SL Advisors Talks Markets

Hedging with Energy

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It’s always interesting to learn how financial advisers use our energy infrastructure investments in their portfolios. Often, it’s for income, because the 6-7% yields are well covered by cash flow, growing and supported by continued reluctance to boost growth capex. America has the pipeline network we need. New construction gets held up by court challenges from climate protesters, with the delays increasing costs. Equitrans with their Mountain Valley Pipeline project is an example. They announced a further delay because hiring is hard. Their recent 8K SEC filing noted, “multiple crews electing not to work on the project based on the history of court-related construction stops when there’s the risk of another court order stopping work.”

Canada’s federal government probably owns the record for cost over-runs, with a 4X increase since they acquired the TransMountain expansion from Kinder Morgan five years ago (see Governments And Their Energy Policies). Developments like these are dissuading growth projects, which is why pipeline sector dividends are growing. A dollar not spent on capex is a dollar coming back to shareholders, through a dividend hike or stock buyback. It’s hard not to love climate extremists.

Because of the prospect of rising payouts and buybacks, we think pipelines offer income with growth. Who says you can’t have both?

Some financial advisors like energy because it’s relatively uncorrelated with other sectors. We think this makes a lot of sense (watch Will Geopolitical Risk Effect the Energy Market?).

I was with one such investor last week who uses midstream energy as a hedge against more conventional equity exposure. He’s very happy with the results, and his business is growing strongly because of this and doubtless many other good calls for his clients.

The American Energy Independence Index (AEITR) handily beat the S&P500 for the past two years. Pipeline companies are not popularly linked with AI so have lagged the market this year. However, the gap has begun to close as Israel has responded to the shocking terrorist attack by Hamas, ratcheting up tensions across the region.

By mid-July the S&P500 was 13% ahead of the AEITR. As of Friday the gap had shrunk to 2.6%. Dividends help – the S&P500’s dividend yield is a paltry 1.6%, less than a quarter of what pipelines pay. Enbridge (ENB) yields over 8.1%. Its C$3.55 dividend has grown annually for 28 years, a record management has pledged to continue. It represents an extreme case of the contrast between energy infrastructure and the overall market. ENB still looks like a good pairs trade with a short S&P500 position. Notwithstanding your blogger’s substantial overweight to the sector, I recently put that trade on too.

Stocks had a bad week. But they still don’t look that cheap. Six months ago (see Inflation vs Regional Bank Crisis) valuations were just average compared with the past couple of decades. Since then, the S&P500 has risen 4%, 2023 forecast earnings are flat and declining, and the ten year note has risen 1.5%.

Today’s Equity Risk Premium (ERP) of 0.3 is the lowest in two decades. Even using 2024E EPS, at 0.9 it’s still unattractive. Moreover, earnings forecasts have been declining in recent weeks, with few upward revisions likely other than for the defense sector.

We’ve also included the ERP for the NASDAQ 100. This is an unconventional way to evaluate the tech sector, and your blogger long ago concluded that he felt more comfortable with value stocks. Over the years I have carefully avoided expensive investments with high growth rates, and such omissions have not always been to my advantage.

Nonetheless, it’s hard to resist publishing the Tech sector ERP chart. Rising bond yields are doubly bad here, because as well as offering a relatively stable return they mean a higher discount rate/lower NPV on those far bigger, far away profits.

Tech stocks lost three quarters of their value during the dot.com collapse. Even during the 2008 great financial crisis they were down by half. Today’s ERP for the sector is around the same level.

This blog doesn’t promise to get you into tech stocks at the low. But they don’t look cheap.

Electric vehicle (EV) sales are flattening out. Everyone I know who owns a Tesla loves it, but also has another car for long drives. But my circle of friends is not representative of America. A journalist on the NYTimes Climate desk recently reported on an EV trip he made in South Dakota that ended with his Volvo C40 being towed because it ran out of juice.

We still worry about our phone batteries going dead.

EVs seem like fun, but compared with much of the world, in the US we (1) drive farther, (2) drive bigger cars, and (3) enjoy relatively cheap gasoline. EV penetration looks as if it’ll be slower than many fans expect.

We have three have funds that seek to profit from this environment:

SL Advisors Talks Markets

Exxon Buys More Of What The World Wants

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Last week the Energy Information Administration (EIA) released their 2023 International Energy Outlook. It came out on Wednesday, the same day that Exxon Mobil (XOM) confirmed their acquisition of Pioneer Natural Resources (PXD), and they’re linked in more ways than simply their announcement date.

When energy companies issue long term energy forecasts they’re well aware that environmentalists will pore over them looking for an absence of fealty to the UN’s Zero By 50 goal – that is, that emissions of greenhouse gases will be eliminated by that date in order to limit anthropogenic global warming to 1.5 degrees C above the levels of 1850.

BP concluded that publishing data and forecasts was so fraught that they handed off their Statistical Review of World Energy after seven decades to the Energy Institute. But the EIA is unburdened by such concerns, and their latest publication should have agitated climate extremists more than XOM investing $60BN in adding oil and gas production.

The EIA produces several scenarios (“cases”) incorporating high versus low global GDP growth, oil prices and zero-carbon technology, along with a Reference Case which is based on current policies. They warn that they’re making projections not forecasts, although the difference is a subtlety only meaningful to the EIA.

The headline could be, “EIA Forecasts Increase In CO2 Emissions By 2050” if their publications received such coverage. Higher living standards and population in developing countries will more than offset improving energy efficiency. When people have more disposable income, they use more energy. There is no historical precedent suggesting that can be avoided, so the EIA projects primary energy consumption will grow from 640 Quadrillion BTUs (Quads) to 856 Quads, a 1.1% annual growth rate.

The EIA includes some other dramatic changes

Their Reference Case assumes that non-fossil fuels will increase their share of primary energy and fulfill 58% of the increase in world energy consumption over that time. Increased global electricity consumption will be met primarily (italics added) by zero-carbon technologies. This is an extraordinary projection. Much of the rich world is dedicated to decarbonizing its power supply and electrifying more of its energy use – such as by shifting to Electric Vehicles (EVs) in the transportation sector. And yet, because of an increasing middle class in poorer regions such as Africa and much of Asia, electricity generation will consume more coal and gas than it does today. Perhaps most disappointingly, CO2 emissions from coal are projected to be the same in 2050 as today. The case for increased use of natural gas has never been stronger.

Aviation will more than triple.

The EIA sees EVs reaching 36% of new auto sales by 2050, which would still mean 1.4 billion internal combustion engine cars on the world’s roads. India’s energy consumption per capita will increase by 140%. China’s use of coal in iron and steel production will fall by 70%.

Other long-term forecasts typically see fossil fuel use declining over the next several decades. The International Energy Agency (IEA) in their Stated Policies Case (STEPS) expects fossil fuel consumption to peak within the decade, higher non-fossil fuel composition of primary energy and slower overall demand growth. They expect CO2 emissions to fall, but not by much.

Which brings us to XOM’s acquisition of PXD. Two years ago Engine No 1 criticized the company’s strategy, pushing it to be better prepared for the energy transition by focusing on short-cycle projects and renewables. Since then, XOM has committed $17BN to carbon capture and storage technology, biofuels and hydrogen. Nonetheless, a year ago critics such as Climate Action 100+ were complaining that 73% of their capital allocation was misaligned with the UN’s Zero By 50.

And now they’ve doubled down on the Permian basin in Texas. If production increases, Plains All American should be one of the beneficiaries. XOM also notes that they plan to accelerate PXD’s plans for zero-emission production from the wells they’re acquiring by fifteen years.

XOM’s long term outlook probably has much in common with the EIA.

The IEA’s scenario for reaching the UN’s target sees declining overall energy consumption. That only seems possible with extended slow growth in GDP and/or population.

The increase in M&A activity in the sector shows that boards are becoming comfortable making new long-term commitments to traditional energy. Oneok’s recent acquisition of Magellan Midstream, and Energy Transfer’s pending buy of Crestwood, are two more examples. They’re reaching the same conclusion as the EIA, which is that the world is going to need more of every kind of energy. America is well positioned to be part of the solution, especially with cheap natural gas.

We have three have funds that seek to profit from this environment:

SL Advisors Talks Markets

Fiscal Policy Moves Center Stage

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I traveled down the east coast last week – stopping along the way to see clients. My first stop was Washington, DC to see Robert Dove, an old friend from high school in London and a long-time client. We can both still recite the school song in Latin, an obscure skill not as highly valued by today’s younger alumni. I was privileged to join Robert at the unveiling of a stamp honoring the late Ruth Bader Ginsburg.

Additional stops were made in Virginia, South Carolina and SE Florida on my way to Naples. I always enjoy meeting our investors.

Politics came up more than usual, because of the news. The House Republicans’ defenestration of speaker Kevin McCarthy must increase the odds of a government shutdown when the brief agreement he negotiated expires next month. Indeed, it’s hard to see how any incoming speaker can avoid this without suffering their predecessor’s fate. It might even be more likely than not.

Bond yields have been rising, but inflation expectations are not. The increase in real yields has prompted articles suggesting that the market’s reckoning with our dire fiscal outlook is finally at hand. The WSJ’s Grep IP is one of several journalists linking the two. A government shutdown more clearly demonstrates the absence of any fiscal middle ground than it does a pathway to resolution.

One of the most dramatic illustrations of the problem is that Federal interest expense is now expected to reach 3% of GDP in 2028 based on the Congressional Budget Office’s June 2023 long range projections. Less than a year prior, in July 2022, the 3% threshold wasn’t expected until 2030. Fed tightening is the reason.

The June 2023 outlook assumes a real yield on the ten year treasury of 0.9% next year and 1.6% for the rest of the decade. It’s currently 2.4%. Fed tightening has worsened our fiscal outlook. The FOMC would argue that a less hawkish policy response would have allowed longer term inflation expectations to become embedded at a higher level, pushing up long term yields even more. It’s unknowable. So far the real economy has been remarkably resilient to higher rates.

Canadian pipeline stocks have been relatively weak this year, including Enbridge (ENB), the biggest midstream company in North America. The market didn’t like their acquisition of three natural gas utilities businesses from Dominion Energy for C$19BN, partly financed by issuing C$4BN in equity. The S&P Dow Jones Utility Index is down 14% YTD. ENB, which increasingly shares their characteristic of stable, regulated returns, has been dragged down with the sector.

Except ENB sports a yield over 8%, roughly 1.5X covered by distributable cash flow. It’s true their leverage will rise uncomfortably once they close on their acquisitions, but the company is confident they’re on track to get back within their prior range of 4.5-5X with a dividend payout ratio of 60-70%.

ENB has raised their dividend for the past 28 years. Canadian management teams exhibit the Scottish Presbyterian conservatism that is part of the culture. During times of market stress, we’ve mused that some American companies could do better than being run by risk-loving Texans (see Send in the Canadians!)

ENB is certainly not overlooked but compared with the S&P500 which yields 1.4%, it looks pretty attractive.

Long ENB/short SPY looks like a good trade to this blogger. If bond yields keep rising, the broader market will fall, and if nothing dramatic happens there’s over 6.5% of positive carry on the trade. If rates fall ENB will look even more attractive. And if AI stocks recommence their ascent…well, there’s always a way for a trade to lose and that is probably it.

ENB’s high and growing dividend is a decent metaphor for the entire midstream energy infrastructure sector.

RBNEnergy noted some weaknesses in the Energy Information Administration’s (EIA) long term US natural gas consumption forecasts – they’ve been consistently too low, by an average of around 3 Billion Cubic Feet per Day for several years. Part of the reason is the EIA has been overly optimistic about renewables utilization.

The past couple of years illustrate – comparing 1H22 and 1H23, solar and wind utilization both fell while natural gas rose. The problem of intermittency with weather-dependent energy remains a problem. Some states are enjoying good success with wind – notably Iowa which gets 55% of its electricity from this source. But the extended bear market in clean energy stocks and companies closely identified with renewables such as Nextera reflects a realization that it’s not an easy business. The declining utilization of existing solar and winds assets is another indication.

We three have funds that seek to profit from this environment:

SL Advisors Talks Markets

Just In Time Oil

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Changes in US oil inventories sometimes cause a sharp move in the price of crude. It makes perfect sense, even if it’s hard to tease out much of a statistical relationship from the data. Oil stocks, meaning oil held in inventory, have been falling since the early days of the pandemic when the collapse in demand left traders scrambling for places to store it. The most recent weekly data showed our inventories are the lowest in almost forty years.

The US Strategic Petroleum Reserve (SPR) has also been falling. Privately held inventories move based on economics, whereas changes in the SPR are a political choice. This was most notable a year ago when high gasoline prices prompted the Administration to release oil to avoid losses in the mid-term elections. Such sales have continued (see Crude Climbs The Wall Of Supply Worries).

So for different reasons, both privately held inventories and the SPR are falling. Historically the two moved more or less independently given their differing objectives. Now, both the Federal government and commercial operators are concluding they need to hold less.

Businesses generally hold inventories of the inputs they need for production and finished goods awaiting sale. Such decisions are made to smooth production lines. Oil has the additional motivation in that speculation on higher prices may increase inventories. And the Federal government has its own, non-commercial goals.

One way to think about inventory adequacy is to measure how many days of domestic consumption could be supported if output and imports stopped. It’s well short of a perfect measure, because it assumes all the oil in storage could seamlessly move to where it’s needed and be of the correct grade to be acceptable to the refineries or other users taking delivery. So the current ratio of total oil in storage divided by average daily consumption of 57 days doesn’t mean inventories could satisfy domestic demand for that long. It’s undoubtedly far less. But it is the lowest ratio on record, going back 37 years. We’re on track to find out what inventory level is too low. Rising crude will tell us we’re there. It may already be happening.

“Just in time inventory” has made manufacturing more efficient. Delivering inputs only when needed to an automobile factory reduces the needed working capital and improves profitability. The decline in privately held oil stocks in recent years combined with stable refinery runs shows a similar improvement in operating efficiency.

Increased domestic oil production reduces our need to hold inventories for energy security. We’re less reliant on imports but because US refineries can’t use all the light shale oil we produce, two-way trade brings in the heavy crude they’re designed for and exports lighter grades. We have enormous inventory underground, accessible when needed.

Domestic production is growing, but slowly. The Baker Hughes oil rig count is at 513, down almost 20% from its peak late last year. Current output remains just shy of the 13 Million barrels per Day record of November 2019.

Exxon Mobil (XOM) is operating 17 rigs, down from 65 four years ago. Energy companies are staying disciplined, unmoved by the recent run up in prices. “If you think about capital efficiency, and you want to make sure you’re thinking long-term about your business, moving [drilling rigs] up and down a lot is not a good idea,” said Jack Williams, a senior vice president at XOM.

Pipeline operators often complain about the difficulties with construction. The experience of Equitrans with Mountain Valley Pipeline (MVP) is perhaps the most famous example of the cost that endless environmental legal challenges can impose on infrastructure projects.

But renewable energy is more urgently dependent on permitting reform because future Infrastructure projects will be concentrated there. We mostly have the oil and gas pipeline network we need, which is why midstream companies are buying back stock and raising dividends.

Wind turbines and solar panels are built in remote, sparsely populated locations. They need long-distance, high voltage transmission lines to move power to population centers. Decarbonizing our energy systems means converting more demand to electricity.

A recent WSJ report showed that more than 10,000 energy projects were awaiting permission to connect to electric grids at the end of last year, almost all wind and solar. The SunZia wind project in New Mexico filed for permits in 2006 and just received the go-ahead to begin construction. America’s system of government creates many opportunities for NIMBY opponents to file legal challenges at the local and state levels as well as federal.

Consequently, 17% of our primary energy comes from carbon-free sources. Half of that is nuclear, which given public resistance is unlikely to grow much. Switching from coal to natural gas for power generation remains our biggest source of reduced greenhouse gas emissions. Ironically, court challenges to new energy infrastructure from environmental extremists represent a significant challenge to renewables.

We three have funds that seek to profit from this environment:

SL Advisors Talks Markets

The Super Cycle Or Peak Oil?

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In March of 2020 when crude oil was collapsing dragging energy stocks, including pipelines, along, I tried to focus on the positive, which was that it had become cheaper to drive places. Except there was nowhere to go because of the lockdown. And even if there had been, I would have had to make roughly three round trips to the moon and back to generate enough savings on gasoline to compensate for my losses on infrastructure.

What some might deem an imprudently high allocation to the sector was paired with a timid appetite for leverage (ie there was none). With no need to sell I was miserable only until prices started recovering. Having endured low oil prices, I find high prices wholly more agreeable.

Therefore, JPMorgan’s chart depicting a widening supply deficit over the next several years causes me little angst. Those around me might even enjoy my pleasant demeanor if the forecast is true.

Interestingly, JPMorgan’s 2028 forecast of global demand matches the International Energy Agency (IEA) in their Oil 2023 publication at 105.7 Million Barrels per Day (MMB/D), an annual growth rate of just under 1%. Both agree that gasoline demand will soften while other oil products such as jetfuel, LPG and heating oil will continue to rise.

However, they reach very different conclusions on supply. The IEA is more bullish on US output, and therefore doesn’t foresee a supply/demand imbalance. By contrast, JPMorgan expects only 1% annual US production growth. They attribute this to (1) declining productivity, (2) continued focus on accretive projects to drive shareholder returns, and (3) higher interest rates. They see US upstream capex declining 7% annually through 2030.

The result is that JPMorgan is overweight global energy, proclaiming the “Supercycle returns.” They believe, “the upside risk to oil is $150 per barrel over the near to medium term.” They see a “higher for longer” outlook as financial discipline and increased cost of capital combine with “institutional and policy led pressures driving an accelerated transition away from hydrocarbons and peak demand fears.”

The IEA report strikes a more politically correct tone, asserting that increased investment in renewables is bringing “peak oil demand into view.” Reading it is supposed to leave investors in traditional energy despondent. JPMorgan disagrees: “We don’t see peak oil demand on our investment horizon (2030)”. They have a multi-year bullish outlook.

The IEA has a more optimistic supply view combined with a more pessimistic demand outlook. Energy producers embracing both would be disinclined to invest in the very supply growth the IEA expects. They’re forecasting peak oil within a decade or so to stimulate increased capex in oil projects that typically require well over a decade to generate an acceptable return. Only one part of that scenario can plausibly occur.

Analysts at Citi and Bank of America are similarly bullish, which contrarians will view as evidence of an already crowded trade.

If crude oil was falling, we’d note the unimportance of commodity prices to the pipeline sector. Rising prices reflect improving sentiment towards the energy complex and perhaps a modest EBITDA uplift for midstream infrastructure. But given attractive valuations, as generalist investors have begun to revisit their exposure to energy it doesn’t take much to push the sector higher. Market outperformance of the American Energy Independence Index has coincided with the rally in crude oil. They’re likely to continue moving up together.

Oneok’s (OKE) acquisition of Magellan Midstream (MMP) was approved by owners of both companies last week. Now comes the big rebalancing. MMP unitholders will receive $25 per unit, which means about $5BN in cash will be available for reinvestment early this week. Some will be set aside for taxes, but much of what’s left will go back into midstream c-corps, which should give the sector a bid.

$5.6BN is the amount of MLPs the Alerian MLP ETF (AMLP) would have to sell if they decide to rebalance away from the declining MLP sector towards c-corps. Wells Fargo reviewed the challenges this is creating for MLP-dedicated funds that follow Alerian indices. It’s an issue we have noted in the past.

The family of Invesco Steelpath funds would have to sell around $4.5BN in MLPs if they similarly rebalanced. Neither will want to make such a choice after the other. And if Alerian changes their index construction it might force the issue.

As much as $10BN of MLP positions might be swapped into c-corps if such a rebalancing goes ahead. Wells Fargo reviewed the available options but stopped short of predicting what will happen. The issue won’t go away. Fund flows ought to favor c-corps over MLPs.

We three have funds that seek to profit from this environment: