ENERGY IS POISED TO REMAIN HOT
On April 17th, SAM Partners presented our bullish outlook for the energy sector in in a webinar hosted by ELCO Management, “Outlook on Energy: A Bullish View.” This month’s Market Commentary features some of our key takeaways from the presentation.
THE NARRATIVE FOR TRADITIONAL ENERGY HAS IMPROVED
This is a key point for us: the notion that traditional energy (i.e., oil, natural gas, and coal) were destined for oblivion has largely dissipated. Russia’s invasion of Ukraine in February 2022 may have been a turning point as Europe and the rest of the world were reminded that energy security is national security. Further, the too rapid transition to clean energy and quest for decarbonization is both costly (read inflationary) and impractical. Finally, the Artificial Intelligence (AI) thematic has come to energy (see last month’s commentary). The new epiphany is that AI-driven data centers, electric vehicles, and more broadly electrification, will require massive amounts of power. Wind and solar can’t carry the load alone. We believe the big winners are likely to be natural gas and perhaps nuclear (however, the latter will take years to ramp up). Hence, the narrative and sentiment are improving for energy, as reflected in higher stock prices.
Energy was the best performing sector in the S&P 500 over the last three years, (including a down year in 2023). Its total return of nearly 14% made it the second-best sector in the S&P 500 in the first quarter. Rising oil prices, geopolitical tensions and rotation from growth stocks to value and higher dividend paying stocks have helped fuel the rally in energy stocks.
|
The Energy Sector Has Outperformed Both S&P 500 And Crude Oil Prices Over the Last Three Years
Source: Bloomberg
THE U.S. IS AN ENERGY POWERHOUSE THAT SUPPLIES THE GLOBE
U.S. crude oil and natural gas production have grown rapidly since 2005 due to the shale revolution. Currently, oil production has grown ~2.5 x to about 13 million barrels per day, while natural gas production has doubled to ~104 bcf/d. Technology has facilitated the growth and most importantly, the resource base is abundant and can support future growth, albeit at a slower pace, well into the future.
Today, the U.S. is a leading exporter of oil, natural gas, and liquid petroleum gas (LPGs) such as propane and ethane. U.S. liquefied natural gas (LNG) exports to Europe have filled the void left by Russia and is helping to lift the developing world out of energy poverty. In 2023, the U.S. set record highs for petroleum product and natural gas exports. Specifically, domestic petroleum product exports averaged a record 6.1 million barrels per day (BBls/d) in 2023, a 2.5% increase from 2022, according to the Energy Information Administration (EIA). The EIA noted that the growth was driven by the increase in U.S. propane exports—14% year-over-year to a record high of 1.6 MM Bbls/d in 2023.
Last year, the U.S. also exported a record volume of natural gas via LNG, mostly to Europe and pipeline deliveries to Mexico, according to the EIA. The EIA estimates that U.S. LNG exports averaged a record 13.6 Bcf/d in December 2023 and is poised to double before the end of the decade as new export facilities come on stream.
Annual U.S. Petroleum and Natural Gas Exports
BULLISH ON NATURAL GAS
Unsurprisingly, we are bullish on natural gas. Wood Mackenzie suggests that U.S. natural gas demand (consumption plus) exports can grow by 19% through the end of this decade as onshoring of manufacturing and power will drive greater demand for energy. We believe this will require the construction of additional infrastructure such as natural gas power plants and pipelines. The stocks in SAM’s portfolio that are most levered to the natural gas theme are Cheniere Energy, Inc. (NYSE-LNG), DT Midstream Inc. (NYSE-DTM), Energy Transfer LP, (NYSE-ET), Kiner Morgan, Inc. (NYSE:KMI), and Williams Cos Inc., (NYSE:WMB).
U.S. Natural Gas Demand
Source: Wood Mackenzie Gas 15-Year Investment Horizon Outlook, October 2023
Kimberly Dang, CEO of Kinder Morgan, Inc. (NYSE: KMI) stated in the company’s Q1’24 earnings release:
We expect demand for natural gas to grow substantially between now and 2030, led by more than a doubling of demand for liquefied natural gas (LNG) exports and a more than 50% increase in exports to Mexico. We are also anticipating significant new natural gas demand for electric generation associated with artificial intelligence operations, crypto currency mining and data centers.
OIL CONSUMPTION GROWTH: IT DEPENDS ON YOUR PERSPECTIVE
The International Energy Agency (IEA) still expects oil demand to peak this decade and then decline slowly over the next several decades. They forecast oil consumption to increase by just over 1 million barrels per day, or about 1% per annum in 2024 and 2025. This contrasts with a somewhat more optimistic outlook from OPEC that estimates demand growth of 2.2 million barrels per day this year and 1.8 million barrels per day next year. Actual results will most likely fall somewhere in between. The IEA has been a strong advocate for a transition away from fossil fuels and their forecast for oil demand has frequently increased over many years. OPEC clearly has their own biases in supporting oil consumption growth.
According to the EIA, solar, wind, and battery storage will account for 94% of planned expansion in US electric-generating capacity this year. Natural gas accounts for just 4% of the planned expansions. To be clear, clean energy will continue to grow, gain market share, and the winners will prove to be wonderful investments. However, higher for longer interest rates are a headwind for companies that need to finance growth and the present value of its future cash flows is heavily discounted. We suspect that clean energy stocks are poised to appreciate when the visibility of rate cuts by the Federal Reserve becomes clearer.
U.S. Planned Utility-Scale Electric-Generating Capacity Additions (2024) Gigawatts (GW)
Source: U.S. Energy Information Administration, Preliminary Monthly Electric Generator Inventory, December 2023
THE ENERGY SECTOR CAN RE-RATE HIGHER—SAM’S FOCUS IS ON THE MIDSTREAM SUBSECTOR
Ten years ago, the S&P 500 energy sector made up 11% of the S&P 500 market capitalization versus a current 4%. Its valuation is compelling when compared to the broader index (see chart below).
Energy Sector Weighting in the S&P 500
Source for table and chart: FactSet and Wells Fargo Securities, LLC
Below are the S&P 500 energy sector valuation metrics:
| S&P 500 | S&P Energy | ||
Price 4/19/24 | 4967.23 | 725.99 | ||
| 2024e | 2025e | 2024e | 2025e |
P/e | 20.4 | 18.1 | 12.6 | 11.4 |
EV/EBITDA | 13.6 | 12.2 | 6.6 | 6 |
Free cash flow yield | 3.4% |
| 7.2% |
|
Dividend yield | 1.4% |
| 3.1% |
|
Source: Bloomberg
WE WOULD FURTHER ARGUE THE FOLLOWING:
Paradigm shift in traditional energy’s business model is underappreciated. “Drill baby drill” and unprofitable growth has given way to a focus on return on capital and free cash flow generation. Industry consolidation is occurring and very positive for the energy sector. Disciplined mergers and acquisitions portend higher earnings, cash flows, and returns. Significantly, free cash flow is being returned to shareholders via dividend increases and stock buybacks. The surviving companies are bigger, better, and more valuable.
Move to sustainable business models. The paradigm shift should result in more stability and lower risk, as businesses are being operated more efficiently with drilling activity less sensitive to fluctuations in commodity prices. For example, the major oil companies can operate profitably with oil prices below $40 per barrel. Additionally, energy companies are focused on and actively reducing their emissions intensity. For example, in its recent April presentation, Enterprise Products Partners L.P. (NYSE:EPD) highlighted that since 2011 it has invested $51 billion in organic growth projects and acquisitions while improving its emissions intensity by 30%!
Potential multiple expansion is meaningful for midstream. We believe that there is room for multiples to expand. Notably, midstream is currently trading at an EV-to-EBITDA multiple of 9.5x, in-line with the 5-year median but below the 10-year median of 11.0x. Assuming a 0.5x and 1x improvement, this would equate to price appreciation of approximately 10% and 20%, respectively. With current yields of 5-7%, midstream is well-positioned to deliver attractive double-digit returns, in our view.
Midstream EV/EBITDA Multiple
Source: Wells Fargo Securities; April 3, 2024
MARCH REVIEW: ENERGY LEADS THE PACK
The rundown:
· SAM’s Infrastructure Income Portfolio produced a return (net of fees) of 6.8% compared to 3.2% for the S&P 500 and 5.4% for its customized benchmark as of 3/28/24.
· SAM’s Energy Transition Portfolio generated a return (net of fees) of 8.0% versus 3.6% for its customized benchmark as of 3/28/24.
· Midstream posted solid gains in March with a total return of 6.5%, as measured by the Alerian Midstream Energy Index (AMNAX).
· Utilities outperformed and the clean energy sector remained essentially flat, generating a total return of 7.0% and 0.5%, respectively, as measured by the Philadelphia Stock Exchange Utility Index (XUTY) and the S&P Global Clean Energy Index (SPGTCLTR).
· In March, 10 out of 11 sectors in the S&P 500 reported a positive performance, with Energy as the best performer and Consumer Discretionary as the worst. Energy delivered a 10.6% monthly total return. Energy performance was positively impacted by higher crude oil prices. March month-end WTI crude oil and Henry Hub natural gas prices were solidly above the ~$80 per Bbl ($83.96) but below ~$3 per MMBtu ($1.54) levels, respectively, which was up ~6% and down ~8% from last month.
2024 Year-To-Date Total Return
Source: Bloomberg, NASDAQ and S&P Global
RESULTS: SINCE INCEPTION & ONE YEAR
SAM’s Infrastructure Income Portfolio produced a return (net of fees) of 78.8% and 15.5% for the periods since 11/10/20 inception and 1-year, respectively. This compares to a total return of 73.3% and 9.1%, respectively, for its customized benchmark and 56.3% and 29.9%, respectively, for the S&P 500 as of 3/28/24.
SAM’s Energy Transition Portfolio generated a return (net of fees) of 5.9% and -4.2% for the periods since 4/29/21 inception and 1-year, respectively. This compares to a total return of 4.2% and -5.5%, respectively, for its customized benchmark and 30.6% and 29.9%, respectively, for the S&P 500 as of 3/28/24.
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 ~5% and growth potential of ~5-7%; while the Energy Transition Strategy that is more heavily weighted with clean energy stocks and aligns with favorable ESG ratings, offers investors a current yield of greater than 4%. In a world searching for yield, we believe these Strategies offer a compelling value proposition.
IMPORTANT DISCLOSURES
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.