Public policy is becoming more important to energy investors. Democrats now own the climate change issue. The desire of progressives to advance a world of solar panels and windmills is confronting pragmatists who’d like to keep the lights on. Rising oil and gas prices are helpful to the energy transition, by improving renewables’ competitiveness. But $4 gasoline would have political repercussions. So the spirit of St. Augustine prevails (“Give me chastity, just not yet”). Last week U.S. Energy Secretary Jennifer Granholm reported “a productive call with Saudi Energy Minister Abdulaziz bin Salman al-Saud” to “ensure affordable and reliable sources of energy.”

The Administration’s proposed $2TN infrastructure plan is likely to rely on reconciliation to get through the Senate, which means it has to look like a tax/spending plan rather than new laws. Eliminating the filibuster would allow more expansive policies, including on climate change, to be passed with a simple majority rather than the 60-vote filibuster-proof margin.

West Virginia Senator Joe Manchin’s (D) power stems from his less than perfect fealty to Democratic ideals. He is against changing the filibuster, which limits the prospects for new laws including on energy. Manchin wants to, “…usher a new era of bipartisanship where we find common ground on the major policy debates facing our nation.” Hence, Congress can spend money on building an electric vehicle charging network, but can’t impose a carbon tax, even though it’s supported by the American Petroleum Institute.

The Administration’s desired path is to show progress without imposing visible costs, since numerous polls show voter concern about climate change stops once the monthly cost competes with their Starbucks budget. Hence the call to the Saudi oil minister.

Energy investors should welcome the increased political debate. It forces the shrill rhetoric of climate extremists to confront reality. For example, the Texas legislature is considering passing the costs of windmill intermittency back to windmill operators. Texas has enjoyed great success in using more windpower, but the grid’s vulnerability to calm days increases with dependence on wind.

Berkshire Hathaway Energy helpfully showed what intermittency costs, by offering to invest $8BN to build ten natural gas power plants. The proposed Texas Emergency Power Reserve would normally remain idle but could meet any plausible power shortfall by ramping up within ten minutes. The cost of ensuring reliable power would be passed on to customers.

Texas state senator Shelly Hancock (R) has argued that renewable energy providers should instead pay the cost of these natural gas power plants whose main purpose would be to provide back-up power for wind. It’s a reasonable suggestion, but is opposed by renewables operators whose investments were based on a socialized approach to the cost of compensating for intermittency.

The power outages Texas endured last month were caused by multiple failures, including of natural gas plants (see Why Texas Lost Power). But wind and solar power plants are chronically intermittent, with typical utilization of only 20-30%. Despite the outages, natural gas was the only source of power in Texas whose output rose. Renewables often get a free ride by providing power opportunistically with no penalty for unreliability.

Although CO2 emissions are a global problem, OECD countries aren’t making it worse. All the growth is coming from developing countries, notably China and India. Climate change is supposedly a bigger threat to those less able to afford mitigation. While this ought to make poorer countries big supporters of lowering emissions, raising living standards is a higher priority. The most vulnerable nations don’t share rich world goals aimed at protecting them from rising sea levels.

India’s Energy Minister Raj Kumar Singh offered an articulate summary, “The developed world has occupied almost 80% of the carbon space already. You have 800 million people who don’t have access to electricity. You can’t say that they have to go to net zero. They have the right to develop. They want to build skyscrapers and have a higher standard of living. You can’t stop it.” In other words, it’s their turn to pursue a western standard of living. Until emerging countries acknowledge the problem, it’ll be hard to induce rich world voters to pay for solutions.

The increased political debate is good news for all except the climate extremists still clinging to purist impracticality. Climate change is all about politics and economics. The technology already exists for carbon capture, hydrogen sourced electricity and other zero-emission solutions. They’re just expensive. The diminishing likelihood of extreme policy responses (see The Bovine Green Dream) is removing the always low-probability existential risk faced by parts of the energy sector.

The components of the American Energy Independence Index yield 7% on a market cap weighted basis, and announced buybacks add a further 2%. This helped the index to a 20% return in the first quarter. Past performance is not indicative of future returns.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

Goldman almost always sidesteps trouble. That’s one of the conclusions from the Archegos blow-up that is estimated to have cost the firm’s lenders as much as $10BN.

Imagine the discussion among Credit Suisse, Nomura, Morgan Stanley, Goldman Sachs, UBS and Wells Fargo as they considered an orderly liquidation of the hemorrhaging Archegos portfolio. It was a mismatch of men and boys – according to reports, Goldman warned that the market would quickly realize the scale of the problem, depressing the prices of what they were trying to sell and leading to a very disorderly liquidation.

It seems so obvious. Some Wall Street firms are sharper than others. Goldman and Morgan Stanley, who had sensibly adopted the role of observers not participants, evidently relied on this subtle distinction to immediately sell the Archegos collateral they held once they understood the scale of the problem. Nomura and Credit Suisse, in a high stakes version of the Prisoner’s Dilemma, thought time was on their side. They just forgot that Goldman wasn’t.

Goldman Sachs is full of street smart, talented people. In the 1980s and 1990s when I was trading interest rate swaps at JPMorgan, if Goldman was your counterparty to a trade it was worth taking a second look. They rarely seemed to be forced participants – often they’d identified a mis-pricing or arbitrage opportunity. Whenever I found Goldman on the other side of my trades, I often traded less than my full position while I figured out what could be driving their decision to go the other way. Pausing rarely cost the opportunity – markets moved their way more often than not.

In 1998, when hedge fund Long Term Capital Management (LTCM) was blowing up, their biggest swap counterparties gathered to discuss an orderly liquidation. LTCM was our biggest counterparty, but then LTCM was everybody’s biggest counterparty. Their abundance of PhDs and egos had created a colossus that generated tens of millions of dollars a month in profits for the banks trading with them.

I was running interest rate derivatives for Chase Manhattan (later merged into JPMorgan). I received a phone call late one night from a colleague informing me that LTCM was collapsing due to many highly leveraged bets going awry simultaneously. The following morning, our head of credit summarized the exposures we and the other big counterparties had to LTCM. As with Archegos, an orderly liquidation of positions looked to be the best option. But the economic incentives were similar to a cartel – each member was incentivized to secretly cheat.

The LTCM bank group was apparently sworn to secrecy. The information I had been provided made me an insider – it was obvious what trades should be done to generate immediate profits (“pay fixed in ten year swap spreads”) but I respected the rules and waited. Goldman didn’t. I saw them trading on the information they possessed about LTCM’s portfolio.

Goldman never got in trouble. Maybe what they had wasn’t inside information under a strict legal definition – interest rate swaps were bilateral agreements, not SEC-registered securities. Maybe they understood the information sharing agreement to be loose enough to allow trades to be done. What I do know is that they acted differently than we did. David Pflug, the patrician head of credit at Chase, was a man of his word who would never have resorted to legalistic identification of loopholes. Not trading on the information we had required no further explanation. We passed up a hugely profitable trading opportunity – but LTCM had been a money spigot for years.

Derivatives traders use the Greek alphabet (delta, gamma, theta) to identify portfolio risks. David Pflug later commented on the glittering mathematicians of LTCM, “for all their knowledge of Greek, they didn’t understand the meaning of hubris.”

I’ve always felt that Goldman regards legal and regulatory risk as just another risk alongside credit, rate, FX and equity risk. They all offer a risk/return trade-off. Most banks, including the one I worked at, put legal and regulatory risk off limits. There was no such thing as acceptable legal risk. Having watched Goldman over decades, I believe their culture incorporates a highly sophisticated assessment of legal/regulatory risk that allows them to consider the upside of a transgression against the possible penalty. They are very good at it, which is why they so rarely mis-step. The 1MDB disaster is one of the few.

It looks as if Goldman used the Archegos discussions to obtain a clear view of the group’s exposures while retaining the freedom to act. They would have considered their market risk as well as any legal/reputational downside from moving quickly. As skilled risk managers, they quickly decided that your first loss is your best one and sold. Credit Suisse and Nomura discovered they were playing poker at the wrong table.

Credit Suisse is estimated to have lost $3-4BN, and Nomura $2BN. As Warren Buffett has said, if in a poker game you don’t know who the patsy is…

Last Tuesday, Goldman downgraded Nomura’s stock. They noted, “market concerns around risk management issues may persist.” It’s unlikely Nomura will find cause to reciprocate.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

The inaugural ESG Day is becoming more common. Enterprise Products Partners (EPD) held theirs in early March. Pipeline companies are quite rightly asserting their role in combating climate change. EPD noted the beneficial effects of natural gas in limiting coal consumption.  SVP Tony Chovanek also discussed the growing interest in clean-burning hydrogen. Every energy company that can is talking up hydrogen on their earnings calls, although EPD’s plain spoken CEO Jim Teague noted on their 3Q call in October that, until it’s cheaper to produce, …” this one is going to take a while to develop.”

As a fuel, hydrogen’s most appealing quality is that when combusted, it generates heat and water. The technology to produce it is well understood, although the cost makes it higher than conventional fuels. Hydrogen is well suited to be moved and stored through existing pipeline infrastructure, which is why today’s energy infrastructure companies are increasingly talking about it if not yet making large scale investments.

The vast majority of hydrogen is produced from natural gas or coal, in an energy-intensive process that produces around 830 million tonnes of CO2 annually. In the color-coded world of hydrogen production, this is known as “grey”. “Blue” hydrogen relies on the same inputs but captures the CO2 emitted in its production. “Green” hydrogen is produced using renewables and offers the potential for emission-free energy if costs can be brought down substantially.

Green hydrogen is produced using electrolysis powered with solar or wind – hence no emissions. It separates the hydrogen molecules from water. It’s currently less than 1% of produced hydrogen, becayuse it’s expensive. The EU’s 2030 Hydrogen Strategy seeks to create a new “green hydrogen” industry producing 40 Gigawatts (GW) of hydrogen by 2030 (versus 0.1 GW now), and 500 GW by 2050. Electrolysis is an energy hog. Goldman Sachs, in a report called Green Hydrogen, noted that at least 2GW of power is required for each 1GW of hydrogen produced. This only makes sense if power is free, or nearly so.

The EU’s hydrogen initiative envisages enormous scale. Goldman Sachs estimates that green hydrogen production could eventually double Europe’s electricity consumption, becoming the region’s largest electricity customer.

Solar and wind are both weather-dependent and unresponsive to demand shifts. Using solar for example during the middle of the day, when the sun’s high and electricity demand dips between the peaks of breakfast and dinner time, could be a good way to store energy that would otherwise be wasted. In the EU, Spain and Portugal would be attractive candidates for using solar to produce hydrogen, as would the SW U.S.

An Italian utility, Snam, has estimated that a hydrogen pipeline from sunny North Africa to Italy could deliver energy at just 13% of the transportation cost of an ultra-high voltage power line.

A U.S. pipeline investor who bears the scars of the increased investment caused by the Shale Revolution might pause at this point. Although the U.S. has no equivalent to the EU’s 2030 Hydrogen Strategy, the Biden administration is surely working on one. In some regions such as southern California, hydrogen is being blended into the natural gas supply.

The last thing U.S. midstream energy infrastructure investors want is another period of increased growth capex. In the EU, a group of gas transport operators estimated that modifying natural gas pipelines to move hydrogen would require €40BN of investment over 20 years, or $2.4BN p.a. In 2018 the U.S. industry spent $45BN on growth capex, so this seems manageable.

Pipeline investors will be relieved to know that hydrogen is well suited to move through natural gas pipelines, though some modifications would be needed.  Hydrogen has nearly twice the energy density of methane, but less than half the energy content by volume, because it’s so light. So more cubic feet of hydrogen are needed to deliver the same energy as natural gas.

Hydrogen burns with an almost invisible flame, by contrast with the familiar blue flame of natural gas. Prolonged exposure to hydrogen can make the steel used in pipelines brittle, although companies like EPD already supply hydrogen to industrial customers so are familiar with that problem. America’s has 1,600 miles of hydrogen pipelines already, with the biggest network located in Texas. Perhaps most interesting is that hydrogen molecules (H2) are small enough to leak through metal if stored for an extensive time. This creates challenges with long term storage, although salt caverns can be repurposed from holding natural gas to hold hydrogen.

In Utah, Intermountain Power Project (IPP) burns coal to generate electricity for southern California. It plans to convert to a 70/30 blend of natural gas (methane) and hydrogen by 2025 and expects to be 100% hydrogen by 2045, aided by hoped for improved technology. The plant is conveniently located atop a vast salt cavern which will be used to store hydrogen. Natural gas power plants can be modified to run on a methane/hydrogen blend, adding further to their clean energy credentials.

The EU’s 2030 Hydrogen Strategy is going to jumpstart a new industry. The existing European pipeline network will be key to European plans for reduced emissions. North American pipeline companies should be well situated for a similar initiative here.

There was some additional clean energy news last week — NextDecade (NEXT), which plans to deliver Liquified Natural Gas (LNG) while capturing the CO2 produced during liquifaction (see Making LNG Cleaner) announced an agreement with Oxy Low Carbon Ventures (a unit of Occidental) to transport and permanently store CO2. Solar panels and windmills are far from the only story in the energy transition.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

In November, Engie, a French utility, pulled out of discussions with NextDecade Corp (NEXT) to import up to $7BN of Liquified Natural Gas (LNG). It was a big blow to NEXT, which is seeking partners to underwrite its construction of an LNG export facility in Brownsville, TX. Engie concluded that the natural gas sourced by NEXT would be tainted by its involvement in fracking, methane leaks and flaring. It wasn’t consistent with their energy transition goals.

Last week, NEXT launched a new business, NEXT Carbon Solutions (NCS). Their intention is to use Carbon Capture and Sequestration (CCS) to keep 90% of the CO2 generated by their proposed LNG plant as it chills methane in preparation for transfer onto an LNG tanker.

It’s a natural response to the market. Engie’s decision was a wake-up call. Natural gas has a clear edge over coal when it’s burned to generate electricity. But the flaring and methane leaks that are part of natural gas production worldwide are a consideration for some buyers.

Liquifaction of natural gas uses a lot of energy. NEXT plans to use natural gas to power this process, and then capture and store the resulting CO2 emissions in former gas wells. The geology of south Texas is well suited to this. By installing the CCS equipment when the LNG liquifaction facility is built, there are substantial savings compared with adding CCS to an existing facility. NEXT intends to make the clean credentials of its product a competitive advantage.

Interestingly, the added cost is modest, maybe 2% of the price of natural gas based on its U.S. benchmark once tax credits are added. It’s less than 1% of its ultimate delivery cost to European buyers

NEXT is going further, by planning to use Responsibly Sourced Gas (RSG). This will be natural gas whose production has been independently certified as not associated with routine flaring and reliant only on electricity from renewables.

Their goal is to deliver natural gas to customers in Europe and Asia that has generated almost no Global Greenhouse Gases (GHG) on its way to the LNG tanker. Will it make a difference? NEXT is convinced it will.

It’s a logical development. The world has a huge opportunity to substantially reduce emissions by phasing out coal in favor of natural gas. Reducing the emissions involved in producing natural gas makes it even more compelling. NEXT is betting that gas produced with lower GHGs will attract environmentally motivated buyers, presumably an increasing portion of the market.

Over the next couple of years, U.S. GHG emissions will be moving in the wrong direction (see Emissions To Rise Under Democrats). This is partly an unavoidable result of comparisons with last year’s Covid slump in economic activity. But we’ll also be increasing coal consumption relative to natural gas, reversing a very positive trend that has lowered emissions for the past decade. Higher natural gas prices are the reason, since prior coal-to-gas switching by U.S. power plants has been driven by favorable economics.

This will be an uncomfortable result for a Democrat administration that campaigned on reducing emissions. Promoting coal to natural gas switching should become a more visible part of their strategy, both here and overseas.

NEXT includes an interesting slide comparing CO2 emissions that result from the RSG they plan to ship with competing sources. Nord Stream 2, the natural gas pipeline from Russia to Germany, is already controversial. Trump asked why the U.S. maintains troops in Germany to protect against Russia when Germany plans to increase its energy dependence on this potential adversary. There’s no good response to this question, and the Biden administration is similarly opposed to the pipeline’s completion.

Although geopolitics is a strong enough reason for Germany to buy its natural gas elsewhere (such as from the U.S.), the chart above from NEXT’s presentation suggests that different sources of gas come with a different climate impact. Maybe Climate Czar John Kerry can use such data in his discussions with other countries about lowering emissions.

NEXT is a tiny company with big plans. Their latest move may be a last, desperate attempt to sign up enough customers to finance the construction of their LNG facility. Or it may be an important step in the energy transition. If other established companies, such as Cheniere, make similar plans it’ll confirm that NEXT is on to something.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

Covid accelerated a trend already in place in the U.S. energy sector, which is to grow Free Cash Flow (FCF) rather than production. Chevron’s Investor Day last week promised 10% annual increase in FCF through 2025. This return to shareholder-friendly metrics is attracting investors – including recently Berkshire Hathaway.

Midstream energy infrastructure has grasped this as readily as their upstream E&P customers. Full year 2020 earnings have been reported. The companies in the American Energy Independence Index, the best representation of the North American pipeline industry, grew FCF to $25BN last year. This is almost three times their 2019 performance, a result that seemed implausible a year ago when Covid drove panic selling.

Continued reductions in growth capex are the reason – Distributable Cash Flow (DCF), equivalent to cash from operations minus maintenance capex, was flat last year. Pre-Covid, DCF was expected to increase from $54BN to $60BN, but Enbridge (ENB), Enterprise Products Partners (EPD), Kinder Morgan (KMI) and TC Energy (TRP) each came in $1BN or more below target. However, capex reductions were widespread during the year, and these largely offset the drop in DCF which is why FCF came in around target.

The result is the bridge chart shown below, which continues to track a path towards higher FCF for the industry. On current trends we should exit 2021 with a FCF yield of over 10%, more than twice the S&P500. Having rallied so far, one might conclude that the sector’s mis-valuation prevailing last year has been eliminated. The FCF yield shows this isn’t the case.

The biggest single variable in the industry’s capex figures is Enbridge’s planned replacement of Line 3. This is a 1,000 mile crude oil pipeline oroginally built in the 1960s that runs from Edmonton, Alberta to Superior, Wisconsin. Canada has long struggled to find economic ways to get its crude oil to market. The proposed new pipeline will more than double capacity, from the current 370 thousand barrels a day (MB/D) to 760 MB/D. ENB recently raised the estimated total cost of this project by almost $1BN, to $7.3BN.

Predictably, environmental extremists are opposing the pipeline, although it’s a safe bet that they drive regularly, including to their protests. With Biden having canceled the Keystone XL project shortly after his inauguration, the Line 3 Replacement (L3R) has become a new target. So far, ENB and most analysts expect the project to proceed. Our estimate of 2021 growth capex for the industry is $4.5BN higher than we forecast in December; $3.5BN of this relates to L3R.

For 2022 and beyond, the pipeline sector is on track to further reduce growth capex.

Energy executives provided quarterly updates over the past few weeks, which included updating their capex guidance. On the energy transition, typically they acknowledge it and have plans to reduce their company’s carbon footprint. The prevailing view is that global energy consumption will increase for all forms of energy, including oil and gas.

Consider the following: China’s oil consumption is about two thirds the U.S. But China’s per capita consumption is only 15% of the U.S. Its population is growing at around 0.4% p.a., versus about 0.6% for the U.S. China’s per capita consumption of crude is growing at 4.3%, and total consumption at 4.7%.

If China’s per capita oil consumption grows over the next decade at the same rate as it has for the past five years, China would be consuming more than the U.S. if we kept consumption flat. If the U.S. wanted to lower consumption to offset China’s growth, our per capita consumption would need to fall by almost 10% p.a. Currently it’s growing at 0.9%.

Even in this implausible scenario, crude oil consumption is unchanged – it’s simply shifted from the U.S. to China.

This is the daunting math that confronts efforts to reduce emissions. Electric vehicle penetration is higher in China, and they drive around a quarter as many miles as Americans. But 1.4 billion Chinese striving for western living standards is going to require a big adjustment from 330 million Americans, if crude oil consumption and emissions are to fall.

There are many more variables to consider, but this simple example illustrates why Exxon Mobil and Chevron think oil still has a future.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.