WE MISSED THE MAGNIFICENT SEVEN
After a stellar two years, energy has vastly underperformed in 2023. Admittedly, we’ve been surprised at how well the technology sector has done given Fed tightening, higher interest rates, and stubbornly high inflation—albeit inflation, as measured by the Consumer Price Index (CPI), is well off its peak of 9.1% (June 2022) and stood at 4.0% as of May (it should be noted, however, the CPI, excluding food and energy, has only declined to 5.3% from a peak of 6.6% in September 2022). So, what did we get wrong? The stock market appreciation year-to-date has been driven higher by seven mega cap technology stocks, the so called “Magnificent Seven.” They are Apple (AAPL-NASDQ), Microsoft (MSFT-NASDQ), Alphabet (GOOG-NASDQ), Amazon (AMZN-NASDQ), Nvidia (NVDA-NASDQ), Tesla (TSLA-NADQ), and Meta (META-NASDQ). Initially, investors bought these companies because of their defensive characteristics, i.e., their fortress-like balance sheets and free cash flow generation. Then Nvidia’s earnings release on May 24th unleashed the AI theme, turbo charging these stocks to new heights.
The S&P 500 is a market cap weighted index, which means that the larger the company, the greater its impact on the index. Thus, the Magnificent Seven have a disproportionate impact on the index. As of May month end, the total return for the S&P 500 was 9.65%. However, if all stocks were weighted equally, the S&P 500 would have had a negative return of -0.06%. As the chart below shows, more stocks have joined the party since June and the equal weighted index has generated a return of 6.6% (as of 6/16) versus 5.5% for the S&P 500. Perhaps this is the start of tech stocks losing steam and passing the baton to other sectors, maybe even energy!
S&P 500 YTD Total Return
Source: S&P Global
A WORD ON AI
We won’t pretend to be AI experts, but we do have a viewpoint. This is not yet a replay of the dotcom bubble, in which many unprofitable companies with nothing more than a vision and, in some cases, just had “dot com” in their company name went public. In contrast, the mega cap companies have solid financials, resilient businesses that generate substantial free cash flow and have already invested billions of dollars in AI technology that has begun to bear fruit, such as Nvidia’s chips and Microsoft’s ChatGPT. However, we are still at the early stages and valuations appear very rich and stretched. Still, investors’ FOMO (fear of missing out) may very well drive these stocks higher.
VALUATION MATTERS: WE LIKE DIVIDENDS, FREE CASH FLOW, AND MIDSTREAM ENERGY STOCKS.
By historical standards, the stock market’s (S&P 500) valuation looks lofty on a forward p/e basis that is approaching 20x versus an average multiple of ~17x. In contrast, the S&P 500 energy sector trades at less than 11x. The midstream energy subsector has generated positive returns this year (+ 2.9% as of 6/16/23) in contrast to the negative return (-6.6%) for the broader energy sector whose earnings are sensitive to commodity prices.
We believe midstream stocks have held up well because these companies have little commodity price risk, stable cash flows, and attractive dividends. The Alerian Midstream Energy Index sports a dividend yield of more than 6%, and we expect dividend growth of 4% to 6%. All else being equal, this should provide investors an expected total return of 10% to 11%. There is also the potential for valuations to improve, i.e., multiple expansion, that would add to the total return potential. Midstream c-corps trade at approximately 9.0x cash flow (defined as EBITDA) that is one and two turns cheap relative to its five- and ten-year averages, respectively, based on data in the Wells Fargo Midstream Monthly Outlook: June 2023. Our verdict: We can’t time the market, but we can sleep at night by investing in companies with strong balance sheets, attractive assets and businesses (many of which are nearly irreplaceable) and sustainable and growing dividends. As the adage goes, we’re being “paid to wait” until the inherent value of these companies is better reflected in its stock price.
Performance Recap
Source: Bloomberg, S&P Global and NASDAQ
Note: Total returns as of 6/16/23
THE ENERGY SECTOR: FROM BEST TO WORST [but better times ahead]
Energy was the best performing S&P 500 sector in 2021 and 2022. However, in what may be characterized as a reversion to the mean, energy has dropped to the worst performing sector this year, likely caused by the drop in oil and natural gas prices. The latter is the result of a very mild winter in Europe and the U.S. and the 6+ months that the Freeport LNG export facility was offline. Consequently, natural gas storage levels are higher than average.
Crude prices appear stuck in a trading range of $65.00 to $80.00 per barrel (WTI), well below last year’s peak above $120 per barrel. China’s reopening has failed to increase demand as much as anticipated and fears of a global recession have weighed down prices. On the supply side, Russian exports have shown surprising resilience and OPEC + cuts have not yet had the desired effect. The sell-off in crude prices in May were further fueled by financial players exiting their long crude positions, in part because of higher carrying costs. Thank you, Central Banks for higher interest rates!
Fundamentals are widely expected to improve for both oil and natural gas in the second half of this year. Oil markets are likely to tighten, and inventories drawn down as incremental demand from China and OPEC + supply cuts start to bite. A decline in U.S. drilling activity for natural gas has pushed natural gas production marginally lower, and growing power demand have already lifted natural gas prices. Next year natural gas should get a boost from a normal winter and an increase in exports.
YTD Performance Commodity Prices
Source: Prompt future month prices from Bloomberg
SPECTER OF PEAK OIL DEMAND DOESN’T FORETELL THE DEMISE OF OIL CONSUMPTION
Unsurprisingly, investor sentiment toward energy has waned this year as tech stocks have been the better investment opportunity, a stunning reversal from just a year ago when tech stocks were the worst performers.
Another blow to energy sentiment may be the International Energy Agency’s (IEA) recent report, “Oil 2023: Analysis and Forecast to 2028.” It predicts that oil demand will peak in 2028, just 5.9 million barrels (5.9%) above 2022 estimated consumption of 99.8 mb/d. According to the IEA, Russia’s invasion of Ukraine has brought energy security to the forefront and hastened deployment of clean energy technologies such as renewables for power generation. Additionally, the biggest impact is from efficiency gains and new electric vehicle (EV) sales that, when combined, shaves 7.8 mb/d of oil demand over the 2022–2028 period.
We hasten to note that the IEA’s crystal ball over the years has been… less than prescient. As such, the drop in oil demand is likely to be gradual when the peak does occur. Research from BloombergNEF points out that road transportation will likely still consume about 20 mb/d of oil (or roughly half of today’s levels) by 2050. For context, Bloomberg notes that there are about 1.2 billion internal combustion engine (ICE) vehicles in circulation today, compared to 27 million battery-electric and plug-in passenger vehicles at year-end 2022 (expected to grow to 41 million in 2023).
Essentially, the growth in EV adoption needs to accelerate to meet climate goals and surpass ICE vehicles. The road won’t be easy given lithium battery resource constraints as well as the additional power and transmission lines that will be required for electrification. Will that source of incremental power be all renewables?
BRIGHT FUTURE FOR CLEAN ENERGY, BUT COST OF CAPITAL WEIGHS ON STOCKS
We remain bullish on the long-term prospects of clean energy stocks given the huge runway of investment opportunities, private investment allotted to the sector, and regulatory and financial government support towards the energy transition. Clean energy stocks have been excluded from the mega cap technology rally despite having a long growth runway. While the Magnificent Seven have an abundance of cash, financing concerns and higher interest rates have weighed on the valuations of the clean energy stocks. These concerns may be overstated…
We believe clean energy companies with proven technologies and track records will continue to have access to capital markets. For example, the U.S. Department of Energy (DOE) is providing billions in loans toward the energy transition. The latest is a $9.2 billion government loan to Ford Motor Co. (F-NYSE) for the building of three battery plants in Kentucky and Tennessee. This follows a $3 billion conditional loan guarantee for Sunnova Energy (NOVA-NASDQ) to provide residential solar loans to disadvantaged communities. Additionally, Sunnova was able to raise $286.7 million from the issuance of asset-backed securities (ABS) notes at attractive rates of 5.6 to 6.0%, maturing in May 2028.
There’s good news and bad news. The International Renewable Energy Agency (IRENA) reports that a record $1.3 trillion was invested across all energy transition technologies in 2022, but “annual investment must more than quadruple” to meet climate goals by 2050 (for context, less than $500 billion was spent for oil and gas upstream activities in 2022). The good news is that the demand for clean energy is growing rapidly, and the investment opportunity is in the trillions of dollars over the next several decades. As for the bad news, the cost to finance clean energy investments will be substantial, but not insurmountable as noted above.
Our positive outlook in clean energy was reinforced by themes from ISI Evercore’s Global Clean Energy & Transition Technologies Summit, which was well received with over 500 investors and 52 companies in attendance earlier this month. Two key takeaways from the conference2:
1. Demand remains strong across all clean energy verticals and is, in most cases, accelerating.
2. Significant legislative efforts such as the IRA (U.S.’ Inflation Reduction Act and GDIP (Europe’s Green Deal Investment Plan), alongside emerging legislation in numerous regions globally, are further accelerating clean energy deployment.
The table below breaks down IRENA’s estimate of the amount required to meet climate goals by 2050 (note that the cumulative investment requirement exceeds $130 trillion).
Investment Needs for IRENA’s 1.5 °C Scenario
Source: ISI Evercore 2“Key Takeaways from Evercore ISI's Global Clean Energy & Transition Technologies Summit 2023”, Evercore ISI, June 20, 2023
MAY REVIEW: ENERGY SLIPS WITH DECLINE IN COMMODITY PRICES The rundown:
· SAM’s Infrastructure Income Portfolio produced a return (net of fees) of -3.9% compared to 0.4% for the S&P 500 and -4.8% for its customized benchmark.
· SAM’s Energy Transition Portfolio generated a return (net) of -4.2% vs. -3.8% for its customized benchmark.
· Utilities and Midstream were the biggest underperformers in May, with a total return of -6.0% and -5.4%, respectively, as measured by the Philadelphia Stock Exchange Utility Index (XUTY) and the Alerian Midstream Energy Index (AMNAX).
· The clean energy sector generated a total return of -2.0% as measured by the S&P Clean Energy Index (SPGTCLTR).
· Most sectors in the S&P 500 (8 out of 11 sectors) reported a negative performance, led by Energy with a -10.0% monthly total return. May month-end WTI crude oil and natural gas prices fell below $70 per Bbl ($68.11) and to ~$2 per MMBtu ($2.10), respectively, which were down -11% and -7% from month ago prices.
RESULTS: YEAR-TO-DATE & SINCE INCEPTION
SAM’s Infrastructure Income Portfolio produced a return (net of fees) of -5.1% and 49.6% for the 1-year and since 11/10/20 inception periods, respectively. This compares to a total return of -8.3% and 45.9%, respectively, for its customized benchmark and 2.9% and 22.7%, respectively, for the S&P 500.
SAM’s Energy Transition Portfolio generated a return (net of fees) of -9.8% and 3.8% for the 1-year and since 4/29/21 inception periods, respectively. This compares to a total return of -7.9% and -0.1%, respectively, for its customized benchmark and 2.9% and 2.7%, respectively, for the S&P 500.
Sam Partners’ Infrastructure Income and Energy Transition Strategies seek to provide sustainable income and growth with capital preservation. This is accomplished by investing in a concentrated portfolio of high-quality clean energy companies, midstream energy companies and utilities that are well positioned to participate in the energy transition to a net zero carbon future. A diversified approach to investments across these sectors should optimize risk-adjusted returns, in our view. Our Infrastructure Income Strategy offers investors a current yield of greater than 5% and growth potential of ~5-6%; while the Energy Transition Strategy that is more heavily weighted with clean energy stocks and adheres to strict ESG criteria, offers investors a current yield of greater than 4%. In a world starved for yield, we believe these Strategies offer a compelling value proposition.
IMPORTANT DISCLOSURES
Siegel Asset Management Partners is a registered investment adviser located in Plainview, New York. The views expressed are those of Siegel Asset Management Partners and are not intended as investment advice or recommendation. This material is presented solely for informational purposes, and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness, or reliability. All information is current as of the date of this material and is subject to change without notice. Third-party economic, market or security estimates or forecasts discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates or forecasts. Certain products and services may not be available in all jurisdictions or to all client types. Unless otherwise indicated, Siegel Asset Management Partners' returns reflect reinvestment of dividends and distributions. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
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