SL Advisors Talks Markets

4Q Earnings Wrap

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Earnings for 4Q23 are almost complete. Most companies came in at or a few per cent ahead of market expectations. Cheniere (CEI) beat sell-side estimates by 11%, continuing a remarkable run. They are targeting a 1:1 ratio between buybacks and debt reductions and based on their long run desired share count should be retiring 12-13% of outstanding shares over the next few years.

CEI’s FY2023 EBITDA came in at $8.77BN. The stock dipped last week as 2024 EBITDA guidance came in a little below expectations at $5.5-6.0BN. Last year they benefitted from large regional price differences in natural gas on the portion of their LNG capacity not committed under long-term agreements. They have not assumed the same opportunity this year. Despite CEI’s flat stock performance over the past year, JPMorgan and Wells Fargo continue to rate them Overweight. It’s one of our bigger holdings.

Plains All American (PAGP) came in 10% ahead of expectations as their crude oil and Natural Gas Liquids segments both reported strong results. They increased their distribution by 19%.

PAGP stock has performed strongly in the past year, +31% versus the American Energy Independence Index (AEITR) at +17%. We tend to underweight crude oil businesses in favor of natural gas where we believe the long-term growth prospects are more assured. Nonetheless, the softening of US demand for electric vehicles will encourage the view that US crude oil demand is not going to fade away.

Energy Transfer’s (ET) 4Q EBITDA came in close to consensus at $3.6BN. However, 2024 EBITDA guidance was slightly below expectations while capex was somewhat higher. The stock remains attractively priced in our view, and any disappointment over the guidance was short-lived. It’s up 26% over the past year, including that high dividend which currently yields 8.4% and is covered 2X by Distributable Cash Flow (DCF). ET is rated Overweight at JPMorgan and Wells Fargo.

Targa Resources (TRGP) is another strongly performing stock, +33% over the past year including its low dividend which currently yields 2%. TRGP is well positioned to transport NGLs from the Permian to export terminals on the Gulf coast, providing an integrated service to customers with multiple opportunities to add value.

JPMorgan expects 9%+ EBITDA growth this year and next. With management committed to returning 40-50% of cash from operations to shareholders via dividends and buybacks, there is plenty of room for TRGP to increase its quarterly payout.

The Canadians have been lagging the sector because of market concerns about their capex. Enbridge’s (ENB) C$19BN acquisition of three utilities from Dominion last year wasn’t well received. They’ve raised 85% of the funds needed through debt, equity and asset sales. ENB stock is -4% over the past year, meaningfully underperforming the sector. Their 7.8% yield is 1.4X covered by DCF. Analyst opinion is mixed – JPMorgan is Overweight while Wells Fargo is Underweight.

TC Energy (TRP) has also lagged the sector, +4% over the past year. Their capex has been higher than investors would like over the past couple of years, but projects are nearing completion and spending is coming down. Coastal GasLink was completed late last year and will provide natural gas to LNG Canada’s export terminal in Kitimat, BC for export to Asian customers. The Southeast Gateway project will connect customers in Mexico with domestic supply. It is scheduled to be completed next year. This year capex is forecast to be C$8-8.5 and closer to C$6BN next year. Their 7% dividend yield is 1.5X covered by DCF.

Overall earnings confirmed the predictability of cashflows in the midstream sector. It is often described as a “toll-like” business model. The pandemic-induced collapse in 2020 challenged this description, but performance since then has shown that the description remains apt. Attractive dividends with ample coverage from DCF is common across the sector.

I was struck by a chart the other day showing a sharp drop in the price of used Teslas. A couple of years ago wait times of as much as a year were common for buyers to take delivery of their new vehicle. Nowadays it’s a few weeks, and sales have slowed so that Electric Vehicles (EVs) are taking dealers longer to shift than conventional cars.

The halving of resale values for EVs reflects consumer realization that they’re nice to drive but charging is inconvenient. Cold weather reduces their battery range, as does age. As suggested in this video (see Stop Paying For Overpriced EVs), these are the reasons they ought to be cheaper than an equivalent gas-powered car. Reduced resale value boosts annual depreciation, increasing the cost of ownership.

EVs are gradually finding a more appropriate price point.

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

SL Advisors Talks Markets

Our Darkening Fiscal Outlook

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There are two ways in which our looming fiscal catastrophe draws closer. One is through the passage of time, as entitlements grow with more aging Medicare recipients. The other is through worsening projections from the Congressional Budget Office (CBO).

Both are happening.

Start with interest expense. In the CBO’s May 2022 ten year Budget and Economic Outlook, this line item was forecast to hit $1TN in 2030, eight years hence. Last May, the CBO brought this date closer by two years, to 2028. And in the February outlook just released it’s now 2026. Since 2022 the $1TN date has gone from eight years out to just two.

Inflation ran higher than projected in 2022, which also pushed up nominal GDP. But even as a % of GDP, the interest expense figures have worsened. This year we’ll spend 3.1% of GDP on interest, rising to 3.7% in 2032.

Projections for the Fed’s balance sheet are moving higher as well. Ever since Ben Bernanke unleased Quantitative Easing (QE) during the 2008 Great Financial Crisis (GFC), the Fed has struggled to bring its bond holdings back down to the level that’s needed to operate monetary policy.  Fearful of causing a spike in bond yields, they rely on maturing bonds rolling off to shrink their holdings.

The Fed’s balance sheet is currently $7.7TN, of which $4.7TN is US treasury securities. Most of the balance is Mortgage-Backed Securities (MBS). Two years ago, the CBO expected the Fed’s holdings of US treasuries to drop to $3.3TN by 2025. Now they’re projecting $4.4TN and expect it to be back at $4.7TN by 2026. An excessive balance sheet has become an enduring feature of our monetary policy.

When such holdings become permanent it represents a partial monetization of our debt. Moreover, the Fed’s % of outstanding government debt is now projected to be 19% by 2032, 4% higher than the CBO was forecasting a couple of years ago.

The CBO doesn’t forecast MBS holdings, but virtually all these securities have an average life greater than ten years. Prepayments will knock this down, but MBS has also become a permanent item on the Fed’s balance sheet.

The CBO assumes real GDP growth of 2.0% pa. Recessions are usually unexpected and forecasting them is hard. But when the next one occurs, ample fiscal stimulus will be part of the solution and inevitably the Fed will feel compelled to start QE again.

The only good thing about our deteriorating fiscal outlook is that the perennially forecast day of reckoning hasn’t come. We’re still muddling along. We’re about to head up the steep path into unknown territory as shown in the last chart.

Federal debt held by the public will reach 99% this year and is headed higher. However, when adjusted by Federal financial assets and debt held by the Federal Reserve it’s 75%. Japan’s equivalent figure is 119%.

Japan’s defining economic challenge over the past couple of decades has been deflation. GDP growth averaged less than 0.5% pa over the past decade. Many economists blame this partly on their high levels of government debt.

It’s unlikely an extended period of anemic growth would be politically acceptable in the US. The depression of the 1930s defines American economic policy, in that every president is expected to preside over economic growth. Germany’s equivalent is avoiding a repeat of the inflation of the 1930s under the Weimar Republic that led to Hitler’s ascent.

Japanese voters have accepted mediocre GDP growth far longer than would be the case in the US. If excessive US debt led to Japanese-style deflation here, fiscal stimulus and QE would quickly follow.

How this issue resolves itself is of great importance to the long term investor. QE depresses long term yields and impedes the Fed in its ability to constrain growth when inflation is above target. Barry Knapp of Ironsides Macroeconomics regularly warns about the harm to profitability of all but the biggest US banks caused by the persistent inversion of the 3 Month/10 Year portion of the yield curve.  Loans priced off the long end of the treasury curve don’t yield enough to generate acceptable profits for banks whose marginal cost of wholesale funding is close to the Fed Funds rate.

And yet US economic growth remains strong with unemployment low. An unintended consequence of QE is the pressure the Fed’s bond holdings put on regional bank profitability by keeping yields low. It also probably means they need tighter monetary policy than would otherwise be the case at the short end, since long-term yields aren’t that restrictive.

Inflation expectations are the likely casualty rather than GDP growth. Eventually our excessive debt along with increasing debt monetization will cause slow but steady currency debasement, the time-honored refuge of profligate governments. We believe owning infrastructure and other real assets is how investors should position themselves.

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

SL Advisors Talks Markets

America’s Still Increasing The Right Energy

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The US Energy Information Administration (EIA) released its Short Term Energy Outlook (STEO) last week. It confirmed the current trends of increased production, improving mix and declining CO2 emissions.

Most notable is that coal production is continuing to fall. This year should see output 20% below 2022, at 470 Million Short Tons (MSTs). We use most of it at home but will still export 94 MSTs this year. Opponents of LNG exports should take note – this is where they should be focusing their attention.

Natural gas and crude oil output are both edging up. We averaged 12.9 Million Barrels per Day (MMB/D) of crude output last year, which the EIA forecasts will increase to 13.1 MMB/D this year and 13.5 MMB/d in 2025.

Overall petroleum products consumption is stable at around 18 MMB/D. The link between crude prices and pipeline cashflows continues to weaken (see Pipelines Shed Their Oil Sensitivity) because of stronger balance sheets. But volumes are more stable than prices. US liquids consumption grew at 0.9% per annum in the decade to 2022 according to the Energy Institute’s 2023 Statistical Review of World Energy (formerly published by BP). This stability is an under-appreciated feature of midstream infrastructure.

US gasoline demand is peaking at around 8.9 MMB/D. Increased Electric Vehicle (EV) penetration is a factor, along with improved mileage on conventional cars. EV sales have slowed recently, and the EIA doesn’t disclose its assumptions on future growth. Your blogger remains unconvinced that an EV purchase would meaningfully improve household happiness.

Consumption of aviation fuel is growing, and not just thanks to Taylor Swift. This is especially true in developing countries as a result of rising living standards. Jet fuel consumption was growing at 3% pa until the pandemic struck. Volumes are still recovering.

Use of hydrocarbon gas liquids (also known as Natural Gas Liquids) including propane (heating/cooking) and ethane (plastics and other petrochemical uses) is also growing.

Power generation continues to deliver good news. Coal’s share of electricity generation will drop to 14% by 2025, from 21% in 2022. Natural gas reached 42% last year but is expected to slip to 41% by 2025 as non-hydro renewables grow from 15% to 19%. Our electricity is getting both bluer and greener.

Windpower currently provides almost twice as much electricity as solar. However, from 2022-2025 solar capacity is set to more than double, which will bring them roughly in line. Many will be surprised to learn that windpower output will grow at less than 3% pa 2022-25.

The net result is that we’re becoming better able to export energy security to our trade partners while also reducing our own CO2 emissions, which will fall from 4.9 billion metric tonnes to 4.7 (2022-25).

A pragmatic energy transition is unfolding. Patrick Pouyanné, CEO of France’s TotalEnergies, was interviewed recently in the Financial Times. He rejects the notion that renewables will lead to cheaper electricity, noting that, “renewable intermittency is less efficient.” He feels the prospect of permanently higher prices makes power an interesting sector in which to invest. Total has also been active in signing LNG deals, including with US-based NextDecade, whose planned Rio Grande export terminal is not affected by the recent White House pause on new approvals.

China convinced outgoing climate czar John Kerry that they’re striving hard to reduce their CO2 emissions. They burn over half the world’s coal which is the main source of electricity for their EV market, as this blog often points out. They’re adding coal-burning power plants at more than one a month.

China is also adding substantial solar and wind capacity. It’s often seemed to us that energy security is the driver of China’s choices, rather than the energy transition. If they’re anticipating conflict over Taiwan in the next few years, it makes sense to reduce their need for oil imports as much as possible.

The WSJ recently noted the huge growth in China’s renewables capacity (see China’s Carbon Emissions Are Set to Decline Years Earlier Than Expected). The 300 Gigawatts of solar and wind China added last year is more than total US capacity. China installed over 500 million solar panels.

The photo showing a vast area of solar panels dotted with wind turbines is unlike anything you see in America. Climate Action Tracker now thinks China’s emissions could peak next year but doesn’t expect them to immediately decline.

There are many examples of progress in reducing emissions, and US natural gas production continues to grow because it’s part of the solution.

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

SL Advisors Talks Markets

Is Energy Becoming Less Cyclical?

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It’s a question posed at every mid-cycle. Observers of commodity markets will often advise that the cure for low prices is low prices. Meagre profits reduce production, eventually curbing supply and driving prices higher.

2014 was the last cycle peak for energy. The shale revolution brought new US supplies of oil and gas onto the market, which upset the prior equilibrium. The downturn that followed had run its course by 2019 when the pandemic caused another leg down. But the industry embraced financial discipline, reducing capex and improving returns.

An essay by Veriten’s Arjun Murti makes the case that the current cycle of positive returns has many years left.

Murti’s favored metric is Return On Capital Employed (ROCE), and he notes that high ROCE generally corresponds with a high weight in the S&P500. Today energy remains at an historically low 4% market weighting, while returns are the best in over three decades. Murti believes that we’re a couple of years into a 10-15 year bullish cycle.

This theory will please energy investors. But another possible explanation is that energy companies are eschewing the normal boom/bust capex spending cycle that has long pervaded their industry. High ROCE would normally draw additional capital, but continued capital parsimony generally prevails.

Adjusted for inflation, energy capex is still less than half of the 2014 peak.

Uncertainty about the path of the energy transition has added to the caution practiced by many CFOs. Climate extremists stand ready to criticize the big publicly traded energy companies and file lawsuits to impede their activities.

The other day I was in a discussion sponsored by the Naples Council on World Affairs. One participant bitterly criticized Exxon Mobil for withholding internal research decades ago that showed the potential for fossil fuel combustion to lead to global warming. I reminded him that climate extremists have been at least as disingenuous. Many have preached that the world can run entirely on solar and wind, in willful disregard of science and the facts.

If energy companies have presented facts to suit them, the Sierra Club and wretched little Greta have routinely offered policy prescriptions grounded in fantasy. Alex Haraus and his anti-LNG TikTok crowd belong in the same gang of socialists trying to impose poverty and starvation on billions of people (see White House Adopts An Energy Policy Where Everyone Loses).

The coincidence of a high industry ROCE with low market weight could have another possible explanation – that we’re in a profitable equilibrium where high returns aren’t drawing dilutive capex because the reasons for financial caution are likely to persist.

This is illustrated in the “Quadrilateral of Death” which shows low returns leading to higher oil followed by higher returns, then lower returns caused by inferior capex and finally lower prices, returning to the starting point. But today we’re sitting in the middle of the quadrilateral, with decent returns and moderate prices. Perhaps it’s the sector’s Goldilocks moment – neither too hot nor too cold. The market has found a balancing point where excess returns aren’t self-destroying because of the continued uncertainty about the energy transition.

Oil and gas projects often require a decade or more to generate adequate returns. Forecasting demand and prices over such a long period is harder than in the past. Perhaps we are at the point of Happy Equilibrium.

If you read Murti’s research paper you’ll find it informative, and perhaps like me be mildly amused at the pretentious use of plural first person pronouns. For example, at SL Advisors we are bullish on energy infrastructure. But we can’t emulate Murti when he says “we … moved to Goldman Sachs in 1999” (emphasis added) or refers to “our career.” Smile and look beyond the misused pronouns.

In other news, the White House’s moratorium on new LNG approvals has drawn criticism from moderate Democrats in Texas, Alaska and California. They’re worried that there aren’t enough progressives in their districts to offset those employed in the energy sector or perhaps don’t see this as an effective way to lower emissions.

Germany’s extreme climate policies are part of the political discourse. Siegfried Russwurm, head of Germany’s main industry association BDI, criticized the government’s approach as “dogmatic” and “absolutely toxic.” The country is facing a recession driven by high energy prices. There’s no place for nuclear power and they want to derive 80% of their electricity from solar and wind by 2030, up from 41% in 2021.

Germany’s recent progress on reduced emissions has largely come from lower industrial output. China and other developing countries will easily make up for it.

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

SL Advisors Talks Markets

White House Adopts An Energy Policy Where Everyone Loses

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With his moratorium on new LNG export terminals, aging President Joe Biden and his advisers have stumbled on a way to upset both ends of the political spectrum. Domestic energy businesses want to export more, cheap US natural gas to foreign buyers. Following Russia’s invasion of Ukraine two years ago the US pledged to replace the natural gas no longer flowing through Nordstream to western Europe.

Many new LNG export terminals are at various stages of development. Planning and construction take several years. Now that the Department of Energy has been directed to examine the climate impact of each new facility awaiting approval, that will impose additional delays even assuming they’re approved. Venture Global’s Calcasieu Pass 2, or CP2, is the immediate casualty. This $10BN project is slated to export over 2.5 Billion Cubic Feet per Day (BCF/D), raising exports by 20%.

But enough projects have already been approved and begun construction that we’re still on track for a doubling of US LNG exports to around 24 BCF/D by 2027.

The White House has turned to Alex Haraus, a 25-year-old Colorado social media influencer, in an effort to excite young people enough to re-elect a doddering octogenarian. Like too many climate extremists, Haraus combines well-intentioned enthusiasm with poor recommendations.

His social media profile caught the attention of White House adviser John Podesta, and a Zoom meeting followed, which evidently impacted the new policy. Haraus and his TikTok followers believe that building LNG terminals assures long term trade in natural gas. Haraus presumably believes the world needs to run on solar and wind.

It’s a shame that youthful enthusiasm to curb Greenhouse Gas emissions (GHGs) isn’t directed towards practical solutions. LNG buyers are largely Asian. The International Energy Agency reports that China, India and other south-east Asian countries consume 75% of the world’s coal. They noted that last year’s 5% demand growth in China was driven by increased electricity consumption. This is partly because of the growth in EVs, often lauded by policymakers as evidence of China’s commitment to reduce GHGs. Yes, China’s EVs run on coal.

Coal-to-gas switching is how GHGs have fallen in the US and is our best chance to achieve similar success in emerging Asia. Haraus and his band of idealistic young supporters are pushing policies whose results won’t match their aspirations.

To cite just one example, Pakistan last year decided to quadruple coal-based power generation because of high LNG prices. Perhaps shocking to the Haraus TikTok crowd, Pakistan did not immediately turn to solar and wind.

Coal is cheap and easy to use. Its consumption keeps hitting new records as emerging economies consume more energy.

China and Russia are planning the Power of Siberia 2 gas pipeline to redirect supplies no longer going to Europe. Slow negotiations over the final terms have delayed construction, but it will eventually be built. This will reduce China’s need for coal, and thereby its GHGs.

Emerging economies would like to use more natural gas. We should encourage them.

So far the White House has upset energy companies around the world who are planning for more US LNG exports. Foreign business groups have expressed concern over America’s inconsistent posture on providing energy security. Japan’s government said they’re worried about the possibility of delays at facilities that haven’t yet gained approval.  The White House has implemented a policy that will set back climate ambitions in the hopes of gaining youthful, idealistic votes in November.

Wall Street analysts regard it as a temporary delay that will be reversed after the election. That’s why there’s been little impact on stocks that might otherwise be affected. Cash flows from Energy Transfer’s proposed Lake Charles terminal were not reflected in the stock price. JPMorgan thinks further delays would reduce near term capex, a positive.

Similarly, delays to Cheniere’s planned addition of Trains 8 and 9 at their Corpus Christi Midscale facility could also boost near term free cash flow. Both Wells Fargo and Morgan Stanley expect the moratorium on new approvals to be lifted after the election regardless of who wins. Trump has already said he’d do so immediately.

This means that Alex Haraus and his idealistic TikTok followers are being played. Investors are betting that Biden will reverse himself if he wins the election. So by December the moratorium on LNG approvals will have upset just about everyone possible, from the energy sector and its customers to the climate extremists whose election support was rented. And it won’t have helped reduce GHGs, because of the widespread reliance on coal among Asian LNG importing countries.

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