- Yves Siegel
Market Commentary: Energy Stocks Make New Highs While the S&P 500 Flirts with a Bear Market
As of this writing, the S&P 500 energy sector, heavily weighted in upstream stocks, is making new highs as the broader market (as measured by the S&P 500) flirts with falling into a bear market (arbitrarily defined as a decline of 20% from its peak). The fundamental backdrop for energy remains very constructive given tight global supplies across fossil fuels, (oil, natural gas, and coal). Demand is still high as global economies have substantially reopened (China being an exception) and have exceeded pre-Covid energy consumption levels. Consequently, we expect energy commodity prices to stay elevated for a prolonged period. We believe that energy companies will generate substantial free cash flow and importantly, remain financially disciplined. Indeed, during first quarter earnings calls, energy companies deviated little from the script written about two years ago; namely, live within cash flow, focus on returns on capital, and return cash to shareholders in the form of dividends and share buybacks. (For the record, we prefer dividends as the most optimal way to give money back to shareholders. More to be written on this topic in future commentaries).
Given the current economic backdrop, we are concerned about the potential for a recession later this year or next. The energy sector will not be immune but should hold up relatively well for the following reasons:
Dividend support: The S&P 500 energy sector sports an attractive yield of more than 3% (according to Bloomberg), while the Alerian Midstream Energy Index (AMNA)’s yield is approximately 5.5%. It should also be noted that E&P companies with variable dividends have yields in the upper single-digits. For reference, SAM’s Infrastructure Income Strategy, a three-pronged portfolio of midstream, utilities, and renewable energy companies, provides a yield of 4.5%.
Substantial free cash flow: E&P and midstream companies historically have outspent their cash flow from operations and relied on the capital markets, debt, and equity, to finance their capital expenditures and dividends. That model has been retired. E&P and midstream companies are reinvesting only about 30-35% of their cash flow with the balance used to reduce debt and return cash to shareholders. The 2023E free cash flow yield for these energy subsectors are very attractive at about 19% and 9%, respectively, according to U.S. Capital Markets LLC and Wells Fargo Securities, LLC.
Breakeven costs are well below current commodity prices for most basins. Oil and gas prices could fall by more than 50% and it would still be profitable for E&P companies to drill and complete wells.
Balance sheets are strong: Energy companies have substantially deleveraged and are well positioned to weather a recessionary storm. This alleviates concerns of midstream companies’ counter party risk that was prevalent during the oil price collapse of 2014-2015.
Value and dividend paying stocks should continue to outperform growth stocks during a period of rising interest rates.
Source: Marketwatch and Yahoo Finance
Why Aren’t Oil and Gas Companies Producing More?
It seems odd that oil and gas companies are not ramping up production faster given such high commodity prices. The U.S. rig count of 690 in April is up from 436 in the comparable year ago period but is still well below the pre-pandemic peak of 791 rigs in 2020.
Source: Baker Hughes
Production has also risen. But why haven’t companies pushed the pedal to the metal?
The focus has shifted to generating sustainable returns on capital and generating free cash flow. The industry has learned that ramping activity up and down based on current commodity prices is inefficient and destroys capital.
Shareholders have rewarded companies for financial discipline. Management compensation is no longer widely based on production growth but on other metrics such as return on capital and ESG metrics such as emission reduction goals.
There are infrastructure constraints such as labor and materials shortages.
Planning is difficult when there is regulatory uncertainty regarding permitting for drilling as well as permitting for pipelines. The lack of pipeline infrastructure in the northeast to transport natural gas has limited production growth in Appalachia (the largest natural gas producing basin in the U.S.).
As an aside, it’s a bit of a headscratcher that the U.S. is promoting LNG exports to support our European allies’ quest to replace Russian natural gas while hampering needed infrastructure to deliver natural gas to future LNG export facilities along the U.S. Gulf Coast.
If producers believed that oil and gas consumption was on the precipice of decline, it would make sense to produce as much as possible today. However, the growing consensus appears to be that oil and gas will be around for decades to come to support basic human needs for power, transportation, and industrial uses. For example, the petrochemical, steel, and pharmaceutical industries are beholden to fossil fuels.
Coal to the Rescue
Rumors of the impending death of coal were greatly exaggerated. Global coal consumption was on the rise even before Russia’s invasion of Ukraine. According to the International Energy Agency’s (IEA) Coal 2021 report, coal was the fastest grower among electricity sources of supply— in 2021, global coal power generation grew by 8.6% to an all-time high of 10,350 terawatts. China and India, (when combined, account for over two-thirds of global coal demand) grew consumption by 9% and 12%, respectively. Despite commitments to invest in renewables, global coal consumption (led by China and India) is expected to continue growing through 2024. Germany plans to phase out coal consumption by as early as 2030. But in the meantime, should Russia threaten to cutoff the country’s natural gas supply, Germany will activate shuttered coal plants. Coal to the rescue.
Yes, reducing global CO2 emissions is a noble endeavor, but it needs to be balanced by national security concerns and the need to have reliable, sustainable, and affordable energy supplies, especially for developing nations that are impoverished and lack basic power needs. Russia’s invasion of Ukraine has exacerbated the energy crisis that manifested last year due in part to the rebound in pre-pandemic demand, severe weather and declining fossil fuel investment.
At last week’s Energy Infrastructure Council conference in West Palm Beach, Florida, we hosted a fireside chat with Joe Craft, Chairman, President and CEO of Alliance Resource Partners, L.P. (NASDAQ-ARLP). The key takeaway is that ARLP is not your daddy’s coal company. It’s now an energy company that recognizes that the energy transition is underway, and it has begun to invest in new technologies to support a decarbonized future. However, for the next couple of decades, coal will be vital for energy security that equates to national security and as Joe puts it, “to freedom”.
“Managing the move away from coal will not be straightforward. Renewable energy options are the most cost-effective new sources of electricity generation in most markets, but there are still multiple challenges to reducing emissions from the existing global fleet of coal power plants while maintaining secure and affordable electricity supplies.” IEA Executive Director, Fatih Birol
Total Coal Consumption for Generating Power (2000-24)
Source: International Energy Agency (IEA) and Bloomberg
EU’s Response to Russia Accelerates Region’s Clean Energy Transition
Last week, the European Commission released details of its REPowerEU Plan, which aims to ultimately end Europe’s reliance on Russian energy supplies following the invasion of Ukraine. The plan adopts a three-pronged approach: (1) acceleration of Europe’s clean energy transition away from fossil fuels, (2) diversification of energy supplies and (3) energy conservation (efficiency). Approximately €300 billion of financing has been earmarked for these initiatives. Over the longer-term, the clean energy sector should benefit from the acceleration in demand. However, the transition away from fossil fuels will still take time. Although its supply chain may change, the EU’s demand for coal, crude and gas is not expected to significantly wane in the near-to-intermediate term, in our view.
Renewable energy is expected to account for 45% of the EU’s energy mix by 2030 under the REPowerEU plan. Total renewable energy generation capacity is projected to increase to 1,236 GW by 2030 (vs. 1,067 GW previously under the Fit for 55 proposal of the European Green Deal legislation). The targeted growth in renewables, which appears ambitious, in our view, is primarily driven by: (1) more than 320 GW of solar installation targeted by 2025 (doubling solar photovoltaic capacity) and 600 GW by 2030, (2) 480 GW of wind capacity, (3) targeted annual production and imports of 20 million tons of hydrogen by 2030 and (4) a projected increase in biomethane production to 35 Bcm (about 3.4 Bcf/d) annually by 2030, up from 3.5 Bcm in 2022.
In April, the EU agreed to ban Russian coal imports (likely to be implemented by August). Earlier this month, the EU proposed to ban all Russian crude oil imports within six months and ban petroleum product imports by the end of the year. Approval of the ban has been stalled by Hungary, which derives roughly 58% of its oil imports from Russia. The EU is also planning to cut Russian gas imports by two-thirds this year, which would be more difficult to execute, in our view, given the greater logistics/infrastructure challenges in the EU to secure alternate supplies.
Supply Chain Issues Hurt Clean Energy in the First Quarter
For the month of April, the S&P Global Clean Energy Index (SPGTCED) was down -12.1% (-11.9% including dividends), underperforming the overall market (e.g., S&P 500 was down -8.8%, -8.7% including dividends). Concerns over inflation and a potential recession driven by higher interest rates weighed on the clean energy sector. Notably, the ten-year treasury yield peaked at 3.12% on 5/6/22, up from 2.33% at the end of March. Additionally, clean energy performance was likely impacted by Q1 earnings reports, which mostly missed expectations (e.g., below consensus based on the results of the top 10 constituents of the SPGTCED by index weight).
Key issues raised on earnings calls include: margin pressure, supply constraints, COVID-19 shutdowns in China and the potential impact of higher tariffs. Regarding the latter, a key concern for solar stocks has been the Commerce Department’s investigation on 3/25 into the circumvention of U.S. tariffs on Chinese solar products through Southeast Asian countries. As reported in the New York Times on 4/29/22, “In a matter of weeks, 318 solar projects in the United States have been canceled or delayed, and hundreds of companies are considering layoffs, according to the Solar Energy Industries Association.” Despite these near-term headwinds, management teams, for the most part, maintained their full-year guidance for 2022 and long-term outlooks. We will continue to monitor these developments and remain cautiously optimistic that these companies can deliver on their targets.
Energy Posted a Slight Loss in April but is Still Well Ahead of the Pack Year-to-Date
In April, SAM’s Infrastructure Portfolio produced a return (net) of -4.0% compared to -8.7% for the S&P 500 and outperformed its customized benchmark, which decreased -4.5%. The biggest laggards in April were the clean energy stocks that generated a total return of -11.9%, as measured by the S&P Clean Energy Index (SPGTCED).
The S&P 500 Energy sector posted a one month return of -1.5% in April and is still the best performing of the 11 S&P 500 sectors year-to-date with a return of 36.7% as of April month end. This compares with the S&P 500 negative year-to-date return of 12.9%. Consumer Staples was the only other S&P 500 sector with a positive return through April month end, just 1.5%. The Alerian Midstream Energy Index (AMNA) and the Philadelphia Stock Exchange Utility Index (UTY) posted total returns of -2.1% and -4.4%, respectively, last month.
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 4.5% and growth potential of ~7%; 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 3.7%. In a world starved for yield, we believe these Strategies offer a compelling value proposition.