None of us will forget the past couple of weeks. Investors and money managers are grappling with collapsing markets, working remotely and the challenges of ever stricter controls on our movement.

Below we’ll highlight some information that investors may have missed, combined with what we’ve learned from multiple conversations.

Pipeline companies that said anything publicly were reassuring. Ten days ago and well into the market crisis, Oneok (OKE) cut growth capex by 20% and reaffirmed 2020 guidance. On Monday Enbridge (ENB) provided a reassuring assessment of their business prospects (see Enbridge Fireside Chat). Since then, Pembina (PBA) cut growth capex by 40% and reaffirmed EBITDA guidance, and Enterprise Products Partners (EPD) declared their normal quarterly distribution. Targa Resources (TRGP) slashed their distribution by 90% which was no great surprise, and lowered growth capex by 30%. Williams Companies (WMB) announced a poison pill lasting a year, to fend off any unscrupulous buyer seeking to acquire the company at a rock-bottom price.

MLP closed end funds and leveraged MLP exchange traded notes were almost wiped out by forced develeraging (see The Virus Infecting MLPs). Incredibly, many of these funds, run by well-known MLP managers such as Tortoise and Kayne Anderson, were leveraged up to 40% as recently as the end of February. In looking at the size of these funds and volume figures, it’s plausible that they were a significant portion of the selling in this sector earlier last week. While coronavirus was unpredictable, the arrogance of these fund managers in maintaining maximum leverage exposes a complete absence of risk management at their firms, and others like them. They have caused a steeper fall than would have happened otherwise. Their NAVs have shrunk far enough that they’re now too small to have much impact going forward.

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Entering 2020, midstream energy infrastructure was set for a doubling of Free Cash Flow (FCF) (see Updating the Coming Pipeline Cash Gusher). The analysis was based on guidance all provided prior to the coronavirus outbreak, although recent updates have been encouraging. We had estimated 2020 growth capex at $37BN for the components of the American Energy Independence Index (AEITR). Average reductions of 20% would free up $7BN in FCF, and since we’re almost through 1Q20 they represent a bigger cut in previously planned spending for the remainder of 2020. We see the industry as broadly in pretty good shape to withstand the type of drop in energy demand that seems likely.

Making forecasts over the next year or two is reliant on the path that the virus takes, the success we have in defeating it and resolving the economic damage. In countless conversations with investors this week, we have stressed that while we can offer our insights on the sector we cover, we won’t pretend to be virus experts. We have a constructive view that the severe health threat posed by the virus will be met within a few months. Someone with a more negative view might infer, say, a severe drop in domestic energy consumption for a couple of years, and that would alter the outlook for pipelines. Our portfolio companies are >75% investment grade with customers that are around 80% investment grade. Exposure to crude oil, and gathering and processing networks, is small because stocks with that type of exposure have already fallen so far.

We have found investors are mostly sitting tight, regarding the drop as too sudden and sharp to warrant a hasty response. There are investors with cash looking for a good entry point. And to bring home the widespread economic damage, we’ve spoken to clients who anticipate providing financial support to children and other family members who have lost their jobs.

The AEITR is down 55.6% for the year, and the S&P500 is  down 28.6%. From October 9, 2007 to March 6, 2009, the S&P500 fell 56%. On Friday, it was 32% off its high of February 19th, a very long month ago.

Finally, this chart caught our attention.

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Outcomes vary widely by country. South Korea stands out as handling the health crisis as well as anybody. Germany is carrying out 160,000 tests a week, has 19K cases and 67 deaths (as of Friday 4:30pm NY time). The 0.3% fatality rate is still higher than flu, but contrasts with Italy’s 4,032 deaths and 8.6% fatality rate. Although there can be many reasons for the difference, infection numbers may be low depending on testing availability, while deaths are probably counted correctly. So Germany’s figures are likely more representative. U.S. infection numbers will increase as testing becomes more widespread. But if the curve eventually flattens to look more like South Korea, that would be the best news we’ve had in a while.

We are invested in ENB, EPD, OKE, PBA, TRGP and WMB.

Closed end fund investors are passionate about the product. Because they generally own a portfolio of publicly traded securities, their NAV per share is easily calculated. The fixed share count means their share price can deviate from the NAV, and this attracts investors keen to buy something for less than it’s worth.

MLP closed end funds have been around for years. They’re a low-octane version of levered ETFs. If you’re good at market-timing, a skill claimed by far more than actually possess it, you can navigate the ups and downs. Leverage magnifies your exposure, and strategies with fixed leverage have to rebalance in the direction the market has moved (i.e. buy high and sell low).

We have warned investors about this before (see Lose Money Fast with Levered ETFs).

In 2015 we pointed out how the Cushing MLP Total Return Fund (SRV) had persistently destroyed value, because of leverage (see An Apocalyptic Fund Story).

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MLP closed end funds use leverage. Because they are more than 25% invested in MLPs, they are non-RIC compliant and therefore their profits are subject to corporate income tax. The interest expense on their borrowings can be deducted against taxable income, thereby reducing or even offsetting the tax obligation that few holders realize exists.

But adding leverage to a single sector fund is a dumb idea. Investment grade midstream energy infrastructure companies generally operate at around 4.0X Debt:EBITDA. Non-investment grade are a little higher. The manager of a sector-specific leveraged fund is essentially rejecting this leverage as too conservative, even though such a fund has little diversification in a sharp fall in the market.

This is an expression of arrogance, that the managers of these funds have some insight superior to the collective opinion of CFOs and rating agencies. They don’t. They are just willing to gamble other people’s money that they do.

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An investor pointed out to me leverage at some of these funds, from fact sheets recently published at the end of February. Goldman was running a fund with 35% leverage. Tortoise had one with 40%. YTD these funds were down 85% and 95% respectively as of 2pm today.

Given the collapse in March, these funds have all been forced sellers. As long-only investors we are down a lot. But the delevering of MLP CEFs has exacerbated the drop for everyone. Leveraged MLP closed end funds are a financial virus that is infecting the rest of the sector, by driving prices even lower. They harm all investors, but most especially the poor souls who sadly bought them. Fortunately, most of these funds are nearly dead, with little capital remaining to protect.

Earlier today Enbridge (ENB) CEO Al Monaco held a “virtual fireside chat” with an analyst from RBC. ENB, like the other Canadians, is run more conservatively than many U.S. businesses. We’ve often noted that a bit more Canadian management would be beneficial in the U.S. energy sector.

The slides below are from the ENB presentation deck that was published at the same time.

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We estimate that within the American Energy Independence Index (AEITR), 80% of the customers are investment grade. ENB does better than this with 95% as this slide shows.

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This chart lists the profile of their natural gas customers. Monaco noted that these customers are often “must-run” facilities such as power plants in the north east U.S. and Canada. He also said that many of their liquids customers run the most competitive, complex refineries.

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This slide shows how their EBITDA showed no visible hit from the 2014-16 collapse in crude prices, even though Canadian tar-sands is among the most expensive crude oil to produce.

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This chart lists their top ten liquids customers along with their credit ratings.

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ENB has been reducing their leverage in recent years. This is because their backlog of growth projects has been coming down. In 2015-16 they had a $25BN backlog, whereas today they have half that with $6BN remaining to fund for new investments over the next three years.

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Monaco sounded very calm about his company’s position. We think they’re the kind of company that can get through just about any plausible economic disruption.

We are invested in ENB.

Client interaction has been overwhelmingly constructive – we haven’t had a single call from anyone wanting to “sell everything.” Our fund has seen very modest net outflows, and new money has been coming in every day.

One investor said on the weekend that we need to present the positive case more forcefully. So, here it is:

• Our midstream energy infrastructure investments and the components of the American Energy Independence Index are >75% investment grade companies. The industry has been reducing leverage and strengthening balance sheets since the 2014-16 oil collapse. Growth projects are increasingly funded with cash from operations, with less reliance on debt and no equity issuance. 4X Debt:EBITDA is common, using 2020 guidance which will be revised down in the coming weeks.
• We estimate around 80% of the customers of our portfolio companies are themselves investment grade. Cheniere Energy is 100% in this respect, so although they’re in the 25% of our companies that’s not investment grade, the credit quality of their customer base provides some comfort. .avia-image-container.av-q9cdnq-c376cf74d693c85eb38fbf92ff46600f img.avia_image{ box-shadow:none; } .avia-image-container.av-q9cdnq-c376cf74d693c85eb38fbf92ff46600f .av-image-caption-overlay-center{ color:#ffffff; }
  
• While energy demand will dip, and economic activity is contracting, there’s plenty of reason to think that in the weeks and months ahead all the efforts at mitigation and control will leave society confronting a new but manageable virus. Getting through the near term is understandably everyone’s focus, but life will eventually return to something we all recognize. Global crude demand fell just 2%% from 2007 to 2009. Natural gas volumes were unaffected. Demand may fall more than then, and supply further still. Although exports are more important than before, the U.S. pipeline business is mostly natural gas and NGLs (primarily petrochemical feedstock), and is mostly about U.S. consumption. We estimate that crude & refined products contribute just 20% of cash flows.
• Companies can improve cash flow by curtailing growth projects. Upstream companies are likely to cut production and growth capex by 20-40%. So far, Oneok (OKE) is the only midstream company to have issued any revised guidance, and they reduced 2020 growth capex by $500MM (20%), while surprisingly reaffirming EBITDA guidance. In Updating the Coming Pipeline Cash Gusher we forecast 2020 Free Cash Flow (FCF) of $22BN (up from $9BN last year). This forecast relies on guidance from companies that is all pre-Coronavirus. However, it also incorporates $37BN of capex spending this year. It’s quite conceivable that pipeline companies’ capex reductions could more than offset any drop in cash flow from operations. We were assuming Distributable Cash Flow (DCF) of $59BN. FCF is derived from DCF minus growth capex. If DCF fell by 20%, which is not in any forecast we’ve seen so far, growth capex would likely drop by more, which would cushion the ultimate impact on FCF.
• Unlike the 2015 downturn, capex is now internally financed. Midstream energy infrastructure companies stopped accessing public markets for equity a couple of years ago, and have no need to do so now. Moreover, debt is long-term and staggered. We don’t see near-term debt financing problems.
• Lastly, assuming an average 20% decline in growth capex similar to Oneok’s announcement, the sector trades at a 2021E 15.6% FCF yield (that’s after capex), fully supporting its 13% dividend yield. Few other sectors have such valuation support today.

The energy sector has taken a triple hit from Coronavirus, OPEC+ collapse and Saudi supply hikes. Investors are most worried about which names will survive. Those with leverage were forced to sell last week, notably including MLP closed end funds. We don’t use leverage and haven’t been forced to sell anything, either for ourselves or for client accounts. Today for example, we have not made a single sale. Sit tight. This will eventually pass. It’s not inconceivable that prices could eventually double from here.

Once America confronts a challenge, history shows that we deploy unmatched resources to take it on and defeat it. The impact on society arrived like a thunderbolt in recent days, and as a country we’ve been knocked on our heels. But our response is coming, and no country is better equipped to come right back and do whatever is required to overwhelm this threat.

Thursday’s fall in equity markets was the worst since the October 19^th, 1987 stock market crash. I was a young interest rate trader then, and that evening I warned my wife that we should stock up on canned food while we prepared for another 1930s Depression. She scoffed that only Wall Street had a problem, and that Main Street was fine.

1987, 2008 and today have different causes, but the need for some solid valuation guideposts is the same. The Equity Risk Premium (ERP) is the difference between the S&P500’s Earnings Per Share (EPS) yield (inverse of the P/E) and ten year treasury yields. Assuming, EPS drop 15%, the ERP is showing stocks to be attractive. A 15% drop seems conservative, and would be approximately the same as 2008, but we’ll emerge from this crisis into a different world. Based on what we know today, broad equity exposure looks cheap.

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Energy sector investors have endured several years of underperformance. The industry has invested more in exploiting the Shale Revolution than investors wanted them to. Crude oil has been hit by the Covid-19 demand shock, collapse of OPEC+ and Saudi Arabia’s subsequent decision to increase supply into an over-supplied market.

Domestic energy demand will drop, but it will eventually recover. The upstream companies that drill for oil are at the epicenter of the price collapse. Midstream energy infrastructure companies care about the financial health of their customers as well as the volumes flowing through the system. The sector entered this downturn with stronger balance sheets than in 2014 and with a developing very positive free cash flow story (see Updating the Coming Pipeline Cash Gusher).

We expect most to follow Oneok (OKE) in cutting spending on growth projects this year, which will free up cash to further reduce debt. The American Energy Independence Index consists of 75% investment grade companies doing about 80% of their business with investment grade customers. The index is down around 50% YTD, roughly the same as U.S. airline stocks, which are regarded as needing some type of short term Federal government support.

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Finally, an interesting chart from Ethan Bellamy at RW Baird, which illustrates the shift in the crude oil curve over the past three months. Spot prices have moved much more that deferred futures contracts. Saudi Arabia and Russia are generally sellers into the spot market, while shale drillers tend to hedge future output for the next couple of years. Because the curve is in contango, sales in the spot market have the lowest realizations.

A strategy to damage the shale industry would create backwardation, as existed in December. In that environment, forward sales of output realize lower prices than spot, which is good for big producers like Saudi Arabia. Their goal is to drive down futures prices along the curve, and the chart shows that spot prices have dropped $30 to produce a far smaller change at, say, the 36 month point. It’s a very expensive strategy for the sellers. At least the Strategic Petroleum Reserve is being replenished cheaply.

Energy had the worst week any of us can recall, and few readers probably have much appetite for a bullish view. For investors and asset managers in the sector, Friday’s rally was welcome but well short of compensating for prior losses. So we’ll just let the chart speak for itself.

Bankruptcy risk is the topic investors want to discuss in calls this week. Within the American Energy Independence Index, the pipeline industry is 80% investment grade companies. We estimate that around 20% of it is direct exposure to crude oil pipelines. 80% of their customers are themselves investment grade.

During the 2008 financial crisis, crude oil consumption dropped 10% and natural gas was unaffected (see With Energy Uncertainty, Natural Gas Offers Stability).

These are some of the facts and figures investors should rely on in assessing the outlook. Then we have to judge how Americans are going to respond to the spread of coronavirus. Everybody can form their own judgment, because none of us has any prior experience with the issue. Avoidance of the virus is far more economically destructive than the sickness itself.

German chancellor Angela Merkel said two in three Germans may become infected in the years ahead. It seems that it’ll be hard to avoid.

Companies are lowering their growth capex plans for this year, which will improve Free Cash Flow (FCF) from what it would otherwise be. Oneok (OKE) yesterday reaffirmed their 2020 EBITDA guidance, while cutting capex.

The OPEC+ collapse and subsequent Saudi production increase are a direct hit at a sector that’s been under pressure for years. A month ago, the outlook was positive with FCF set to rise sharply.

None of us knows how society will respond in the weeks ahead. The best advice we can offer is that this is generally an investment grade industry, and that while energy consumption will temporarily drop, it will recover. The components of the index have a trailing dividend yield of 13%, with payout ratios of just 60%.

The spreading coronavirus and effective end of OPEC+ were a one-two punch that caused the worst  collapse in midstream energy infrastructure stocks any of us have ever seen.

The IEA forecasts a 2.5 Million Barrels per Day (MMB/D) drop in demand for 1Q20, but clearly oil markets are pricing a bigger drop.

Medical experts typically describe Covid-19 as a form of flu that we’ll eventually learn to live with, albeit more infectious and fatal than flu. The economic disruption caused by every-day life shutting down so as to avoid infection is far harder to forecast.

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For pipeline investors, it’s helpful to look back at U.S. energy demand during the 2008 financial crisis.

Crude oil demand did roughly follow the path of the S&P500, with demand dropping as much as 2 MMB/D, or about 10%.

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But natural gas demand followed its regular seasonal pattern with no discernible response to the economic contraction.

The pie chart shows where we consume natural gas. The question is, how much of each different segment is vulnerable to lower demand? If the U.S. quarantines entire regions, or bans mass gatherings such as sporting events, even natural gas demand may dip somewhat. But it’s most likely fairly robust. Whether people are at home or in the mall, they’re still going to want air conditioning. They’ll still need to cook meals. Industrial use isn’t going to disappear.

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So in trying to assess the wreckage after yesterday, stable natural gas consumption seems like one of the more reliable assumptions.

Yesterday’s blog on the positive free cash flow story was largely written before Saturday’s news that precipitated today’s sharp sell off. It’s doubtful any company would reaffirm prior guidance if asked right now.

Investment grade names are better to own than high yield issuers; exposure to natural gas infrastructure is better than crude oil pipelines; corporations are preferred over partnerships.

We would not recommend outright sales at present.

We doubt $30 crude oil will produce enough supply to meet demand over the long run, but we have to get through the short run first.

Almost a year ago, we published The Coming Pipeline Cash Gusher. Midstream energy infrastructure companies, especially MLPs, have long relied on Distributable Cash Flow (DCF) as a measure of profits available for distributions. As the funding needs of growth projects increased, the difference between DCF and Free Cash Flow (FCF) became stark. FCF is a GAAP term and more widely recognized by the broad investment community. MLPs have destroyed the trust of their original investors, because the gulf between DCF and FCF led to distribution cuts. Drawing a new set of investors requires describing results in a recognizable form, and FCF is part of that effort.

Last April, we showed that the need for growth capex had peaked, and that existing assets were generating increasing amounts of cash. Both of these developments are positive for FCF. In combination, they produced a startling trajectory. We calculated that over 2018-21, FCF would leap from $1BN to $45BN – very meaningful for a sector with a market cap of around $450BN.

We did this analysis on the American Energy Independence Index (AEITR), because it’s the broadest representation of North American midstream energy infrastructure companies. It’s the only index that omits companies that pay Incentive Distribution Rights (IDRs) to a controlling general partner. Paying IDRs increases a company’s cost of capital and is the most visible evidence of a misalignment of interests between management and investors. We never invest in a company that pays IDRs, and where available we hold companies that receive IDRs from someone else.

Now that 2019 earnings have been reported, capex guidance for 2020 is available and we’ve updated our forecast. FCF is still set to soar – albeit not quite as fast by 2021 as we found a year ago. But a closer look at the figures reveals a story just as positive. Growing FCF remains the most compelling bull case for this sector.

We should note that the forward guidance that we’ve used was all provided by companies before the market’s sudden drop in response to Covid-19. There’s a strong case to expect domestic pipelines to fare better than most businesses in an economic slowdown, but we’ll explore that topic in more detail in another blog post.

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We now forecast 2021 FCF to be around $41BN, $4BN less than we thought last year. $0.5 of this is because of changes to index membership. Some names have joined the index – either because they dropped IDRs which had previously disqualified them, or because they’re a recent IPO. Others left the index because they were acquired, either by another public company or by a private equity buyer. For today’s index members who were in a year ago, our 2021 FCF forecast has come down by $3.5BN.

For the 28 members of the AEITR who remained in the index since last year, 2019 FCF came in $4.5BN ahead of our April 2019 forecast. TC Energy (TRP) was the biggest surprise here, with $1.1BN of FCF versus our prior forecast of $0.1BN. As we’ve noted before, along with Enbridge (ENB), which also came in $0.6BN ahead of our expectation, the two big Canadian firms generated $4.9BN of the $9.2BN in AEITR 2019 FCF. As more American companies emulate the financial discipline of our neighbors up north, FCF will grow.

Other positive surprises came from Energy Transfer (ET) at $2.1BN versus $0.9BN, Cheniere Energy (LNG) at $1.0BN vs $0 and MLPX at $1.3BN vs $0.5BN. The biggest miss came from Enterprise Products Partners (EPD). Over the 2019-21 period, we estimate their FCF will now be $3.6BN less than we thought a year ago. Their growth capex guidance is now $1BN per annum more than it was previously. Following their 3Q19 earnings report, EPD added $3.6BN to their backlog.  The bulk of this spending is going towards expanding the Midland to Echo crude oil pipeline system. They’re also  investing $1.5BN in a second propane dehydrogenation facility, which will convert propane into propylene for later use in combustion and plastics. The Shale Revolution isn’t just about oil and natural gas – natural gas liquids, such as propane, have also created new business opportunities. EPD’s history of capital discipline and reliable distributions gives them more latitude than many to pursue growth projects.

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EPD stands out in significantly increasing their growth capex – most companies have made only modest changes, although ET raised their capex guidance too, partly because of their acquisition of Semgroup.

For 2021, Kinder Morgan (KMI) and ENB each raised growth capex by $1BN. So the $4BN drop in 2021 forecast FCF for the sector is largely because these two companies, along with EPD, have raised their spending plans.

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Nonetheless, some of the increases in FCF 2019-21 are big. Ten names will collectively increase FCF by $12BN over this period. ENB and KMI could both add almost $3BN apiece 2020-21.

Energy remains out of favor, with pundits like Jim Cramer dubbing it the “new tobacco” and some calling it “uninvestable”. Climate extremists direct their anger at 80% of the world’s energy supply with no practical solutions. Although it may sound as if investors are shunning stocks because of fear that public policy will harm their prospects, TRP and ENB both outperformed the S&P500 last year. That these two were most of the sector’s FCF suggests that explanations for poor stock performance are more driven by capital allocation. As FCF growth becomes more widespread, investors will find more to like.

One of the challenges facing solar energy in providing electricity is that demand often peaks at the beginning and end of the workday. When people are preparing to head to work or school, electricity demand rises. The second peak occurs during early evening during dinner. Solar output peaks around midday, inconveniently between the twin household peaks.

The Energy Information Administration (EIA) produces more detailed data on electricity consumption that shows intra-day consumption by region and at different times during the year. It presents a much richer picture of how we use electricity.

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The twin peaks around breakfast and dinner apply most clearly during winter. There are clear regional differences too. In the southwest, consumption during the day is barely above nighttime, which is normally the trough in all cases. In the northeast and Pacific coast, evening demand is higher than morning, while in Texas and the southeast the reverse is true. It’s probably driven by relatively fewer hours of daylight in northern latitudes, but perhaps Texans watch more morning TV as well.

In summer, the need for air conditioning dominates, and intra-day electricity consumption is highest around mid-afternoon in every region, which aligns more conveniently with solar output. As a result, demand is highest in the summer, with spring and fall being lowest.

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You can also see how we source our electricity on an hourly basis. The chart takes a recent seven-day period. Solar and wind are intermittent, so they produce when they can. Natural gas and to a lesser extent coal produce when they’re needed, which highlights a huge advantage fossil fuels have over renewables. Often the intra-day peak for natural gas is when renewables generation is low. Coal burning power plants are less able than natural gas plants to change output easily in response to shifts in demand. Over the sample period, natural gas output had a -0.40 correlation with wind, neatly capturing the symbiotic relationship that exists between the two. As a grid increases its reliance on renewables, fluctuations in output must be balanced either with battery storage or natural gas. Nuclear output is steady, making it a poor renewables partner, although an energy policy focused on reduced emissions would favor increased nuclear power.

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Although renewables receive substantial press coverage, solar provided only 1.5% of our electricity in mid-February. Wind has been more successful, at 9.1%. But the big change in mix has been the steady displacement of coal by natural gas, which drove America’s 2.5% drop in CO2 emissions last year. Natural gas burns cleaner and runs when it’s not sunny or windy. It’s part of our energy future.