The energy sector is down 8.2% so far this year, driven by declines in oil prices and a cooldown from a red-hot 2022. However, the sector can still do very well even at current prices. In fact, many companies are banking on oil staying where it is or suffering only a minor decline. Here's why the energy sector is set up nicely for 2024 and why it could be worth investing in now.
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Consolidation is driving the upstream industry
The last few months have featured a flurry of mergers and acquisitions on the upstream side of the energy sector. In October, ExxonMobil (XOM -2.78%) announced an all-stock merger with Permian Basin producer Pioneer Natural Resources for $59.5 billion. Later that month, Chevron (CVX 0.37%) announced a merger with Hess for $53 billion, gaining access to the oil reserves offshore Guyana among other global plays. And earlier this month, Occidental Petroleum (OXY -0.15%) announced a $12 billion acquisition of privately held Permian producer CrownRock.
In the case of Exxon and Oxy, the idea is to get more acreage in a familiar region. This approach can save costs through synergies and boost free cash flow (FCF) if done right. Chevron's deal is a diversification move. It gives it access to a low-cost offshore oil play, which pairs nicely with its existing Permian and liquefied natural gas position.
The deals vary in scope and scale. But the rationale behind them is the same: produce more oil and gas at a lower cost per barrel. It's good old-fashioned leverage that can amplify gains during certain conditions and compound losses if oil prices take a turn for the worse.
On Dec. 6, ExxonMobil published a corporate plan centered around doubling its earnings by 2027 based on Brent crude oil (the international benchmark) averaging $60 a barrel. However, it also said that 90% of its planned upstream capital investments over the next five years will be able to return 10% or more even if Brent crude oil is $35 a barrel. That's a massive margin for error on the downside and plenty of upside potential even for mediocre oil prices.
Assuming its merger with Hess goes through, Chevron expects to be able to double its free cash flow by 2027. On the downside, Chevron said it is "built for $50 Brent," as it can cover its capital expenditures and dividend payments at that level in addition to its operating costs.
Meanwhile, Occidental Petroleum expects to be able to generate an additional $1 billion in free cash flow in the first year following its acquisition, assuming $70 West Texas Intermediate (WTI) crude oil (the U.S. benchmark). Oxy also said that the acquisition increased the portion of its unconventional portfolio that can break even below $40 oil by 33%.
Exxon, Chevron, and Oxy are just a few of the many upstream producers. But in general, a lot of upstream corporate plans are based around breaking even somewhere around $40 a barrel, and assuming a price of $60 to $70 to fund long-term growth. For example, ConocoPhillips (COP 0.10%) has a 10-year plan to grow FCF at a compound annual growth rate of 6% to 11% per year based on $60 WTI oil prices. But ConocoPhillips can also achieve FCF breakeven at $35 per barrel of WTI crude.
Improved financial strength
As much as oil and gas producers will try to build a growth plan around a certain price range, there's simply no telling what energy prices will do in the short term. Even if oil prices take a huge dip, many producers have the balance sheets needed to weather the storm. Sure, companies like Oxy are taking on a lot of debt and banking on at least decent oil prices.
But in the case of Exxon, Chevron, and ConocoPhillips, these companies can still fund growth plans even if oil prices fall, and pause buybacks and pull back on spending if prices collapse. Moreover, these three companies sport excellent balance sheets, with total net long-term debt positions and debt-to-capital leverage ratios near 10-year lows.
CVX Debt To Capital (Quarterly) data by YCharts
In short, the balance sheets and the cost profiles of many top producers should allow these companies to thrive even if oil prices stay the same or fall to an extent. While the industry as a whole should rake in the cash if oil prices rebound to levels they were at just a few months ago (in the $80 to $90 WTI range).
What about midstream and downstream?
Although the integrated majors and upstream producers make up the majority of the energy sector, there's still the transportation and storage (midstream) and refining and marketing (downstream) segments to consider.
Many midstream companies feature slow growth but pay high dividends thanks to the reliability that comes from long-term contracts. These contracts, many of which are take-or-pay (paid no matter what) or fee-based (locked-in prices) limit exposure to oil and gas prices. Many companies want to avoid over-expanding or building infrastructure that won't be needed as the energy transition accelerates in the years to come. Overall, the midstream industry is a good value with manageable debt and attractive dividends.
Downstream leaders like Valero, Marathon Petroleum, and Phillips 66 also have inexpensive valuations. Despite excellent results, many downstream stocks have sold off over the last few months. Renewable energy is having a major impact on power generation. And electric vehicles have certainly pierced the passenger vehicle market. But refining crude oil into useful sources is an essential process that underpins modern society and the transportation industry.
How to think about 2024
The Energy Select Sector SPDR Fund (XLE -0.92%), which tracks the performance of the broader energy sector, has a yield of 3.6% and a price to earnings ratio of just 7.5. Granted, these earnings are based on the last 12 months, which featured higher oil prices. But still, the sector is cheap and does a good job of unlocking income and value from the integrated majors, conservative producers, the midstream industry, and the downstream industry, which also balances out the high risk and volatility that comes with more aggressive and smaller producers.
The sector stands out as a haven for value and passive income, as well as strong earnings results, even if oil and gas prices stay the same or modestly decline.
