Oil Stocks: The Next One Hundred Years

I want to address one of the more insightful questions that I have received about oil stock investing. It generally goes like this: Does the non-renewable nature of petro-carbons pose a significant risk to the long-term survival of oil majors like ExxonMobil, Chevron, Royal Dutch Shell, BP, Total SA, and ConocoPhillips?

This is a smart risk to consider. If you own an asset, and if you reinvest into it over the course of your lifetime, you should be fixated on the risk of whether there will be something leftover for you at the end of your compounding period. In the past, I have lamented the path of Wachovia investors who receive large chunks of dividend income in the 1980s, 1990s, and early 2000s only to find it all collapse from $40 to $2 in the fall of 2008. All your years of compounding and delaying gratification didn’t mean squat because you ended up multiplying the final figure by a near zero number.

When you think about the future of oil, I want you to first think about its history. What was the precursor to John David Rockefeller’s Standard Oil Trust that was launched in 1882? The answer to that question would be a book in its own right, but he built his wealth by turning gasoline into fuel while his competitors treated gasoline as a waste product to pour into the Cuyahoga River and watch it burn. He manufactured paraffin which we use to make candles. He created benzene, the cleaning fluid and varnish ingredient. And perhaps least known of all, he was the manufacturer of white petrolatum which got marketed under the trade name Vaseline and is now part of Unilever’s multinational empire today.

I mention this because it is important to note that there are plenty of marketable products that arose out of the early gas industry and have served as bridges to the next frontier. The same man who got rich off of petroleum was doing just fine with whale oil. The riches from the latter funded the ownership stake and development of the former.

Aside from the generic PR, there is reason to take it seriously that the major oil stocks have gone to great lengths to rebrand themselves as energy companies. Perhaps this rebranding has been a bit premature, but the industry’s signal that it is moving beyond oil is the right one to convey. ExxonMobil has bought in heavily to chemicals, and Chevron has followed suit. Shell has heavily diversified into natural gas. Total SA is making pledges and setting quotas for the amount of energy it will generate from renewable resources. Conoco dug in even deeper on its commitment to oil, and I suspect the harsh experience during the recent price decline will modify their strategy in the future. And BP has been busy with litigation costs from the 2010 oil spill and maintaining its dividend, and will probably get around to energy-source diversification during year two or three of the next big oil spike.

In years like 2008, ExxonMobil brought in $35 billion while only allocating $20 billion towards stock repurchases and dividend payments to shareholders. Of the remaining $15 billion, some of it went to cash and others went towards investment into new drilling projects.

Fifteen to twenty years from now, that $15 billion in retained earnings won’t go towards new drilling projects. Instead, it will go towards nascent technologies. Maybe it will be wind. Maybe it will be nuclear. Maybe it will Charlie Munger’s favorite energy source—the sun.

You don’t need to predict what will be the next major energy source. Instead, just as whale oil profits provided the “start-up funds” for Rockefeller to develop refineries, I expect that oil and natural gas cash flows will be used to fund the entrance into new markets for the major oil stocks of today.

I should also mention that this transition may still be decades in the offing. Exxon itself doesn’t even imagine that peak oil will hit until the 2040s, and then will gradually taper off thereafter. Energy source changes tend to make place over multi-decades; it doesn’t happen overnight like the iPhone overtaking the Blackberry. My own view is that the pace of technological change will be driven by necessity. If Americans continue to enjoy $2 per gallon-type pricing for much of the next decade or two, the pace of progress will be slow because the status quo will be satisfying enough. However, if the price moves above the $4 mark or so, then innovation will be spurred on faster by discontent with a high gas price status quo.

Despite the low prices of the past few years, oil businesses will see a period of high commodity prices again. This means that there will be a large amount of retained earnings. As surely as Unilever purchased the Dollar Shave Club after its start-up success or Coca-Cola bought a 16.7% interest in Monster Energy or Johnson & Johnson acquired Rydelle Laboratories to get its hands on the Aveeno brand, the major oil companies will see the rising energy firms and acquire them. Waiving around 40% premiums can buy your way to a lot of market access.

If this is something you worry about, I suppose you could mitigate the risk by draining your dividends out of the paying corporation and then reinvest them elsewhere. For instance, if you have built up a sizable position of 3,300 Royal Dutch Shell shares, you could take the $12,400+ in oil dividends and make an investment into a timeless business like Brown Forman, Colgate-Palmolive, or Hershey. You’d effectively milk out all of your initial investment amount within fifteen years and build a standalone diversified portfolio of stocks in case some sort of worst-case scenario plays out that is different from what you had initially planned.

But with mega-cap behemoths, the businesses tend to remain intact after technological change so long as there is an identifiable bolt-on acquisition to make in the sector. I suspect that will be the case with emerging energy technologies. And plus, companies usually run into trouble because they get out-branded or there is a competitor with a lower cost in a razor thin industry. Well, if these firms encounter a solar competitor, they could even fund start-up alternates because wealth in the commodity sector gets created by economies of scale and operating efficiencies which the oil majors already possess in abundance.

In short, I think oil stocks will be fine to buy over our lifetime because the pace of change will take place over decades and these companies have the cash to buy a market position in whatever energy source becomes the next backbone of the world’s economy. And, if this isn’t assuring enough, you could always have oil dividends get paid out as cash and use the proceeds to fund other investments. I don’t know what energy production will look like in 2070, but I suspect the legacy shareholders of Exxon, Chevron, Shell, BP, and Total SA will be the ones creating commodity-sector wealth.