SL Advisors Talks Markets

Drilling Down On AI

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It says something about one company’s dominance of AI chips when a presentation on power demand growth starts with Nvidia’s revenue forecast. But that’s how John Schultz of the Advanced Data Center Consulting Group opened a recent webinar. Unit volumes can be derived from sales, and the number of chips being bought determines the amount of new power demand.

Consequently, AI electricity use is forecast to more than double this year versus 2023.

Blackstone is investing $8BN with data center provider QTS preparing for the AI boom.

AI chips are power hogs, but less appreciated is the need for electricity to cool them as well.  As more computing is packed into smaller spaces, the physical limits of blowing cold air on the equipment are being reached. Combining water with data centers was long rejected by the industry as too risky, but direct to chip liquid cooling is becoming the only practical way to stop the expensive kit from from melting.

Microscopic fragments in the cooling fluid can damage the chips, so stainless steel pipes are required to move PG25 (85% water/15% anti-freeze).  Mesh filters with openings measured at 100 microns – ten times the size of a human blood cell — are used to trap particulates.

Schultz reviewed some of the AI uses already deployed.

Microsoft Office uses Copilot (dubbed “AI for the workplace”) to create powerpoint presentations, write in Word based on an outline and build Excel macros. Google’s Duet aims to compete.

There are important applications in drug research, where development times are coming down sharply. Terray Therapeutics captures 50 terabytes of raw data (more than 12,000 movies) on billions of molecular interactions every day in their quest for new treatments. McKinsey thinks pharmaceuticals have a “once in a century” opportunity.

Interpretation of medical images is 2.5X more effective since AI can learn from 10,000 examples in less than three months whereas a radiologist would need twelve years to see the same number of images.

Finance is using AI-powered chatbots for customer service, to detect fraud and to evaluate investments.

Data center location depends on proximity to its customers. AI training can be done anywhere as long as the data consists of words and text that can be moved easily. Video data requires far more bandwidth, so this type of AI training happens where the video is stored.

Latency is another issue. Microsoft’s Copilot can tolerate latency of 100-250 milliseconds, which means they need fewer data centers (Schultz believes four) across the US to serve most of their customers. Applications requiring less latency need more data centers across the country to reduce the physical distances data must cover to the customer.

Powering the AI revolution will be challenging. Some data centers will rely on dedicated electricity generation, with natural gas an obvious choice. Given the sensitivity of many IT companies to their green credentials, expect much buying of carbon credits and other efforts to offset CO2 emissions.

Solar and wind will require excess generation capacity to compensate for their intermittency. And nobody likes power lines passing over their land.

Microsoft is considering using small modular reactors, but given popular opposition to nuclear power, they’ll need to be in rural areas.

The scale of the jump in power demand is already a political issue. The Electric Reliability Council of Texas (ERCOT) now expects electricity demand to increase to 150GW by 2030, up from 85GW today. Last year their 2030 forecast was for 130GW.

This will challenge the current approach whereby customers sign up for power supply whenever they’re ready. ERCOT CEO Pablo Vegas said more than half the new demand will come from crypto-miners and data centers. Bitcoin production is a misallocation of resources and should be near the bottom of any priority list.

Data centers create few local jobs once they’re built, so there’s the potential for a political backlash if retail electricity prices are perceived to be rising because of AI. Some new customers, such as hospitals, schools and residential areas may receive priority in connecting to the grid.

It is somewhat reminiscent of the dot.com excitement 25 years ago. The internet brought hype but was hugely consequential. Overbuilt fiber-optic networks led to sharply lower communications costs which stimulated demand.

AI hasn’t yet had a discernible impact on how we do our jobs at SL Advisors. I still type every word of every blog, and the videos are me. But the use case examples provide compelling evidence that another computing revolution is underway. Increased power demand will boost natural gas consumption, benefiting companies such as Energy Transfer, Kinder Morgan and Cheniere.

Try googling will AI boost natural gas demand?

Pipeline multiples are still too low, with 6% dividend yields plus 4% growth providing a potential 10% total return.

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

SL Advisors Talks Markets

The Pipeline Outlook Keeps Improving

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The trend of positive assessments is continuing for the pipeline industry. Sell-side analysts are pressing the case for their favorite names. JPMorgan sees further upside for Targa Resources (TRGP) even though it’s returned 40% YTD. They have a $140 price target for the end of next year, up from ~$120 today. They cite a “fully integrated well-to-dock Permian NGL value chain” and attractive Enterprise Value /EBITDA multiple of 9.0X (2025E) versus a peer group median of 9.7X.

NGLs are natural gas liquids, mostly ethane and propane. The latter is used in agriculture (for crop drying) cooking and heating where natural gas isn’t available, and also as a petrochemical feedstock. NGLs get less attention than oil and gas, but their production has also grown through fracking. US propane exports are now well above 1.5 Million Barrels per Day. They’ve more than tripled in the past decade. TRGP is one of the beneficiaries.

Years ago when MLPs were overinvesting and investors wanted to see reduced capex, then-CEO Joe Bob Perkins would flippantly talk about “capital blessings” on earnings calls where he defended unwelcome big outlays.

Today TRGP has a greater focus on capital discipline, but it’s also fair to note that many of those prior investments have worked out fine.

Wells Fargo recently upgraded several natural gas-oriented names based on attractive valuations and power demand from AI data centers. Some investors are skeptical that enough new power plants will be built to drive the 7 Billion Cubic Feet per Day of increased natural gas demand they expect. New rules from the Environmental Protection Agency require all coal-fired and any new gas-fired power plants operating past 2039 to control 90% of their CO2 emissions, meaning capture and sequestration.

Regulations can always be changed, but the counter is that enough existing power generating plants have available capacity to drive gas demand higher anyway.

Morgan Stanley expects the median pipeline stock to return 21% over the next year, including a 6.1% median dividend yield. Buybacks are supportive of this, with $1.5BN of stock retired during 1Q24. Cheniere was $1.2BN of this and TRGP $124MM.

Some of the best energy analysts in the market remain constructive on the sector.

I’ve been searching for a good energy podcast. Progressive “renewables will solve everything and the world’s on fire” podcasts are abundant and useless. I did stumble on the educational Energy Policy Now and found Power Struggle: The Electric Grid’s Natural Gas Challenge informative. AI will drive the increased demand for natural gas. This drills down into some of the consequences.

When Storm Uri hit Texas in 2021 it didn’t only highlight the need for winterized natural gas production facilities. Many power plants had natural gas contracts that didn’t guarantee supply, because there’s a big price difference. The Texas grid, run by ERCOT, has tended to place less importance on reliability than the rest of the country in exchange for low prices. Uri led to a reassessment.

At the Federal level, NERC, which oversees electricity, prioritizes reliability while FERC, which regulates interstate natural gas, values safety most highly. Electricity “days” that govern contracts start and end at midnight, whereas gas “days” begin at 10am ET. So a gas-fired power plant faces a mismatch between its pricing for inputs versus outputs.

These problems can be solved more easily than coping with the 20-35% utilization that burdens intermittent solar and wind.

If you enjoy learning about the intricacies of the energy business, you’ll enjoy the podcast. Or you can rely on me to chronicle the highlights.

Once or twice a year I play golf with my old boss from JPMorgan, Don Layton. In 1986 he decided to hire a 23 year old derivatives broker as a trader. It was to my great benefit and hopefully not something he had later reason to regret. Don (often referred to by his initials, DHL) went on to become vice-chair of JPMorgan, running the investment bank. I soon took over interest rate derivates trading in NY.

Later in his career Don was CEO of E*Trade and then Freddie Mac, from 2012-2019.

Don was a terrific leader, with the rare ability to combine strategic vision with command of detail. I’ve remained in touch with many who used to work for Don in the 1980s and 90s. We all retain fond memories and great respect for him. On Monday we reminisced with two other former colleagues, Don Taggart and Don Allison.

DHL remains strongly competitive and draws unseemly pleasure from beating me at golf on one of his home courses. The nostalgia easily compensates.

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

SL Advisors Talks Markets

Blue State Energy Policies

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Oregon is typical of many liberal states in that it is reviewing the infrastructure plans of the utilities it regulates. The concern is that too much capital will be invested in new natural gas infrastructure that will subsequently result in “stranded assets” as renewables reduce natural gas demand. The fear is that poor capex decisions will saddle future ratepayers with the cost of un-needed infrastructure as cheap solar and wind gain share.

Renewables aren’t cheaper – that theory has been debunked by the rising price of electricity over the past couple of years (see The Inflationary Energy Transition). There’s a case that reducing CO2 emissions is a desirable public policy goal and pursuing it is worth more expensive electricity. Liberals rarely make this case, preferring instead to claim that weather-dependent power costs less in defiance of evidence to the contrary.

So the Oregon Public Utilities Commission is challenging assumptions about future natural gas demand, which they deem “unreasonably optimistic.”

Additions to US natural gas pipeline capacity were a record low in 2022, down 97% from the high five years earlier. It’s helping boost cashflow at pipeline operators because their capex is down but may not always be in the public interest.

By contrast, India’s PM Narendra Modi is pushing to turn India into a “gas-based economy.” The country’s largest steel mill is planning to invest $1BN to help it switch to natural gas, which will reduce its coal consumption and therefore India’s CO2 emissions.

The Indian Oil Corporation recently signed a long-term LNG deal with TotalEnergies, a key investor in NextDecade.

The White House pause on new LNG export permits impedes India’s energy objectives even though they’re in everyone’s interests. India’s JSW Steel is not going to use solar and wind to make steel.

This is why it’s correct to bet on continued growth in demand for US natural gas. The world is shifting to a more realistic energy transition which acknowledges it’ll take generations and that reducing coal consumption anywhere and everywhere is good. As policymakers and businesses adopt practical solutions, the US is well positioned to lead.

Several major European power companies are scaling back their renewables’ targets.  Italian, Spanish and Portuguese electricity prices may be among the highest in the world, but they aren’t high enough to make such investments profitable.

“There has been a big reality check around renewables growth,” said Norman Valentine, head of renewables research at consultancy Wood Mackenzie.

It is against this backdrop that your blogger is replacing an old oil furnace with a new gas one. This requires the local gas company to upgrade our existing gas line to higher capacity, work that is mercifully still permissible in blue New Jersey. In New York, Con Edison requires anyone with a gas service request to accept the “Acknowledgement of the Climate Leadership and Protection Act” which sounds as if they’d rather you didn’t make such a request in the first place.

Heat pumps have outsold natural gas furnaces for the past two years. This doesn’t mean that more homes are installing heat pumps, because some homes may be using more than one unit. For example, we already have one natural gas furnace so will be adding a second.

Heat pumps, which run on electricity, use less energy and are cheaper to operate. This should mean they’ll eventually displace natural gas furnaces. However, their installation is complex and expensive. They also don’t work well with the cast iron radiators in our almost century-old home, which require large volumes of very hot water to operate effectively.

Heat pumps reportedly run less efficiently as it gets cold, when they rely on a backup heating element which is much less efficient. I’d be concerned that they wouldn’t keep the house as warm as I’d like – I have little tolerance for being cold, which is why I spend much of the winter in south Florida.

Unlike our gas furnace, a heat pump would be placed outside where it would be vulnerable to ice formation. Defrosting it would reduce the heat available for the house, probably just when it is most needed. They’re apparently also noisy. They use a longer operating cycle than gas furnaces which means they’re running more of the time.

The added gas infrastructure that will enable our additional gas furnace will not be stranded for at least as long as we’re living here. My criteria for a heating system begins with whether it will keep us warm enough. There’s no efficiency or cost benefit that would compensate for being cold. And any reduced emissions would be offset by one of China’s new coal-burning power plants within a few moments, so that doesn’t factor in at all.

I don’t want to be forced to rely on a heat pump in the future if I don’t think it’ll meet my needs.

Ray Dalio sees political polarization in America causing people to, “…move to different states that are more aligned with what they want.”

Energy policy in liberal states is one reason why.

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

SL Advisors Talks Markets

Picking The Top Pipeline

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Which is the best pipeline company? It depends on what you’re measuring. Income-seeking investors might focus on Distributable Cash Flow (DCF) yield or distribution (dividend) yield. Dividend coverage is usually important. Lowest leverage would provide comfort to those concerned about downside. Momentum investors will look at dividend growth – and few will ignore price performance. So how do they rate?

We’ll focus on the biggest companies and MLPs, all part of the American Energy Independence index (AEITR). If DCF yield is what you’re after, Energy Transfer (ET) is top at 17.2%. For years this stock labored under the “Kelcy discount” as potential buyers were wary of past management actions that weren’t fiduciary best practice (see A Look Back At Energy Transfer).

However, this company knows how to execute. Last year’s acquisition of Crestwood has been absorbed with more synergy benefits than forecast. Many advisors we talk to own ET, and their reputation has evolved away from most likely to self-deal to great operator with an “in-your-face” posture to competitors and regulators.

One investor said he’d heard that some analysts are downgrading ET, but JPMorgan and Wells Fargo both reaffirmed Overweight ratings following earnings earlier in the month.

The highest dividend yield is Western Midstream Partners (WES) at 9.4%. Their DCF yield is only 10%, giving them a scant 1.1X coverage. It’s many years ago now but low distribution coverage ratios used to be typical when MLPs were the dominant corporate form in midstream energy infrastructure. They were routinely doing secondary offerings to buy “drop-down” assets from their controlling general partner.

The shrinking pool of MLP-oriented money forced a more conventional single entity c-corp structure on most of the industry. Giving up the partnership structure meant accepting the double taxation common to most equity securities (ie first on corporate profits then on dividends paid to owners).

Depreciation charges help lower taxable income in many cases.

The best payout coverage is a whopping 10.2X at Cheniere. Their DCF yield of 11.2% is close to the median. They paid their first dividend in November 2021. It’s grown by a third since then but still only represents a derisory 1.1%. One of the features we like about Cheniere is that once an LNG terminal is built its ongoing maintenance capex is low. As a % of EBITDA Cheniere has the lowest ratio in the industry.

Pipelines have been reducing leverage in what’s become a virtuous cycle. Falling capex, caused in part by opposition from climate extremists, has boosted free cash flow. This has allowed some debt paydown as well as driving EBITDA higher. MPLX currently has the lowest Debt/EBITDA of 2.7X.

The two big Canadians, Enbridge (ENB) and TC Energy (TRP), have both been bucking this trend (5.1X and 5.4X respectively) with big capex programs and (in ENB’s case) acquisitions. This has caused their stocks to lag the market, although both are continuing to raise dividends and reduce leverage.

Growth, as measured by three-year CAGR in payout, is distorted by companies that have significantly increased their payout ratio. Hence Targa Resources (TRGP) is top with a 22% CAGR having raised their annual payout from $2 per share in 2023 to an estimated $3.63 (re JPMorgan). More representative growth rates from companies that were always paying a reasonable dividend are Williams Companies (5%), ET (6%) and MPLX (7.1%).

When it comes to trailing one year performance, Equitrans is the clear winner with a +155% return. Resolution of Mountain Valley Pipeline (MVP) thanks to its inclusion in a debt ceiling bill makes Senator Joe Manchin (WVa) their MVP.

In 2022 NextEra, a JV partner in MVP, was so pessimistic about the prospects of completion that they wrote down their interest to zero (see Why Pipeline Construction Is Hard). The repeated delays and cost overruns show why making the permit process more predictable is so important to all kinds of energy infrastructure, especially renewables. If courts can rescind authorizations years after the fact, building big projects will carry an additional layer of risk.

Other strong performers over the past year include TRGP (+66%), WES (+58%) and Oneok (+46%). I received a hefty tax bill due to their acquisition of Magellan Midstream (MMP) last year, which we and others opposed (see Still Uncovinced By Oneok Magellan Combo).

Since New Jersey doesn’t recognize tax loss carryforwards, the gain on MMP which I’d held for close to two decades was fully taxed on my state return while my federal return allowed some older losses to offset.

The NJ tax code is the most effective tool for encouraging those with means to flee the state. Fortunately, the OKE-MMP combination has performed better than expected.

Whichever metric you prefer in selecting stocks, midstream energy infrastructure has names that measure up well. It’s why the sector continues to outperform.

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

SL Advisors Talks Markets

What’s Next For NextDecade?

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NextDecade (NEXT) has drawn plenty of investor questions over the past ten days. It began with their most recent 10Q, filed with the SEC on May 13^th. The phrase, “... there is substantial doubt about the Company’s ability to continue as a going concern.” wasn’t pleasant reading for many. How can a company that reached Final Investment Decision (FID) on trains 1-3 for its Rio Grande LNG export facility last year have any doubts about its survival?

Investors initially looked past the company’s reiteration that it has secured funding for Stage 1 (Trains 1-3). The “going concern” language referred to Stage 2 (Trains 4-5) which is not financed and hasn’t yet reached FID.

The stock swung wildly over the two trading days (May 10-13), covering a range from $7.41 to $6.37. On Tuesday 14^th it recovered strongly, perhaps as investors reassessed.

Our opinion remains that the market is giving little if any credit for the economics of Stage 2. The costs of completing Trains 4-5 should be lower than 1-3 because the site will have already undergone its initial preparation. So we think it’s undervalued. However, the company disappointed investors when they reached Stage 1 FID last July because they wound up with only 21% of the economics.

My partner Henry and I often debate how to assess this. I think they negotiated poorly. Global Infrastructure Partners (GIP) and TotalEnergy outsmarted them. No doubt capital and offtake agreements are vital to the project. But if you’re acquiring the land, capital, infrastructure partner and customers it seems that should be worth more than a fifth of the resulting business. NEXT had led investors to expect a 30%+ share, so on this they disappointed.

The counter, as Henry points out, is that they’re in a much stronger position to negotiate over stage 2 where we expect them to achieve a higher share than Stage 1. Even though Stage 2 is two trains versus three in Stage 1, it’s plausible that Stage 2 could be more valuable.

The LNG permit pause, ill-advised though it is, has helped NEXT. This is because, crucially, they have permits for Stage 2 already. Energy Transfer, whose planned Lake Charles LNG project is currently hostage to the pause, has seen negotiations slow because of the uncertainty. Japan’s Minister of Economy, Trade and Industry Ken Saito has sought clarification since Japanese companies are among the potential customers.

NEXT is not impacted by this. As if to demonstrate, on Monday they announced a 20-year 1.9 million tons per annum offtake agreement for Train 4 (ie Stage 2) with ADNOC of the United Arab Emirates. ADNOC additionally acquired an 11.7% stake in Stage 1 through GIP.

NEXT’s 10Q reminded that they plan to resolve the going concern issue by, “obtaining sufficient funding through additional equity, equity-based or debt instruments.”

This deal didn’t raise any equity for NEXT, so the possibility of a secondary is still there. But it did provide welcome confirmation of Stage 1 economics for the current investors.

NEXT hopes to reach FID on Train 4 later this year.

Deals can get done before FID has been reached on a facility, as NEXT has shown repeatedly in recent years. Permit uncertainty is a more difficult hurdle to overcome.

The contrast with Tellurian (TELL) is stark. Former CEO Charif Souki pursued deals that let TELL retain natural gas price exposure, a risky approach that made it impossible to obtain financing. Agreements expired as TELL failed to make progress. Souki left a job that had already awarded him success bonuses even though he hadn’t been. He was better at negotiating payment for performance in advance than in making TELL successful (see What’s Next For Tellurian?).

In other news, JPMorgan reiterated their bullish outlook on Cheniere (CEI) with its 11% Distributable Cash Flow (DCF) yield and highly visible cashflows. One of my favorite charts is from Wells Fargo where they rank companies in the sector based on what percentage of EBITDA they need to reinvest as maintenance capex.

CEI is top on this metric. LNG terminals don’t require much spending to preserve their functionality.

Earnings for the sector generated few surprises other than CEI’s predictable beat of expectations. Midstream energy infrastructure businesses are generating steadily increasing cashflow. Yields betray that a substantial percentage of investors remain skeptical. Fund flows are modestly positive but there is no irrational exuberance evident. Energy is the best performing S&P sector for the past three years, but to us it still looks like we’re in the early innings.

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