- Yves Siegel
Market Commentary: Exuberance in the Energy Market
“How Excited Are You About the Future? Extremely Excited!”
We recently attended the Barclays CEO Energy-Power Conference in New York. Companies across the energy value chain were represented (i.e., refiners, oilfield services providers, oil and gas producers, integrated oil and gas companies, pipelines, and utilities). We were struck by how optimistic companies were regarding the outlook for traditional energy, as well as opportunities to invest in clean energy (primarily carbon capture and hydrogen aided by the recently passed Inflation Reduction Act). After one Q&A session we asked a prominent company CEO, “What was a question that wasn’t asked, that should have been?” His response was noteworthy: “How excited are you about the future? Extremely excited!”
Although energy companies gave rosy outlooks, not necessarily pollyannish, in our view, one Barclays’ analyst described investors as still somewhat skeptical. The contrarian investor in us views this positively because it indicates more potential buyers remain on the sidelines. Admittedly a recession, depending on its severity, would crimp demand and create a headwind for energy stocks. The futures price curve for oil and gas is also backwardated, meaning future prices are lower than current prices. (As an aside, we would note that the futures price curve has proven to be a poor predictor of prices but an excellent gauge of sentiment, which appears muted at best). While a recession may very well create a speed bump, we believe it would not derail the beginning of a multi-year upcycle for energy stocks.
Capital discipline has become a core principle. This was a common theme among executives. Management teams are generally now compensated on generating attractive returns rather than growing revenues.
The world needs our energy. Exports of U.S. commodities are likely to grow and remain robust. We are particularly bullish on LNG (liquefied natural gas). More on that later.
*Others includes Middle East, Americas, Africa, other markets, bunkering and operational/voyage LNG losses (such as boil-off). Demand is based on normal weather (10-year average) and current futures prices. Source: BloombergNEF
The Permian Basin is the preeminent natural gas growth engine. Midstream companies are building new processing facilities [e.g., Enterprise Products Partners L.P. (EPD-NYSE), Energy Transfer LP (ET-NYSE), Targa Resources Corp. (TRGP-NYSE)] and pipeline capacity [Kinder Morgan, Inc. (KMI-NYSE), MPLX, LP (MPLX-NYSE), Williams Companies, Inc. (WMB-NYSE)] to accommodate increasing natural gas volumes.
Costs are going up 10 to 20% for oilfield services and equipment. Supply chain issues and labor shortages (in addition to capital discipline) will dampen increases in drilling activity.
Free cash flow, defined as cash flow from operations minus capital expenditures, supports dividend growth and stock buybacks. This should hold true even with lower commodities prices as efficiencies have driven breakeven prices lower for oil and gas producers.
Most midstream companies have price escalators in their customer contracts that protect them from inflation.
Growth in intermittent renewable energy requires more natural gas-fired power plants and increased pipeline capacity as a backup when wind and solar are unavailable and as global energy consumption grows. Today, battery storage is not sufficient to meet peak demand requirements.
Clean energy and environmental, social and governance (ESG) factors are still company priorities. However, they were not a visible focus of investors attending the conference—companies emphasized that clean energy investments need to compete with traditional energy projects for capital (i.e., must generate attractive risk adjusted returns).
KEY TAKEAWAY: Traditional energy is in the midst of a multi-year upcycle and should generate attractive returns for investors
To be fair, we’re not exactly breaking new ground here in reiterating our bullish long-term stance on the energy sector. Here’s why we believe investors should allocate a portion of their investment portfolios to the energy sector.
REASONS TO BELIEVE:
1. Global energy demand is poised to continue growing while the transition to clean energy will take decades to complete. Population and economic growth will require more energy, both fossil fuels and renewables through 2050. Global energy consumption from all fuel sources is expected to grow 47% from 2020 to 2050, according to the Energy Information Administration (EIA).
Source: EIA International Energy Outlook 2021
2. Commodity prices are likely to remain at elevated levels that will allow energy companies to invest capital at attractive returns and generate free cash flow. Oil, coal, and natural gas supplies are structurally tight due to years of underinvestment.
3. The sector is well positioned to withstand an economic downturn and continue to pay attractive and growing dividends. The energy sector’s ability to do so is supported by actions already taken to fortify balance sheets through significant reductions in leverage.
4. Energy is the cheapest sector in the S&P 500 and pays the highest dividend. As of the end of August, energy traded at a price-to-2022 estimated earnings multiple of only 7.7x compared to 18.8x for the S&P 500 and provided a yield of approximately 4% versus just less than 2% for the S&P 500.
5. We believe that the energy sector’s weighting in the S&P 500 can more than double from below 5% today to over 10% (i.e., the weighting just before the energy downturn that began in 2014 when OPEC flooded the oil market).
Tight LNG Market Likely to Persist Over the Next Several Years
The outlook for natural gas remains very positive and supports our thesis that gas should be viewed as a necessary complement to renewables in the transition to clean energy. SAM Partners’ Income Infrastructure and ESG Infrastructure Strategies include gas-focused midstream companies that are well-positioned to benefit from favorable fundamentals.
Earlier this year, the U.S. became the world’s largest LNG exporter with an average of 11 Bcf/d exported during H1’22, according to the EIA. By 2025, the agency expects U.S. LNG peak capacity to increase by more than 40% (or 5.7 Bcf/d) from 13.9 Bcf/d based on three projects currently under construction (i.e., Golden Pass LNG +2.4 Bcf/d, Plaquemines LNG +1.8 Bcf/d and Corpus Christi Stage III +1.6 Bcf/d).
Note: EIA estimates are based on information from Federal Energy Regulatory Commission and U.S. Department of Energy filings, company websites, trade press, and other industry sources. Source: U.S. Energy Information Administration, Liquefaction Capacity File
Analysts are anticipating a tight global LNG supply/demand market resulting in sustained high LNG prices for at least the next few years. Europe is accelerating efforts to replace Russian gas supplies, which accounted for ~40% of supplies before the Ukraine invasion. Although new long-term contracts are being executed, there is a long lead time, typically three to four years, to get a new LNG facility up-and-running.
On September 13, the European Union Commission proposed emergency measures to address Europe’s growing energy crisis. Gas flows from the Nord Stream 1 pipeline have completely halted since August 31. These proposals aim to lower gas and electricity prices (e.g., levies imposed on non-gas power plants and fossil fuel companies) as well as curb electricity consumption. As reported by the Wall Street Journal, “Europe consumed 10% less gas than the average for the time of year in August, according to commodities-data firm ICIS.”1 This is still, however, below the EU’s targeted demand reduction of 15%.
U.S. Gas to Benefit from Favorable Demand Outlook
In our view, domestic gas-focused producers and midstream/infrastructure players are well-positioned to benefit from elevated natural gas prices and visible demand growth. As previously noted, this was a key theme at the Barclays CEO Energy-Power conference. Energy companies touted their exposure to attractive supply regions (e.g., Permian, Haynesville, and Marcellus) as well as their interconnectivity to LNG facilities [e.g., Enbridge, Inc. (ENB-NYSE), Energy Transfer LP (ET-NYSE), EQT Corporation (EQT-NYSE), Kinder Morgan, Inc. (KMI-NYSE) and The Williams Companies, Inc. (WMB-NYSE)].
Cheniere Energy, Inc. (LNG-American), the leading U.S. LNG company, is a primary beneficiary of the global growth in natural gas demand. Earlier this month, the company increased its earnings guidance and updated its long-term capital allocation plan, introducing its “20/20 Vision.” The plan envisions generating over $20 billion of available cash through 2026 in addition to over $20 per share of Distributable Cash Flow (discretionary cash flow from operations that can be used for debt repayment, dividends, share repurchases, and expansionary capital expenditures). There are three pillars that make up the plan: 1. achievement of an investment grade credit rating and sustainable balance sheet, 2. return of cash to shareholders by authorizing the potential repurchase of 10% or more of its shares (in addition to annual dividend increases of 10% after an initial 20% bump this year), and 3. disciplined expansion.
Cheniere highlighted $4B ($1B/year) of incremental investments through 2026 that would increase its liquefaction capacity by one third, from 45 million tons per annum (mtpa) to 60 mtpa. The company could potentially expand its Sabine Pass and Corpus Christi complexes even further to 90 mtpa. If successful, Cheniere alone could increase U.S. consumption of natural gas by 7.5 Bcf/d, more than 8% from today’s level.
Source: Cheniere Energy, Inc. OUR TAKE: ENERGY REMAINS A BRIGHT LIGHT AMID OVERALL MARKET DIMNESS
In August, SAM’s Infrastructure Portfolio produced a return (net of fees) of 1.2% compared to negative 4.2% for the S&P 500 and outperformed its customized benchmark, which generated a 0.0% return. SAM’s ESG Infrastructure Portfolio generated a return (net) of 2.8% vs. 0.0% for its customized benchmark. The positive differences from the benchmarks were primarily attributable to favorable stock selection. The biggest portfolio laggards in August were the clean energy and midstream stocks that both generated a total return of -0.1%, as measured by the S&P Clean Energy Index (SPGTCLTR) and the Alerian Midstream Energy Index (AMNAX), respectively. The Philadelphia Stock Exchange Utility Index (XUTY) posted a total return of 0.7% last month.
The only two sectors in the S&P 500 with a positive return were energy (i.e., 2.8%) and utilities (i.e., 0.5%). The S&P 500 Energy sector is still the best performing of the 11 S&P 500 sectors year-to-date with a return of 48.7% as of August month end. This compares with the S&P 500’s negative year-to-date return of -17.0%.
1 The Wall Street Journal, “European Manufacturers Reel from Russian Gas Shutoff”, September 11, 2022.
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 4.7% 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 3.6%. 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 Great Neck, 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.