Market Commentary: The Energy to Achieve Great Things
THE ENERGY SECTOR: DIVIDEND GROWTH IS IN VOGUE
We continue to believe that energy stocks can outperform this year after leading the market in performance over the past two years. Throughout a period in which money is no longer free and interest rates are normalizing, valuations again matter and companies that pay attractive and growing dividends should compete well with other income-oriented investments. For perspective, as of this writing, the energy sector represents just 5.3% of the S&P 500 with an earnings multiple of less than 60% of the market (10.3x vs. 17.6X), and a dividend yield of 3.0% vs. just 1.8% for the S&P 500.
Financial discipline came to the energy sector several years ago and it isn’t leaving. The mindset of returning cash to shareholders has stuck and companies have been rewarded with higher stock prices. The exploration and production companies (E&Ps) led the way with substantial free cash flow that was first used to pay down debt (deleverage) and then return cash to shareholders via share buybacks and dividend growth. The midstream sector has followed that path and is poised to accelerate dividend growth now that the deleveraging phase is largely complete.
We recognize that this is a broad generalization as some have already significantly bumped up distributions, while some have aggressively repurchased shares. This was addressed in an excellent report earlier this month from Wells Fargo’s Midstream Energy team entitled, “Weekender: The Debate is Over – Dividend Growth Over Buybacks.” In its report, Wells Fargo maintains that they find the competing yield argument (“midstream companies need to increase payouts to compete with other yield securities in a higher interest rate environment”) most compelling.
In addition, Wells Fargo stated the rationale for dividends/distributions over buybacks as follows:
For MLPs, distributions are a more tax efficient means to return cash to unit holders.
Distribution growth needs to keep pace with inflation.
After reducing distributions (for some), management teams are incentivized to restore payouts to previous levels.
Companies with lower yields, for example, Targa Resources Corp (NYSE-TRGP) and Cheniere Energy Inc. (NYSE-LNG), need to increase payouts to be competitive with midstream peers.
Rising interest rates have made alternative yield securities more attractive. Thus, midstream needs to raise payouts to compete on yield.
MLP Yield Relative to Other Income-Oriented Investments
Source: FactSet, Bloomberg and Wells Fargo Securities, LLC
(1) High yield index performance based on FINRA - BLP Active High Yield US Corporate Bond Index. (2) Investment grade performance index based on FINRA - BLP Active IG US Corporate Bond Index. (3) Municipal bond index performance based on the S&P National AMT-Free Municipal Bond Index. (4) U.S. 10-year Treasury performance based on S&P/BG Cantor 7–10-year U.S. Treasury Bond Index.
DT Midstream: “WE’VE GOT THE ENERGY TO ACHIEVE GREAT THINGS”
We recently had the pleasure of hosting a fireside chat with David Slater, President and CEO of DT Midstream Inc. (NYSE-DTM), a pure-play investment in natural gas infrastructure. Its integrated assets connect two world class dry natural gas basins (Haynesville and Appalachia) to LNG export terminals and high-quality end use markets. The topics we discussed included the role of natural gas in the energy transition, the macro-outlook for DTM’s assets in the Haynesville and Appalachia, the company’s predictable, robust contracted cash flows, strong financial position and environmental, social and governance (ESG) initiatives. You can view the replay by clicking here.
DT Midstream exemplifies the role that traditional energy companies will play in a low carbon emissions future. The company has a stated goal of reducing its emissions by 30% by 2030 and achieving net zero emissions by 2050. Today’s vast energy infrastructure will be expanded and, in some cases, repurposed to meet a clean energy future. In our opinion, not to recognize this is foolish and naïve if we globally hope to come close to achieving our aspirational climate goals.
FIRESIDE CHAT KEY TAKEAWAYS:
Natural gas is part of the solution to reducing greenhouse gas emissions. Natural gas accounts for about one third of the U.S.’ energy consumption. It’s the cleanest burning fossil fuel and is abundant, affordable, and reliable; it’s also made in America (the latter is my point!). Europe has shown the cataclysmic impact that a natural gas shortage can have on human welfare and economies.
DTM is investing in the energy transition, while adhering to its disciplined capital return criteria. Its carbon capture and sequestration project will utilize CO2 from its treating facilities and enable the company to achieve about one third of its targeted emissions reduction by 2030. The economics of the project are fully supported by 45Q tax credits.
Blue Hydrogen: Combine natural gas with carbon capture and sequestration (CCS). DTM is also evaluating potential hydrogen projects. Billions of dollars globally are being invested in hydrogen technology. Hydrogen is seen as a critical component in the pathway to a net zero future; it produces no GHG emissions when combusted. Hydrogen can be substituted for natural gas in industrial applications such as steel making, as well as power generation and transportation, just to name a few. Multiple studies have concluded that hydrogen can be blended into natural gas systems at 5–20% concentrations (although some activists may beg to differ). The bottom line is that blue hydrogen can complement green hydrogen (made from renewables) to reduce GHG emissions.
Permitting is a problem. Unfortunately, Senator Manchin’s permitting bill has not gotten to the finish line. Abundant natural gas reserves in Appalachia will not be produced unless new pipelines can be permitted and constructed to provide egress. But it’s not just gas! Onshore and offshore wind farms require permits as do transmission lines for electricity. NIMBY (not in my backyard) persists everywhere. (Fortunately, DTM’s footprint in the basin has enabled capacity expansions along its systems.)
Production growth in the Haynesville serves LNG facilities along the Gulf Coast. Drilling activity is robust because of low development costs and proximity to a growing LNG export market along the Gulf Coast. DTM believes that longer horizontal laterals improve the economics of the play. DTM will double its Louisiana Access Pipeline (LEAP) capacity by 2024 in three phases to 1.9 Bcf/d. The company is having ongoing discussions for further expansion up to 3 Bcf/d. Importantly, the project is underwritten with long-term take-or-pay contracts. In other words, DTM gets paid whether any gas is transported. Federal permitting is not an issue because this is an intrastate pipeline.
Doubling Louisiana Energy Access Project (LEAP)’s Capacity by 2024
Source: DT Midstream, Inc.
Potential for LNG Export Facility on the east coast. Evidently there is chatter about building an export facility on the east coast to tap Appalachian natural gas reserves. This may however be a long putt, in our view.
DTM takes ESG seriously. Admittedly, not a highlight of our discussion but it should be noted that the company is environmentally conscious and is making strides reducing emissions. It’s very active in its community and has a strong and diverse board of directors.
DTM is financially sound. The company sports a strong balance sheet and is on a path to investment grade; it has no debt due until 2028, no commodity risk, and has a stable and growing cash flow.
RENEWABLE POWER GENERATION GROWTH TO ACCELERATE
The International Energy Agency (IEA) expects installations of renewable power to accelerate with total capacity growth worldwide set to almost double in the next five years, per its Renewables 2022 report published last month. Over the 2022-27 period, global renewable power capacity is now expected to grow by 2400 gigawatts (GW), which is 30% higher than the amount of growth that was forecasted a year ago. The IEA attributes the step change primarily to the current global energy crisis, energy security goals, and accelerated renewable deployments in the EU, China, U.S. and India. The IEA expects wind and solar to account for over 90% of the renewable power capacity that will be added over the next five years. Notably, the agency projects that global solar PV capacity will almost triple in 2022-27 and become the largest source of power capacity in the world, surpassing coal.
Renewable Annual Net Capacity Additions by Technology, Main and Accelerated Cases, 2015-2027 (in GW)
Note: The report also lays out an accelerated case in which renewable power capacity grows a further 25% on top of the main forecast.
Source: IEA, Renewable annual net capacity additions by technology, main and accelerated cases, 2015-2027, IEA, Paris https://www.iea.org/data-and-statistics/charts/renewable-annual-net-capacity-additions-by-technology-main-and-accelerated-cases-2015-2027, IEA. License: CC BY 4.0
A SIMILAR STORY IS PLAYING OUT IN THE UNITED STATES
Wind and solar generation have grown rapidly in the U.S. over the last several years. Combined, they accounted for about 14% of U.S. power generation last year and are expected to reach about 18% in 2024, according to the Energy Information Administration. Solar is growing more quickly because of declining construction costs and favorable tax credits. Solar capacity stands at 74 GW and based on planned expansions is expected to grow to 137 GW by the end of 2024 (~ 85% growth). Wind grows more slowly (~15%) to 165 GW in 2024 from 143 GW today. Coal retirements will push down its share of electric power generation to 17% in 2024 from 20% last year, while natural gas’ market share shrinks slightly to 37% from 39%. As we’ve mentioned, we do wonder if permitting issues (and supply chain concerns) could hamper the future growth of renewables.
U.S. Electricity Generation by Energy Source (2018–2024)
Source: U.S. Energy Information Administration, Short-Term Energy Outlook (STEO)
SAM PARTNERS HAD ANOTHER GOOD YEAR IN 2022
The S&P 500 Energy sector was the best performing of the 11 S&P 500 sectors in 2022 with a total return of 65.7%. This compares with the S&P 500’s negative 2022 return of -18.1%. SAM’s Infrastructure Income Portfolio produced a 2022 return (net of fees) of 15.4% compared to 12.1% for its customized benchmark. SAM’s Energy Transition Portfolio (formerly known as ESG Infrastructure) generated a 2022 return (net of fees) of 4.9% vs. 5.3% for its customized benchmark.
In December, SAM’s Infrastructure Income Portfolio produced a return (net of fees) of -5.9% compared to -5.8% for the S&P 500 and -4.6% for its customized benchmark. SAM’s Energy Transition Portfolio generated a return (net) of -6.9% vs. -4.5% for its customized benchmark. The variances from the benchmarks were primarily attributable to the SAM portfolios’ higher weightings in midstream, which underperformed in December. The midstream sector generated a total return of -6.0%, as measured by the Alerian Midstream Energy Index (AMNAX). The Philadelphia Stock Exchange Utility Index (XUTY) and S&P Clean Energy Index (SPGTCLTR) posted a total return of 0.0% and -4.8% last month, respectively. For December, every sector in the S&P 500 reported a negative performance with Energy posting a -2.9% monthly total return.
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 rising interest rate environment, we believe these Strategies offer a compelling value proposition.