Market Commentary: Energy Security is National Security
Our hearts and prayers are with the courageous people of Ukraine as we struggle to imagine the overwhelming loss of innocent lives, especially children, and millions of displaced persons. We are thankful that the world is coalescing to support Ukraine, including a joint ban on Russian energy imports. The latter has led to global spikes and volatility in commodity prices (WTI crude oil prices peaked to around ~$130 per barrel (Bbl) earlier this month). Consequently, energy continues to outperform and was the only S&P 500 sector posting a gain for the month of February (e.g., +6.4% versus -3.1% loss for the S&P 500).
Energy is still the sector to overweight and we expect commodity prices will remain elevated due to the geopolitical backdrop, low inventories, constrained supply, and growing global demand. As we see it, despite the recent outperformance, energy stocks are still undervalued. Energy cash flow valuations (e.g., EV-to-EBITDA) are discounting oil prices below $60 per barrel and natural gas prices below $3.00/MMBtu, according to several sell-side firms. Additionally, the sector’s free cash flow yield is greater than 10% (and growing) and compares very well to the broader stock market’s free cash flow yield of just under 4%.
The chart below shows that the XLE (Energy Select Sector SPDR Fund) at 71.29 (as of 3/1/22) is still about 28% below the level the last time WTI crude oil prices were above $100 per barrel (7/30/14).
Source: EIA and Yahoo Finance
Note: XLE price adjusted for splits.
Importantly, investors are beginning to recognize that the energy sector’s operating business model has changed. Companies are operating with greater financial discipline and less debt—they’re generating attractive returns on capital employed and significant free cash flow, returning more cash to shareholders, and implementing stricter environmental, social, and governance (ESG) standards. Additionally, the energy sector has historically done well during periods of inflation and should be viewed favorably by those seeking income. We expect that over time these factors should result in lower volatility, higher earnings multiples, and consequently, higher stock prices. However, during the current time of heightened geopolitical risk and growing fears of a recession or stagflation, investors should anticipate continued volatility until there is a clearer resolution in sight.
The energy sector is becoming relevant again, currently representing just under 4% of the S&P 500. Although the weighting is up from about 2% during the pandemic, it is still well below 8.4% at 2014 year-end and the last peak of 12.3% at the end of 2011. If energy stocks continue to outperform, as we believe, the sector’s weighting will continue to grow. We suspect that both retail and institutional investors will be attracted to energy stocks because of a fear of missing out (FOMO) given the strong returns, while portfolio managers given the higher sector weighting need to pay attention or risk posting poor relative returns.
Reliance on Russian Oil and Gas Supplies
Energy has been weaponized because of Europe’s over-reliance on Russian oil and natural gas, which has only emboldened Putin. Here are some facts regarding Russia’s energy industry, according to the International Energy Administration (IEA):
• Russia is the world’s largest oil exporter (crude oil and refined products combined):
o ~5 million Bbls per day of crude, or about 12% of global trade
o ~2.85 million Bbls per day of products, or about 15% of global trade
• As of November 2021, about 4.5 million Bbls per day of Russian oil was exported to Europe, representing about 60% of Russian exports and accounting for about one-third of Europe’s supply
• China is the largest buyer of Russian oil, accounting for about 20% of its exports. It imported about 1.6 million Bbls/d of Russian oil in 2021
• Russia is the 2nd largest natural gas producer behind the U.S.
o In 2021, Russia supplied 32% of the total gas demand in the EU and United Kingdom (UK)
o ~9% of the EU and UK’s combined natural gas demand passes through Ukraine
• Revenues from oil and gas-related taxes and export tariffs accounted for 45% of Russia’s federal budget in January 2022
• Russian export revenues for crude oil and refined products exceed $700 million per day (as of March 2nd)
The U.S. is in a much better position than Europe, although not quite as energy independent. While quickly becoming the largest exporter of liquefied natural gas (LNG), the U.S. is a net importer of oil to run its refineries. On March 8th, the U.S. officially banned imports of Russian oil that represent less than 10% of its imports, or about 600,000 Bbls per day. The UK has joined the ban and will gradually wean off Russian oil and gas by year end. Russia supplies 11% of UK’s oil imports and less than 5% of its gas imports.
Russian exports face additional headwinds as traditional buyers have lightened trading due to high shipping costs, logistics barriers, diminished credit support/financial backing of transactions, and reputational risk.
Oil and Gas Companies Can Grow Domestic Production Faster The U.S. is currently producing 11.6 million Bbls per day of crude compared to peak production of 13 million Bbls per day in 2020. Production fell to as low as 9.7 million Bbls per day during the pandemic (May 2020) because demand dropped precipitously, prices crashed (turning negative in April 2020), and drilling activity dried up. Oil production in the U.S. is expected to reach 12.0 million Bbls per day this year and average 13.0 million Bbls per day next year—new record levels, according to the EIA’s March Short Term Energy Outlook. A reassessment of the U.S.’ oil gas policy and legislative support of energy independence could accelerate production, in our view.
We note that the governor on even more robust growth has NOT been poor government policy (although that doesn’t help) but rather shareholders demanding stricter financial discipline from oil and gas companies. As prior noted, there has been a paradigm shift away from production growth to free cash flow generation, returning more cash to shareholders and bringing about better returns on capital employed. Part of the rationale is that historically oil and gas companies were poor stewards of capital, outspent their cash flow, and took on too much debt. We believe it to be a misconception that investing in fossil fuels doesn’t makes sense if we successfully transition to clean energy and fossil fuels go the way of the dinosaur. Alas, the narrative has changed with growing recognition that the “energy transition” will take longer (decades, in our view) and fossil fuels, oil, gas, and coal will be required to facilitate decarbonization.
It’s a bit ironic that proponents of clean energy don’t seem to recognize that the U.S. produces energy in a much more environmentally friendly way than elsewhere in the world, such as Russia. In other words, if US oil and natural gas displaced “dirtier” or more carbon-intensive produced oil and gas from countries such as Russia, global carbon issues would decline.
We gather that for oil and gas companies to grow production more rapidly, the U.S. government needs to streamline regulations for building pipelines and LNG facilities. It is difficult to envision companies committing capital to accelerate production growth if they fear they will be unable to reach end use markets. We believe the Appalachian production growth has been stalled because of the inability of pipeline companies to get natural gas pipeline projects approved that would facilitate the closure of coal fired power plants and expansion of LNG facilities. The most recent example of this is the stalled Mountain Valley Pipeline, although it’s 94% complete, the project has not been able to obtain its remaining water crossing permits.
To be clear, there is a time lag of up to a year before an oil and gas well can be drilled, completed, and begin producing. Additionally, because of a scarcity of capable rigs, oilfield services equipment and labor shortages, operating costs are escalating. Finally, oil and natural gas prices are in backwardation—in other words, prices in the future are lower than current prices. Consequently, we anticipate oil and gas producers will continue to be conservative in their deployment of capital or else face the ire of their shareholders. Accordingly, a meaningful near-term ramp in U.S. production above the consensus forecast of about 1 million barrels per day, appears unlikely to us.
Energy Security is National Security It is bad policy to be over reliant on one source of an essential resource, albeit energy, minerals, chips, technology, etc., especially if that resource comes from a “bad actor” on the world stage. That seems like common sense. Additionally, we believe that reaching out to other bad actors, such as Iran and Venezuela, to solve a short-term issue is reckless. More durable solutions include conservation, energy efficiency, increasing U.S. oil and natural gas production, and yes, the adoption of clean energy and nuclear power.
“Don’t pour out your dirty water until you have fresh.” Germany made a classic mistake of abandoning its nuclear power in a rush to adopt renewable clean energy. In the process, it has become overly reliant on Russia supplies to meet more than 50% of its gas demand and increase its coal consumption. Regardless, the country does deserve credit for pivoting and for not sanctioning Nord Stream 2 Baltic Sea natural gas pipeline project that would have doubled the capacity of Nord Stream 1.
Renewable Energy Can Help The latest events demonstrate how essential fossil fuels are to our daily lives and how dangerous it can be to: 1. overly rely on a potential adversary and 2. abandon fossil fuels before having a replacement. The energy transition is underway, and this crisis will likely hasten the adoption of clean energy alternatives. As we’ve written before, the transition to a net zero carbon future will likely take decades. As this occurs over time, energy security dictates that the world should still invest in traditional energy sources. Multiple global energy crises in 2021 have also underscored the importance of reliable and affordable energy. As noted in the latest EIA Annual Energy Outlook 2022 report, renewables will continue to gain market share from coal and nuclear through 2050. However, domestic demand for petroleum and other liquids and natural gas will still be robust over the coming decades.
Source: EIA Annual Energy Outlook (AEO) 2022
Let’s not make the same mistake. The U.S. and other countries must diversify its supply chain away from China to successfully develop clean energy technologies. There is a global reliance on China for materials and the manufacturing of renewables (solar modules and wind turbines, in particular) and battery storage. According to Wood Mackenzie, China accounts for ~66%, 50%, and 90% of global solar and lithium-ion battery manufacturing capacity, respectively.
Energy Continues to Outperform
Both SAM’s Income Infrastructure Portfolio and ESG Infrastructure Strategy hold companies that would benefit from accelerated investments in renewable/clean energy, LNG exports and/or domestic crude and gas production (e.g., Permian Basin). Our portfolios should be considered by those investors seeking income and concerned about inflation/stagflation. Many of our portfolio companies have price escalators embedded in their contracts.
In February, SAM’s Infrastructure Portfolio produced a total return of 4.1% compared to -3.1% for the S&P 500, but underperformed its customized benchmark, which was up 5.3%. However, year-to-date, our strategy has outperformed both the S&P 500 and its benchmark with a total return of 9.4% (net) compared to -8.2% and 7.7%, respectively. Clean energy stocks surged in February and generated a total return of 11.7%, as measured by the S&P Clean Energy Index (SPGTCED), while utilities, a defensive sector, posted a modest loss of 2% as measured by the Philadelphia Stock Exchange Utility Index (UTY).
The S&P 500 Energy sector posted a one-month total return of 7.1%, and year-to-date is the only S&P 500 subsector with a positive return, 27.6%. The Alerian Midstream Energy Index (AMNA) posted a total return of 5.5% last month. To note, SAM’s nascent ESG Infrastructure Portfolio generated a positive 4.6% total return in February.
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.