A Healthy Correction
Normally I regard a “healthy correction” after a long rally as the description of those uninvolved. There’s nothing healthy about a market drop for the longs, regardless of if it was preceded by an extended rally, as is the case for energy this year. A sell-off under any circumstances is only good for shorts and market commentators bereft of more imaginative descriptions.
Nonetheless, the softening of global Liquefied Natural Gas (LNG) benchmarks, which was the catalyst for a sharp drop in the associated stocks, should not be unwelcome to investors.
A reporter asked me the other day what I worry about. I sleep pretty well, but the typical response of a midstream investor to that question is “demand destruction.” High prices are good in energy to a point, but eventually consumers start considering alternatives.
This is why last week’s drop in LNG prices was good for the long term. Exporters want global prices that are just below the point at which buyers start switching to alternatives. Several countries in Asia have increased their use of coal. Japan has given older, less efficient coal plants more freedom to operate. Thailand is restarting previously decommissioned coal power stations. India and the Philippines are planning to use more coal this summer. Meanwhile, NextDecade has filed with the Federal Energy Regulatory Commission (FERC) for a higher maximum work force at their Rio Grande facility in Texas. They’re seeking a cap of 7,500 (versus 5,225 currently) and the ability to work 24/7 on the construction site. An earlier completion date will boost cashflows.
In Europe, the switch to coal has been more muted because the region has been phasing out such power plants. Thermal coal prices are up around 15%, far less than LNG. None of this is going to help reduce emissions, but Russia’s invasion of Ukraine along with the closure of the Strait of Hormuz have made energy security a bigger concern. The EU has pursued the most aggressive decarbonization plans at the expense of secure energy supplies.
Regulations have been far-reaching, including a requirement next year that European importers of natural gas be able to verify the amount flared or leaked from the specific well(s) providing their supplies. Non-compliance could expose non-EU exporting companies to penalties as high as 20% of global revenues.
Unsurprisingly, this has hindered the bloc’s ability to find suppliers willing to risk such a penalty. With their energy strategy in shreds, the EU Commission’s director-general for energy Ditte Juul Jorgensen has promised “flexibilities”, since for most people keeping the lights on ranks above moderating greenhouse gas emissions. Europe’s airlines are also warning that supplies of jet fuel are running low with systemic shortages likely within three weeks. US exports to Europe are increasing.
Several investors have asked if the disruption to energy supplies will boost renewables. There’s no sign of it yet, but while solar and wind face many disadvantages from intermittency to cost and land use, they do provide energy security. We have long felt that this is driving China’s enormous investment in renewables, more than any concern about emissions, since they continue to consume more than half the world’s coal.
Higher energy prices will raise the construction costs of windmills and solar panels, but it still shouldn’t be surprising to see the biggest energy importers considering their supply mix.
Last week UK Prime Minister Keir Starmer said, “I’m fed up with the fact that families across the country see their bills go up and down on energy…because of the actions of Putin or Trump across the world,” Britain gets 30% of its electricity from wind, but that works out to be only 6-7% of its primary energy. For all the positive press left wing media heaps on solar and wind, they provide a small part of every country’s total energy needs.
Following Friday’s 3.3% CPI print, it’s worth remembering that midstream energy infrastructure is one of the few sectors with a business model that incorporates inflation protection. Several years ago Wells Fargo estimated that at least half the industry’s EBITDA benefitted from automatic price escalators on fees linked to PPI. Interstate oil and gas pipelines most commonly operate under this regime. Enterprise Products (EPD), Energy Transfer (ET), Williams (WMB), and MPLX often highlight this in their presentations. Other analysis has estimated that well over 60% of the industry’s EBITDA benefits from the PPI link. It’s an under-appreciated feature of the sector. Illustrating the sector’s strong cashflows, last month WMB raised its dividend by 5% quarter-on-quarter.
Look at last week’s weakening of LNG prices as some needed demand stimulus.
We have two have funds that seek to profit from this environment: