Carolyn Bigda: Welcome to this special series of Research in Action, where we provide a quick take on the outlook for the major economic sectors and related investment opportunities in 2024. We’re your hosts, Carolyn Bigda…

Matt Peron: … and I’m Matt Peron, Director of Research.

Bigda: And in this episode, we’re joined by Research Analyst Josh Cummings, who heads the Consumer Sector Team. Josh, welcome to the podcast.

Josh Cummings: Thanks for having me.

Carolyn Bigda: Welcome to this special series of Research in Action, where we provide a quick take on the outlook for the major economic sectors and related investment opportunities for 2024. We’re your hosts, Carolyn Bigda…

Matt Peron: …and I’m Matt Peron, Director of Research.

Bigda: And in this episode Research Analyst Noah Barrett, who leads our Energy Sector Team, offers his views on what’s next for fossil fuels, electricity, and renewables. Welcome to the podcast, Noah.

Noah Barrett: Thanks for having me.

Bigda: If we start with oil prices, Noah, 2023 was a tale of two halves. Prices declined in the first part of the year and then rose in the second half. Do you think we could continue to see price increases in 2024? And will that be necessary for oil and gas companies to continue delivering positive returns, as they did in 2023?

Barrett: As you noted, oil prices were weak in the first half, rebounded in the second half. I think at the end of September, we saw a high of around $96 a barrel oil. Prices have pulled back since then. I guess we’re down about 15% from the highs of the year, but still at what I would consider healthy levels.

When we look into 2024, I think there’s a lot of moving pieces that are going to tie into the oil price. And if we think about on the demand side, I would say demand feels okay right now. And I know that’s a generic term and it feels a little flaky, but when I say demand feels okay, if we look at the leading fundamentals and the economic indicators, we don’t really see demand falling off a cliff. I’m not quite in the bullish camp of OPEC [Organization of the Petroleum Exporting Countries], where they see demand increasing by two million barrels/day, year-over-year in 2024. But I think we will see oil demand growth north of a million barrels/day next year, which is a pretty healthy level, all things considered.

Bigda: And what are those indicators that you look at to measure demand or forecast demand?

Barrett: Sure, we look at a lot of different data. China, of course; emerging markets tends to be an area of focus. We look at a lot of high-frequency mobility data trying to track how transportation trends are going, whether or not people are moving. Overall economic strength of developing economies because that is really the main driver of oil demand growth. In developed markets, oil demand tends to be flat to even slightly declining in some areas.

Bigda: And on the supply side, we’ve heard about production cuts in 2023. What are we seeing for supply in 2024?

Bigda: On the supply side, I’d say there’s three areas that I’m really looking at. And the first is OPEC and what they do there. And if we say, looking into 2024, that we’re going to have non- OPEC oil supply growth of roughly 1.5 million barrels/day, and, say, we see demand growth of

1.5 million barrels/day, that would indicate that the market from today’s levels is fairly balanced. And OPEC policy is going to be really interesting to watch. Whether or not they decide to take additional supply off the market to help support oil prices or if they get concerned about market share and they actually bring some spare capacity back into the market, which would certainly be a headwind if the demand isn’t there to meet it.

The second thing on supply that we’re watching closely is Russia. To date, the embargoes and the price caps really haven’t been that effective. Russian supply continues to find a home in the market, often at prices above the price cap. But I continue to think over a longer-term period, if our prior baseline was that Russian supply was going to be flat to slightly growing through the end of the decade, I think now it’s flat to slightly declining through the end of the decade. And slightly declining doesn’t sound that bad. But when you’re the third-largest producer in the world and you’re declining at 1%, those barrels really add up.

And then the last thing I think we’re focused on is the rest of the world, non-OPEC supply primarily coming from the U.S., but other areas around the world – Guyana, Brazil, and Canada. Their supply is actually fairly easy to model. You know what projects are coming on and the cadence at which they come online.

U.S. supply growth tends to be the biggest swing factor. And I think here, there’s an interesting dynamic where the U.S. rig count has declined steadily over the course of the year, but U.S. production is actually flat to slightly higher over the course of the year. And I think that’s just a reflection that companies continue to get more efficient. They see more productivity, efficiencies, and gains, things like drilling longer laterals. One rig is either drilling more wells per year or it’s just attacking more surface, I guess. For each well that’s drilled, it’s tackling a bigger part of the reservoir. And those dynamics are explainable. But I do think that U.S. production growth, we could see some downside surprise there, so less production maybe than consensus is expecting in 2024.

Peron: And that’s a really interesting point, if I could pick up on that, because I think you’ve got very interesting longer term…looking now beyond 2024, how do you look at the supply picture then? Just given those decline rates that you say might be coming, how does that set us up for the long term? Are we in an energy super-cycle like some people say?

Barrett: I would probably pump the brakes a little bit on the super-cycle word. But I do think we’re either investing at a rate that’s just enough to balance global markets or investing at a rate at the industry level that’s not sufficient to provide enough supply for the markets. I do think over time, if you look at even outside of Russia, other emerging markets that have seen some oil production growth, they’re just not investing enough in the reservoirs to keep that supply coming.

We will need continued supply from areas like the U.S., Canada, Brazil, Guyana, and the North Sea. But right now, I would err on the side of a supply shortfall rather than an excess of supply if we look out over that medium to longer term.

Bigda: Another big component of the energy sector is electricity, utilities. And that’s been a pretty interesting area over the last 12 months, right Matt?

Peron: It certainly has been. By interesting, you mean going into freefall or decline?

Bigda: Yes.

Peron: I think that’s right. Let’s talk utilities.

Barrett: Utilities, I think there’s three things, I guess, that are weighing on the group. If we think about this concept of utilities as a bond proxy, and their…utilities’ earnings and cash flows are very predictable. They pay very steady dividends. And income folks, investors will often look at a utility in comparison to a bond and decide, where is the yield higher? If we look back a couple years ago, when rates were very low, utilities looked great compared to bonds. That’s totally flipped on its head. And now for an investment-grade bond, you might be getting a yield in the mid-single digits, where a utility still has a dividend around 3%, maybe 3.5%. From that concept, for the income-focused investor, maybe less of a focus on utilities and more in favor of fixed income.

The other thing to consider there is just the utility business model, effectively. And when rates move higher, your cost of capital goes up. Utilities, by definition, are regulated entities. And as your cost of capital is going up, your return on capital isn’t moving. And that spread is getting compressed. That’s not really a problem over the longer term because utilities can pass through these higher costs to customers. They go through what they call a rate case, and they work with a regulator and they try and push their allowed returns higher over time. But in the near term there’s a mismatch, and effectively, your cost of capital is getting more expensive but your return on capital is static. And that’s been another headwind for the sector.

And then the last one I would say, too, is the types of investments, as regulated utilities have switched or pivoted and put more of their capital towards renewables projects. These projects are particularly rate sensitive. And for a renewable generation project, typically there’s a large upfront cost and then you have this long tail of cash flows. Not almost dissimilar to tech, where a lot of the value in the investment is predicated on this long tail of cash flows that aren’t going to come for a very long time in the future. And when rates move higher quickly, your returns get compressed. And that’s been the third factor that’s really weighed on the utility group, is a lot of the investments they’re making today don’t look great in a high-rate environment.

Bigda: Let’s say if the Federal Reserve comes to the end of its tightening cycle and they actually start to cut rates, is that a significant tailwind? Is that a game changer, essentially, for the industry?

Barrett: It would certainly be helpful. And I think any idea that rates are stabilizing or potentially coming down, that certainly would be a tailwind for the utility sector. I do think, though, that rates – even if they pull back 50 basis points or 100 basis points – we’re likely not going back to the zero-rate environment, the free money environment that we saw not too long ago. And I think utilities still might struggle. And even if rates pull back a little bit, again, versus bonds or other fixed-income opportunities, utilities may still struggle.

Bigda: You mentioned renewables, and this is a question that I really wanted to get to you. Because in a note that you wrote last year, you said, “It’s clear that oil demand is more resilient than previously thought. And the energy transition away from fossil fuels, while still happening, is going to take a lot longer than previously expected.” What do you mean by that? And how might that impact the outlook for renewables and their stocks in the coming year?

Barrett: Big question. When I say it’s going to take a lot longer than expected, I think what most people miss – both companies, but policymakers – is the scope and the scale of the energy transition. And if we just think about oil, we use 100 million barrels of oil a day. And to think that we can just displace that with other forms of energy in a short amount of time is really not possible. And it’s not just transportation fuel. It’s not just people trading in their ICE [internal combustion engine] vehicle for an EV [electric vehicle]. We use a lot of oil for petrochemicals. In certain parts of the world, we use it for power generation as well. And in the context of a global energy system, this idea that we’re just going to get off of oil in five years, 10 years completely, I think is a little bit misguided.

Another issue is that global population continues to move higher. And if you look at correlations, generally, as countries grow, as populations grow, they tend to use more oil in their daily lives.

And we’re already moving pretty fast. We’re trying to move pretty quickly on this energy transition. But every year, if oil demand is chugging along and growing at one million barrels/day, that’s just more oil we need to displace. That’s where this concept of, it’s really, really hard. And it doesn’t mean that we’re not going to spend money and try and get there and try and look for alternative forms of energy. It’s just that I think people are starting to realize that it’s going to take a lot longer than we thought.

Peron: The risks and opportunities: We talked about the risks with utilities. Talked about the opportunity. Let me characterize it as moderate opportunity on the energy side and [?] all set to grind higher. No, super-cycle. Don’t get carried away. I know you’ve talked about natural gas as an opportunity. Is that one that you still are positive about or any other opportunities in the sector?

Barrett: Yes. I guess maybe starting with the risks, I think, global oil demand, if we go into a global recession, certainly that wouldn’t be good for oil demand and wouldn’t be good for oil prices and the energy equities. That’s something to think about.

I think on the supply side, if we did see a meaningful amount of supply come back into the market that we weren’t expecting, if OPEC decided to go for a market share policy and brought all the spare capacity back into the market, that would certainly be a negative.

I don’t think U.S. companies…I think the discipline that we’ve seen on capital and companies sticking to a low, single-digit production growth rate target, I don’t see that changing. But if we did see any wavering on that front, that could be a negative as well.

On the opportunity side, I think that the total return value proposition with energy, even in a static price deck, is pretty attractive. And if you look at a lot of upstream companies, E&Ps [exploration and production] or integrated oil companies, just on a flattish price deck, we’re looking at double- digit free-cash-flow yields.

And I think, importantly, shareholders participate in that cash-flow generation – that cash-flow stream via dividends, base dividends, variable dividends, share repurchases. And you don’t need to believe in $100 oil to get a really nice total return proposition by investing in conventional energy.

You mentioned [natural] gas, too. I think global gas is really interesting. I don’t think we’ll see necessarily the price spikes that we saw last winter, particularly in Europe and in Asia. But we will see continued volatility, and companies that have large gas trading operations or are in the business of LNG [liquified natural gas] and have the flexibility to move those cargoes around and exploit price differentials, I think those are also really interesting opportunities within energy.

Bigda: It sounds like potential strength ahead for the energy sector. Noah, thanks so much for joining us today. We really appreciate it.

Barrett: Thanks for having me.

Peron: Thanks, Noah.

Correlation measures the degree to which two variables move in relation to each other. A value of 1.0 implies movement in parallel, -1.0 implies movement in opposite directions, and 0.0 implies no relationship.

Basis point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.

Free cash flow (FCF) yield is a financial ratio that measures how much cash flow a company has in case of its liquidation or other obligations by comparing the free cash flow per share with the market price per share and indicates the level of cash flow the company will earn against its share market value.