Market Commentary: Positive Energy Momentum – Takeaways From the Road
We recently spent time in Houston and, as you may imagine, the mood among midstream energy company executives was very upbeat (some might even say…energetic). The energy sector continues to outperform driven by robust commodity prices. This bodes well for SAM Partners' Infrastructure Income and ESG Infrastructure Strategies, which invest in concentrated portfolios of high-quality midstream infrastructure, utilities, and renewable/clean energy companies. All three sectors posted strong gains since Russia’s invasion of Ukraine. Given the sector’s defensive qualities, Investors flocked to utilities, while both traditional oil & gas and clean energy posted strong gains given recognition that “an all of the above strategy” will be required to diversify energy sources away from Russia.
Source: S&P Global, NASDAQ and Alerian as of the close on 4/22/22 from 2/24/22 when Russia invaded Ukraine
The Federal Reserve and China have created headwinds for the stock market, including energy stocks. Federal Reserve members have poured cold water on the stock market in recent weeks with their hawkish remarks. After raising their main policy rate by a quarter point to a target rate range of 0.25% to 0.5% in March, Fed members have postured the likelihood of raising rates by 50 basis points at one or more future meetings. The 10-year treasury has nearly doubled from 1.51% at year end to nearly 3.0%. In addition, the lockdown in China has softened oil prices on concerns of slowing demand.
Where We Stand: Energy is Still Poised to Outperform
The energy sector is as well positioned today as at any time during our careers (30 plus years). Fundamentals are quite strong given the revival of demand and tight supply. Importantly, the industry’s newfound focus on return on capital and generating free cash flow is unlikely to change, in our view, owing to the positive response of investors and soaring stock prices. Balance sheets are very strong and should provide downside support when this multi-year upcycle inevitably turns. We believe that the energy sector provides investors with protection against inflation and an attractive dividend stream that is growing. SAM Partners' Infrastructure Income Strategy currently yields 4.5% with expected dividend growth of about 4%.
The horrific war in Ukraine and recent energy crises in Europe and Asia serve to highlight the importance of reliable and affordable energy such as oil, gas, coal, and nuclear energy. Currently, clean energy is not quite ready for prime time and can’t carry the load on its own. There is growing recognition that the runway for fossil fuels is still decades long.
As we’ve continued to highlight, environment, social and governance factors (ESG) are important considerations when evaluating investments. However, most ESG funds have ignored energy and overweighted technology that served them well for a decade. But these funds underperformed in the first quarter, and we believe can no longer afford to avoid the energy sector. Energy still only represents about 4% of the S&P 500. We believe that the energy weighting can easily double over the next couple of years to just reach its level of 2014. SAM’s ESG Strategy invests in a concentrated portfolio of midstream energy companies, utilities, and clean energy companies that have a favorable ESG profile.
A common misperception is that traditional energy companies is anathema to reducing greenhouse gas emissions. That is wrong. The world will always need fossil fuels to a certain degree and the energy sector is striving to produce oil and gas in a more environmentally friendly manner. (Please see, Seven Reasons a World Without Fossil Fuels is Not Practical). Many companies are already reporting their emissions (see below) and have set goals to reach net zero emissions in the future. Positive steps undertaken include electrification of the drilling process, replacing old compressors with electric, using solar power, eliminating gas flaring, and reducing methane emissions - just to name a few.
A note of caution: we expect the volatility in the stock market and for oil and gas prices to persist. Items to watch include how quickly the Fed slams on the brakes, the war in Ukraine, China’s lockdown and how all this may perpetuate a global recession. Most pundits believe that there is only a modest chance of a U.S. recession this year and next. In any event, we believe firmly that investing in companies that have solid balance sheets and pay attractive dividends can outperform in an uncertain macro environment. The energy sector fits the bill!
Some Observation from our Houston Meetings:
1) The business model has evolved. Financial discipline is front and center. Priorities include to maintain a strong balance sheet, earn an appropriate return on capital employed, raise dividends and buy back stock.
2) Production growth may exceed expectations. High oil and gas prices have spurred incremental drilling by private oil and gas producers, while public companies have remained disciplined. The fundamentals group at Enterprise Products Partners L.P. (NYSE -EPD) postulates that oil production could grow by 8% annually through 2027, and natural gas and NGL volumes even faster.
3) Capital expenditures are likely to creep higher to meet customer needs. Production growth will necessitate more gathering and processing assets and eventually greater natural gas pipeline takeaway capacity from the Permian Basin.
We view increased allocation to capital projects as a good thing. Companies are supposed to invest capital to grow earnings and generate attractive returns for investors. Today’s tight energy markets has underscored the importance of fossil fuels and has informed many that fossil fuels will be needed for decades to come. So, the narrative has changed. Capital investments today are unlikely to create stranded assets in the foreseeable future.
4) ESG issues were not as prominent. Clearly, ESG has become a priority for all companies, but it was not nearly as emphasized as it was last year. Positive company fundamentals took center stage.
This may be subtle recognition that investors are recognizing the importance of the domestic oil and gas industry to national security, impact on inflationary woes and their everyday lives.
5) Midstream companies will be part of the energy transition but will invest gradually and carefully. Natural extensions will include carbon capture and sequestration, hydrogen production, and pipeline transportation. A common misperception is that today’s oil and gas pipelines can be repurposed to transport CO2 and hydrogen. Given pressure constraints and other issues, this can’t be done, although some hydrogen blending (5-15%) into the gas stream may be practical. However, midstream energy companies do have the expertise to build pipelines, and we expect will be major players in new builds when the technology, i.e., hydrogen, warrants it.
6) Exports, exports, exports. The U.S. presence as an energy exporter will continue to grow. LNG has garnered most of the attention in recent weeks due to the Ukrainian crisis, but the world needs U.S. crude, LPGs and chemicals.
We are strongly in favor of streamlining regulations to accelerate the time for needed project commercialization. It remains a head scratcher to us that while the U.S. Administration tries to cajole the oil and gas industry to produce more, it continues to promulgate regulations that sabotage the effort. For example, the Biden administration announced last week plans to reinstate National Environmental Policy Act (NEPA) measures, which some industry experts argue will hinder the development of energy infrastructure. Under the more rigorous environmental rules, which will take effect next month, a project's cumulative effects (e.g., impact on climate change) will need to be taken into consideration in the approval process.
Taking the Temperature on SEC Climate Change Disclosures
Last month, the U.S. Securities and Exchange Commission (SEC) released its climate-related disclosures proposal for corporate reporting required for all registrants. Investors have expressed their desire for consistent and reliable information on the impact of climate-related risks. How do these risks impact a company’s business and what is the company’s response to such conditions, events, and transition activities?
Under the proposed SEC rules, companies would need to disclose the financial materiality and financial impact of climate-related risks and opportunities as early as 2024 (for fiscal
year 2023 by large accelerated filers). Registrants would be required to “include certain climate-related disclosures in their registration statements and periodic reports, including information about climate-related risks that are reasonably likely to have a material impact on their business, results of operations, or financial condition, and certain climate-related financial statement metrics in a note to their audited financial statements. The required information about climate-related risks also would include disclosure of a registrant’s greenhouse gas emissions, which have become a commonly used metric to assess a registrant’s exposure to such risks.”1
We expect that there will be court challenges to the mandated disclosures. Most glaring is that the materiality threshold is just 1 % compared to the traditional accounting standard of 5%.
Our Key Takeaways on the SEC Proposal:
1) The disclosures should provide investors with a valuable tool in their investment decision making process given the focus and growth in ESG investing. Currently, there are different ESG frameworks and recommendations that companies may adopt, which makes it difficult to compare companies within and across industries. The SEC reporting requirements should generate more consistent and reliable information on climate-related risks that will be available to the public.
2) The proposed scope of climate-related disclosures and timeframe for compliance could be a large undertaking for companies. For example, the compliance date for all disclosures, except Scope 3, for large accelerated filers is Fiscal year 2023 (filed in 2024). This implies that these companies will likely need to have policies and procedures in place by year-end. Depending on the registrant type, there are phased in periods and accommodations for proposed disclosures [e.g., compliance date for all disclosures, except for Scope 3, is later for a smaller reporting company (fiscal year 2025 (filed in 2026)]. To date, many companies have not adopted ESG practices, monitoring and/or disclosures. Notably, only 28% of companies MSCI analyzed disclosed Scope 1 and 2 emissions, and 15% disclosed any portion of their Scope 3 emissions. Although the energy sector appears to be tracking ahead of other industries with Scope 1 and Scope 2 disclosures, the disclosure rate (i.e., 47%) was still less than half of the companies MSCI examined.
Average GHG-Emission Disclosure Rates Of US-Listed Companies by Sector and Scope
Source: MSCI ESG Research LLC. Data as of March 23, 2022. Total universe includes 2,565 constituents of the MSCI USA Investable Market Index, as of March 22, 2022, with market cap greater than USD 75 million and which are covered by MSCI ESG Research Carbon Metrics. Sectors are derived from the Global Industry Classification Standard (GICS®), which was jointly developed by MSCI and S&P Global Market Intelligence. Data includes latest disclosures, as of 2019 or 2020.
3) The SEC’s proposal promotes a higher level of accountability for climate-related disclosures as well as for a company’s publicly stated GHG emission targets or goals. For example, all proposed disclosures would be subject to Sarbanes Oxley sections 302 (corporate responsibility of CEO and CFO for financial reports) and 906 certifications. Additionally, more disclosures are required for registrants that have announced climate-related targets, including their progress and plan towards meeting such goals.
Energy Continues to Post Gains—SAM’s Infrastructure Portfolio Outperforms
In March, SAM’s Infrastructure Portfolio produced a return (gross) of 7.2% compared to 3.7% for the S&P 500 and outperformed its customized benchmark, which increased 7.0%. The biggest laggards in March were the clean energy stocks that generated a total return of 3.9%, as measured by the S&P Clean Energy Index (SPGTCED).
The S&P 500 Energy sector posted a one month return of 9.0% in March and is still the best performing of the 11 S&P 500 sectors year-to-date. The Alerian Midstream Energy Index (AMNA) and the Philadelphia Stock Exchange Utility Index (UTY) posted total returns of 7.0% and 10.2%, respectively, last month. SAM’s ESG Infrastructure Portfolio generated a 9.5% total return (gross) in March, ahead of its 5.9% total return for its customized benchmark.
1 U.S. Securities and Exchange Commission 3/21/22 press release “SEC Proposes Rules to Enhance and Standardize Climate-Related Disclosures for Investors.”
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 ~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.