SL Advisors Talks Markets

Oil And Pipelines Look Less Like Fred And Ginger

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The outlook for crude prices is a frequent conversation topic among energy investors. We’re often asked for our thoughts – over the next several years we’re bullish as growing demand from developing economies competes with insufficient investment in new supply. But we don’t trade oil or reflect that outlook in portfolio construction.

Crude oil and midstream are linked in the minds of many. Over the last decade they have often moved together. The price chart shows a very close visual relationship in years past. The original appeal of MLPs a decade or more ago was that they operated a “toll model”, indifferent to commodity prices and reliant on volumes. The quantity of oil and gas consumed in America fluctuates much less than its value.

The volume of crude oil and petroleum products supplied in the US has stayed remarkably stable for decades. We use around 20 Million Barrels per Day (MMB/D) with little regard for the economy other than the brief dip during the pandemic. This is why pipeline owners don’t spend much time worrying about the price of crude. Prices respond rapidly to changes in supply and demand and bring them back into alignment without much change in volumes.

Oil is heavily used in transportation. Economic slowdowns have little impact on the movement of people and goods. Lockdowns during covid did hurt demand and caused prices to collapse, but this was rare, and we can all hope that such loss of freedom will never be revisited on us again.

Interestingly, investors rarely consider the relationship between natural gas prices and pipeline stocks. There is no relationship – natural gas consumption for power demand and other purposes has been growing for years with little impact from prices.

Crude prices and midstream stocks were searingly correlated in March 2020 when demand collapsed, oil prices went briefly negative and people stopped moving. The correlation (defined using daily changes over the prior three months) reached 0.87 on March 25^th. It was unforgettable.

That day marked a peak in the relationship. Although both crude prices and midstream stocks recovered strongly from that low, the link has steadily weakened. The 80% rally in oil when inflation jumped in 2022 was not matched by the American Energy Independence Index (AEITR) although the inflation-linked contracts widely prevalent in the industry underpinned the sector’s 21% return that year.

The relationship continued to weaken, driven by falling leverage and capex among pipeline companies. Debt:EBITDA moved from 4-5X to 3-3.5X among most investment grade companies, a substantial reduction that made the stocks less risky. Capex came down as it became clear we mostly had the pipeline network we needed. Greenfield projects also ran into opposition from climate extremists such as the Sierra Club, whose ill-conceived policy prescriptions (anti-nuclear; anti US LNG exports to displace foreign use of coal) are helping drive global CO2 emissions higher.

The past three years of strong sector returns have come with little participation from oil, and the correlation has come close to zero at times this year. The recent jump above 0.30 is more reflective of a negatively correlated period dropping out of the past three months than of a changed relationship, as a visual inspection of recent price performance shows.

The weak relationship of recent years is the new normal, because the underpinnings of reduced leverage aren’t going away. Investors are increasingly able to assess the outlook without much regard for the price of oil, because it doesn’t matter that much. Oil and gas consumption will continue to grow, driven by developing economies.

This was vividly illustrated by a recent story about Indonesia’s challenges in reducing its coal consumption. Like many countries in Asia, coal is Indonesia’s biggest source of primary energy at 43% according to the Energy Institute’s Statistical Review of World Energy. Plans to replace some of the power generation derived from coal with renewables are running into problems because the government is worried that they won’t get enough financial support from rich countries like America to offset the increased cost.

Yes, renewables cost more, as is clear wherever they’re used. This is less of a problem than its consistent denial by climate extremists and others. Renewables cost more and they may be worth it depending on the consequent reduction in CO2 emissions. But they cost more, not less than our existing energy systems. Otherwise, we’d all be using solar and wind already and there wouldn’t be any need for subsidies.

Fuzzy thinking by climate policymakers is colliding with the reality of developing countries, in that they don’t want to pay more for energy. US LNG could solve this problem for Indonesia and others if opponents would get out of the way. We think pragmatism, inspired by the failure of today’s solar/wind obsession to meaningfully reduce global emissions, will eventually prevail.

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

SL Advisors Talks Markets

Britain’s Energy Transition

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I spent two weeks recently touring southern England with my wife. It’s 42 years since I moved to the US, and I appreciate my old country more now than as a teenager itching to escape to the new world. We did some sightseeing and saw old friends. As we traveled around, the British approach to the energy transition was never far from my mind.

Despite voting for Brexit, which was a populist, right wing decision, Britain is a politically liberal country like much of Europe. Reducing greenhouse gas emissions to limit global warming is not a contentious issue. The Conservatives, who were in power from 2010 until an ignominious electoral drubbing in July, passed a “Net Zero” law in 2019 mandating zero emissions by 2050.

The UK has been surprisingly successful in heading towards this goal. Emissions are down 44% from their 2006 peak, meaningfully ahead of the EU whose equivalent reduction is 31%. Germany may be the self-styled leader of the “energiewende” but Britain has been quietly getting it done.

In 1900 coal provided 95% of Britain’s electricity. As recently as 2012 it was still 40%. The last coal-burning power plant will be decommissioned by the end of this year. They’re also planning to add more nuclear.

Renewables provide 20% of the UK’s primary energy, substantially ahead of the US (9%) and the OECD (11%). Last year wind provided 29% of their electricity, just behind natural gas at 32%. What the National Grid calls “zero carbon energy” (mis-named since manufacturing wind turbines relies on traditional energy) regularly produces most of their electricity and was 51% last year.

The North Sea is a reliably windy place, and offshore wind turbines are far less controversial than in the US. We saw them from numerous spots while traveling along the south coast. Windpower suffers from cost and intermittency, but the view of turbines miles out to sea doesn’t strike this blogger as particularly offensive.

US windpower is overwhelmingly onshore. Offshore has been plagued with cost over-runs and cancelations. Coastal residents complain about the view, and a 300-foot fiberglass blade recently shattered near Martha’s Vineyard, with jagged pieces washing up on the beach. Voters along the New Jersey shore, politically red in a very blue state, are outraged at plans for offshore wind (see Windpower Faces A Tempest).

In the UK you’re never far from a wind turbine.

Energy costs more in Britain. Electricity is around $0.40 per kilowatt hour, more than 2X the US. People commonly shut the lights off when leaving a room. One hotel we stayed at required your room key inserted in a slot for the lights to stay on, preventing guests from going out and leaving the lights on.

Gasoline (petrol to Brits) costs around twice as much as the US because of higher taxes. But the cars are smaller and the roads narrower. Even though I learned to drive there, it was over 40 years ago. Driving through the English countryside, it felt like small cars were zipping around impossibly narrow lanes. But our 800 miles of driving cost £100 ($133), just under $0.17 per mile and similar to the average for US drivers.

British drivers grumble about the cost of petrol (and the traffic) but unlike the US it’s not a political issue. Everyone knows the British government has no influence over oil prices.

Americans drive more miles per year than most countries, which is why gasoline prices get people so worked up. Moreover, Britain’s more extensive public transport system generally gets you around faster than in the US. Taking a painfully slow NJ Transit train into New York compares unfavorably with the faster commuter trains servicing London.

In Britain, it’s household heating bills that earn the public’s ire.

Natural gas is widely used, and Russia’s invasion of Ukraine boosted winter heating bills. For a couple of years households were protected from the full impact of higher gas prices, through government caps, but that costly program has ended. During our trip the new Labor government’s plan to cancel pensioners’ annual heating rebate was a leading news story.

Britain has a good energy transition story to tell. But how do people feel about making a considerable effort while developing economies led by China overwhelm their efforts? Most haven’t given it much thought, and those that have shrug and say it’s important to “do your bit.”

Young people care more. My nephew, who’s a data scientist, even considers the energy required of a data center in constructing the form of AI queries he submits.

Unquestioning fealty to green energy is common among liberals. If climate change is such an existential threat, why don’t their governments make it a priority in dealings with China? I think it’s because the politics of climate change aren’t driven by solving the problem, but rather by imposing costly and inconvenient local measures that appear effective but are globally irrelevant.

Britain is ahead of its peers in reducing emissions, but the worldwide effect is inconsequential. The 44% reduction they’ve achieved since 2006 is only 0.6% of the total. For reference, the UK is around 3% of global GDP.

Climate extremists are driving policy in the UK as elsewhere and are missing the big picture. At its worst it’s wokeness trying to impose guilt on everyone simply for being here, on Planet Earth, living.

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

SL Advisors Talks Markets

The World Of Natural Gas

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It’s hard to overstate the global success of US natural gas production. Over the past decade we’ve grown output by 37 Billion Cubic Feet per Day (BCF/D), accounting for half the global increase. We now produce over a quarter of the world’s gas. And it’s cheap.

The development of fracking happened in America not elsewhere for many reasons. The geology, water availability, access to capital, technology and a culture of entrepreneurship. Least appreciated is the concept of privately owned mineral rights, which has enabled thousands of landowners to partner with drillers, earning royalties subject to state regulation and taxation.

All over the world except in the US, governments own mineral rights.

Several years ago, a Spanish E&P company found out how hard it is to drill when you’re not welcome. In the north of England, the British government granted Cuadrilla rights to extract natural gas using fracking. The local population was strongly opposed. Britain surely needs natural gas, but the residents living above the reserves saw no financial benefit while enduring all the noise and disruption. It quickly became a political issue and the government backed down (see British Shale Revolution Crushed: America’s Unique Ownership of Oil and Gas).

The Energy Institute’s 2024 Statistical Review of World Energy provides informative detail on natural gas, which provides 24% of the world’s primary energy, up from 22% at the start of the century. It’s 23% of the world’s electricity. In the US it provides 43% of our power. Even the International Energy Agency, which has transformed from an objective observer of energy markets to a renewables champion, concedes that last year “Coal-to-gas switching was the largest driver behind emissions reduction in the US electricity sector.”

The US Energy Information Administration (EIA), credits coal to gas switching for 61% of the power sector’s emissions reductions since 2005.

Global consumption has grown broadly, with the notable exception of the EU. Their strategic blunder of reliance on Russian piped gas along with ruinous climate policies have constrained GDP growth (see Natural Gas Demand Keeps Growing). German emissions are falling because they’ve made energy too expensive. They are de-industrializing, to the benefit of the US (see Gains From Energy).

Gas is much harder to transport than oil, so only moves via pipelines or LNG tanker. Transportation costs are a much bigger percentage of the value of the commodity than for oil. Shipping costs from the US to Europe via LNG tanker are $1.50-$2 per Million BTUs (MMBTUs), but liquefaction can add another $2-$3.50. With US spot gas prices at $2, that still leaves a profit margin vs Europe’s TTF benchmark at around $10, but this shows why large regional price differences persist.

Shipping crude oil over the same route is around $2-$4 per barrel, so a much smaller percentage of the value of the commodity.

Nonetheless, global trade in LNG is growing, even while intra-regional pipeline trade has shrunk with the loss of Russian shipments to the EU. Almost 14% of natural gas was shipped as LNG last year, up from only 6% in 2000. Pipelines represented another 10%.

LNG provides both buyer and seller optionality in a world more prone to geopolitical trade disruption. Pipelines linking neighboring countries require extremely stable relationships (think US/Canada, or UK/Norway). Nordstream 2 had its gas supply cut before it flooded with seawater after a sabotage. Pipelines reduce flexibility for both parties. It’s why the China-Russia negotiations over Power of Siberia 2 continue to drag on.

By contrast, the global oil trade was 68 million barrels per day last year, around two thirds of consumption. Oil and gas reserves are unevenly distributed. Coal trade was only 21% of consumption. It’s easy to move, but reserves are widely distributed. It’s why developing countries use so much of it – because it’s easily accessible.

Natural gas consumption will continue to grow, to meet the developing world’s relentless demand for more energy. Policymakers may even acknowledge that renewables are hopelessly inadequate to replace fossil fuels and instead emulate the US success by prioritizing coal-to-gas switching.

Gas generates around half the CO2 of coal when burned for power, and also generates far less local pollution. Critics argue that flaring and methane leaks offset this advantage. However, the US is far stricter on flaring than other big producing regions such as Russia or the Middle East. We produce 26% of the world’s supply but only 7% of the flaring.

This all highlights the huge opportunity of US natural gas. Our supplies can help poorer countries meet their growing energy needs, while displacing more damaging coal. And because our environmental standards are higher than in Russia or Iran, our natural gas is a more climate-friendly product.

The simpletons at the Sierra Club and the knuckle draggers at Extinction Rebellion who hurl paint in art galleries will never embrace this. But increased US exports of natural gas are the most effective way to reduce CO2 emissions. In our opinion it offers continued attractive returns, and by delivering what is expected rather than unmet promises, it is the most ethical investment in the energy sector.

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

SL Advisors Talks Markets

Renewables Are An Energy Footnote

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Journalists love to write about fast growing renewables. It fits the narrative that solar and wind can eventually replace our traditional sources of energy. It allows the absence of any serious push towards nuclear power to go unanswered. It avoids the uncomfortable question of why China’s increasing emissions from coal are acceptable when in America California is a decade away from banning sales of gasoline-powered cars and NY forbids natural gas hook-ups to new buildings.

The Energy Institute’s 2024 Statistical Review of World Energy is a rich source of data on how the world obtains and uses energy. Careful analysis allows many energy shibboleths to be put to bed.

Start with America. The biggest energy story of the past decade is the growth in oil and gas output, which has in turn enabled a drop in coal. The shale revolution delivered mixed results to investors because at times executives were overly enthusiastic about the returns they could earn. But there’s no doubt that it was good for the US economy.

Since 2013 our total output of primary energy has grown at 3.3% pa, by 27.7 Exajoules (EJs). 49% of that increase came from natural gas, and 44% from crude oil and condensates. Together they provided 93% of increased production.

The typical liberal journalist hails the 6.3% pa growth in output from all renewables including hydro. It sounds impressive. But starting from a low base it’s an additional 1.6 EJs. Increased output of natural gas alone was 8X as much, supporting energy security, job growth and exports to our friends and allies. There should be 8X as much news coverage of this enormous success.

Few casual readers of energy news would be likely to guess anywhere near this 8X ratio if asked.

It’s fortunate that natural gas grew this much, because coal production fell at a 5.1% pa rate, or by 8.2EJs. This is 5X the increase in renewables. By reducing coal burned in power plants we have lowered our CO2 emissions along with other harmful pollution. Renewables were barely relevant to this success story. It was mainly achieved with natural gas.

Along the way we reached energy independence. In the popular imagination this refers narrowly to crude oil, when exports exceed imports. A broader measure compares energy production with consumption. America’s use of energy is flat over the past couple of decades.

Our economy and population have grown, but we’ve become more energy efficient. Activity has also shifted to less energy-intense sectors – more services and less industrial output – although cheap natural gas has caused a resurgence in US manufacturing employment following decades of decline.

The bottom line is that renewables provide 3.5% of our primary energy output, up from 2.7% a decade ago.

Turning to China, they recently reported hitting their renewables power target six years ahead of schedule. To the casual observer of energy news, it appears that the world is moving in lockstep to solar and wind. Some even worry that America is at risk of falling behind China’s ambitions on climate change.

Then there’s the facts.

China’s energy consumption has quadrupled this century, as the country began to make up for decades of socialist central planning. The biggest energy story in China is the yawning gap between energy production and consumption. China has a substantial energy deficit, at 48 EJs equal to approximately half of all US energy production.

It is a national security imperative for China to close this gap. It complicates any potential military steps against Taiwan. China’s growing EV market and renewables capacity must be seen in this light. They want to reduce their dependence on foreign oil.

China obtains 8.5% of its primary energy from renewables (10.4 EJs), substantially more than the US. It’s grown at 10.1% pa over the past decade. However, this is only 6.1% of China’s energy consumption since they have such a big deficit.

What the cheerleaders for China’s renewables ambitions overlook is that coal production has increased by 13.8 EJs over the past decade, over 2X the 6.5 EJs growth in renewables. Coal provides more than half of China’s primary energy. It’s down from 65% a decade ago, but only because their energy demand has risen faster than their ability to meet it domestically. Coal is13% of US primary energy production.

Energy reporting generally overstates the impact of renewables. It missed the enormous impact of increased US natural gas production. It gives China a free pass on their growing use of coal. It’s clearer when you look at the numbers. Many journalists overstate the impact of renewables and their ability to meet our energy needs. Natural gas is the world’s favorite energy.

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

SL Advisors Talks Markets

Oneok’s Deal Makes Everyone Happy

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Oneok (OKE) is developing a habit of surprising the market with their acquisitions. Last year’s deal with Magellan Midstream (MMP) was roundly criticized, including by us, because of few obvious synergies and an unwelcome tax bill for MMP unitholders (see Oneok Does A Deal Nobody Needs).  

MMP’s refined products business didn’t look like a natural fit with OKE’s oil and gas pipeline network. For a while it looked as if shareholder approval might not be forthcoming, but OKE executives eventually got it across the line. Efficiencies from the combination have turned out to be more lucrative than expected, and strong operating performance has seen OKE return 46% over the past year.  

However, the tax bill was as bad as expected. Being a long term MLP investor means an increasing deferred tax liability, and the recapture of this took all the fun out of tax time. 

OKE has returned to the acquisition trail by purchasing a controlling interest in Enlink Midstream (ENLC) from Global Infrastructure Partners (GIP), with the intention to acquire the remaining publicly traded interests in ENLC via a tax-free transaction.  

Once again, we own both stocks, and as with MMP had no reason to consider they might combine. We had been looking at ENLC more closely than usual in the past couple of weeks and found the relative value compared with Williams Companies (WMB) sufficiently appealing that we shifted some exposure towards it.    

Casting around for a blog topic, I summarized our thought process last week (see Deciding When To Sell). Once published, I waited for the relative valuation to explode back through our entry point, exposing our timing on the switch as inopportune while providing great mirth for the blog gods. 44 years of navigating markets is enough to ensure humility comes with every buy or sell decision.  

Thanks to OKE the opposite happened. I imagine they were attracted to the distributable cash flow yield, which was 15% prior to the news. They must have been drawn to the prospects for NGL pipeline tariff savings like us but went further and identified multiple points of synergy with their existing business.  

OKE paid $14.90 for GIP’s ENLC units. There’s an expectation that the remainder of the outstanding units will be purchased at the same price, but it probably depends on how events play out in the meantime. OKE may conclude that they paid a control premium and that the remaining units can be acquired at a lower price. In any event, ENLC’s value has been more properly recognized.  

The transaction is expected to close next quarter, and OKE’s acquisition of the remaining ENLC units during 1Q25.  

ENLC is an LLC that elects to be taxed as a corporation. So although investors don’t receive a K-1, it is a holding in the Alerian MLP ETF (AMLP). Like its MLP-dedicated peer funds, AMLP will once more have to hunt among the shrinking pool of MLPs for a replacement.  

Analysts responded favorably to the transaction. Wells Fargo’s Michael Blum raised his price target for OKE from $91 to $100 since the ENLC deal, along with the acquisition of Medallion, a private crude oil pipeline and storage business, “…transforms OKE into a vertically integrated competitor in the Permian.” 

It’s quite a deal when both the acquirer and target stock rise. Over the past month both have now handily outperformed the American Energy Independence Index (AEITR). Following the successful integration of MMP last year, there’s little skepticism among investors that OKE will be able to realize synergies this time around. 

The brief but very sharp collapse in stocks during the early stages of the covid pandemic is increasingly a distant memory. Over the past five years midstream energy infrastructure has continued to outperform both the S&P500 and the energy sector itself. Capex fell in response to some cases of overinvestment in shale plays, although Americans continues to benefit via cheap energy and higher employment. Midstream companies have stronger balance sheets and with less to build they’ve been increasing cash returns to owners via buybacks and dividend hikes.  

Existing investors know this, and yet also understand how narrowly it’s appreciated by the larger market. The energy transition continues to deter many from committing capital to traditional energy because of fears of stranded assets. This overlooks the fact that the portion of the world’s primary energy provided by fossil fuels remains consistently around 83%. Increases in solar and wind are barely enough to satisfy additional energy demand. 

 As a result, energy businesses that generate reliable, growing cashflows have generated the best returns. The S&P Global Clean Energy Index has lagged the S&P500 by 8.5% pa over the past five years, and the AEITR by 10% pa. 

The pick-up in M&A activity illustrates greater comfort in the outlook.  

From where we sit, the energy transition is going well.  

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