Morningstar - Q1 2021 - 67

that. We don't expect meaningful declines in the
next decade. There's a lot of running room
there for the oil industry to generate some cash
flows and pay dividends and generate value.
Lallos: Looking to the longer term, what are
the integrated oil companies doing to improve their
environmental, social, and governance profiles?

Meats: Probably the best example is BP BP,
which has gone on record recently with a fairly
aggressive climate-oriented program. They
intend to transition their business so it's not just
about producing oil as responsibly and
cleanly as possible. It's also about offsetting the
emissions from oil production with things
like carbon capture and investing in renewables
to ultimately progress toward being a netzero-emitting company.

Total TOT and ExxonMobil XOM and a lot of the
major companies are also moving in that direction.
Some are more focused on carbon capture,
some on transitioning from producing oil to natural
gas, which is still a fossil fuel but potentially
cleaner than oil. There are renewables in various
forms, and cleaning up the oil and gas operations
is also a priority, to the extent that's possible.
Most of the integrated firms are using one or more
of those strategies. But for the next few years,
crude oil and fossil fuels will be the dominant
business line. And, despite their best efforts, it will
take many years for them to achieve the goal
of zero emissions, as well.

In the absence of that storage technology,
fossil fuel power is effectively acting as
a backup fuel. Historically, this has been coal.
More recently, natural gas is the preferred source.
It's cheaper and cleaner. Also, it's faster
to turn a natural gas power plant on and bring
extra energy to the mix. The recent blackouts
in California, which does prioritize renewables,
are pretty good evidence that renewables
only have so much capacity. Fossil fuels need
to stay in that mix until storage technology
improves to the point where a backup
fuel is no longer necessary, and we're not
near that point.
Lallos: You've written that when demand for energy
does recover, there will be a shortage. Why is that?

Meats: Globally, the swing producer for
crude oil is the United States. When demand
increases, a large portion of the incremental
demand will need to be met by U.S. shale
producers, who are best positioned to bring
surplus onto the market quickly. We estimate that
to keep global oil supply and demand in balance
over the next few years, the Goldilocks level
for U.S. shale producers for activity, in terms of the
number of rigs that those companies are
operating, is about 600 rigs. There are fewer than
200 rigs in service today. The U.S. rig count
has collapsed over the course of 2020 in response
to the pandemic and the decline in prices.

Zero emissions for an oil company is a bit of a
misnomer. Drilling for oil involves emitting
greenhouse gases into the atmosphere, but most
of the emissions come at the point when the
end user is driving around using gasoline in their
car, and that, of course, is beyond the control
of the integrated companies. Ultimately, you can't
make oil a clean fuel.

If there is a recovery, as we expect, beginning
at some point in 2021, then producers will
need to accelerate their operations. To do that,
they'll need a pricing incentive. With the futures
strip for oil signaling $40, the market's
extrapolating current prices to infinity. That doesn't
make any sense because the marginal cost
for shale producers is about $55 a barrel. That's
why we think what's currently a glut will become
a shortage in the next couple of years.

That's where renewables come in, and that's
where I think governments will focus.
But it's important to bear in mind that renewables
are highly intermittent. Solar power only
works when it's sunny, and wind power only
works when it's windy. Right now, we
don't have a good storage solution to offset that
intermittency problem.

Meats: The majors are a good option because
they have very strong balance sheets and
the ability to tolerate a longer period of weaker
prices if necessary. Investors looking to play
the recovery in crude prices won't take on too
much idiosyncratic risk or lose sleep at
night over whether the company will remain

Lallos: What companies are the most attractive today?

a going concern long enough to ultimately benefit
from higher prices.
We like Exxon. Its strategy of protecting
its dividend makes sense. Exxon is leaning on the
balance sheet here, but by doing so, it's putting
a stake in the ground and saying its dividend
is sacrosanct and its value proposition for investors
is sustainable return of capital.
Then you have the oil-services companies.
Here, we like Schlumberger SLB. A change in
crude prices will influence the ability of
upstream producers to drill more and spend more
capital, and that capital spending will go to
the services companies. But oil services in the U.S.
is extremely competitive because crude
wells are essentially commoditized. It's very
difficult for services companies to defend
their margins and keep those businesses profitable
because there's really no barrier to entry.
Internationally, though, the opportunity is
strong for oil-services companies because crude
projects tend to be large, highly complex,
unique operations. New offshore drilling platforms
like the Campos and Santos basins in Brazil, for
example, require custom solutions. Outside of
the U.S., investments in developing new reserves
have been well below what's necessary to
keep international production at a level that keeps
global crude supply and demand in balance.
A dramatic increase in non-U.S. capital spending
by the upstream companies is necessary, and
the services companies are the direct beneficiaries.
Schlumberger has probably the most
comprehensive technical advantage, given its
scale and experience, and it's also more exposed
to the international markets.
Within the United States, our top pick would
be Pioneer Natural Resources PXD, a shale
company. Unlike a lot of the shale companies that
struggle to generate free cash flows and pay
dividends, Pioneer is unique. Pioneer was drilling
in the Permian Basin for natural gas well
before the shale boom began and got its land
cheaply because nobody else was bidding on it at
the time. Permian acreage is now going for
anything from $20,000 to $40,000 an acre. Pioneer
paid less than $1,000 for its acreage, and as

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