In 2002, I was working at Morgan Stanley when the energy research analyst Doug Terreson wrote a note titled, “The Golden Age of Refining”. The simple thrust of Terreson’s observation was that the refining industry domestically had finally moved into a position of tight capacity after decades of excess capacity and terrible investor returns. Over time, gasoline and distillate demand grew alongside GDP, while on the supply side of the equation, uneconomic capacity was shuttered, never to be reopened. Most importantly, Terreson recognized that the refining industry was getting serious about capital discipline. Not only would the integrated majors like Exxon and the independents like Valero not add capacity, but they would continue to exit their less economic facilities. As the 25-year chart of Valero below illustrates:

Terreson was dead right.  It was maybe the best sell-side research call I can remember.  Paradigm shifts like an industry going from a dog to a secular winner start in deep pessimism making a big call like that a career risk.  That said, as the chart also shows, the industry would again face cash incinerating difficulty post the slow demand recovery of the Great Financial Crisis and again through the sudden Covid driven demand collapse of 2020. While refining has become obviously a far better business, it is still cyclical and the downturns can be punishing.  The same can be said across the spectrum of the oil patch from refining to exploration & production. 

Twenty years after the Golden Age of Refining call, capital discipline has become King.  If you listened to twenty energy company conference calls in the most recent earnings season, you would have heard twenty management teams tell you that they are prioritizing the return of cash over the growth of resources or capacity. 

Vicki Hollub, the CEO of Occidental Petroleum opened the earnings call with this comment: “Thank you, (investor relations person), and good afternoon, everyone. We delivered another strong quarter operationally and financially, enabling us to further advance our shareholder return framework as we made meaningful progress toward completing our $3 billion share repurchase program…As we enter 2023, we expect that our free cash flow allocation will shift significantly towards shareholder returns. We intend to reward shareholders with a sustainable dividend supported by an active repurchase program…We've mentioned before that we're not going to try to grow our oil and gas production from 2022 to 2023. We're going to hold that flat.”

In other words, growing resources is an afterthought.  We are running the business for cash because that’s what our investors, including Warren Buffett, want.   

The Chevron call sounded just like the OXY call with the company announcing a long-term plan to spend $75 billion to buy back over 20% of the company’s outstanding shares.   During the Q&A, the CEO Michael Wirth responded to a question about possibly trying to accelerate production growth by saying, “We are growing production, but what we’re really focused on is growing returns and cash flow. If we can grow returns and cash flow, the equation works…We can grow cash flow, we can improve returns at the rate that we’re spending at, so I don’t know why there would be a question about our ability to do that. The production numbers are an outcome of those decisions. It’s not the goal.”  In other words, the goal is to return as much cash as possible and if we can grow along the way, super.

The result of this single-minded mantra of returning cash over investment is that we can be sure that US supply in terms of future refining capacity and upstream resource growth will be limited.  The US is the largest producer in the world at over 12million of the roughly 100million barrels produced and consumed globally. The world has extremely limited spare capacity as evidenced by the fact that the vast majority of OPEC + nations are incapable of producing to their quotas.  Outside of the US, the only spare capacity is in Saudi and the UAE.  This morning, the Russians announced that 500,000 barrels a day will be coming off the market. The supply picture is not just tight, but precarious.  All that said, while the supply picture is secularly constrained, calling for an oil bull market at a time when the US and European economies are on the precipice of recession hasn’t been a good idea historically.  But, longer-term, the supply/demand dynamic is compelling.  Ten years from now, the world will consume more oil than it does today and unfortunately, the same will probably be true twenty years from now as demand from the inexorably rising global middle class consumes more of the densest and cheapest form of energy even as developed nations will be consuming less. 

The point I am making is twofold.  One, is that the US energy companies from downstream to upstream trade at cheap valuations and will return double digit cash returns for a really long time.  Second, is that energy is going to be a secularly inflationary force on the global economy, also for a really long time. 

How is Valero thinking about growth versus shareholder value these days?  Well, they said that in the fourth quarter of 2022, they spent $291 million on growth capital expenditure while they spent $2.2 billion on buybacks and the dividend.

For more from Tim, follow his podcast The Weekly Bull and Bear wherever you listen to your podcast or read his weekly blog posts here.

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