SL Advisors Talks Markets

Windpower Faces A Tempest

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At the end of August Orsted, a Danish developer of wind turbines, announced they’d be delaying their first planned installation off the New Jersey coast until 2026. They blamed supply chain issues, interest rates and insufficient US Federal tax credits. The Federal government had only recently approved the project.

New Jersey Democrat governor Phil Murphy and the Democrat-controlled legislature are big proponents of the garden state switching to windpower. New Jersey has regrettably moved to the left in recent years, partly because Republican voters are leaving for southern states such as Florida.

But even though New Jersey is a solidly blue state, there is plenty of opposition to windpower along the Jersey shore, which tends to be more conservative. Cape May county, opposite which the wind turbines are planned, is both especially conservative and opposed. Turbines already in place are blamed for a jump in whale deaths although this is disputed. It’s also feared that they will spoil the view. Protect Our Coast NJ is adopting some tactics from the environmental extremists’ playbook in using court challenges to impose costly delays. Treasurer Frank Coyne said, “The objective is to hold them up and make the cost so overwhelming that they’ll go home.”

The cost of installing windpower is going up. Orsted said it may take a $2.3BN writedown on its US projects. New Jersey Democrats even passed legislation redirecting Federal tax credits from residents to Orsted in order to make the economics more appealing. The delay until 2026 means the project won’t be completed before Phil Murphy leaves office, casting further doubt over its ultimate viability. Orsted has said it considered abandoning the project but for now intends to proceed, which is likely to encourage opponents to keep up the pressure. So far they’ve invested $4BN in US offshore wind projects including Montauk point at the tip of Long Island, and Rhode Island. They plan to make a final investment decision on all three by early next year.

Orsted is not alone. Spain’s Iberdrola canceled a planned wind farm off the coast of Massachusetts. Sweden’s Vattenfall backed out of a project off the coast of Britain, citing cost inflation. Siemens is expected to lose up to $5BN in its wind turbine manufacturing unit.

It’s tough to make money in renewables.

Then there’s NextEra Energy (NEE) and its MLP NextEra Energy Partners (NEP). NEE is “an industry-leading clean energy company” and is building its renewables capability as fast as it can. Four years ago we wondered if rapid depreciation in its asset base would ultimately hurt earnings (see Is NextEra Running in Place?). At the time the company was depreciating 5.5% of its Property, Plant and Equipment (PP&E), higher than other utility companies and suggesting a useful life of under twenty years.

Rapidly improving costs for renewables power generation cause older equipment to depreciate more quickly. And solar always faces the challenge that if a region is sunny enough a utility might find its customers investing in their own solar panels and batteries, disconnecting from the distribution network which means the fixed cost of transmission lines is spread across fewer users. It still doesn’t look like an appealing business to us.

NEE pulled ahead of the American Energy Independence Index (AEITR) for the next three years following our 2019 blog post, and its depreciation as a % of PP&E fell back to its peer group. In recent weeks it’s lagged and is now behind the AEITR over that time period. Over the past year NEE and NEP have substantially underperformed the AEITR.

An investor asked me last week what I thought of NEP. It is an old-fashioned MLP, with a controlling General Partner (GP) that can drop down assets. Midstream energy infrastructure, still known colloquially as the MLP sector, used to have many similar structures. The GP, in this case NEE, has a similar position to a hedge fund manager with respect to her hedge fund, in this case NEP.

When MLPs were controlled by a GP, we always favored the GP, just as you’d rather be the hedge fund manager rather than a hedge fund client. In 2012 I published The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True which revealed how investors had in aggregate done poorly in spite of hedge funds being wildly profitable, because fees had siphoned those returns over to the manager.

We recognized the analogy with MLPs and their GPs. NEE is NEP’s GP. They retain the old model but are in new energy. So we would avoid NEP and favor NEE because we always prefer the GP.

Nonetheless, it’s easy to see why both stocks look attractive especially if you want exposure to solar and wind. Within three years NEE is planning to have more renewable generation capacity than total installed capacity for any other US company. NEP is planning to sell its natural gas pipeline business and be 100% renewables.

NEP yields 7.6% and is guiding for 12% annual distribution growth. Its one year total return is –40%, probably dragged down by the challenges faced by Orsted and others.

NextEra’s wildly bullish outlook on renewables runs counter to the experience of the windpower manufacturers. They are a pureplay bet on renewables profitability, contrasting with writedowns being taken elsewhere in the industry.

It’ll be fascinating to see how this plays out.

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

SL Advisors Talks Markets

The Growing LNG Trade

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Nearly three years ago, French utility company Engie pulled out of negotiations with NextDecade (NEXT) to buy Liquefied Natural Gas (LNG). Concerns about leaks during the production of natural gas (methane) were the reason. Methane is a GreenHouse Gas (GHG) that is many times more potent than CO2 over a decade or so at trapping heat in the atmosphere. Over longer periods it decomposes, whereas CO2 remains for a century or more.  

Energy sector methane leaks are far from the biggest source. The International Energy Agency (IEA) estimates that natural gas related leaks are only 7% of the total. A third of methane emissions occur naturally in wetlands. Agriculture is responsible for a quarter, mostly from ruminants (cows and sheep) belching and farting. Several companies are developing a seaweed-based animal food additive that would alter the digestive process of such animals.  

Last year I met Steve Turner, CEO of Australian company Sea Forest at a wedding. Usually a Brit and an Aussie talk trash about each other’s national cricket teams upon meeting for the first time, but I quickly learned Steve’s company was turning asparagopsis into a solution to agricultural methane emissions (see How Seaweed Can Fight Global Warming). It’s an area worth following. 

Anyway, Engies’s conclusion in 2020 that US natural gas was harming the planet was a big setback for NEXT, which was trying to line up enough buyers of LNG from their planned Rio Grande terminal in Brownsville, TX to justify making a Final Investment Decision (FID) to go ahead. The company responded within a few months by launching NEXT Carbon Solutions to develop Carbon Capture and Storage (CCS) at Rio Grande. Recognizing the sensitivity of European buyers like Engie to the environmental impact of their product, they committed to provide “responsibly sourced gas” that is certified as being produced with minimal leaks, and to ensure their liquefaction process is GHG emission-free, by using a combination of renewable energy and CCS.   

NEXT negotiated agreements with other buyers to provide environmentally friendly gas. In April 2022 Engie returned and signed a 15 year deal for 1.9 Million Tonnes Per Annum (MTPA). Russia’s invasion of Ukraine dramatically changed Europe’s access to natural gas, but the changes NEXT had implemented addressed Engie’s earlier objections. FID on the Rio Grande LNG project came in July.  

Bechtel Energy has the contract to build the facility, having been Cheniere’s longtime construction partner for their Sabine Pass, LA and Corpus Christie, TX terminals. Recently Bechtel Energy’s President, Paul Marsden, and NEXT’s CEO Matt Schatzman, held a videotaped mutual lovefest during which each emphasized the climate-friendly features of the project. Climate extremists should be supportive, because by displacing coal in the world’s biggest emitters such as China and India, US LNG is a most effective counter to rising GHGs.  

NEXT’s FID in July was poorly received by the market because they were left with 20.8% of the economics in Trains 1-3 (Phase 1), less than the approximately one third investors had been led to expect. Global Infrastructure Partners and the sovereign wealth funds of Singapore and Abu Dhabi share 62.5% in exchange for $4.75BN of equity capital. France’s TotalEnergies took 16.7% in exchange for $1.1BN and a 20 year commitment to buy 5.8 MTPA. The $6.1BN in equity plus $11.8BN in debt financing makes Rio Grande Phase 1 the largest greenfield energy project financing in U.S. history. 

The modest 20.8% stake retained by NEXT looked as if they’d been out-negotiated.  

Global LNG demand is rising. Research firm ICIS Analytics expects the US to increase its market share from 22% to 31% over the next five years. Germany, the Philippines and Vietnam all began importing LNG for the first time earlier this year. More countries are expected to follow. The EU continues to buy LNG from Russia, as they try and impose sanctions that don’t drive energy prices up. Belgium and Spain are the world’s second and third-biggest importers of Russian LNG this year. They aim to stop completely by 2027. 

NEXT currently trades at the low end of the $6-8 per share valuation range sell side analysts ascribe for Phase 1. The upside potential for the stock relies on the completion of Trains 4-5 (Phase 2). The Rio Grande project is estimated to work out at $700-800 per tonne of capacity for 17.6 million tonnes per annum. Qatar’s expansion is estimated to cost $900 per tonne. Total’s Mozambique LNG project has faced many problems and is reported to cost $1,500.  

Rio Grande Phase 2 will benefit from the site preparation done for Phase 1, and as a result could cost under $500 per tonne. What’s unknown is what NEXT’s percentage ownership of Phase 2 will be. The market currently places minimal value if any on Phase 2. NEXT should be able to negotiate a much bigger stake, because Total already has an option on 32% of its capacity. Timing is uncertain, but the odds of Phase 2 ultimately going ahead look good to us. NEXT will be part of America’s increasing share of global LNG.  

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

SL Advisors Talks Markets

The Sunshine State Runs On Natural Gas

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If you google “Florida solar” or “Florida natural gas”, both searches return around 150 million results. NextEra Energy, which owns Florida Power and Light (FPL), the utility that covers much of the state, is targeting zero emissions by 2045. Their 2022 ESG report says FPL expects to quadruple its solar generation capacity by 2031. They currently operate 63 solar sites across the sunshine state. 

As its nickname suggests, Florida is well situated for solar power. Casually following the announcements of new solar installations and battery centers to back them up, one might think the state is largely powered by the sun. But as the Energy Information Administration (EIA) recently noted, 75% of Florida’s electricity comes from natural gas.  

The biggest change in Florida’s sources of power generation over the past decade has been the increase in its use of natural gas, which generated 191 Terrawatt hours (TWh) last year, 53 TWh more than in 2012. This 2.6% annual growth rate pales against solar’s 50.3% annual rate over the same time. But growth rates starting with a very small base number often look deceptively high. Renewables fans use this mathematical sleight regularly to overstate their impact. Last year solar power generated 11.4 TWh for Floridians. Even the year-on-year increase of 2.4 TWh was less than a quarter of the jump in natural gas. And it’s safe to say that solar growth rate will not sustain anything close to 50%. 

Florida relies on solar power for 4.5% of its electricity, a little higher than the US at 3.4%. Generation over the past decade has grown at a 1.6% annual rate, three times the US at 0.5%. As a Florida homeowner I think FPL is getting it right. They’re delivering reliable power at a reasonable price. Their mix of sources roughly matches Florida’s, since they’re the states’s biggest provider. Also note that solar is 11% of capacity but only 5% of supply. Solar and wind tend to run at 20-30% of capacity (offshore wind can be higher). Florida’s solar may run higher because it is usually sunny, but after each glorious sunset those solar panels stop working.  

NextEra’s ESG document is fortunately not being implemented in a way that’s harming consumers, because adding nuclear’s 12% share means 87% of the state’s electricity comes from reliable sources.  

Liberal states have higher electricity prices, partly because they are adopting more stridently anti-fossil fuel policies. More renewables mean more costly power. New York won’t let new buildings connect to natural gas. Massachusetts has high prices even though their reliance on natural gas rivals Florida. This is because they’ve blocked the new pipelines and storage facilities that they clearly need, limiting their benefit from low domestic prices. Instead, they import liquefied natural gas (LNG) and therefore have to compete on the global market at much higher global prices.   

Florida’s use of coal has dropped by two thirds over the past decade. China plows ahead with new coal burning power plants at the rate of around two per week. They’re building six times as many as the rest of the world. Climate extremists in liberal states drive energy policies that impose higher costs on their own citizens and any modest benefit in reduced emissions is swamped by China’s actions. 

US residential solar is losing momentum, because of higher interest rates as well as a sharp drop in the rebates California residents can earn for sending surplus solar power back to the grid. Wells Fargo estimates installations this year will be up only 3% versus last year and is forecasting a 13% drop next year. The EIA expects cheap natural gas to cause a slight drop in electricity prices next year. Florida should benefit more than most. Massachusetts probably won’t. 

Tesla offers installation of photovoltaic roof tiles that don’t look like ugly solar panels arrayed on top of your house. The WSJ recently interviewed two homeowners happy in spite of long delays. But volumes are far below the company’s forecast of five years ago and the story suggests Tesla severely underpriced the jobs. Solar really isn’t that cheap, especially in northern states.  

Job growth in Florida is double the rate of New York and New Jersey, and 50% faster than Massachusetts and California. Remote work is allowing Americans to spread out, and they’re choosing Republican states because they’re generally better run and more pro-business.  

Long-time Florida residents often express the fear that “northern liberals” will turn Florida blue. The opposite has happened, because political conservatives are generally the ones that move. My golf club in NJ has seen an increase in members moving to Florida. Few voted for Democrat governor Phil Murphy. This is why migration south has created a liberal shift in states like New York and New Jersey instead. Energy policies are starting to reflect this.  

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

SL Advisors Talks Markets

An Uncontroversial MLP Merger

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Energy Transfer’s (ET) acquisition of Crestwood (CEQP) highlights the shortcomings of the proposed merger of Oneok (OKE) with Magellan Midstream (MMP). Because ET and CEQP are both MLPs, combining the two entities doesn’t constitute a taxable event for unitholders. This contrasts with OKE/MMP where MMP unitholders will face the recapture of deferred income tax on prior distributions. The synergies in ET/CEQP are modest and achievable – likely understated given ET’s strong operating history. Projected OKE/MMP synergies were never very convincing because they handle different commodities.  

The market-derived odds of the OKE/MMP deal closing have risen recently, and it looks likely to receive shareholder approval although not ours. We calculate the odds at close to 80%, sharply higher over the past couple of weeks. Both management teams have clearly been actively making the case to institutional investors. MMP investors and their financial advisors should be ready for an unwelcome 2023 tax bill. 

As we noted last week (see AMLP Fails Its Investors Again), the Alerian MLP ETF (AMLP) will suffer another loss of its rapidly depleting constituents when MMP ceases to exist as a stand-alone entity. ET’s acquisition of CEQP will remove yet another, reducing the total to twelve. 

MMP is 12.44% of AMLP’s portfolio and CEQP another 5.24%. They’ll have to reallocate 17.68% of the portfolio, further concentrating their positions.   

There are no good options for AMLP, but that doesn’t mean its advisor Alps won’t try something. Converting AMLP to a RIC-compliant fund by limiting MLPs to 25% of its portfolio would allow for more diversified holdings. However, this would signal to the market the sale by AMLP of three quarters of its portfolio, depressing the prices of the MLPs it owns and causing its holders great offense.  

Existing investors in AMLP and any other non RIC compliant funds such as the Invesco Steelpath family are all exposed to any of their peer group funds making such a change. AMLP investors must assess the odds of Invesco moving first, and vice versa. It’s a percolating problem and at some point, a resolution will create an overhang of MLPs for sale. The smaller MLPs, favored by AMLP because there are so few to choose from, are especially vulnerable because their only other buyers are the K1 tolerant US taxable individuals that historically owned MLPs for the tax deferred distributions.  

Last week the Energy Information Administration released data showing that US pipeline exports of natural gas to Mexico hit another record. Living standards in our southern neighbor are rising, which means energy consumption is too. This trend is clear across most of the developing world. Much of the world and especially poorer countries aspire to American lifestyles. Per capita energy consumption and GDP are closely linked. This is what’s driving growth in global energy consumption. Rich world OECD countries want lower emissions, and generally energy consumption isn’t rising among this group. In Germany it’s been falling, a consequence of their disastrous energy policies which are making it a less attractive location for any industry that needs reliable, reasonably priced energy.  

Our southern neighbor exhibits many of these trends. Mexico’s population has more than tripled since 1960. The UN expects further population growth through 2050. More people with rising living standards mean more energy consumption. As with most countries, improving efficiency has kept consumption below these twin trends. 

Mexico’s energy consumption grew at a 0.8% Compounded Annual Growth Rate (CAGR) over the past decade. This was behind Asia which averaged 2.6% but well ahead of Europe which saw –0.9%. At 0.6% the US stands out among G7 nations as the only one with growing energy consumption – cheap domestic natural gas has spurred investments in industry.  

Mexican electricity generation is also growing, following a sharp drop in 2020 due to the pandemic. The CAGR for the past decade is 1.4%, a third of Asia (4.6%) but well ahead of the US at 0.5%.  

Good news for US natural gas exporters is that this remains Mexico’s biggest source of power generation at 56% last year. From 2020-22 solar and wind combined went from a 10.9% share to 11.7%. Renewables are gaining, but slowly.  

US natural gas will increasingly supply global buyers as our LNG export capacity grows and consumers in developing countries enjoy rising living standards supported by increased energy consumption. The energy transition and efforts to reduce global greenhouse gas emissions will need to align with this reality.  

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

SL Advisors Talks Markets

AMLP Fails Its Investors Again

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Last week the Alerian MLP ETF (AMLP) announced a reduced quarterly distribution. Regular readers know that AMLP has been a rich source of material for this blog. Launched in 2010 when MLPs were synonymous with pipelines, it was designed to offer exposure to midstream energy infrastructure without the K1s that so many investors and their accountants dislike.  

Today MLPs represent about a third of the sector’s market cap. The narrow base of potential buyers has persuaded many former MLPs to convert to conventional c-corps, so as to be attractive to a much wider investor base. It also didn’t help that MLPs cut their dividends in half from 2015-20 – not the way to treat the traditional holders who were high net worth US taxpayers seeking stable income.  

AMLP’s recent 3.5% distribution cut is especially odd because it’s against the prevailing trend. Dividend hikes are becoming the norm, including at: Magellan Midstream (1%), Oneok (2.1%), Enterprise Products Partners (5.3%), Williams Companies (5.4%), Cheniere (19.7%), Targa Resources (42.9%) and Energy Transfer (54%). 

Since its 2010 launch through the end of June, AMLP has returned 2.61% versus its benchmark of 5.02%, a big underperformance for a passive ETF. Taxes are a big reason why. Alps, the fund’s advisor, has had to make two downward revisions to its NAV in the past year, both the result of recalculating the fund’s tax liability. AMLP is a corporate taxpayer, at least when it has unrealized gains on its portfolio. This unusual concession is necessary to jam MLPs into a ‘40 Act fund, which makes it a non-RIC compliant ETF.  

Because MLPs represent a declining share of the pipeline sector, AMLP’s number of holdings has been shrinking. They’re down to 14, and if Oneok’s acquisition of Magellan Midstream goes through that’ll knock them down to 13. They have an overweight to petroleum products – crude oil pipeline operator Plains All American is their biggest holding. They are underweight natural gas names, because most of them converted to c-corps. We prefer natural gas exposure over crude oil because it has a more robust growth outlook. Oil is primarily used in transportation.  

AMLP is also overweight smaller names, because there are so few MLPs to choose from. Crestwood (CEQP) is a 5.3% position, whereas it’s only 0.42% of the market as defined by the American Energy Independence Index. AMLP, ostensibly a passive ETF, has a 12X market weight position in CEQP because it has so few choices. 

Although global crude oil demand recently touched a record 103 million barrels per day, it is in the crosshairs of governments around the world adopting policies to reduce CO2 emissions. Natural gas is America’s biggest source of electricity generation at almost 40% and is used in many areas that solar and wind can’t serve, such as petrochemicals and fertilizer production. AMLP holders are unwittingly concentrating their exposure in the riskier part of the sector, because that’s where MLPs are.   

AMLP investors don’t just endure the drag of corporate taxes on the fund’s NAV versus its benchmark; they also face the uncertainty that those taxes have been calculated correctly. Last November (see AMLP Trips Up On Tax Complexity) and then again three months ago (see AMLP Has Yet More Tax Problems), Alps suffered the ignominy of disclosing a reduced NAV because of tax complexity. The two adjustments taken together wiped out the last three quarterly distributions.  

It’s unclear why AMLP’s distribution has dropped. Perhaps they have discovered yet more errors in their tax calculations. It remains the biggest ETF in the sector at $6.7BN, evidence that lethargy outweighs critical analysis among its holders. The characterization of its distributions as largely a return of capital used to appeal – this is common among MLPs because the tax code allows them to depreciate their assets even though their ability to generate earnings is growing. In effect MLP investors pay taxes on their distributions when they sell, at which point there’s a deferred income tax recapture. AMLP has in the past incorporated this appealing feature. 

However, this year its distributions have all been classified as income, meaning that taxable accounts have a tax liability this year. The changed nature of AMLP’s distributions coincides with the two NAV restatements, so it’s possible the tax analysis Alps has carried out is responsible. So AMLP now offers declining distributions wrapped in a vehicle that is taxed as a corporation, has restated its NAV twice in a year and no longer offers tax deferred distributions. If your financial advisor still holds AMLP in your account, you might want to see how much of this he really understands.  

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