20%+ ROCE in the 2020s for traditional energy leaders

ROCE Deep Dive Post #4

This week I return to my favorite topic and attempt to answer the question: what is a reasonable "normalized" return on capital employed (ROCE) for first- and second-quartile (1Q/2Q) traditional energy companies in the current decade?

A few figures to start (for 1Q/2Q traditional energy companies only):

• In 2020, ROCE collapsed to negative 7%.

• In 2021, ROCE recovered to 12%.

• In 2022, it is on-track to be over (and potentially well over) 25%.

We know negative 7% is too low; that is not a sustainable ROCE even in a scenario where oil demand structurally declines (not my view) as the inherent decline rate for supply is almost certainly faster than the world's ability to decarbonize. But is 25% ROCE "too high"? That answer is most likely "yes, it is too high" if you have a 30 year view of industry. But I think it is in the realms of a possible “normalized" ROCE if we limit our analysis to the current decade and focus on the top two quartiles of traditional energy companies. There is precedent during the Super-Spike era.

Competitive ROCE is the pre-cursor to sustainable capital returns to shareholders. It is the prerequisite for companies to earn the right to spend. It is the foundation upon which going concern companies are based. Competitive ROCE goes hand-in-hand with sustained free cash generation and a fortress balance sheet. It is what will attract generalist investors back to the sector and Energy returning to a meaningful 8%-12% weighting in the S&P 500. It is the best hedge against inevitable commodity price volatility. When commodity price pullbacks or economic recessions happen (often these are one and the same), ROCE leaders will be well positioned to take advantage of down-cycle opportunities that materialize—consolidation, accelerated stock buybacks, or both.

Cyclical businesses compete away excess returns, positive and negative

In a cyclical commodity business that requires significant ongoing capital expenditures in order to sustain and grow production, sectoral ROCE (i.e., for all companies) should at least equal the industry's "cost of capital". The latter is a moving target on what investors demand of industry in order to provide financing. While "10%" has often been used as the short-hand cost-of-capital hurdle, in reality the figure I believe has cycled between 6%-8% on the low-end to 12%-15% at the high-end; it can vary by company and sub-sector. Broader macro economic factors along with company-specific considerations all play a role. The nature of "cost of capital" is that it is an estimate and not a hard number you can look up or calculate with precision.

Positive excess returns are usually competed away back toward cost of capital as investors are attracted to the sector, leading to over-supply versus ultimate demand. The opposite occurs when excess returns are negative; investors flee, starving industry of capital and tightening supply/demand conditions. The great book Crude Volatility by Bob McNally (link) details the long history of boom-bust oil cycles since the industry's founding in the late 1800s. While Mr. McNally doesn't use an ROCE framing per se, he clearly details cycling between periods of speculative excess to drought and back again.

One of my motivations for creating Super-Spiked was to shine a brighter spotlight on return on capital cycles. I believe the topic is broadly mis-understood and under-analyzed by a wide swath of professional investors as well as sector management teams and boards. As I discussed in ROCE Deep Dive Posts #1 (link), #2 (link), and #3 (link), the topic of "returns" is often mangled to the point that it’s not recognizable. During the 2010s, the US shale oil industry mangled returns via the obsessive and mis-guided focus on "well IRRs"—a topic I will spare myself and my readers from another diatribe on its failure (see previous posts).

If a company is not profitable at the corporate level, it will not be sustainable. Corporate America should never be confused with not-for-profit charitable endeavors. We need actual charities to fill gaps where we either don't have or don't want government "solutions". And the world is far better off with profitable private (i.e., non-government owned) companies than state-owned enterprises. I am, as you know, pro capitalism and anti socialism.

Three structural ROCE regimes over the past 30 years

I believe there have been three distinct ROCE regimes for traditional energy over the past 30 years:

(1) Pre-Super-Spike Era, 1991-2002: 14% average ROCE for 1Q/2Q oil & gas companies

• These are the years after the 1980s bust but before the Super-Spike era that followed.

• A bearish mindset that oil would “forever” trade in a $15-$20/bbl band led to an emphasis on cost reductions, asset high grading, and similar returns-accretive actions.

• This era laid the groundwork for modern “shrink to grow” restructurings that has been a staple of successful oil & gas turnaround stories.

(2) Super-Spike Era, 2003-2014: 19% ROCE

• These of course were the boom years catalyzed by China/emerging market oil demand growth and what we may look back on as "peak" globalization.

• Companies benefitted initially from having a $20/bbl cost structure at a time oil rallied to $60-$70/bbl.

• The move from $60-$70/bbl to $100+ was met with both cost and capital intensity increases; still ROCE for leading companies remained at very healthy levels.

(3) Post Super-Spike Bust, 2015-2020: 4% ROCE

• This sad story is well known. Initially cost structures were consistent with the previous $100/bbl era.

• Cost reductions and productivity improvements helped companies adjust to the new $50/bbl oil world.

• However, by focusing only on “well IRRs” in shale plays (that incidentally over-stated the performance of all wells drilled), most shale E&Ps over-drilled on the incorrect perception that the business “worked” at $50 oil. It obviously didn’t.

Exhibit 1 shows returns on capital employed for the traditional energy sector. The blue-ish line is the median for the sector. The green line shows the median 1st and 2nd quartile company (i.e., those in the top 2 ROCE quartiles). The red line shows ROCE for companies in the lower two ROCE quartiles. All ROCE figures are graphed on the right axis. The grey bars show nominal WTI oil prices on the left axis. The green dashed lines shows the average for each of the three ROCE regimes discussed above for the 1st and 2nd ROCE quartiles. The black dotted line is a hypothetical 12% minimum ROCE threshold to be considered a “good” company.

Exhibit 1 (Bloomberg, S&P Capital IQ, Super-Spiked)

Why has it felt so bad? Because it was a really bad post-bust six year stretch

The post Super-Spike Bust phase averaged 4% punctuated by the aforementioned negative 7% bottoming in 2020...and that is for the TOP two quartiles of traditional energy companies! Yikes, not good. The best year was 2018 with a 12% ROCE at $65/bbl WTI oil (nominal).

The era coincided with the rise of ESG investing and the mainstreaming of climate concerns. But make no mistake, the problem with traditional energy has been its own poor track record of profitability during this period. The issues with the virtue-signaling component to ESG investing and climate-only ideology from various left-of-center politicians and policy makers is a separate challenge that is likely going to contribute to HIGHER ROCE going forward as the impediment to new capital formation is a growing hurdle. Remember, this is a bizarro world sector—what’s good is bad, and what’s bad is good.

What evidence is there for sustained 20%+ ROCE?

I get it that many of the professional investors reading this will instinctively scoff at the idea that a sector that generated negligible ROCE over the last decade can suddenly jump to a sustainable ROCE of over 20%, even if only for the current decade. A few supporting points:

• A near 20% ROCE has precedent: 2003-2014.

• For the first time in my 30 year career, companies are being judged by growth in dividends and shareholder returns, not production volumes. This is a big deal and a big change for the better.

• Reinvestment rates are on-track to be structurally lower than any previous period over at least the past 30 years (Exhibit 2).

• There is uncertainty on the long-term outlook for oil demand in a decarbonizing world; the fear of future demand erosion (even if inaccurate) is leading to near-term supply tightness.

• There is little appetite for long-cycle CAPEX or exploration; I believe this will change but that concern is clearly for another day.

Exhibit 2 (S&P Capital IQ, Super-Spiked)

Why am I focusing on only 1Q/2Q companies? Why wouldn't I focus on the better run, potential going concern leaders that have the ability to attract generalist investor interest and have earned the right to continue on as going concerns? I will discuss the appropriate fate for the laggards in a future post. This post is about those deserving your support, not those deserving your activism.

When will the new era of 20%+ ROCE end?

It will end the same way it always ends: over-capitalization. Capital intensity is a metric I will look at in a future post. In a nutshell it is the capital spending cycle that normally lags the ROCE cycle by a few years. There is no reason to believe we will never have a traditional energy CAPEX cycle again. In fact, the better perspective is likely how many years of 20%+ ROCE is needed to stimulate the CAPEX response? The answer appears to almost certainly be greater than one or two.

To be clear, these perspectives are at the sector level. For individual E&P companies, inventory life is a key metric to watch. Once a company reaches no further than the half-way point of drilling its "premium" locations, the hunt begins for the next basin or project area. Technology and Big Data is providing investors more transparency than what I have had for most of my 30 year career. Still, it is not an exact science. Surprises, both positive and negative, can and will happen. This is an area where professional investors are often better than management teams and boards at sniffing out when things are heading south.

(Virtue signaling) ESG: More of a sideshow than substantive

In my view, topics like ESG are neither new nor a meaningful driver for ROCE boom-bust cycles. In the late 1980s while attending the University of Denver, I vividly recall a class on what was then called "stakeholder capitalism". The professor seemed, politically speaking, clearly to the left of yours truly, but, to his credit, encouraged significant debate/discussion on a variety of topics around the issue of corporate responsibility and what was or was not appropriate or needed. I enjoyed the class even as it likely forewarned of the risks of virtue-signaling ESG we see today.

Today we also have the topic of climate change and the drive to decarbonize. But we have always had questions about what the future growth rate for oil demand and supply would be. "The End of the Oil Age" has been forecast many times before; some day, perhaps even this day—or maybe 50 years from now—it will come true. But even if it is now (not my view), the inherent decline rate of oil supply almost certainly would exceed the pace by which the world can reduce its demand for crude oil-based products like gasoline, diesel, and jet fuel. As such, ongoing new capital expenditures—and investors to fund that capital—will be needed for the foreseeable future.

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⚡️ On a personal note…

A Super-Spiked reader recently shared with me the gift of this great George Carlin video. It's brilliant and well worth the seven minutes of your time. Spoiler alert to the question of “Why Are We Here?”: Plastic! Mr. Carlin's comedic views mesh well with my perspective that the broader energy discussion is still badly mis-centered around climate. Left-of-center politicians and policy-makers in the wealthy western world are still not recognizing the core Energy issue should be centered around availability, affordability, reliability, and security, with climate and traditional environmental issues important but ultimately secondary objectives (right-of-center politicians and policy makers spend too little, if any, time on climate and the environment which is also unfortunate). Disconnected Global Elites (DGEs) which you can think of as the Davos crowd are driving the mis-guided "climate only" ideology. Educate yourself on Energy; pushback on DGEs.

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⚖️ Disclaimer

I certify that these are my personal, strongly held views at the time of this post. My views are my own and not attributable to any affiliation, past or present. This is not an investment newsletter and there is no financial advice explicitly or implicitly provided here. My views can and will change in the future as warranted by updated analyses and developments. Some of my comments are made in jest for entertainment purposes; I sincerely mean no offense to anyone that takes issue.

Regards,

Arjun

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📘 Appendix: Definitions and Clarifications

Traditional energy. The universe of traditional energy companies included in my ROCE commentary include 66 past and present publicly-traded US, Canadian, and European major integrated oils, US and Canadian E&Ps, major US oil service companies, and US refiners.

Return on capital employed. This is a book accounting measure of profitability, which I define as net income plus after-tax interest expense divided by average capital employed at the start and end of the year. Capital employed is defined as total debt plus shareholders equity less cash and equivalents.

While ROCE is a metric I prefer, there are other measures of corporate level profitability that are also worth understanding. There is no one size fits all or singular answer to measuring success, or lack thereof. I would, however, push back against incomplete measures of profitability that do not reflect all of the costs and capital a company directly or indirectly faces.

Impact of 2020 write-offs. The significant write-offs taken in 2020 has the effect of boosting 2021 and 2022 ROCE by about 1.5% for industry overall. When looking at long-term ROCE metrics, I use reported net income. For shorter-term time frames, it can make sense to clean up the numbers to add back previous write-offs to the denominator and potentially use adjusted net income in the numerator. I do not believe the write-offs have a meaningful impact on the main points expresed in this post.