August 7, 2024
By Greg Buckley
The transition away from fossil fuels toward sustainable energy sources means that oil will likely become “a less profitable and a riskier business as net zero transitions accelerate,” the International Energy Agency (IEA) concluded in a report released late last year.1 But is this prediction supported by realistic assumptions? And does this mean that oil and gas companies can’t generate robust earnings growth?
There are plenty of reasons to believe fossil fuel demand will peak much later than expected. It will likely take decades—not years—for this transition to play out.
If you ask equity analysts covering traditional oil and gas companies today, the answer seems to be “yes.” The consensus forecast is that energy sector profits will shrink 1.5% in 2024, according to FactSet.2 And over the next three years, earnings before interest, taxes, depreciation, and amortization (EBITDA) are expected to show very little growth, if at all.
Clearly, many analysts believe demand for oil will fall significantly in the coming years as the global economy moves to replace fossil fuels with renewable resources. But these surprisingly dour forecasts are probably less a sign of what’s wrong with the oil industry and more an indication of what’s amiss with the market’s perception of the sector. In fact, there are plenty of reasons to believe fossil fuel demand will peak much later than expected, as it will likely take decades—not years—for this transition to play out.
Consider that, despite all the progress that’s been made in wind, solar, biomass, and hydroelectric in recent years, fossil fuels still account for approximately 80% of the world’s energy supply. By 2030, that figure is only expected to decline to 73%, according to the IEA.3 This estimate could prove to be far too aggressive, as fossil fuel use as a percentage of total energy consumption has only declined from 82% in 1990 to 80% today.
There are also plenty of reasons to believe earnings will continue to grow during this time, even as the energy transition advances and accelerates. Among them:
#1: The Developing World is Driving Fossil Fuel Demand
While demand for crude oil among developed nations is expected to be flat for the next several years, that’s not the case for the developing world, where tens of millions are joining the middle class every year, bringing with them improved lifestyles, diets, and consumption.4 In 2024 alone, 113 million people in the developing world are expected to join the global middle class, with more than half of them coming from India and China.5 By 2030, that figure is expected to balloon to more than 700 million.6 Because of this, global demand for oil is expected to continue to grow through at least 2030, if not for the next decade, with the emerging markets accounting for virtually all of that additional demand.7
#2: Oil Prices Are Likely to Remain Elevated
Oil companies are less inclined to invest in future production in the current environment, which in the context of continued demand growth, will likely put upward pressure on oil prices. A decade ago, global upstream spending peaked at around $700 billion a year, at a time when oil companies were producing around 92 million barrels a day. Last year, capital expenditures on exploration and production fell below $500 billion, in a year when nearly 102 million barrels of oil a day were being produced.
Upstream spending is not expected to rebound anytime soon, especially in light of the current political and social environment surrounding fossil fuel production. In its FY 2025 budget, for instance, the Biden Administration has proposed repealing favorable tax provisions for oil and gas producers, including deductions on intangible drill costs. This climate should help keep a lid on supply growth and keep prices elevated.
#3: Oil Companies are Producing Free Cash Flow
The typical free cash flow yield of energy companies in the S&P 500 hovers between 8% and 12%. Oil companies used to invest most, if not all, of their free cash flow back into the business, but that has changed. Thanks to disincentives for upstream spending and pressure from shareholders, oil companies are using most of their free cash flow to pay dividends and buy back their own stock, reducing the number of shares outstanding and, in turn, improving earnings on a per-share basis. Marathon Petroleum (Ticker: MPC) is a poster child for this push. Over the past three years, MPC has repurchased more than $29 billion of its stock, reducing its total number of outstanding shares by roughly 45% and increasing EPS growth by almost 50%.8
Buybacks may not seem significant on their own, but taken together with resilient demand, higher prices supported in part by the lack of upstream investments, and strong free cash flow yields, it creates a framework to keep energy sector earnings growing.
Conclusion
There is no doubt the energy transition will impact energy sector earnings in the decades to come. And there’s no question that renewable energy sources will play an important role in fueling growth in developing markets and emerging technologies, such as AI and EVs. But it’s also true the transition to clean energy will be a gradual process that will likely take longer than is currently assumed, making near-term forecasts for anemic earnings growth highly doubtful. To meet these growing energy needs, the world will need both renewables and fossil fuels in the coming years—something many analysts don’t seem to appreciate, creating potential mispricing opportunities to exploit.
1 The Oil and Gas Industry in Net Zero Transitions, International Energy Agency, November 2023.
2 Earnings Insight, FactSet, May 17, 2024.
3 World Energy Outlook 2023, International Energy Agency.
4 What Drives Crude Oil Prices: Demand OECD, U.S. Energy Information Administration, May 7, 2024.
5 “113 Million People Will Enter the Global Middle Class in 2024,” VisualCapitalist.com. Oct. 19, 2023.
6 “The World’s Growing Middle Class 2020-2030,” VisualCapitals.com. Feb. 3, 2022.
7 “Peak Oil Demand Still A Decade Away, Goldman Sachs Analysts Say,” Yahoo! Finance. May 27, 2024.
8 Marathon Petroleum Corporation 2023 Annual Report.