- Yves Siegel
Market Commentary: The IRA is Good for Both Traditional and Clean Energy
The Inflation Reduction Act of 2022, (IRA) signed into law by President Biden on August 16, aligns well with our balanced approach and should, in general, benefit clean energy, utilities and midstream companies which underpin SAM Partners’ Income Infrastructure and ESG Infrastructure Strategies. Notably, clean energy (as measured by the S&P Global Clean Energy Index) and utilities (i.e., PHLX Utility Sector Index) have outperformed since July 27 when Senator Joe Manchin of West Virginia announced his support for the IRA. Despite the recent pullback in oil prices to below $100 per barrel, midstream and the broader energy sector have also posted gains.
Price Performance Since IRA Announcement
Note: Performance from 7/27/22–8/12/22
Source: S&P Global, NASDAQ and VettaFi
The European energy crisis exacerbated by the Russia/Ukraine war has highlighted the importance of energy independence and the reality that fossil fuels will still be required during the transition from hydrocarbons to renewables (and long afterward, in our view). Renewables are not without its challenges given supply chain issues: China’s dominance in the manufacture of solar panels and production of critical minerals and needed technological advances, such as in energy storage, hydrogen and carbon capture, utilization, and sequestration (CCUS). However, these issues are much easier to overcome with government subsidies and private investment.
We maintain our strong conviction that traditional energy companies can prosper in the years ahead while simultaneously reducing their greenhouse gas emissions and investing in clean energy. At the same time, we are constructive on the long-term outlook for clean energy companies.
Largest Climate Investment in U.S. History
This historic $740 billion climate, healthcare and tax package addresses some key items on the current Administration’s agenda. Supporters, including Senator Joe Manchin of West Virginia, have touted the IRA as an “all-in energy policy” that embraces traditional as well as clean energy and acknowledges the need for both fossil fuels and renewables in the transition to net zero.
The Inflation Reduction Act of 2022 – Top Line Estimates
Source: Senate Democrats Inflation Reduction Act One Page Summary
THE RUNDOWN The IRA is comprised of climate-related initiatives and energy provisions totaling ~$370 billion. This includes almost $280 billion in clean energy tax incentives. The projected impact is a 40% reduction in greenhouse gas emissions from 2005 levels by 2030.
The IRA’s clean energy tax incentives allocates a large amount for clean electricity and energy transmission (i.e., ~$120 billion) including enhanced investment and production tax credits (ITC and PTCs) that benefit solar, wind, geothermal, electric storage, nuclear projects and clean technologies like storage, and carbon capture, utilization, and sequestration (CCUS)
The electric vehicle (EV) industry also benefits, given the investments allocated to accelerate clean transportation including tax credits for the purchase of new and used EVs
The IRA is also expected to create millions of jobs in connection with efforts to bolster domestic clean energy manufacturing (e.g., ~$30 billion in production tax credits related to U.S. manufacturing of solar panels, wind turbines, batteries, and critical minerals processing, $10 billion investment tax credit to build clean technology manufacturing facilities)
Analysts are predicting that the clean hydrogen tax credit will be a game changer for green hydrogen. The Wells Fargo Securities Utilities and Midstream Energy & Renewables Infrastructure equity research teams say,
“We believe the $3/kg clean hydrogen PTC included in the IRA will kickstart the industry... this would have the effect of making clean hydrogen even more economic vs. competing fuels, thereby vastly broadening out the use cases beyond displacing grey hydrogen in industrial processes.”
 “Clean Hydrogen—Let the Good Times Roll” published on August 9, 2022 by Wells Fargo Securities, LLC
Green Hydrogen Economics - Existing & Future Market Potential for Hydrogen in the U.S.
Source: NREL and Wells Fargo Securities, LLC
FOSSIL FUEL INDUSTRY PROVISIONS
While the IRA should help accelerate the U.S.’ adoption of clean energy, incentivizing the increase in supply and demand of renewables, we maintain our belief that there will still be demand for fossil fuels during this transition period.
Additionally, streamlining the permitting process for pipelines and other energy infrastructure could be significant in unlocking natural gas reserves that are trapped due to the lack of egress (primarily in the Marcellus/Appalachia region). Please see our June 15 Market Commentary: EQT Chief on Unleashing U.S. LNG.
Provisions that should benefit traditional energy companies include:
A requirement for the federal government to auction off more public lands and waters (e.g., Gulf of Mexico, Alaska) for oil and gas drilling as a prerequisite for approval of utility-scale renewable energy projects (e.g., offshore wind)
A concession to streamline the permitting and expedite the approval process for pipelines and other energy infrastructure
A commitment to complete the Mountain Valley Pipeline, which would alleviate natural gas takeaway constraints from the Marcellus/Appalachia region
Tax incentives to further develop carbon capture, utilization, and storage technology. Section 45Q of the tax code has been extended to projects starting before January 1,2033 and the credit for qualifying projects increased from $50 per metric ton of carbon sequestered to $85.
Provisions that could increase the cost of doing businesses for traditional energy companies include:
An increase in royalty and rental rates, elimination of noncompetitive leasing, and minimum bids set on federal parcels
A fee on excess methane emissions (i.e., beginning in 2024 at $900/ton, increasing to $1,200/ton and $1,500/ton after two years)
A 15% alternate minimum tax on adjusted financial statement income of at least $1 billion and a 1% stock buyback fee on all companies across industries, which is expected to raise almost ~$300 billions of revenues in aggregate
OUR TAKE: The net impact of the IRA appears negligible for the midstream sector
The 15% alternative minimum corporate tax rate will likely accelerate cash tax payments but reduce taxes in later years resulting in a neutral net present value impact (based on our conversations with company managements), while methane emissions for most companies fall below the threshold that would trigger the methane emissions tax. Finally, we doubt that the 1% tax on stock buybacks will impact decision making.
Energy Sector’s Weighting in the S&P 500 Has Room to Grow
Energy has become relevant again and is the top performing sector in the S&P 500 (i.e., S&P 500 Energy YTD total return of 44.7% vs. S&P 500 of -12.6% as of 7/29/22). Despite the outperformance, energy’s weighting in the S&P 500 (i.e., 4.4% as of July month-end) has not materially increased this year (was just under 4% as of February month-end). Although the weighting is up from about 2% during the pandemic, it is still well below 6.1% five years ago at 2017 year-end and the last peak of 12.3% at the end of 2011. If energy stocks continue to outperform, as we believe, the sector’s weighting will continue to grow. We suspect that both retail and institutional investors will be attracted to energy stocks because of a fear of missing out (FOMO) given the strong returns, while portfolio managers given the higher sector weighting need to pay attention or risk posting poor relative returns.
Source: Bloomberg and S&P Global
Energy Continues to Post Gains in July
In July, SAM’s Infrastructure Portfolio produced a return (net) of 9.3% compared to 9.2% for the S&P 500 and slightly underperformed its customized benchmark, which increased 10.6%. SAM’s ESG Infrastructure Portfolio generated a return (net) of 11.4% vs. 13.1% for its customized benchmark. The biggest portfolio laggards in July were the utilities stocks that generated a total return of 5.3%, as measured by the Philadelphia Stock Exchange Utility Index (UTY).
The S&P 500 Energy sector posted a one month return of 9.7% in July and remains the best performing of the 11 S&P 500 sectors year-to-date with a return of 44.7% as of July month end. This compares with the S&P 500’s negative year-to-date return of -12.6%. The Alerian Midstream Energy Index (AMNAX) and the S&P Clean Energy Index (SPGTCLTR) posted total returns of 10.0% and 17.6%, respectively, last month.
NO Change to Positive Stance on Traditional Energy, Getting More Bullish on Clean Energy
We continue to be bullish on the longer-term outlook for the energy sector and midstream. As noted above, the energy sector has ground to make up to just get back to its historical weighting in the S&P 500. Even with oil prices falling to below $100 per barrel, the sector will continue to generate substantial free cash flow that will be returned to shareholders via dividends and stock buybacks. The midstream sector sports an average dividend yield of 6.3% and free cash flow yield of ~9.0% based on Wells Fargo’s calculations. We strongly believe that equity investors should have a portion of their portfolio invested in the energy sector. Additionally, we are more bullish on the near and longer-term potential of clean energy stocks given the positive momentum generated from the Inflation Reduction Act of 2022 and moderation in interest rates and inflation.
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 ~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 3.5%. In a world starved for yield, we believe these Strategies offer a compelling value proposition.