Market Commentary: Renewable Natural Gas – Waste Not, Want Not
RENEWABLE NATURAL GAS—WASTE NOT, WANT NOT
Earlier this month, Siegel Asset Management (SAM) Partners hosted a fireside chat with Nick Stork, CEO and co-founder of Archaea Energy Inc. (NYSE-LFG), one of the largest renewable natural gas (RNG) producers in the United States. Topics discussed included the macro-outlook for RNG and Archaea Energy’s industry-leading platform and expertise in developing, constructing, and operating RNG facilities. The full video of the fireside chat can be accessed on the SAM website.
WHAT IS RNG? Renewable natural gas helps meet decarbonization goals by capturing methane that would have otherwise been emitted into the atmosphere. RNG is biogas (gaseous product of the decomposition of organic matter) that has been processed to pipeline-quality gas that is fully interchangeable with fossil fuel-based natural gas. Biogas is formed from waste streams such as landfills, dairy farms, and wastewater facilities. Just like fossil fuel-based natural gas applications, uses for RNG include transportation (compressed natural gas or CNG), power generation, heating homes, industrial uses, and the production of green hydrogen. According to the RNG Coalition, RNG has the lowest carbon intensity (CI) of any clean energy source available today.
KEY TAKEAWAYS FROM FIRESIDE CHAT:
Demand for RNG far outstrips current supply. Voluntary goals and regulatory mandates to meet decarbonization targets drive demand. For example, the California Public Utilities Commission mandated this past February that gas utilities procure 12% of their 2020 natural gas consumption (72.8 Bcf/year) with RNG by 2030. This would require nearly all the RNG produced in 2021. Given the anticipated longer-term supply shortfall of RNG, Mr. Stork noted that we may soon reach a tipping point for significant contract price increases from $14-$18 MMBtu currently to lock in RNG volumes. BP’s Energy Outlook 2022 projects that global demand for biogas could grow by 25-fold from 2019 to 2050 if decarbonization goals are met.
Notes: 1. Source: Argonne National Laboratory Renewable Natural Gas Database. 2. Comprised of publicly disclosed RNG purchase agreements and announced RNG goals and targets. 3. Includes future RNG purchases from California gas utilities such as SoCalGas, Pacific Gas & Electric, San Diego Gas & Electric and Southwest Gas Corp.
Source: Archaea Energy Inc.
Growth is highly visible. Mr. Stork estimates RNG supply potential could approximate 4-6 Bcf/d (i.e., 2-3 Bcf/d from landfill gas and 2-3 Bcf/d from livestock operations). This implies significant growth from current domestic RNG production levels (i.e., 212 MMcf/d in 2021, according to Wood Mackenzie), which represent less than 1% of total U.S. natural gas production. Archaea is one of the largest U.S. RNG producers with an approximate 20–30% market share. It currently operates 46 facilities, 13 of which produce RNG, and 33 of which produce electricity (landfill gas to electric). The company has a backlog of nearly 90 projects, which provides visible line of sight to growth for at least the next five years.
Note: LFG: Land Fill Gas
Technical expertise is a competitive advantage. Technical and operational expertise is a significant barrier to entry for other companies interested in participating in the growing RNG market. This is primarily due to the challenges related to the gas separation process. Archaea V1 is a standardized, modularized plant design that is expected to lower development costs by 40% compared to industry averages and reduce project development timeline to 18 months from more than three years for an average industry plant design. Supply chain issues are less of a risk given the V1’s standardized design. Mr. Stork indicated that Archaea could complete about 20 RNG projects annually vs. a run rate of 2–3 projects annually by its competitors. He also noted Archaea’s strong relationships with landfill owners as another competitive advantage, particularly with municipalities, which own a significant market share of landfills in the U.S.
Archaea generates predictable, long-lived cash flows. Archaea targets to have approximately 70% of its RNG volumes (currently about 50%) under long-term contracts of 10-20 years with inflation protection mechanisms. Landfills can operate for 30 years and produce more biogas each year unlike natural gas wells that deplete over time. Mr. Stork remains highly confident of Archaea’s ability to achieve $600MM of cash flow from its core RNG business after the company completes its current project backlog.
Potential upside from complementary businesses. Archaea is also pursuing carbon sequestration (CS) and hydrogen opportunities, which could help drive upside to long-term cash flows (i.e., $1B in aggregate vs. $600MM projected for its core RNG business). CO2 is extracted during the production of RNG while RNG can be used to produce green hydrogen.
Attractive returns on RNG projects. Archaea targets a minimum 10% cash on cash return on its investments. Mr. Stork noted that build multiples have been much more attractive in the 2-3x range utilizing the Archaea V1 design. The company has also been able to hedge its 12-month renewable identification number (RIN) exposure at attractive prices. (RINs were created by the EPA to track compliance with the Renewable Fuel Standard (RFS). The RFS requires transportation fuels sold in the U.S. contain minimum volumes of renewable fuels. Archaea assumes RIN prices of $1.50 per gallon in its long-term guidance. However, current RIN prices are about twice that amount.)
Third-party M&A is likely to accelerate. In response to a question on M&A, Mr. Stork noted that there will likely be large RNG platforms for sale in the market. Oil majors and midstream companies have been active buyers. Investors should expect LFG to remain disciplined and focus on business development given the higher returns of its RNG projects relative to M&A valuations.
THIS JUST IN!
On October 17, 2022—just a few days after our fireside chat—Archaea Energy agreed to be acquired by BP P.L.C. (NYSE-BP) for $4.1 billion. The purchase price of $26 per share represents a 54% premium to Archaea’s closing price on the day before the announcement and a 38% premium to Archaea’s 30-day volume weighted average price. The transaction is intended to further BP’s clean energy transition ambitions such that by 2025 more than 40% of its total annual capital expenditures will be directed toward clean energy. BP’s push into RNG will help it meet its interim target to reduce its carbon intensity by 5% by 2025 and by 15-20% by 2030 from a 2019 baseline. Based on Wall Street estimates, BP paid about 17x 2023 EBITDA, but only 4x BP’s expectation that Archaea will generate over $1 billion by 2027!
FAVORABLE SPOTLIGHT ON MIDSTREAM
Midstream has the potential to re-rate higher, in our view. Our positive outlook is supported by favorable fundamentals and the sector’s successful transition to a new paradigm that no longer rewards excessive growth but rather capital discipline, free cash flow (FCF), return of cash to shareholders via secure dividend/share buybacks and importantly, strong balance sheets. SAM Partners’ Income Infrastructure and ESG Infrastructure Strategies target a sizeable midstream weighting of 60% and 35%, respectively, in the portfolios to capture the potential upside.
Note: Free cash flow equates to distributable cash flow minus growth capex Source: Wells Fargo Securities; October 5, 2022
In general, the Street also shares the favorable sentiment on the midstream sector. As succinctly stated by the Wells Fargo Securities Midstream/MLP equity research team [in its “Weekender: Still (Relatively) Bullish Midstream” report on October 3, 2022], “we remain bullish midstream heading into Q4 as we believe the sector’s solid underlying fundamentals, defensive characteristics, reasonable valuations, and improved FCF should support outperformance on a relative basis.” Specifically, the team favors midstream companies with natural gas exposure (Permian, Haynesville) and robust/growing free cash flow yields.
The growth in midstream free cash flow has been driven, in part, by the sector’s enhanced discipline in capital spending. We expect this trend to continue and support an uplift in valuation. In a recent study, the Wells Fargo research team highlighted the improvement in the midstream sector’s 2021 cash return on investment (CROI) and expects returns to increase in 2022 due to “the improving fundamental backdrop (better demand & higher commodity prices), combined with improved capital discipline.” For the 5-year period ending 2022, the team forecasts a median CROI for midstream of 11.8%; that’s up from the median CROI of 10.9% (or ~9.1x EBITDA) for the 5-year period ending 2021, and the median CROI of 9.8% (or ~10x EBITDA) for the 5-year period ending 2020. For details, please see Wells Fargo Securities’ report “Show Me the Money: 2021-2022 Edition—A Look at Midstream ROIC” published on October 12, 2022.
Midstream Companies with Highest/Lowest Cash Returns (5-Year Period Ending 2021)
Source: Wells Fargo Securities, LLC estimates
ENERGY MAINTAINS YEAR-TO-DATE SECTOR LEAD
In September, SAM’s Infrastructure Portfolio produced a return (net of fees) of -9.5% compared to -9.2% for the S&P 500 and outperformed its customized benchmark, which generated a -10.9% return. SAM’s ESG Infrastructure Portfolio generated a return (net) of -10.5% vs. -12.0% for its customized benchmark. The biggest portfolio laggard in September was the clean energy sector that both generated a total return of -13.7%, as measured by the S&P Clean Energy Index (SPGTCLTR). The Philadelphia Stock Exchange Utility Index (XUTY) and the Alerian Midstream Energy Index (AMNAX) posted a total return of -11.4% and -9.9% last month, respectively. For September, every sector in the S&P 500 reported a negative performance, except for Communication Services.
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 34.9% as of September month end. This compares with the S&P 500’s negative year-to-date return of -23.9%. Year-to-date, SAM’s Infrastructure Portfolio produced a return (net of fees) of 7.7% compared to 4.2% for its customized benchmark. SAM’s ESG Infrastructure Portfolio also outperformed and generated a year-to-date return (net) of +0.6% vs. -1.0% for its customized benchmark.
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 ~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 ~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.