SL Advisors Talks Markets

Natural Gas Demand Remains Firm

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00:00 / 00:06:11

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Midstream energy infrastructure lagged the market sharply following last week’s FOMC meeting with its revised dot plot. The odds of a recession have increased. Although infrastructure businesses have very visible cashflows, enough holders operate on a hair trigger that requires little inducement to sell. It’s doubtful you’ll see any revision to guidance as a result of the last few days.

Increasing demand for US natural gas provides a strong underpinning. NextDecade was the subject of a positive article by RBN Energy (see Jump In The Line, Part 4 – NextDecade Eyes FID On Rio Grande LNG Project With Carbon Capture). They have signed commitments for 75% of the capacity of their first two Liquefied Natural Gas (LNG) trains – the name given to the structures that chill and condense methane before its loaded onto specialized LNG tankers.

A Final Investment Decision (FID) to move ahead with construction of the Rio Grande LNG facility in Brownsville, TX is expected before year’s end. Further selling agreements may result in FID on three trains. At its full capacity of five trains, NextDecade’s Rio Grande LNG terminal will ship 3.6 Billion Cubic Feet per Day (BCF/D) of natural gas. Cheniere, the leader, currently ships 5-6 BCF/D. NextDecade also promises to capture 90% of the CO2 expended at Rio Grande, a feature likely to appeal to climate-conscious European buyers. 

US LNG exports will increase, but the results will take several years to show up given the complexity of construction. LNG contracts are typically designed with a liquefaction fee and limited price exposure to natural gas for the LNG operator.

NextDecade’s success contrasts with Tellurian’s struggles to obtain financing for their project. Tellurian’s bullish view on natural gas prices meant they structured agreements such that they retained price risk. Consequently, they have found it hard to attract investors for this riskier business model. Two selling agreements recently lapsed, so Tellurian moved a step farther away from FID.

Meanwhile, some US drillers are prioritizing natural gas production over crude oil. In west Texas, “associated gas” produced along with crude oil, has often been flared – capture and transportation being unprofitable. Today that is reversing, as increased global demand for LNG trickles through the energy sector (see Dregs of US Oil Patch Are More in Demand Than Crude Itself).

Critics of the Federal Reserve are finding more ammunition. Former NY Fed president Bill Dudley believes the Fed is underplaying the pain of inflation fighting. He thinks the unemployment rate (currently 3.6%) will need to rise much higher than the FOMC projected peak of 4.4% in order to meaningfully impact inflation. He notes still very benign long term inflation expectations – ten years of 2.4% based on US treasuries. Dudley fears that the Fed will lose support for its policies when it becomes clear rates must move higher than expected.

We’ve pointed out the weaknesses in Owners’ Equivalent Rent (OER), the statisticians’ measure of the service (shelter) a home provides (see The Fed Is Misreading Housing Inflation). Yesterday the Case Shiller 10-city composite index of home prices recorded a 14.9% annual increase, down from 17.4% the prior month.

Home price index futures (yes, they do exist) present a gloomy outlook for housing. CME Metro Area Housing Index futures imply a 9% drop over the next year. At the depths of the 2008-09 financial crisis the Case Shiller Metro Area Home Price Index (on which the futures are based) registered a –12.8% annual drop in February 2009.

If the market forecast is correct, we’re in for more than just a little softness. Nonetheless Fed chair Jay Powell said at last week’s press conference that he expects shelter inflation to, “remain pretty high for a while.” He knows OER has little to do with home prices.

We continue to think that over the long term 3% inflation is more likely than 2%. Voters long ago ditched any tolerance for pain to reduce the Federal deficit, the outlook for which steadily worsens. There’s no reason to believe that higher unemployment today in search of lower inflation tomorrow will garner widespread support once the newly unemployed realize they’ve been sacrificed for the greater good.

For evidence of today’s demand for pain-free economics, look no further than the president’s student loan forgiveness program which the nonpartisan Congressional Budget Office (CBO) estimates will cost $400BN. Even the New York Times seems to have lost some enthusiasm. Critics note that the CBO analysis excluded, “a plan to reduce payments for future borrowers who go on to earn low incomes after college, which outside analysts say could cost hundreds of billions of dollars more.”

You might think that, since the student loan problem is caused by young people borrowing to purchase educations inadequate to subsequently deliver sufficient income for repayment, thoughtful policy might seek to dissuade more of the same.

Apparently all this can be achieved through an executive action by the president. A country where such is possible seems likely to find slow debt monetization with 3-4% inflation preferable to fiscal and monetary discipline. We believe midstream energy infrastructure offers attractive upside in such circumstances.

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

Please see important Legal Disclosures.

SL Advisors Talks Markets

Why Liberal States Pay Up For Energy

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00:00 / 00:06:49

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The northern hemisphere winter is approaching, which means more opportunities for amusement or shock at New England’s masochistic energy policies. Massachusetts and neighboring states have denied themselves access to abundant US natural gas in the Marcellus shale in Pennsylvania by preventing the construction of new pipelines that would connect them. As with most initiatives embraced by climate extremists, this one rests on the questionable belief that making it harder to use natural gas for power generation will somehow shift demand to renewables.

The US Energy Information Administration (EIA) is forecasting a 7.5% increase in the retail price of electricity this year. However, the pain of higher energy prices will not be spread evenly. Eversource Energy, a New England based utility with about four million customers, recently more than doubled rates from 10.67 cents per Kilowatt Hour (KWh) to 22.57 cents per KWh.

The New England Independent System Operator (ISO) reports that last year natural gas represented 46% of the energy used to generate electricity, above the US average of 38%. Liberal politicians in Massachusetts and neighboring states may be hoping that preventing new natural gas pipelines will somehow reduce its consumption, but instead shipments of Liquefied Natural Gas (LNG) are covering the shortfall. On its website the ISO notes that following the shale revolution, “… natural gas generators became the go-to resource for New England.” Not sharing politicians’ zeal to impede access to reliable energy, the ISO warns, “… we are finding that during severe winter weather, many power plants in New England cannot obtain fuel to generate electricity.”

In August Boston took delivery of its tenth LNG shipment of the year, bringing their seaborne imports to 16 Billion Cubic Feet. They have to compete with strong demand from European buyers, where LNG prices have been as much a 10X the US Henry Hub benchmark, currently around $8 per Million BTUs (MMBTUs). If Boston paid a mere $30 per MMTBU premium, that’s almost $0.5BN more in expense than if they were able to access this supply domestically.

Customers in New England are used to paying more than the US average for electricity. Retail sales of electricity in Massachusetts are around 50 Million Megawatt Hours annually. The average US price is 10.19 cents per KWh. In Massachusetts it’s 18.19 cents.

CO2 emissions have fallen over the past decade across the US to around 5.2 Gigatons (2019), down by 4.4%. Coal to gas switching is the biggest driver. Massachusetts has done a little better, lowering emissions by 7 million tons or about 10%.

If we assume that residents of the Bay state are paying an extra 5 cents per KWh for their electricity to achieve this CO2 reduction, that works out to $2.5BN in added expense. Divided by the 7 million tons of reduced CO2 means Massachusetts is spending $357 per ton.

This is an astronomical amount. The recently passed Inflation Reduction Act provides tax credits of $80 per ton for CO2 that is captured and permanently sequestered underground. Exhaust from ethanol production generates high concentrations of CO2, which makes this a likely use for the tax credit. Direct Air Capture, which pulls CO2 out of the ambient air where it exists at around 412 parts per million, will earn a $180 tax credit for its permanent storage underground.

CO2 tax rates in Europe vary widely. France is €45 per ton ($45) and Sweden is the highest at €117.

Surveys tend to reveal that support for public policies aimed at reducing greenhouse gas emissions is broad but shallow. Gasoline prices have been rising for most of the Biden administration. Global investment in new oil production remains too low to maintain supply at current prices. E&P companies recognize the impediments to new production represented by environmental extremists and left-wing energy policies. Together they have succeeded in driving pipeline sector free cash flow yields to over 10% because new pipeline construction is much less common. As I often say, if you meet a climate extremist, give them a hug and drive them to their next protest.

The Administration has been emptying out the Strategic Petroleum Reserve in recognition that high prices at the pump have political downside. For the same reason, a US carbon tax has never commanded much support even though it would cause more efficient capital allocation.

But there are clearly some parts of the US with a greater tolerance for higher energy prices if perceived to be in support of emissions reduction. New England’s energy policies present an example of what to avoid for many of us, but utility bills aren’t becoming a political issue.

Annual CO2 emissions in California fell by 12 million tons (2009-19), a 3.3% reduction. Assuming Californians are also paying 5 cents per KWh for this achievement, that works out to a stunning $1,042 per ton, along with an inadequate grid that recently asked Tesla owners to refrain from charging their cars.

Climate extremists could point to both these states as evidence that consumers will accept higher energy prices in support of their policies. Or they may calculate that the very high price per ton of CO2 some consumers are paying will draw unwelcome attention to the results of liberal energy policies.

Both states have found that impeding natural gas consumption leads to unexpected difficulties – either LNG imports to Boston or the risk of power cuts in California. Natural gas is hard to beat. It’s displaced a lot of US coal production, including in Newburgh, IN where a strip mine formerly operated by Peabody Coal is now the bucolic Victoria National Golf Club. The energy transition is good.

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

Please see important Legal Disclosures.

SL Advisors Talks Markets

Another Pleasant Suprise From Cheniere

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00:00 / 00:05:32

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On Monday evening Cheniere provided their third revised EBITDA guidance of the year. It’s good that they’re not based in the EU where they would be a target of the planned windfall profits tax. Cheniere has raised guidance by $1.2BN (after 1Q earnings), $1.6BN (after 2Q earnings) and now another $1.2BN pointing to a range of $11.0-11.5BN.

Cheniere now plans to direct around 40% of Distributable Cash Flow (DCF) to shareholder returns, including a 20% dividend hike and an expected 10% growth rate in the future. European LNG demand has helped push margins higher. 2022 is turning out to be an exceptional year and the company is guiding for EBITDA in subsequent years around $7BN, although some analysts believe that is conservative. Their long term “take-or-pay” contracts provide almost 20 years of cash flow visibility. We are long-time investors in Cheniere

The news from Cheniere provided a pleasant distraction from the inflation numbers for energy investors. The core CPI number (ex-food and energy) was sharply higher than expected at 0.6%, well above July’s 0.3% figure. Inflation expectations have remained surprisingly constrained over the past couple of years. Ten year inflation expectations as derived from the treasury market are 2.4%. However, the Fed will worry that stubbornly high inflation will become embedded in consumer expectations. In our opinion savers should plan on a higher inflation rate when assessing their retirement outlook.

The resilience of midstream energy infrastructure compared with the S&P500 reflects the explicit inflation linkage many pipelines offer (usually via the Producer Price Index). We think it’s an excellent component of any equity portfolio.

The US exports around 11 Billion Cubic Feet per Day (BCF/D) of Liquefied Natural Gas (LNG). This will rise modestly over the next couple of years to around 13 BCF/D, but may increase sharply beyond that depending on which projects can sign enough long term contracts to reach a Final Investment Decision (FID).

There are few pureplay LNG export opportunities available beyond Cheniere. NextDecade (NEXT) and Tellurian (TELL) are both early-stage companies with plans to build facilities over the next few years. Of the two we prefer NEXT for its superior governance, but both companies will likely draw increased interest as investors consider other companies that may emulate Cheniere’s success.

The collapse in Russia’s exports of natural gas (methane) to western Europe highlight the expense involved in transportation. Methane moves by pipeline or LNG tanker. Russia invested billions of roubles in the infrastructure to support Nord Stream 1 and 2. These pipelines have no alternative use. Although China is an obvious alternate buyer, more billions of roubles will be required to build the necessary infrastructure. Moreover, as noted in an FT article, China will be a difficult customer. No country wants to be overly reliant on a neighbor for energy. Fixed infrastructure that straddles national borders, such as pipelines, will increasingly require the near-certainty of stable relations. The post-Ukraine world is one where energy supplies can be leveraged for political gain. Energy security makes imported seaborne natural gas in the form of LNG a more flexible alternative, even if it costs more. Consequently, global demand for LNG is likely to benefit from this type of geopolitical analysis. The US is well positioned to benefit.

The US Energy Information Administration (EIA) recently announced that 24% of US electricity generation came from renewables during 1H22. It’s hard to share their enthusiasm for this milestone, since it comes with unreliability and higher prices (see California and Germany). The EIA noted that both hydro and wind, which are the majority of renewables, provide more output in the first half of the year than the second. In the case of hydro it’s because of melting snowpack. Wind evidently has its own seasonality as well. Over the past twelve months renewables are 16%, up 2% year-on-year.

Although it’s politically correct to celebrate increased use of renewables, the dominant story about US power generation for at least the past decade has been the switch away from coal. Since 2012 natural gas has gone from 28% to 38% of our electricity. Over the same period coal has dropped from 39% to 21%. Hydro and nuclear have each dropped slightly, by 1%, and renewables have increased by 10%.

It’s also interesting to see that electricity demand has barely grown over the past decade, reflecting improving energy efficiency across our economy.

The EIA has noted in the past that most of America’s drop in greenhouse gas emissions is the result of coal to gas switching. Natural gas remains the most interesting story in the energy markets.

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

Please see important Legal Disclosures.

SL Advisors Talks Markets

How Occidental Invests In Lower Taxes

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Occidental Petroleum (OXY) has a checkered history. In 2019 CEO Vicki Hollub snatched Anadarko away from Chevron (CVX), who already had a signed deal in place. CVX CEO Mike Wirth showed financial discipline that’s rare in such cases and declined to get into a bidding war. Instead, they walked away with a $1BN break-up fee.

Hollub obtained $10BN in financing from Berkshire in the form of preferred shares in order to close the deal. Perhaps Buffett also had doubts about the price OXY was paying, since he chose to avoid the common in favor of a more secure return. Covid soon struck, and the energy sector plummeted. Within a year of OXY’s audacious purchase crude oil was trading at negative prices as demand collapsed under the regime of lockdowns.

By April 2020 OXY’s stock had lost 80% of its value prior to the Anadarko deal. Although the Covid collapse was to blame, CVX had dropped by just over half. It looked as if Vicki Hollub had been outplayed by a competitor with financial discipline and devastatingly unlucky timing.

The energy sector began its slow recovery, but OXY lagged and by October 2020 was making new lows, down 85% from its pre-deal level while CVX was steadily recovering.

Since then, the gap has narrowed. Buffett evidently liked what he’s learned about OXY since he recently obtained regulatory approval to buy up to half of their common stock. Berkshire’s market outperformance this year has drawn quant funds. One investment manager believes Berkshire will eventually buy the whole of OXY, becoming an oil major in its own right.

OXY’s value lies in its reserves of oil and gas. But energy companies have accepted the energy transition and have initiatives aimed at showing they’re going to be part of the solution to CO2 emissions. Recently OXY announced plans to develop the world’s biggest Direct Air Capture (DAC) facility to remove CO2 from the ambient air.

Carbon Capture and Sequestration (CCS) received a boost in the recent Inflation Reduction Act (IRA). The 45Q tax credit starts at $85 per Metric Tonne (MT) for CO2 that is permanently sequestered underground. Enhanced Oil Recovery (EOR) has long relied on pumping CO2 into mature wells where the pressure has dropped, to force up more oil. The technology is reasonably well understood, and while burying CO2 to produce more fossil fuels doesn’t reflect the spirit of emissions reduction, it can be buried in other secure geological formations. Kinder Morgan has the most extensive CO2 pipeline network in the US because of their EOR business. Several pipeline company executives expressed optimism that they could benefit from the 45Q tax credit.

CCS makes the most sense where CO2 emissions are high – such as the exhaust of coal-burning power plants. But it has its critics. Robert Bryce recently reprised his 2009 criticism of CCS in response to the IRA. He noted that coal burning power plants lose up to 28% of their output when their emissions are being captured. He also warned that pipelines required to move CO2 to its final burial would likely have to be funded by taxpayers. And he estimated that capturing half of the 5.4 billion MTs of CO2 generated in the US annually would mean handling a volume of gas, even compressed to 1,000 pounds per square inch, equivalent to daily global oil production. He warns, “We would need to find an underground location (or locations) able to swallow a volume equal to the contents of 41 oil supertankers each day, 365 days a year.”

In JPMorgan’s 2022 Annual Energy Paper, Michael Cembalest estimated that capturing 15-20% of US CO2 emissions would involve handling a volume of gas exceeding all US production – a more modest estimate than Bryce’s but still staggeringly high.

OXY’s planned DAC facility is seemingly going after an even harder problem. The concentration of CO2 in ambient air (ie not standing downwind of a power plant) is around 412 parts per million. You have to process enormous quantities of air to get much CO2. OXY expects its CCS plant in Ector County, TX to capture 0.5 MT annually with the capability to reach 1 MT. The CO2 will be buried in a formation beneath forest land owned by paper company Weyerhauser. Trees are nature’s carbon capture, but the CO2 is eventually released when the tree dies or burns down.

OXY’s subsidiary 1PointFive (named in reference to the goal of limiting global warming by 1.5° C versus 1850) hopes to have 70 DAC facilities operational globally by 2035. The IRA provides up to $180 per MT tax credit for DAC. Five of the plants planned by 1PointFive in the US operating at 1 million MTs per year would generate $900 million in tax credits, significantly reducing OXY’s tax bill.

Buffett probably expects crude oil demand to remain strong for many years, supported by rising living standards in emerging economies. With enough DAC facilities in place, OXY investors could profit from providing energy the world wants and from mitigating its effects. It’s the kind of two for one deal the Oracle likes.

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

Please see important Legal Disclosures.