive up their earnings again. As dividend plays, they're often used as sources of dividend and income. If things get really bad, they might start cutting their dividend, but that may or may not be on the card, so as a dividend play, probably relatively safe I think.

Nick Sciple: Yeah. I'll tell you for myself personally I own a fair bit of oil and gas stocks in my portfolio, and 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 is 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.

But 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 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 and to truly fix it with marginal new supply we'll really need some more of these longer-cycle investments to take place, and to make that happen, the prices need to remain higher for longer. 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 investment 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. You need to have an opinion about what the cycle looks like. Talking about opinions on the future and looking to the future, one of the areas that I think a lot 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 and one of the areas where maybe we wanted to talk about it 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?

Jim Mueller: I certainly hope that'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 on 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 is a lot more investment that needs to be done and even the big oil majors are beginning to accept that and move toward that. I'll talk about BP in just a moment on that.

To put this into perspective, 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 US, 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. Let's not forget Asia. That's just for residential use. But residential uses only a small fraction of the total amounts used on the planet, about seven-and-a-half percent. 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, and which is why fossil fuels has remained a major supplier of the world's energies and fairly constant supplier at 80 percent of the total consumed over the past decade. It hasn't really moved very much.

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. If India goes all-in on solar, they hurt a major industry in their economy. For the US, there's transmitting energy from where it's produced, winds in the Midwest and solar down in the south, to where it's needed all over the country.

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. Renewables, I think, is going to be a longtime feature and a longtime 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.

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. Two American and two European majors, and there's only a couple of others that are big, but these you could arguably call the four biggest. While all of them have been saying for years that they are going to be getting into renewables any day now, we're investing this, or we promise to invest that, BP and Shell were the only two that really seemed to be acting on the promises. Chevron and Exxon sale up, but don't do very much, at least through 2020. For instance, BP, in 2020, they made some big moves with their new CEO. Big announcements, I should say, about moving toward 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 2.5, that's the previous year in 2019. That's a 20-fold increase.

They just reported their first quarter and they now have 25 gigawatts, so they're halfway there. They are actually moving toward 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've just announced a joint venture with Volkswagen to open 8,000 more by the end of 2024. They are making actual progress and they're getting more into hydrogen production and green hydrogen. Hydrogen production is made by splitting water into hydrogen and oxygen, and it takes energy to do that. If you're using coal or oil, or 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.

Then green hydrogen can feed into things like industry. It can be burned to heat, and during the smelting of iron ore to make steel, and so you end up with something called green steel and cement making requires a lot of heat. If you can grow that more, then you're doing pretty well. But BP is definitely moving in that direction and investing serious dollars and making serious moves into that. Of those four, I would look at BP first and it still benefits, of course, from its oil and gas side.

Nick Sciple: 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 talked about how green hydrogen is where basically you make hydrogen but you make it in a way that is cleaner than it 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 though, you use Virgin 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 are very, very acute in the diesel market. So 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 by-products or about 15 percent 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, as 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 a $1.25 per barrel EBITDA margin. If you look at the businesses valuation today, it's at the low end of its historical range and at the backend 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 oil. 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 and there's actually been some pushback on using those types of products for renewable diesel. Darling has an advantage, though, as Darling controlled something like 40 percent of the supply of feedstocks in North America. There's kind of used cooking oil that goes into renewable diesel. They have an advantage in feedstock pricing relative to other folks on the market, and they're 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 the 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 very much in demand particularly in Europe today. They also have made some investments in the bio digestion business. This is a 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 are in, which is taking trash and taking the byproducts from that trash and selling it for something useful, those by-products 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.

Jim Mueller: I love that idea. It's a non-traditional way to get into a traditional idea. That's awesome.

Nick Sciple: 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?

Jim Mueller: 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 and their customers are billed 34 percent of the onshore global market and 8-9 percent of the US onshore market. They are the makers of the blades so that's one way to get into it. Another way to get into it is companies that build renewable energy power plants, the dams, the solar farms, the wind farms. You might look at a company like Brookfield Renewables, which is part of the big Brookfield Asset Management conglomerates, 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 Techtronic Industries, they sell power tools. You've probably heard of their brands, Hoover, Dirt Devil for appliances.

But Milwaukee and Ryobi are there big power tool brands and those are anything from drills to pneumatic cement, whatever the pneumatic cement breaker upper thing. [laughs] I think you know what I mean. They're making a lot more of those battery-powered electricals. So that indirectly benefiting the renewable energy by not needing as much oil and gas to run and benefiting for the growth of renewable electricity. 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 would probably keep it from moderate.

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. Then when that didn't pass, their prices went screaming down when the funding didn't go through. If you go into these, go into them with a long-term mindset. I think this is a multiyear, even a multi-decade trend that these companies can take advantage of. I would not go all in on these, but keep them at a moderate sized position, maybe a few percentage points in your portfolio.

Nick Sciple: Jim, thanks for spending this time with me. It's great to be back in podcast world with you.

Jim Mueller: Thanks, Nick. I enjoyed it. [MUSIC]

Chris Hill: 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.