Market Commentary: Reflecting on One Year into Russia’s Invasion
THE IMPACT ON ENERGY ONE YEAR INTO RUSSIA’S INVASION OF UKRAINE
Nearly a year ago on February 24th, Russia invaded Ukraine and permanently changed the global energy landscape. Commodity prices spiked as Russia attempted to weaponize its energy exports and triggered a global energy crisis. In March, the price of crude oil peaked at $123.70 per barrel, while the price of natural gas didn’t peak until the end of August. The European TTF natural gas price soared above $90 per MMBtu and the U.S. price (Henry Hub) approached $10 per MMBtu.
Europe has been overly reliant on Russian natural gas, which had accounted for nearly one-third of its supply, (while Germany imported an injudicious ~55% of its gas supply from Russia pre-invasion). The combination of an unseasonably warm winter, efficiency and conservation measures, and increased LNG exports from the U.S. (diverted mostly from Asia) have contributed to crisis mitigation, as it allowed Europe to refill storage to peak levels.
Global Forward One-Month Natural Gas Prices ($ per MMBtu)
CONSEQUENCES OF THE INVASION ON THE ENERGY SECTOR INCLUDE:
The realization that energy security is national security. The world needs available, reliable and affordable energy, i.e., fossil fuels. The importance of fossil fuels can’t be overstated. The shortage of natural gas curtailed industrial production, stoked inflation, and pushed Europe to the brink of a recession. Subsequently, the economic outlook has improved as energy prices have receded.
A shift from globalization to deglobalization. This is unfortunate as globalization (free trade) promotes economic growth as resources are allocated to its most efficient uses. Russia has taught us that we can’t be overly reliant on one source, especially a bad actor on the world stage. Henceforth: the push to diversify the clean energy supply chain away from China. This is a primary goal of the Inflation Reduction Act that promotes clean energy and the onshoring of manufacturing.
Expansion of EU regasification facilities enabling more LNG imports. On an annualized basis, the EU will have increased its LNG import capacity by 25% (40 billion cubic meters) since 2021.
A call for faster deployment of renewables. The European Commission proposed increasing renewables’ share of power to 45% by 2030 and to accomplish this, they have adopted emergency measures to accelerate permitting of renewables. In our view, permitting is a major hindrance to both the growth of renewables and traditional energy. For example, if you can’t build new pipelines in the U.S. Appalachian Basin, you can’t grow natural gas production, thus limiting LNG exports.
DECARBONIZATION OF NATURAL GAS
Natural gas needs to be part of the solution if we expect to achieve the goal of net zero emissions. U.S. emissions declined significantly since 2005 due to natural gas displacing coal and growth in renewables—in fact, natural gas accounted for 526 million metric tons or 58% of the total emissions reduction! This is just another example of how traditional energy and clean energy can co-exist. The path to net zero emissions needs to be practical, economic, and achievable. What good is renewable energy if it is neither available 24/7, nor affordable?
Traditional energy companies are making significant strides in decarbonizing natural gas along the energy chain, from production to market. E&P companies are electrifying the drilling process, while pipeline companies are electrifying compressors and utilizing solar power. It’s still in the early stages and, with government subsidies (thank you the Inflation Reduction Act!), companies have initiatives to capture and sequester CO2, and blend hydrogen into the natural gas stream. Additionally, they are laser focused on monitoring and reducing methane emissions, contributing to their emissions reduction momentum.
Updated capex guidance from some of the largest global producers during the recent earnings season also highlights the sustained role of oil and gas. This is evidenced by BP plc (BP-NYSE), Chevron Corp. (CVX-NYSE), ExxonMobil Corp. (XOM-NYSE), and Shell plc (SHEL-NYSE) continuing to earmark billions of dollars into oil and gas investments. BP also announced its intention to decrease its oil production at a slower pace (25% instead of 40% by 2030), clearly recognizing the sticky global demand for fossil fuels.
WORST PERFORMING SECTORS OF 2022 ARE THE BEST PERFORMING SECTORS OF 2023 (and vice versa…)
Early signs of abating inflation and optimism in the Federal Reserve’s ability to engineer a soft landing have helped spark a stock market rally in which last year’s worst performing sectors (Communication Services, Consumer Discretionary, and Information Technology) are leading the market higher. However, this “risk on trade” may be fleeting if inflation, albeit improving, stays stubbornly above the Fed’s 2% target and interest rates rise. That’s why we believe stocks that provide attractive and growing dividends provide a relatively safe haven in uncertain times such as these.
In January, the energy sector was one of the worst performing sectors after two years of leading the market. The major culprit here is likely the retreat of oil and natural gas prices to pre-Russian invasion levels. Natural gas prices have fallen even more precipitously than oil prices due to its sensitivity to the unseasonably mild winter. However, the energy sector is much more resilient today than in prior cycles—stellar balance sheets and an adherence to financial discipline are facilitating upstream companies’ generation of free cash flow, eschewing the need for external capital, and returning cash to shareholders.
The commitment to financial discipline has been reiterated by management teams throughout the recent earnings reporting season. Companies that have raised their capital expenditures have seen their stocks underperform as investors prefer higher dividends over reinvesting cash (even at attractive returns). We do not see this myopic view changing any time soon.
Monthly Performance Summary
Source: S&P Global
IT MAKES NO SENSE!
Natural gas-focused midstream companies have underperformed with the precipitous drop in natural gas prices. It just doesn’t make sense to us, given the resilience of midstream companies’ cash flow and low sensitivity to commodity prices, strong balance sheets, and attractive and growing dividends. Yes, production growth may slow as E&P companies adjust their drilling programs in response to lower commodity prices, but we do not see this heavily impacting midstream companies’ earnings. Yes, on the margin, there may be less opportunity for midstream companies to benefit from arbitrage opportunities. But again, we believe that earnings guidance and expectations already incorporate this. Our conclusion: ~6% or greater yields plus 5% or greater dividend growth equates to a wonderful risk adjusted value opportunity.
NATURAL GAS PRICES PLUMMET: “IT’S THE WEATHER, STUPID”
The U.S. benchmark Henry Hub natural gas price averaged ~$3.30 per MMBtu in January 2023—a 41% decline from the prior month—and today is hovering just above $2.00 per MMBtu. The average price in 2022 was ~6.45 per MMBtu. This past January was the warmest in the U.S. since 2006 and consumption was about 14 Bcf/d lower than a year ago according to RBN Energy, LLC. Making matters worse for natural gas prices, the Freeport LNG facility that consumes about 2 Bcf/d has been offline since June 2022 and natural gas production was about 6 Bcf/d higher than a year ago. That’s a 20 Bcf/d swing on production that averages about 100 Bcf/d. Storage that was 7% below the five-year average to start the beginning of the year ended January 7% above the five-year average.
U.S. Oil and Natural Gas Prices (2022-current)
Source: U.S. Energy Information Administration
The restart of Freeport LNG, expected in March, and incremental demand from coal retirements should help support prices. However, natural gas prices are likely to remain soft this year due to high inventories and growing production, unless we have an extended cold spell to end the winter, followed by a nice hot summer!
We remain bullish longer term given the expansion of U.S. LNG export capacity. Peak U.S. export capacity is expected to grow by over 40% by 2025 to ~19.6 Bcf/d from about 13.9 Bcf/d today. There are three export projects under construction that will expand U.S. LNG peak export capacity by a combined 5.7 Bcf/d by 2025: (1) Golden Pass LNG (i.e., total capacity of 2.4 Bcf/d), (2) Plaquemines LNG (i.e., 1.8 Bcf/d) and (3) Corpus Christi Stage III (i.e., 1.6 Bcf/d). Beyond these, Williams Cos. (WMB-NYSE) estimates that there are over 20 Bcf/d of additional potential projects awaiting final investment decisions.
Expanding LNG Export Capacity
Source: U.S. Energy Information Administration, Liquefaction Capacity File
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.
THE POSITIVE STREAK CONTINUES
In January, SAM’s Infrastructure Income Portfolio produced a return (net of fees) of 3.1% compared to 6.3% for the S&P 500 and 3.2% for its customized benchmark. SAM’s Energy Transition Portfolio generated a return (net of fees) of 3.4% vs. 3.2% for its customized benchmark.
Utilities were the biggest under performers in January with a total return of -2.7%, as measured by the Philadelphia Stock Exchange Utility Index (XUTY). The midstream sector generated a total return of 4.8%, as measured by the Alerian Midstream Energy Index (AMNAX) and the S&P Clean Energy Index (SPGTCLTR) posted a total return of 4.0% last month. For January, every sector in the S&P 500 reported a positive performance (2.8% monthly total return for Energy) except for Utilities, Healthcare, and Consumer Staples.
SAM’s Infrastructure Income Portfolio produced a return (net of fees) of 13.3% for the 1-year period and 58.3% since its inception. This compares to a total return of 12.6% and 57.2%, respectively, for its customized benchmark and -8.2% and 19.0%, respectively, for the S&P 500.
SAM’s Energy Transition Portfolio generated a return (net of fees) of 10.9% for the 1-year period and 15.7% since its inception. This compares to a total return of 12.3% and 9.1%, respectively, for its customized benchmark and -8.2% and-0.6%, respectively, for the S&P 500 as of January month-end.
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 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 ~5% and growth potential of ~8%; 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 ~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 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.