Energy Today: Relentless Demand, Uncertain Supply

In this podcast, Motley Fool analysts Nick Sciple and Jim Gillies dive into the macroeconomic forces creating an energy crunch and where they are finding investment opportunities. They 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.

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 June 11, 2022. 

Jim Gillies: 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 a multiyear energy boom.

Chris Hill: I'm Chris Hill and that was Jim Gillies, senior analysts at Motley Fool Canada. Jim and Nick Sciple 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 this space.

Nick Sciple: So off to that Jim. There's an energy supply crunch in the market today. Why are we seeing that? What the heck is going on?

Jim Gillies: 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's demand for energy. This is not where it's coming from at all. I agree with you, 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's single-family dwelling uses between generally about 10 [thousand] 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. I mean, it is a 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. There's massive demand, we have a rising demand. The question becomes, where do we get it? How do we fill that bucket? Is what I like to call it. 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 shy of 80% of the share. Oil, gas, and coal are the big three. It was about 79% in 2019.

The problem is, it was about that same percentage 10 years ago, 20 years ago, and 30 years ago as well. Now there has been a shift more from coal to gas within that fossil fuel share, but the overall share of fossil fuels has remained the same. 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.

Nick Sciple: Yes, 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. 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 toward new oil and gas exploration. There are reasons behind that. A lot of investments in the 2010s, particularly in the shale industry, didn't provide economic returns to shareholders.

One of the facts you can cite to that is 2020 was a record year in the history of the oil and gas industry for bankruptcies -- a lot of those investments and debts came home to roost. As a result, when you see poor performance of your investments, 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 prepandemic demand. We are already expecting a little bit of a supply crunch, 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 production 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, OK, gosh, we have this energy shortage. What does this really mean in the real world? Thoughts on that.

Jim Gillies: We're really painting a happy circumstance here. Let's see if we can get to more [laughs] of that happy circumstance. 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 2010's. My logic was simply this, most of these companies were spending like about 20 for every buck they pulled out of the ground. They were in constant reserves, growth, going out buy more oil, do more, and spending. Basically, when you're spending about 20 to raise a dollar, obviously you're burning more money than you are taking in. But when times are good, because you had a $100-plus barrel oil, well circa 2014. These companies look at how well we're doing. They also paid a dividend, but of course they were already, in many cases, cash flow negative. The dividend act was a further drain on cash flow. 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.

But you point out that, oh, 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. If that be, you'd still don't control them. It's inherently unknowable and uncontrollable, the price, future commodity prices. When you do start to get a slowdown, when you are unable to make money, a bunch of these players went boom, down 70-80-plus percent. Their stock prices laid to waste, dividends slashed if not eliminated, financing dried up, and the estimates from the U.S. shale boom, from the early middle part of last decade. The estimates are somewhere between 700 billion to a trillion dollars in capital raised for the industry to make your fine country supposedly energy independent. I mean, it's more complicated than that, but somewhere between 700,000 billion and a trillion dollars was incinerated and didn't earn close to its cost of capital. That has made the industry as a whole and the financing side of things as well as a whole, somewhat reticent to dig in precisely the time when we arguably need more energy.

It's almost like these companies have got religion and we're going to see if they're going to backslide a little bit. The financiers, have said, hey, the last time we raised money for you, we lost our shirts. Investors have said they lost their shirts. We want to see free cash flow generation. We want to see you generating money. We want you to sustainably generate money. We want to see some of that coming back to us, the investors in the form of dividends, share buybacks and maybe deleveraging of the company. Can't believe I'm going to say this. We've got ourselves a little bit of a pickle. I will argue this is probably the most important industry. It 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 underinvested im itself since 2014, and 2015.

Because you need continuous capital investment within the industry. We've not done that collectively. Now we've got oil prices running. By the way, there is that unpleasantness happening in Russia and Ukraine, which again only exacerbates the problem. 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, a very 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 multiyear energy boom. Since we are an investing company, investing shows, that's where I'm now going to look at those.

Nick Sciple: Some of those investments that investors were not realizing return that was 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've been. Alternatively, and now when you have underinvestment in the market, it's arguably putting prices higher than they would've been otherwise. Instead of maybe going to that line that I like to use, energy is the prime commodity and energy is the thing that underlies all, basically, other products. It takes energy to produce products, it takes the 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 and as those prices increased, it will be a headwind to economic activity, and you see that across the board.

Diesel prices at record highs, certainly impacting a company's 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. Though the fact that I think it's a fun fact to say is, Cracker Barrel in their earnings this [laughs] week cited a slowdown from there over-65 consumers. If you think about the folks who are going to be the first hit by these increases in commodity prices, it's the marginal consumer. In a place like North America would be folks on a 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. Then even outside of these core commodities, so we talked about the shortage in products like diesel and shortage in gasoline, there are other commodities where there are effects as well. You look at plastics and building materials, certainly an impact there.

The big impact that I don't think a lot of people realizes 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 nitrogen fertilizers. Vaclav Smil, who is a well-regarded scientist, has cited based on some of his research that without the nitrogen-based fertilizers produced largely from natural gas 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,
OK, You can't drive, you can't go on vacation." At least for folks on the margin, it can impact food demand.

Again, the prime commodity 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 solving the problem in the near term?

Jim Gillies: I think near term it's going to be a problem. I know that your president, I believe, has tapped the strategic petroleum reserve, with all due respect, that's the proverbial drop in the bucket at our current demand. I know that if people said, "Well, why can't OPEC just pump more?" We have seen that OPEC largely is, I believe that article that you shared with me.

Nick Sciple: The secretary-general of OPEC has said this week that, "OPEC is running out as capacity with the exception of two or three members, we're all maxed out. The world needs to come to terms with this brutal fact, it is a global challenge." Those are a series of quotes from the secondary-general of OPEC. 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.

Jim Gillies: A subject near and dear to both our hearts, I think probably nearer to yours, is the substitutive effect of nuclear, of bringing on modern-day nuclear power generation to 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. New nuclear power, if we all get religion on bringing nuclear to scale, it's going to take a decade or more and with permitting and building. I mean, I grew up in the shadow of a nuclear power plant, Pickering, Ontario, so that might explain a bit. But 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, gas, and coal combustion, you have global climate change, CO2 emissions, and what have you. With nuclear, there is the dispensed fuel that has some environmental implications. I'm in the camp that says, you deal with the most pressing problem first. I feel the most pressing problem is the climate change aspects of things, so that's why I'm a fan of nuclear. But I think you are more versed on nuclear than I am, I'm just a conceptual thing. What do you think in terms of how we can speed track or speed walk the nuclear option forward?

Nick Sciple: Sure. I think in the near term if you look at the primary drivers of electricity demand or primary producers of electricity, natural gas, coal, those types of facilities now, there has 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 are intermittent, they only produce when the wind is blowing and the sun is out. Also, there are issues with overall efficiency on some of those projects. If you want to transition the long term away from fossil fuels, you need something that can provide base load 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 have been significant nuclear buildouts. I mean, 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, I think European Commission, excuse me, in their Clean Energy framework earlier this year, included nuclear energy as "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 are 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 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 for these commodities across the board. But regardless, off the top, we led off saying there's an energy crunch and to solve an energy crunch you need to invest in new supply. We said there are 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.

Jim Gillies: Sure. Well, I mean, 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 a 175,000 terawatt-hours a year. We have a bucket that needs a lot and again, it does not matter how we fill that bucket. We just know we have to. That's why we've been proponents of fast-tracking nuclear and 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 still have almost 80% share and have been for decades, where I am most excited. Sounds bad to say the word excited [laughs], where I'm most interested in being in this space as an investor is in a bunch of them, oh, we're going to call the let me 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 wont to say, "Try to destroy cherished beliefs 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 will give you one. It's probably my favorite in this 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 it's ticker, as well as listed over in Stockholm and it's a pretty standard E&P company.

The London family has about 27% stake. They are long-term players in space for multidecades, both in oil and gas and mining. I have 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, the operating leverage of the company is stunning. So 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 a good tender offer to buy a large chunk of their stock and I suspect they might be funded by all the cash they are going to generate in this quarter.

Nick Sciple: 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 oil-field services get paid, they get paid out of that capex budget. So 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 oil-field service businesses. Then lastly, the royalty business. You think about these businesses is like silent partners. If more oil and gas comes out of the ground that they own, they make more money and so of course of oil and gas companies are spending more money into more oil and gas out of the ground, which helps the servicers, guess what, the royalty companies are going to make more money, too.

So the underlying thesis is here, is we think that oil prices are constructed such that it makes economic sense for oil exploration and production companies to continue investing and 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 of the marginal barrel is on the type of barrel that will take a number of years to bring on line, 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 "energy boom" today if you're investing in correcting the "energy crunch" that's going on today. Jim, final thoughts?

Jim Gillies: 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 it's 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 they are investors in the prior cycle, got their heads handed, so 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. I'm not here to say positive or negative things about ESG, I'm just saying what I think reasonably self-evident to say is 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 favor and it's somewhat counterintuitive, but I think it's another factor in favor of going here. It's an imperfect analogy. But I'd 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, multidecade 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 produce a lot of cash flow and they use of 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 are 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'm watching for signs of when do we think we're going to be topped out and that's a whole different conversation.

Nick Sciple: Yeah, it's like tobacco if half the world's population couldn't survive if it didn't exist. To go back to what you said earlier about the fertilizer.

Jim Gillies: Like I said it ain't perfect analogy, yes. Well, and which makes this far more important. But again, I am not making a positive or negative statement about tobacco. I personally find tobacco use disgusting, but I'm saying the returns from those companies are doing been pretty good and there are reasons for that. 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. That to me, there are some similar areas that rhymes with a little bit what's going on with oil and gas and energy right now. That, as something of a contrarian investor, that interests me.

Nick Sciple: It's like the whole 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, and we'll see you later.

Chris Hill: As always, people on the program may have interest in the stocks they talk about. 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!