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Oil and The Trans Generation

“Few industries sing the praises of free enterprise more loudly than the oil industry. Yet few industries rely so heavily on special government favors.” - Milton Friedman


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The Future of Energy

The oil industry knows better than anyone that oil is not their future.  Every oil and gas company has been positioning itself for the eventual shift from the production of fossil fuels to a new energy future. 


I’ll pause for a second until the laughing subsides.

In case you haven’t been paying attention, the whole world is shifting from fossil fuels to sustainable energy.  Whatever you think the reasons are really isn’t important.  Think what you like; the fact is, this is happening.

I always think it’s important to understand the history of every situation, for those who ignore history are destined not to invest in it.


We Are The Trans Generation

The energy transition started long before the Teslarati took over our highways, and the climate change debate became the primary way to divide people politically.  The climate change debate started in the 1970s, long before many Tesla owners were born.  And let’s not forget that we’ve done all this before.  Humans shifted from burning



biomass, to whale oil, to coal gas, burning fluids and, eventually, kerosene and petroleum oil.  By 1850, whale oil production had peaked at 12 million gallons.  By 1860, production was less than 6 million gallons; the whale oil industry was effectively dead.  The need for whale oil was so abysmal that Abraham Lincoln had a fleet of 38 whaling ships towed to the mouth of Charleston Harbor, loaded with rock, and sunk to create a blockade known as “The Stone Fleet.”  The Industrial Revolution needed significantly more energy at cheaper prices, so the energy industry shifted to coal and to coal+steam.  Oil production surged as more uses increased demand but also due to government intervention.  Congress issued a hefty $2.10 per gallon tax on alcohol distilling that didn’t exclude industrial alcohol that was widely in use at the time.  This tax provided an opportunity for the oil industry to take market leadership, and the industrial alcohol industry went the way of the whale oil industry.    


Today, renewables are replacing everything in a transition that arguably began centuries ago. 

 

Why?

The reasons to shift away from oil and gas vary depending on who you talk to. One group is advocating to save the environment and reduce pollution and climate change.  Another group is advocating to stop fighting wars over oil.  Talk to EV owners, and they’ll tell you how much they love the performance and quiet of their cars.  Ask the makers of solar panels, inverts, wind turbines, and hydrogen cells; they all have a sector growth story.  All of this and more own the headlines, and in some cases, the hearts, and minds of the public.


But one group’s view gets little attention, except for negative attention, and it’s a view I’d like to look at today to understand where we’re going next and how all of this impacts our portfolio.  I’m speaking of the oil industry executives, the people in charge of making decisions that require years, even decades, to execute.  I struggle to find other examples of management who must make such large investments, gambles even, with incomplete information to deliver shareholder returns over exceptionally long periods.  In some cases, these executives must direct their company to invent or acquire new technologies to explore an area in hopes they might discover an oil deposit large enough to make their investment pay off in some future year.  Don’t get me wrong, these people aren’t my heroes; there are plenty of reasons to have disdain for oil industry executives.  Pick your own reasons, but I’ll reiterate the obvious: what you think about oil industry executives is not material to the decisions being made.


From right, Lamar McKay of BP, Marvin E. Odum of Shell, James J. Mulva of ConocoPhillips, John S. Watson of Chevron, and Rex W. Tillerson of Exxon Mobil. Oil Industry CEOs testify in congressional hearing, break ranks and try to explain how they are different from BP


What’s Happening Now

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The oil and gas industry is approaching peak oil, the day when oil production ceases to continue growing, and the revenues of oil companies will come from sources other than barrels per day of production.  In 2018, the United States took the lead as the world’s largest oil producer because of the implementation of hydraulic fracturing.  Even though the U.S. ranks 8th in oil reserves underground, we continue to outproduce Saudi Arabia and Russia.  The largest oil reserves are in Venezuela, a country that will eventually fall completely to the majors in return for financial concessions to rebuild and support a failed economy.


The oil industry has no plans to go the way of the whale oil industry. Rather, they will continue to consolidate into a few behemoths, unabated by governments who fully understand the implications and the need to facilitate this transition. At the same time the oil companies are investing massive sums into new market opportunities.  Their next life. In my lifetime, I will likely see EVs charging at Chevron charging stations that receive their power generation from Chevron solar, wind, wave motion, or other renewable resources.  Carbon expelled into the atmosphere will be captured by Exxon’s carbon sequestration plants.  All this and more is already in motion and will direct my next investment in the portfolio.


The need to consolidate is all about the limited amount of productive land and sea that can produce the volume of oil needed to remain profitable and deliver shareholder returns until the current energy transition is complete and the new energy era takes the leadership position.  The race today is to acquire Permian Basin oil in the U.S., with one exception: Chevron acquiring Hess was specifically to get the massive oil reserves recently discovered in Guyana.


The timeline of consolidation began in the 1980s.  Here are just a few big ones and the current race for the last drop.  This is literally a race to the bottom of the barrel.


1984 Standard Oil of California and Gulf Oil become Chevron.

1984 Texaco merges with Getty Oil.

1987 British Petroleum buys Standard Oil.

1998 British Petroleum buys Amoco for $55 billion.

1999 TotalFina and Elf merge in a deal worth 52.6 billion Euros.

1999 Exxon bought Mobil for $82 billion and became the world’s largest oil company.

2000 BP/Amoco buys Atlantic Richfield (ARCO) for $27 billion.

2001 Chevron buys Texaco for $39.5 billion.

2002 Conoco and Phillips completed an $18 billion merger to become ConocPhillips.

2005 ConocoPhillips bought Burlington Resources for $35.6 billion.

2023 Exxon and Pioneer Natural Resources announced a $59.5 billion merger.

2023 Occidental Petroleum bought CrownRock for $12 billion.

2023 Chevron bought Hess for $53 billion.

2024 Diamondback Energy is buying Endeavor Energy for $26 billion.


Here’s how the players in the U.S. Permian Basin fall out after these mega-mergers and who is still left standing alone, for now.

Company

Projected Thousands of barrels per day

% Oil

ExxonMobil + Pioneer

1,380

52%

Chevron

866

46%

Diamondback + Endeavor

820

57%

Occidental + CrownRock

813

48%

ConocoPhillips

750

57%

EOG

650

47%

Devon

446

48%

Permian Resources

334

48%

Apache + Callon

326

46%

Coterra

258

38%

As investors, we must consider the premiums paid to acquire resources in the Permian Basin, who we own now, and who we might want to own.  I don’t recommend buying a company because you think it might get bought out, but a buyout can certainly be a part of an investment thesis, especially when it’s obvious that the biggest players are gobbling up everyone around them.  Let’s look at publicly traded oil companies that might be in the sights of their larger brethren.

Company

Market Capitalization (as of 2/14/24)

EOG Resources (EOG)

$64.735 B

Devon Energy (DVN)

$26.807 B

Coterra (CTRA)

$17.985 B

Marathon Oil (MRO)

$13.104 B

Ovintiv (OVV)

$11.520 B

Permian Resources (PR)

$10.835 B

Civitas (CIVI)

$6.256 B

Vital Energy (VTLE)

$1.594 B

 

Coterra Energy (CTRA)

You’ll notice in the two tables above that Coterra Energy is the smallest producer but has the third-highest market capitalization.  Also, note that only 38% of the production is oil; the rest is natural gas and natural gas liquids.  Most of Coterra’s production is dry natural gas from the Marcellus Shale in Pennsylvania.  The company controls about 307,000 acres of oil-producing land in the Permian Basin and another 182,000 acres in the Anadarko Basin in Oklahoma. 


I’ve long thought that Coterra is a mispriced company that has yet to receive the investor attention I think the company deserves.  Maybe now, with consolidation in the Permian Basin looking like the Oklahoma Land Rush, we might see some appreciation for our shares.  I’ve been slow to do more than dabble in Coterra, with the portfolio holding a mere 25 shares.  Maybe consolidation is the catalyst I've been waiting for.


Coterra Energy trades at 8.33 times trailing earnings but has a forward P/E of nearly 11 times forward earnings.  That’s not a metric I love.  I want to see the forward P/E lower than the trailing P/E, which is an indication that earnings are growing.  But a deeper look can sometimes pay off. 


ROE: Looking at Coterra’s Return On Equity (ROE), a key measure of how efficiently management is using capital, I find a reasonable ROE of 17.67%.  It's not stunning, but it's still a good number.  The ROE forces me to ask more questions.  Why?  Because the stakes are high for any company that has resources in the Permian Basin. 


WACC vs ROIC: the first question is, if I give the company money, will they produce a return?  A quick look at the weighted average cost of capital (WACC%) and the Return on invested capital (ROIC%) tells me a lot.  Coterra’s WACC is 5.97%, and their ROIC is 12.19%, so basically, for every dollar they get, they double it. 


Gross Margin:  Coterra has a respectable Gross Margin of 52.9%, and they manage to hold onto a Net Margin of 33.97%.  This company is efficient.

 

So why is everyone so down on Coterra?  The company appears to be a winner, and as I’ll illustrate, it deserves a higher stock price to reach fair value.


Earnings: During the past 12 months, Coterra Energy's average EPS Growth Rate was negative, delivering a disappointing -42.50%.  That one negative year scared everyone off from what had been a stellar run for the past 5-years.  During the past 3-years, the average EPS Growth Rate was 46.40% per year.  During the past 5-years, the average EPS Growth Rate was 32.10% per year. 


Revenues: Over the last 3-years Coterra’s revenues have grown at a healthy 31.8%, contributing to the 43.9% growth in Free Cash Flow rate over the same period.


DCF: Discounted cash flow analysis is a way to bring future cash flows forward to see what the stock should be worth today.  I’ve experimented with different discount rates; I’m going with 11% and a 10-yer terminal value.  I’ve also approached the DCF analysis from earnings per share, free cash flow, and adjusted dividends. All three approaches give me a fair value of $81 to $90 per share.  I prefer the adjusted dividends approach for Coterra, which gives a $81.25 per share price.  With the stock currently trading around $23.86, we have a margin of safety of 70.63%. That's a bet I'll take.


Dividends: Many investors who buy into oil stocks do so for the dividend.  During the past 12 months, Coterra’s average Dividends Per Share Growth Rate was -21.80% per year.  During the past 3-years, the average Dividends Per Share Growth Rate was 92.30% per year. 


I think we found the culprit that has driven investor enthusiasm down.  Coterra has paid a dividend for at least 10 years, and the growth in the dividend has been good.  However, over the last 12 months, the company has lowered its payout ratio, which means it must be investing that excess capital back into the business.  The ROE isn’t expected to change, though analysts expect the company's earnings growth to slow. The low share price is a result of dividend investors bailing out on their money printing machine and slower earning growth keeping growth investors at arms length.


Conclusion

I think Coterra’s management has decided to beef up the company and improve efficiencies as quickly as they can before the music stops, and they become the only oil company in the Permian without a chair. 

They’re doing this in spite of the fact that they are losing reliable dividend investors.  Coterra could easily be broken up into its oil and natural gas businesses just based on geography alone, but given the size of the company, a major might buy the whole company.  Either way, the stock deserves a premium in a buyout, and any buyer will quickly come to the same conclusion: Coterra is a bargain, up to fair value for the stock.  I plan to take a larger stake in Coterra to lower our cost basis and possibly score a nice win when the company is bought by a larger oil company.  I think it’s a matter of when, not if, Coterra is bought.


ACTION

BUY CTRA

I don't have a BUY size in mind yet. Coterra reports earnings on February 22, 2024. I'm expecting the stock will dip a little on or right after the earnings call. I plan to by some before the earnings call and the rest after. I'm looking to get a little better bargain. If the call goes well and the stock rallies, I'll have to pay up and fill my position. My intent to get a full positon in the portfolio. If the stock takes a big hit I'll consider going overweight and load up on shares. I may be sitting on this position for a long time, but at these prices and in this market it seems like the risk/reward is in our favor.

 




"Markets don't go to zero; portfolios do.

Buy quality, be patient...and look twice for motorcycles."

- Clay Baker

Stay Invested,

Clay Baker

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Clay's Rules

Rule #1: Don't lose money

Rule #2: See Rule #1

Rule #3: Portfolios go to zero, markets don't; Stay Invested

Rule #4: When good stocks you own drop 10% below your cost basis, add shares

Rule #5: Bull markets aren't sustained without the Transports

Rule #6: When Forward P/E is lower than TTM P/E, expect earnings to increase

Rule #7: When an investment bank sells below book value, buy it

Rule #8: Tips are for waiters. Do your own homework.

Rule #9: Don't sell a stock because you're bored with it. Do your homework.

RULE #10: Don't expect a company's stock to perform according to your timeline; be patient.

Rule #11: Investing is easy. Waiting is hard; waiting is the hardest part.

Rule #12: It's hard to be incredibly intelligent. Not being stupid is pretty easy.

Disclosure: I am personally invested long in some or all of these stocks or funds that appear in the Stay Invested portfolio and may purchase or sell shares within the next 72 hours. I am also invested in other stocks and funds that do not appear in the Stay Invested portfolio but may be mentioned or related to this article. It is not my intention to advise or encourage the purchase or sale of any security. I am invested long in these securities mentioned in this post:

None mentioned

I am invested short in these securities mentioned in this post:

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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. This article is not intended to offer investing advice, guarantee 100% accurate predictions, or be interpreted as providing a personal recommendation. This and all articles on this website are provided for entertainment purposes only. Investing involves risk and risk of loss of part or all of your capital. Invest wisely, make your own decisions, seek advice from multiple sources.

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