Market Commentary: Energy Staging a Comeback
The S&P 500 closed at a 2023 high on July 31st but has since swooned in the dog days of summer as tech stocks have lost some momentum and interest rates have climbed higher. In contrast, the energy sector has heated up since the beginning of June, performing best out of the 11 S&P 500 sectors after lagging in the first five months of the year. We believe energy outperformance may continue—
1. Oil and natural gas prices have strengthened. OPEC (Saudi Arabia) has regained control of the oil market and seems set on curtailing production to sustain higher prices. In July, Saudi Arabia voluntarily cut its production by 1 million barrels per day (mb/d) and Russia began making good on its promise to curb exports by 500,000 bpd. They will reassess on a monthly basis.
The International Energy Agency (IEA) noted that world oil demand hit a record 103 mb/d in June, “boosted by strong summer air travel, increased oil use in power generation and surging Chinese petrochemical activity. Global oil demand is set to expand by 2.2 mb/d to 102.2 mb/d in 2023, with China accounting for more than 70% of growth.”1 However, next year’s growth is expected at just 1 mb/d as pent-up demand post pandemic has been satiated and the energy transition “gathers pace.”
U.S. natural gas production has begun to flat line as producers (mostly private companies) have cut back on their drilling activity. The U.S. rig count has declined about 18% to 642 rigs (8/14/23) from the 52-week high of 784 rigs on 12/2/22. Because more of U.S. natural gas production is being exported, its price can be influenced by global supply and demand dynamics. Most recently, the potential workers’ strike in Australia may reduce the global supply of liquefied natural gas (LNG) by as much as 10%, according to Bloomberg.
1 IEA (2023), Oil Market Report - August 2023, IEA, Paris https://www.iea.org/reports/oil-market-report-august-2023
Total U.S. Rig Count
Source: Baker Hughes
2. The energy sector has remained financially disciplined. By now, skeptics may have come to realize that the sector’s focus on returns and returning cash to shareholders is not a passing fad. The message came across loud and clear after another relatively quiet earnings reporting period. Balance sheets are stronger than ever, and this new and more resilient business model equates to a lower risk profile. As we see it, this should justify higher stock market valuations.
We believe more favorable H2’23 earnings comps for energy companies could be a catalyst. Crude prices started to trend below $100 per Bbl starting in H2’22. The Wells Fargo Midstream Energy team published that, “Q2 earnings season brought a balanced mix of beats, in line and misses… management team outlooks for H2’23 is positive with some bullish commentary on oil and NGL pricing and many expecting more robust Permian growth in the back half of 2023.”
3. Growth through consolidation can create shareholder value. Companies in mature industries should return cash to shareholders when they lack investment opportunities that generate attractive returns. Another path is consolidation in which cost, commercial, and financial synergies can be realized. On August 14th, Crestwood Equity Partners LP (CEQP) agreed to be acquired by Energy Transfer, LP (ET) for no stock price premium in a tax-free transaction and this past Mother’s Day, Magellan Midstream Partners, L.P. (MMP) agreed to merge with ONEOK, Inc. (OKE). The primary reason for MMP and CEQP agreeing to be acquired is their limited growth opportunities as stand-alone entities. We applaud these management teams for operating as agents in the best interest of their shareholders.
However, as we wrote in our May commentary, It Takes Two to Tango, mergers are difficult to consummate and require two willing parties. Hostile takeovers rarely work. Further consolidation may be slow to develop.
4. Valuations and dividends are attractive. The energy sector trades at low valuations relative to the technology sectors that have led the stock market higher for most of the year. This is despite the energy sector’s attractive yields and growth prospects. Notably, SAM’s Infrastructure Income Strategy offers investors a current yield of greater than 5% and growth potential of ~5-7% (We confess that we have a bias for value and dividend paying stocks relative to growth stocks).
5. Midstream valuations still below historical levels. We believe that midstream has the potential to re-rate higher. Midstream deserves a utility-like valuation, in our view, because of similar cash flow and risk profiles. Utilities are currently trading at a premium relative to midstream (e.g., 1-2 multiples higher). Additionally, MLPs and Midstream c-corps. are trading at discounts to their historical averages versus a premium for utilities. Specifically, MLPs and midstream c-corps are trading at discounts of -4% and -9%, respectively, relative to their 5-year averages and both at a discount of -26% relative to their 10-year averages.
Midstream Valuation Versus Historical Averages
Source: Wells Fargo Securities, LLC’s Midstream Monthly Outlook: August 2023
COP28 ACTION PLAN ALLOWS FOR “CLEAN” HYDROCARBONS
The 2023 United Nations Climate Change Conference (COP 28) is scheduled to be held from November 30th through December 12th in Dubai. Notably, the first Global Stocktake (GST) will conclude at COP28 in December. It will provide an assessment of what progress has been made to meet the goals of the Paris Agreement, identify shortfalls in countries’ National Determined Contributions (NDCs) and highlight ways to accelerate climate action.
Consensus view is that the world is way off-track to reach goals to limit global temperature increase to 1.5°C above pre-industrial levels and reduce global emissions by 43% by 2030. According to the NOAA, July 2023 was the hottest month in recorded history (~2.0° above average globally). Some scientists have attributed the record global heat and recent natural disasters (e.g. wildfires) to climate change. Other industry experts question the causality and available evidence to substantiate that claim and the need to accelerate the energy transition.
Earlier this month, Dr. Sultan Ahmed Al Jaber, president-designate, provided an agenda for COP28 and reiterated the commitment to limit global temperature increase to 1.5°C. The plan entails capturing greenhouse gas emissions (GHG), tripling renewable energy capacity by 2030, doubling energy efficiency and making climate finance affordable, available, and accessible to developing countries. According to Dr. Sultan Ahmed Al Jaber, “If we are to achieve the goals of the Paris Agreement, emerging and developing countries need in excess of USD 2.4 trillion of annual investment in climate action by 2030.”2
The Use of Fossil Fuels in The Energy Transition
Importantly, the COP28 action plan also allows for new oil and gas production if emissions are captured, and unabated fossil fuels are phased out by midcentury. Notably, the term “unabated fossil fuels” refers to oil, natural gas and/or coal when the intensity of GHG emissions from these fuel sources is not reduced. As such, technology (e.g., carbon capture) can be used to reduce emissions to acceptable levels, implying that there will still be demand for fossil fuels during and at the end of the energy transition. This is aligned with our view: long-term demand for oil and gas does not drop to zero!
Still, some want to phase out fossil fuels entirely. We were astonished to read the following quote in a UN post on climate: “The solution is clear: the world must phase out fossil fuels in a just and equitable way – moving to leave oil, coal and gas in the ground where they belong and massively boosting renewable investment in a just transition.” 3
Major fossil fuel producing countries prefer a more measured approach to phasing out fossil fuels. As noted by Reuters,4 no consensus was reached at last month’s 4th Energy Transition Working Group Meeting of the Group of 20 (G20) held in India. The chart below depicts the significant government support and subsidies for fossil fuels from the major producing countries, especially China, Saudi Arabia, and Russia. It should also be noted that representatives from major producing countries (e.g., Saudi Arabia, Russia, China, South Africa, Indonesia) also opposed the G20 target of tripling renewable energy capacity by 2030.
Fossil-fuel Subsidies By G-20 Country
SAVE THE DATE
It’s unfathomable to us that climate activists have paid so little attention to developing technologies that enable use of our abundant natural resources in a clean burning manner. Please join ELCO and SAM Partners for a fireside chat with Danny Rice – CEO and Akash Patel – CFO of NET Power Inc. on Thursday 9/14/23. Net Power has designed a natural gas power plant that generates electricity with little or no emissions. According to Rice, NPWR has hit the “Energy Trifecta,” by producing clean, reliable, and low-cost energy.
UTILITIES AND CLEAN ENERGY STOCKS HURT BY RISE IN INTEREST RATES
The recent rapid movement upwards on interest rates (e.g., 10-year treasury yield of ~4.25% as of 8/18/23 versus 2.9% as of 8/17/22) has created headwinds for growth stocks (and moved the pendulum in favor of fixed income instruments). Specifically, higher interest rates have negatively impacted the performance of utilities and clean energy stocks. Based on one-year data, the correlation between interest rates and the utilities and clean energy indices appears to be statistically significant (i.e., -0.71 and -0.67, respectively).
U.S. 10-Year Treasury Yield Versus Utilities & Clean Energy Indices
JULY REVIEW: ENERGY LEADS CONTINUED MARKET MOMENTUM
• SAM’s Infrastructure Income Portfolio produced a return (net of fees) of 3.3% compared to 3.2% for the S&P 500 and 2.4% for its customized benchmark.
• SAM’s Energy Transition Portfolio generated a return (net) of 1.28%, in-line with 1.34% for its customized benchmark.
• Midstream outperformed in July with a total return of 3.3%, as measured by the Alerian Midstream Energy Index (AMNAX).
• Utilities and the clean energy sector generated a total return of 2.3% and -0.3%, as measured by the Philadelphia Stock Exchange Utility Index (XUTY) and the S&P Global Clean Energy Index (SPGTCLTR), respectively.
• All 11 sectors in the S&P 500 reported a positive performance, including the largest gain in Energy with a 7.4% monthly total return. July month-end WTI crude oil and Henry Hub natural gas prices were above the ~$80 per Bbl ($81.80) and ~$2.50 per MMBtu ($2.58) levels, respectively, which were up 16% and 4% from last month.
RESULTS: SINCE INCEPTION & ONE YEAR
SAM’s Infrastructure Income Portfolio produced a return (net of fees) of 64.2% and 5.0% for the since 11/10/20 inception and 1-year periods, respectively. This compares to a total return of 58.0% and -1.7%, respectively, for its customized benchmark and 35.0% and 13.0%, respectively, for the S&P 500.
SAM’s Energy Transition Portfolio generated a return (net of fees) of 9.8% and -6.0% for the since 4/29/21 inception and 1-year periods, respectively. This compares to a total return of 5.4% and -7.7%, respectively, for its customized benchmark and 12.9% and 13.0%, respectively, for the S&P 500.
2023 YTD Total Return
Source: Bloomberg, NASDAQ and S&P Global
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 midstream energy companies, utilities and clean energy companies 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 ~5-7%; 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.
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.