- Yves Siegel
Market Commentary: Climbing the Wall of Worry
As of this writing, the S&P 500 has declined ~10% year-to-date, meeting the definition of a technical correction. In contrast, the S&P 500 energy sector has appreciated approximately 20% and is the only S&P 500 sector in positive territory. Geopolitics, i.e., Russia’s aggression toward Ukraine, is clearly propelling commodity and energy stocks currently higher. However, before this flare up, positive energy fundamentals were driving this outperformance. Energy companies are generating record levels of free cash flow, realizing attractive returns on capital employed, staying financially disciplined and returning cash to shareholders. Oil and natural gas prices are elevated because of relatively low inventories, constrained supply, and growing demand. Add to this a premium for geopolitical risks and it’s not difficult to envision oil prices well above $100 per barrel.
Russia is the second largest exporter of crude oil (~ 4.5 million barrels per day or ~ 4.5% of global production). It also supplies about 40% of natural gas to Europe, about one third of which travels through Ukraine. Oil markets are tight. According to the International Energy Agency’s (IEA) recent Monthly Oil Market Report (OMR), the OECD’s inventory levels are at their lowest level in seven years, OPEC+ continues to undershoot production targets, and its spare capacity continues to dwindle. Hence, the specter of less Russian oil and gas available to the West has roiled markets.
Surely, the wild card is Russia, and the central risk is that an escalation of war could lead to a global recession. As we all may recall from our political science class in college, countries always act in their best interest. Although we’re opining beyond our comfort zone, we don’t believe it’s in either Russia or President Putin’s best interest to expand a war beyond Ukraine. We maintain that if the geopolitical tensions ease, oil and natural gas prices are likely to correct to levels that will still provide very attractive returns for the energy sector. Bottom line: expect volatility but stay the course with the energy sector that is still likely to continue to outperform because of favorable long-term fundamentals.
FERC GHG Update Weighs on Gas Infrastructure Requirements
Cognitive dissonance describes the mental discomfort that results from holding two conflicting beliefs, values, or attitudes. A great example of this to note is the U.S. government pursuing policies that limit the use of fossil fuels to reduce greenhouse gas emissions (GHG), while also trying to provide affordable and reliable energy (especially for indigent populations) to consumers. Energy security should also be a pillar of policy.
Last week in a 3-2 vote along party lines, the Federal Energy Regulatory Commission (FERC) issued an “Interim Greenhouse Gas Emissions Policy Statement” that will be used to assess “the significance of the proposed (pipeline) project’s contribution to climate change.”(FERC interim GHG emissions policy statement). We believe that the potential impact is a clear conflict with the current Administration’s goal of ensuring accessibility to affordable and reliable energy. Consumers are already facing hefty utility bills this winter amidst cold temperatures record inflation. The FERC policy will effectively make it even more difficult to build natural gas pipelines and LNG export facilities. The response will be to further tighten the natural gas market and increase prices, while ceding more geopolitical power to Russia (that supplies nearly 40% of natural gas to our European allies). In addition, it’s a misnomer to believe that we cannot both reduce GHG emissions while promoting the use of natural gas. The latter, which has the lowest carbon intensity of any fossil fuel, can reduce GHG emissions if it displaces coal and other more carbon intensive resources. The European Commission's sustainable finance rules currently label natural gas and nuclear power as green transition fuels. Specifically, the E.U. taxonomy classifies some as green investments. Hopefully, the U.S. administration will take notice.
Energy Valuations Provide Attractive Return Potential for Stocks
As previously noted, energy is again the best performing S&P 500 sector year-to-date (i.e., price change of +19.0% in January vs. -5.3% for the S&P 500). Performance has been driven by rising oil and natural gas prices, attractive yields, and cheap valuations, in our view. In January, WTI crude oil and Henry Hub natural gas prices increased 17.2% and 30.7%, respectively, which benefitted the energy subsectors most sensitive to commodity prices (i.e., S&P 500 E&P and Oil Service Sector (OSX) was up 21.4% and 22.0%, respectively). Midstream also posted a strong gain [e.g., +9.1% in January as measured by the Alerian Midstream Energy Index (AMNA)].
As we see it, despite the recent outperformance, energy stocks—specifically midstream—can deliver compelling total returns in 2022. Midstream valuations are currently attractive with MLPs still trading at a discount to historical averages (e.g., median EV-to-2023E EBITDA multiple of 8.1x vs. the 5-year and 10- year average of 9.5x and 11.9x, respectively, according to Wells Fargo Securities, LLC). In comparison to MLPs, the discount for Midstream c-corps have narrowed more (e.g., median EV-to-2023E EBITDA multiple of 10.0x vs. the 5-year and 10-year average of 10.7x and 12.9x, respectively). We would note though that the 5-year (2017-21) averages may be unduly skewed given the inclusion of unprecedented low valuations for midstream during the pandemic.
Another way to gauge midstream valuations is based on free cash flow (FCF) yields. On that basis, midstream also appears attractive. Their projected (2022-24) FCF yields are almost double the yields projected for the S&P 500 and are expected to grow through 2027 in the forecast period.
Supply Chain Woes to Hamper Growth of EV Sales?
Global electric vehicles (EV) sales have more than tripled over the last three years, according to a recent commentary published by the IEA (i.e., 6.6MM (or ~9% of global car sales) in 2021, up from 2.2 million (or 2.5% of global car sales) in 2019.
Global Sales and Sales Market Share of Electric Cars, 2010-2021
Source: IEA analysis based on EV volumes data
Government policies and subsidies/financial incentives continue to be the primary driver of EV sales. As anticipated, China (i.e., 3.4 million in 2021) and Europe (i.e., 2.3 million) are leading global electric car sales. EV market share in the U.S. doubled to 4.5% (~0.5 million cars sold) in 2021, according to the IEA. In other regions, EV market share, however, continues to lag with just ~1-2% of overall sales.
Based on targets set by many governments and auto manufacturers to transition away from conventional cars, the growth of EVs appears highly visible into the end of the decade. However, the IEA highlighted that the supply chain environment has become increasingly challenging, which may result in disruptions/production delays. Both pricing and scarcity of required materials are issues. In 2021, the price of steelrose by as much as 100%, aluminum around 70%, and copper more than 33%, according to the IEA. Prices
for materials to manufacture batteries also surged (e.g., the price of lithium carbonate increased by 150% year on year, graphite by 15%, and nickel by 25%). In addition, potential global shortages of key minerals such as lithium and cobalt as well as microchips are concerns. To support the long-term growth trajectory of EVs, the IEA noted that government policies/intervention may be required to drive investments to address bottlenecks on the supply side.
Energy Continues to Post Gains—SAM’s Infrastructure Portfolio Outperforms
In January, SAM’s Infrastructure Portfolio produced a return (gross) of 5.4% compared to negative 5.2%for the S&P 500 and outperformed its customized benchmark, which increased 2.3%. The biggest losers inJanuary were the clean energy stocks that generated a loss of 12.2%, as measured by the S&P Clean Energy Index (SPGTCED). The S&P 500 Energy sector posted a one month return of 19.1% in January and is still the best performing of the 11 S&P 500 sectors year-to-date. The Alerian Midstream Energy Index (AMNA) and the Philadelphia Stock Exchange Utility Index (UTY) posted total returns of 10.5% and negative 3.9%, respectively, last month. SAM’s nascent ESG Infrastructure Portfolio generated a negative 2.0% total return in January weighed down by its holdings in the utility and clean energy sectors.
Sam Partners’ Infrastructure Income and ESG Infrastructure 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 ~5% and growth potential of ~4%; while the ESG Infrastructure Strategy that is more heavily weighted with clean energy stocks and adheres to strict ESG criteria, offers investors a current yield of ~3%. In a world starved for yield, we believe these Strategies offer a compelling value proposition.