Morningstar - Q1 2021 - 68

Investors

a result, it has a much leaner capital base and is
better positioned to generate strong returns.

Four for the Future These energy stocks are well positioned for a recovery.
Company

It's also able to grow its production from zero
to 5% annually while investing no more
than 65% to 75% of its operating cash flows in new
drilling. That leaves it with 25% to 35% of
its cash flows that could be used to improve the
balance sheet, although it already has an
exceptional balance sheet. The other potential
use is the return of cash to shareholders.
Pioneer already has a base dividend. They're
planning to initiate a variable dividend beginning
in 2022. I suspect that will become a trend
for shale companies, but Pioneer was the first to
announce it. I think that capital discipline
and prioritizing returns to shareholders will be
the priority for the firm.

Price ($)

Fair Value ($)

Price/Fair Value

Enbridge ENB

31.99

43.00

0.74

QQQQ

ExxonMobil XOM

41.22

72.00

0.56

QQQQQ

113.89

159.00

0.72

QQQQ

21.83

48.00

0.45

QQQQQ

Pioneer Natural Resources PXD
Schlumberger SLB
Source: Morningstar Direct. Data as of 12/31/2020.

Lallos: Enbridge ENB has a very nice dividend yield.
Is it a good investment?

Meats: Enbridge is a wide-moat company with
lots of upside at the current price. Its 7.5% dividend
yield speaks to that strategy of underlining
to investors that an energy investment is a reliable
income source.

Lallos: What is the future for these companies?

Meats: When I think about oil producers
today facing the existential threat of long-term
decline in demand, I also think of tobacco
companies after the 1998 master settlement
agreement in the United States. They'd
acknowledged the social cost of their activity, but
there was still substantial demand for the product.
The investment case for those companies was
anchored on their ability to sustainably pay their
dividends. If you look at stocks like Altria MO,
British American Tobacco BTI, and Reynolds from
the late 1990s until as recently as 2015 or so, you'll
see that they dramatically outperformed the
market just by focusing on capital discipline and
prioritizing returning cash to shareholders.

Oil companies, now facing a similar secular decline
in demand, should follow a similar strategy of
prioritizing capital efficiency and demonstrating to
shareholders that there is an impregnable dividend.
Energy investors aren't going to be hanging
their hats on indefinite production and revenue
growth, given that global supply growth is finite.
This industry, particularly in the U.S., has a
horrible reputation for outspending cash flows and
destroying value, particularly in the 2010 to 2015
period at the beginning of the shale boom. But
a lot of these companies have turned a corner. It's
no longer enough to focus on living within cash
flows. Now the mantra is capping the reinvestment
rate and prioritizing returns to shareholders.

68

Morningstar Q1 2021

Morningstar Rating

We think the market underappreciates the
long-term cash flows from the Enbridge Mainline
project, a Canadian egress pipeline. There are
competing projects vying for approval in Canada,
and that is probably the main threat. But even if all
these pipelines are built, we think there would be
enough demand due to the growth of output
from the Canadian oil sands, given our forecast for
higher crude prices. Cenovus Energy CVE is a
good example of a company there that's pioneering
advancements in extraction technology. They
will need to ship that crude to market, and
Enbridge is well positioned to connect oil sands
producers with the U.S. market.
Enbridge is a strong opportunity within the
Canadian oil and gas space. That would probably
be our top pick overall. Within the U.S. energy
space, we'd pick Pioneer. The best oil-services
company would be Schlumberger. The top
integrated oil would be Exxon.
Lallos: What risks should energy investors be prepared

to ride out?

Meats: There is some regulatory risk, but
we think that's overblown. There is concern that
President-elect Joe Biden will overregulate
the energy industry, such as by banning fracking.
Would a fracking ban have a huge effect?
Absolutely. It would have a huge negative impact
on the economy through job losses and reductions

in GDP and higher gasoline prices. But is a ban
likely? Absolutely not.
Fracking is regulated at the state level, and the
executive branch has no mechanism to sustainably
implement a full ban. Even many Democratic
senators wouldn't support that kind of bill because
of the economic catastrophe it would create.
Biden's approach is more pragmatic. He suggested
banning new drilling on federal land, which
he can do by executive order. But only about 10%
of shale wells are currently on federal land.
The remainder are on private land, most notably in
Texas and North Dakota, states that are extremely
friendly to the oil and gas industry. Only a
handful of companies have a disproportionate
exposure to federal land, and none of those are
companies that we talked about today.
The bigger issue is the timing of the recovery
from the pandemic. Energy stocks are priced as
though we will never recover. Morningstar doesn't
think that's the case. By the end of 2021, we
expect the intensity of oil consumption to be close
to where it was before the pandemic began. Of
course, forecasting the end of the pandemic is
fraught with uncertainty, and the longer this goes
on, the worse it is for the energy industry.
Because of that uncertainty, I think the most
important thing for energy investors to prioritize at
this time is the balance sheet. All energy
stocks have been so badly beaten down that
everything is cheap. But if the downturn
lasts longer than we expect, which of these
companies will make it through and participate
in the eventual recovery? K
Laura Lallos is managing editor of Morningstar magazine.
Morningstar - Q1 2021

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