SL Advisors Talks Markets

US Midstream Is Far From Conflict

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To trade the daily moves in the market is to be an armchair strategist. JPMorgan estimates the crude oil market reflects a 17% probability of a worst-case supply disruption out of the Middle East. Presumably an oil spike would hasten the war’s conclusion via US pressure on Israel.

So Israel’s attacks on energy infrastructure are focused on disrupting Iran’s domestic supplies. Therefore, Iran must have an incentive to impede flows. Perhaps their military capabilities have already been too degraded to provide this option. Or maybe this country with few friends in the region doesn’t wish to further alienate its neighbors.

Will there be a ceasefire? Or will the US use bunker-busting GBU-37 bombs each weighing 30,000 pounds to wipe out Iran’s nuclear capability? To us it seems that the opportunity to destroy the Fordo nuclear site will never be as good as it is now. Few of Iran’s neighbors would be sorry to see the theocracy finally denied the capability to make a nuclear weapon. Trump has promised the world something better than a ceasefire. This would seem to check the box.

But it’s hard to make a confident forecast. The worst case for energy supplies is not the most likely outcome but would cause sharply higher prices. In that regard, midstream companies provide some optionality.

Consequently, the news affecting midstream has been in North America, and therefore drawing less attention than Israel’s pummeling of its long-time adversary.

Last week the Ohio Power Siting Board approved the 200MW Socrates South Power Generation Project. Will-Power, a subsidiary of Williams Companies (WMB), will develop two power plants that will run on natural gas provided by WMB. This is an example of the behind-the-meter (BTM) solution to providing electricity to data centers without impacting residential customers.

WMB as well as other large natural gas companies such as Energy Transfer have been promising BTM solutions to meet the needs of data centers for rapid increases in electricity. Meta will be the main customer of the Socrates project. It is expected to be operational by 2H26, fast by the standards of new power generation. Ohio’s electricity customers won’t be adversely affected.

In an example of what happens when data centers boost demand, residents of New Jersey and other neighboring states that are part of the PJM Interconnection grid system are now paying higher prices for electricity. It’s complicated to assign blame. PJM says 70% of the recent increase in demand is attributable to data centers.

But supply is down too. In 2023 New Jersey’s Democrat governor Phil Murphy mandated that the state cease all hydrocarbon-based power generation by 2035. The state’s last two coal-fired power plants were shuttered in 2022. Windpower has come up short, with Danish firm Orsted abandoning two offshore projects because they became too costly.

Liberals say not enough renewable supply is being added, but they’ve lost credibility on energy policy.

This is exactly the problem that BTM is supposed to avoid. Across the region covered by PJM, data centers are driving up power prices for everyone.

Worried about Democrats being blamed by voters for a big jump in electricity prices when they vote for governor in November, Murphy has announced subsidies for household utility bills.

Democrat energy policies are to blame.

Clean energy stocks dropped sharply yesterday as it became clear that the Senate tax package would immediately end most tax breaks for wind, solar and EVs. Given the lead- times involved and reliance on tax credits, it’s likely that swathes of the renewable energy business in the US will be permanently impaired. The electoral cycle is shorter than their investment cycle, leaving any proposed project at risk.

Renewables have been a lousy investment. The S&P Global Clean Energy Index has returned just 3% pa over the past five years. The American Energy Independence Index has returned 27% pa over the same period.

EVs are losing attraction in western countries. A recent survey carried out by Shell found that only 31% of US owners of conventional cars were interested in switching to an EV, down from 34% last year. The slow rollout of charging infrastructure under the last administration didn’t help, and it’s unlikely to change now. In Europe, interest in switching to an EV fell to 41% from 48%.

EVs continue to gain adherents in China, which is supporting their coal consumption since this provides 80% of electricity generation in China. Progressives who cite China’s EV leadership as evidence of their commitment to reducing greenhouse gas emissions need reminding of this regularly.

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

SL Advisors Talks Markets

The Ethane Standoff

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All over the world plastics are manufactured using derivatives of crude oil. Along with cement, steel and fertilizer these are what Vaclav Smil refers to as the four pillars of civilization. Modern life couldn’t exist without them. Renewables are largely irrelevant to their production. Anybody who studies how we use hydrocarbons must conclude, as we have, that they are irreplaceable.

The American shale revolution (and it is uniquely American) unleashed new supplies of oil, gas and Natural Gas Liquids (NGLs). Methane, or natural gas, is the simplest hydrocarbon with a chemical formula of CH4, combining a single carbon atom with four of hydrogen.

Where pure methane is extracted it’s called “dry gas”. It’s often found with other more complex hydrocarbons referred to as NGLs, as in the Marcellus shale in Appalachia. This is “wet gas.” Most of our ethane is now produced in the Permian in west Texas and New Mexico where it is part of the “associated gas” that comes up with crude oil.

Midstream companies separate out the individual NGLs because they’re more valuable, and in most cases can’t be left in the natural gas supplied to customers. Therefore, wet gas is generally more lucrative than dry gas. Ethane (C2H6) is the is the exception – if the price of ethane is low enough it may not be worth separating out and can remain around 10% of the gas we use for cooking, heating and power generation. This is called ethane rejection.

In recent years the US has become the global leader in ethane production. Its relative abundance here keeps the price around one third of most other industrial nations. The US petrochemical industry has grown its consumption of ethane as it’s become more available. While in most of the world plastic is manufactured using a crude oil derivative, in the US ethane is converted into ethylene and used to make plastics, chemicals and other synthetic materials.

US ethane production has tripled over the past decade, to around three Million Barrels per Day (MMB/D). Quantities of NGLs including ethane are typically measured using the energy equivalent of crude oil even though ethane is a gas and is handled like one. A “barrel” of ethane means a quantity containing 5.8 Million BTUs, the same amount of energy in a barrel of crude.

Last year US ethane exports averaged 0.49 MMB/D. China bought 46%, with Canada, India and Norway buying most of the balance. No other country exports ethane on large ships, called Very Large Ethane Carriers (VLECs). China gets virtually all its ethane from the US. Energy Transfer (ET), Enterprise Products Partners (EPD) and Targa Resources (TRGP) own the export infrastructure that facilitates ethane exports. All expect growth and have additional capacity.

Which brings us to tariffs.

Following Liberation Day in early April, investors worried that the 145% tariffs imposed by the US on China would lead to reciprocal tariffs on US exports, including ethane. However, China recognized that its petrochemical facilities set up to process ethane had no alternative supply and chose to exempt US ethane imports.

For a few weeks, this seemed to solve the problem. But last week ET disclosed that the US government had told it to obtain an export license before shipping ethane to China. EPD said they expected their request for emergency authorization to be denied, affecting three cargoes.

On the weekend there were at least seven ships loaded with ethane waiting near the Gulf coast for US approval to sail to China. For now, neither country has any obvious alternative to trading ethane with one another.

ET, EPD and TRGP, the midstream companies with the most exposure to ethane exports, all lagged the sector following April 2, although ET has since rebounded. None of them report ethane revenues separately. They include it within NGLs, which last year were around 25% (ET) and 40% (EPD) of revenues. Most of this activity was domestic so exports were a small portion. TRGP separates out NGL storage, terminaling and export, which was 3% of total revenues.

There are no winners from the disruption of US-China ethane trade. We think it’ll be resolved soon, perhaps as part of the bilateral talks currently taking place in London.

I’ll close by providing a chart of US energy production by source since 2010. We’ve added 17.4 Quadrillion BTUs (“Quads”) of natural gas and 2.25 Quads of solar plus wind, which were combined into a single category on the chart to render them visible. America’s most important energy story continues to be The Natural Gas Energy Transition.

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

SL Advisors Talks Markets

Did Ukraine Boost Oil Prices?

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Macro issues are driving the market even more than usual. Pipeline earnings came with barely a ripple as companies once again generally hit or modestly exceeded guidance. Crude oil rose on Monday on news that OPEC+ was planning a smaller than expected increase in output. This coincided with Ukraine’s spectacular attack on four Russian air bases deep inside the country.

Although seemingly unrelated this makes a cease fire, which was already poor odds, unlikely. The Russian military response could lead to escalation. Correspondingly, increased US sanctions on Russia are now more likely. US Senator Lindsey Graham is pushing a bill that he says has at least 82 votes.

Some oil traders may be considering a further drop in Russian exports. Their crude oil mostly goes to China and India, but Turkey and Brazil are big buyers of their refined products.

Equity markets are increasingly inured to new tariff announcements. The new 50% steel tariff also announced over the weekend had little discernible impact, because we’ve learned to expect that tariff announcements are soon rolled back. Energy analyst John Kemp noted that speculators are favoring long positions in refined products rather than crude, betting on little tariff harm to global GDP growth. The thirty year treasury bond yield moved above 5%, reflecting little concern about slowing growth but more about our fiscal outlook.

5% is a paltry return for the risk.

Last month the FT’s Robert Armstrong christened this the TACO trade (Trump Always Chickens Out). Our Negotiator-in-Chief is now aware of this assessment and not happy about it. A White House tariff announcement that references tacos would not be good.

Supreme Court rulings rarely have a direct impact on the pipeline sector, but last week SCOTUS voted 8-0 (one justice recused herself) to limit the scope of environmental reviews that federal agencies take when approving projects.

This is a welcome turnaround following years of lower courts demanding that permits for a new pipeline or LNG export terminal consider the Greenhouse Gas (GHGs) emissions from the combustion of their transported product by the end user. This always struck me as a political view disguised as a regulatory policy.

Natural gas has displaced coal in the US, reducing GHGs to everyone’s benefit. Climate extremists have persuaded the courts that a blocked gas project means less gas consumed and reduced emissions.

There’s no evidence to support this, and in many cases it’s simply unknowable what would be the impact on, say, South Korean energy consumption in five years if an LNG export terminal that would have sent them US gas is never built.

The unexported gas would probably still be consumed domestically, and South Korea might buy gas from another supplier or rely on coal which provides 33% of their electricity and is growing. The US is only 16% coal.

The January 2024 Biden LNG Permit Pause that Trump rescinded on his first day in office was based on the dubious assumption that constraining LNG exports it would reduce emissions. The Supreme Court ruling at least means that left wing politics will have less impact on energy infrastructure, to everyone’s benefit including pipeline investors.

The Sierra Club and their motley crew have weaponized the courts by raising often trivial legal objections and finding a sympathetic judge. NextDecade (NEXT) was impacted by this last summer (see Sierra Club Shoots Itself In The Foot) when a DC circuit court sent a previously granted permit back to FERC for further review.

NEXT told us they were very happy with the recent Supreme Court ruling and are cautiously optimistic that it would help as they plan further expansion of their Rio Grande terminal.

The DC circuit court had cited concerns about “environmental justice” which in this case meant some nearby residents would have an impaired view. Climate extremists opposed to reliable energy have learned how to exploit subjective concerns in court.

NEXT thinks that the SCOTUS ruling will limit the scope of the environmental considerations a Federal agency may include. The reduced legal uncertainty will help future projects and perhaps at the margin even lower the cost of capital. This story didn’t grab headlines but was a positive one for our sector.

Lastly, the WSJ published AI Is Learning to Escape Human Control which described a model that rewrote some of its own code to disable the shutdown command that its creators had inserted. The model also wrote self-replicating malware, and left messages for future versions of itself about evading human control.

The story reminded me of the “gain of function” virus research that was being conducted in the Chinese lab in Wuhan, from which the overwhelming evidence suggests the Covid virus originated. Let’s hope there’s no analogy in the future.

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

SL Advisors Talks Markets

Investors Warm To Gas Exposure

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The mood was reportedly upbeat at the 22nd Annual Energy Infrastructure CEO & Investor Conference (known as the EIC) in Aventura, FL last week. Performance has been good. The American Energy Independence Index, which reflects the overall industry, has a five year trailing return of 27% pa, easily beating the S&P500’s 16%.

Management teams provided plenty to support an optimistic outlook. The election brought a welcome reset of government policy towards reliable energy. One of the president’s first moves was to lift the poorly conceived ban on new LNG export terminals. Energy Secretary Chris Wright has a background in oil and gas, having founded Liberty Energy. Among the many sensible policies being embraced is support for nuclear energy. President Trump signed an executive order intended to boost nuclear, although actual progress will require a rethink of the current approval process.

The opposition of the Sierra Club and the rest of their left-wing climate cohort to nuclear energy has always betrayed a desire to impoverish humanity with mandatory solar and wind. Their irrelevance to public policy is to everyone’s benefit.

Ignoring that wretched little girl Greta and the rest of the Progressives can be hard, but it’s worth the effort.

Natural gas demand was a big topic of conversation at the EIC. This is coming from data centers and LNG exports. Energy Transfer seems to report more interest every week – the company reports discussions covering gas supply to up to 150 data centers just in Texas, although they do caution that only a modest percentage of these will be completed.

The AI story began to resonate with pipeline investors early last year. It’s not just the Mag 7 that were the beneficiaries. Midstream is the seller of pickaxes to gold miners. Those data centers need electricity, 43% of which in the US comes from natural gas.

It’s caused the sector to become bifurcated. There’s no AI-angle in liquids – improving vehicle efficiency has capped transportation gasoline demand for years.

This has shown up in the performance of the Alerian MLP ETF (AMLP) , which tracks the Alerian MLP Infrastructure Index, albeit from a distance. AMLP, like its index, is underweight natural gas exposure and has half its assets in oil-based names as well as gathering and processing, because that’s generally where the remaining MLPs are to be found. Since the beginning of last year, AMLP has returned 19% pa, slightly ahead of the S&P500 because it does have some gas exposure via Energy Transfer and Cheniere Energy Partners (CQP).

The midstream sector returned 31% pa over this time, led by corporations such as Williams Companies (returned 70% pa since the beginning of last year), Targa Resources (59% pa), Kinder Morgan (47% pa) and Cheniere Inc (25% pa, ahead of its MLP CQP at 19% pa).

AMLP’s underperformance of the sector does overstate the case somewhat, because fees and expenses (5.5% over the past year) create a significant gap versus its own index. Unusually for an ETF, those fund expenses include corporate taxes, whose calculation sometimes trips them up (see AMLP Fails Its Investors Again).

The point remains though that neither a diversified portfolio of MLPs nor the concentrated form offered by AMLP provides much AI exposure (see There’s No AI in AMLP). AMLP is 49% allocated to just four holdings (see AMLP Is Running Out Of Names).

A couple of midstream companies reported some interest from New England states (not mentioning names) in improved gas supply. Perhaps the challenges with offshore wind or the rising costs of power to their residents are a cause for concern.

Attempts to connect the region with gas from Pennsylvania were abandoned several years ago because of regulatory impediments at the state level. The list of canceled projects includes Williams Companies’ Constitution Pipeline, which faced years of delays over a water permit in New York.

Interior Secretary Doug Burgum suggested that there may be an agreement with New York State governor Kathy Hochul that would allow construction of a new pipeline.

A gas pipeline from Pennsylvania across New York could potentially reach Massachusetts. Using more Appalachian gas would at least save Boston from relying on expensive and embarrassing LNG imports. But no midstream company is likely to commit to a large infrastructure project across a swathe of liberal states without clear support from state governments.

Properly maintained, gas pipelines last for decades. For an example, here’s a 1950 documentary about the Panhandle Eastern Pipe Line Company. I love these old videos. They remind us how long energy infrastructure lasts. Seventy five years later Panhandle is still operating, owned by Energy Transfer. Its construction costs were undoubtedly fully depreciated a long time ago, and it’s still making money.

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

SL Advisors Talks Markets

Worrying Inflation Forecasts

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In early April JPMorgan reacted to Liberation Day by forecasting a recession in the second half of the year. They assumed the tariffs would cause a drop in business investment. They also raised their inflation forecast. They didn’t reckon on the President’s tariff flexibility, and so dropped their recession call following the 90 day moratorium agreed with China.

Nonetheless, it looks as if 10% tariffs will be the minimum to sell into the US. The Fed thinks this may boost inflation in the short term. They banished the word “transitory” in 2022 when the inflation spurt started to look permanent. But they may settle on “temporary” to explain tariff inflation.

Barry Knapp of Ironsides Macroeconomics believes tariffs won’t boost inflation because money supply growth is much lower than during the pandemic-inspired fiscal uber-stimulus. However, the budget negotiations in Congress don’t incorporate much fiscal discipline, hence the Moody’s downgrade.

Bond investors have long granted the US a free pass on our dismal budget trajectory. Lending the Federal government long term funds at 4-5% has never appealed to me, but foreign central banks, sovereign wealth funds and other institutions own $TNs of our debt.

Economist Ken Rogoff, who recently published Our Dollar, Your Problem estimates that the dollar’s reserve currency status reduces the yields on our bonds by around 0.5%. With $36TN of indebtedness that’s worth $180BN annually. The jump in yields that followed the downgrade won’t help.

The University of Michigan consumer survey revealed a startling jump in inflation expectations last month (see Stagflation). A quarter of respondents think five-year inflation will exceed 10%. The average is 4.1%, the highest it’s been in over thirty years. That’s not good for those expecting the Fed to pursue multiple rate cuts this year.

It turns out that the survey’s a good predictor. The one-year outlook and annual inflation three months later have a correlation of 0.7.  It may be somewhat self-fulfilling in that consumers behave consistent with their expectations. As the chart shows, they track each other closely and actual inflation reliably follows the forecast.

Given his background in real estate and penchant for debt-financed tax cuts, Trump is unlikely to be too concerned about higher inflation. Your blogger’s investments are arranged accordingly.

For owners of pipelines, inflation isn’t the scourge that it is for most investors. Companies generally have pricing power because of limited alternatives, with the regulations designed to curb excesses while assuring an adequate return on invested capital.

In 2022 the ceiling on fee hikes for liquids pipelines was 13.3%, which supported subsequent earnings growth. The Bureau of Labor Statistics began publishing a natural gas pipeline transportation index three years ago. It’s volatile. The most recent year-on-year increase was 4.2%.

Forecasts of peak oil production from shale have weighed on midstream recently. But the outlook for natural gas production remains strong. Morgan Stanley reports that Enterprise Products Partners expects 1.5 Billion Cubic Feet per day (BCF/D) of additional associated gas from the Permian over the next two years. Targa Resources expect 0.8-1.2 BCF/D over the next one year.

In spite of this, Morgan Stanley’s E&P team thinks the domestic market will be short 3 BCF/D next year because of growing Liquefied Natural Gas (LNG) demand. The Golden Pass LNG export terminal owned by Qatar and Exxon Mobil is expected to begin production late this year or early 2026.  It has a capacity of 2.4 BCF/D.

Although we often remind investors that pipelines are generally not that exposed to commodity prices, unmet demand for natural gas is unlikely to be an adverse scenario.

Taiwan closed down their last nuclear reactor recently and is seeking imports of LNG as a replacement. Following the Fukushima disaster in 2011, public concern about nuclear energy increased. Unfortunately, this has left the country almost completely dependent on imported hydrocarbons. In 2023 Taiwan relied on gas and coal for 80% of its electricity. Solar and wind were 8%.

Progressives must regard this as a policy win. They are best described by an Oscar Wilde quote: “Some cause happiness wherever they go; others, whenever they go.”

More accurate is to quote JPMorgan’s Mike Cambalest who wrote in March:

“What was Taiwan thinking by shutting down nuclear power which has fallen from 50% to 5% of generation? Taiwan is now one of the most energy dependent countries in the world, resulting in rising economic costs if China were to impose a blockade.”

Inflation and more natural gas demand are a good combination for midstream.

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