Holly Black: Welcome to Morningstar. I'm Holly Black. With me is Allen Good. He is an equity analyst at Morningstar. Hello.
Allen Good: Hi, how are you?
Black: So, Allen, you are focused on the oil sector and it was just over a year ago that we were all surprised when the oil price went negative. And that's obviously a big deal for oil companies. So, how have they coped since then?
Good: Yeah. I mean the negative oil price was a bit of a technicality around storage issues and expiring contracts. But I mean, I think the broader issue is that, yeah, oil prices did crash last year, an issue when the pandemic hit, and you had basically a global lockdown. However, since then they have mustered a steady recovery and now oil prices are nearly back at or above January 2019 levels. So, really, the market has come around and fully recovered at least as the price goes.
What you saw over the last year though was what all companies typically do when oil prices crash, or you have a down cycle, which is to certainly reduce costs, lay people off, postpone or cancel projects. And in some cases, we saw major oil companies actually cut the dividend, which is actually something quite a bit different than what we had seen in previous crisis.
Black: So, the world is slowly but surely starting to return to normal. What does that mean for the oil price and these companies? What are the opportunities and risks?
Good: So, as I mentioned, oil prices have already begun to recover. We are at levels that we saw in early 2020 before the pandemic hit, but we think prices can actually move higher from here. We do expect demand to recover to pre-pandemic levels and grow from there given nothing structurally has changed around oil demand. So, we think in the near term, you could have a situation where demand growth far outpaces supply, and that certainly could push prices much higher from where we are at today. Over the long term, however, we still think that oil prices will average around somewhere around $60 per barrel, which is the marginal cost of production.
So, these oil companies, it really depends, because we have seen several companies such as BP and Shell move more towards investing in low carbon solutions or renewables (just sort of) from 15% to 20% of their budgets. So, certainly, going forward, oil prices are going to be less important for their businesses. However, that said, in the near term, oil prices still ultimately dictate the underlying financial health and cash flow for oil and gas companies.
Black: So, with all that in mind, what are your top stock picks in this sector?
Good: If you look at the strategies, if you look at what I just previously mentioned around near-term oil and gas demand, even long-term oil demand doesn't seem to be going away anytime soon. So, we think that investments in oil and gas continue to make sense, despite some of the headlines you've seen around sustainability and carbon, et cetera. And so, you combine that with where we think is valuation, we think Exxon (XOM) stands out. Exxon has made some overtures to investors around capital discipline, about introducing carbon reduction targets, about diverting some investment towards low-carbon solutions, particularly carbon capture. You combine all of that with the valuation, which makes sense given that what we think around a recovering oil and gas price and at about 20% discount to our fair value it opens up a lot of opportunity we think for investors not to mention the strong cash yield.
Chevron (CVX) is another example. The valuation is less attractive, but we do think it's a good play on recovering oil prices. It was another firm that didn't cut its dividend. So, it has an attractive yield. If you are looking for a firm that has more of a mix of low carbon along with oil and gas along with an attractive cash return to shareholders, I'd recommend Total (TOT). It trades at about 15% discount to our fair value estimate, very strong balance sheet, didn't cut its dividends, which yields relatively high and it has a good mix of investment in oil and gas as well as renewables. So, I would highlight those three companies as providing attractive valuation, an attractive capital allocation plan along with a highly attractive dividend yield or cash return to shareholders.
Black: Fantastic. Allen, thank you so much for your time. For Morningstar, I'm Holly Black.
