Market Commentary: The Perceived Demise of Fossil Fuels is Premature
Consumption of fossil fuels are poised to surpass pre-pandemic levels in 2022 as global GDP growth continues to rebound following roughly 6% growth in 2021. Renewable power grew by a robust 6.2% worldwide in 2021, but it was only the second fastest of electricity sources. Can you guess what grew faster? Read on.
Global electricity demand increased by 6% last year driven by a robust economic rebound and more extreme weather conditions, according to the International Energy Association (IEA). This led to energy crises in Europe and Asia, notably China and India, because of the inadequacy of “low carbon supplies” and shortages of natural gas and coal. In a January 14th press release, IEA Executive Director, Fatih Birol stated that, “higher investment in low-carbon energy technologies including renewables, energy efficiency and nuclear power… can help us get out of today’s difficulties.” [In our humble opinion,] he should have added fossil fuels.
Last year’s energy crises in Europe and Asia resulted in record high natural gas prices and soaring coal prices that should serve as a wake-up call—we still need to invest in the oil and gas industry. Oil prices have already surged to above $85 per barrel (a 7-year high) and potentially could spike even higher. Henry Hub natural gas prices are hovering around $4.00 per MMBtu, about twice the average price in 2020 and akin to the average price of $3.91 in 2021. Capital investment in the oil and gas industry has fallen precipitously in recent years to approximately $350 billion. That’s ~50% of the amount spent in 2014 and below the $500 billion plus level that some experts believe is necessary to replace reserves and keep up with demand growth. Inflation is a major global concern that is only exacerbated by rising commodity prices.
Too much is written about the harmful amount of greenhouse gas (GHG) emitted by the oil and gas industry. Not enough is written about the positive steps that the industry is taking to reduce emissions, invest in new clean energy technology, and the necessity of fossil fuels for human welfare. The bottom line is that investing in both new clean energy technologies and fossil fuels is required to serve population growth and an increasing global economy with affordable lower carbon intensive energy.
According to the IEA’s Coal 2021 report, coal was the fastest grower among electricity sources of supply—in 2021, global coal power generation grew by 8.6% to an all-time high of 10,350 terawatts. China and India, (who when combined, account for over two-thirds of global coal demand) grew consumption by 9% and 12%, respectively. Despite commitments to invest in renewables, global coal consumption (led by China and India) is expected to continue growing through 2024.
Energy Remains Hot!!!
January got off to a rocky start as interest rates jumped by more than a quarter point to its highest level since January 2020 and inflation reached its highest level in nearly 40 years. The best performing S&P 500 sector to start the year again is energy, up a whopping 16.4% (vs. -2.2% for the S&P 500, as of 1/14/22).
The energy sector has been aided by rising oil and natural gas prices, attractive yields, and cheap valuations. In a rising interest rate environment, value stocks (i.e., shares of companies that trade at low price to earnings or price to cash flow multiples), are likely to outperform growth stocks that trade at high valuation multiples. Growth companies create value (earnings) far into the future and consequently, the present value of these future cash flows is reduced by higher interest (discount) rates. Value stocks such as energy are less sensitive to rising rates, given relatively high current earnings. We remain optimistic that energy stocks, specifically midstream energy stocks, can once again deliver attractive total returns for the following reasons:
• Attractive fundamentals.
- Oil and natural gas prices are likely to stay elevated as consumption approaches pre-pandemic levels.
- Production growth. U.S. oil production is forecasted to rise by 600,000 barrels per day in each of the next two years and reach a new annual record in 2023.
- Vibrant export market, especially for liquefied natural gas (LNG). U.S. peak export capacity of 13.9 Bcf/d will be the highest in the world by year end 2022 surpassing both Australia (11.4 Bcf/d) and Qatar (10.4 Bcf/d).
- Balance sheets are strong, companies are generating substantial free cash flow and adhering to financial discipline. Long gone are the days of drill, baby, drill and grow, grow, grow!
• Hedge against inflation.
- The midstream sector can contractually pass along higher costs
• Attractive income investment.
- Current yields range from 6 to 9% for midstream stocks with the likelihood of a resumption in dividend increases.
• Rotation into value and income-oriented stocks.
- Valuations are compelling particularly for the midstream sector. Midstream MLPs and C-corps are currently trading at EV-to-EBITDA multiples of 7.9x and 9.5x, respectively, vs. the 5-year averages of 10.4x and 12.5x, according to Wells Fargo Securities, LLC.
Value Stocks Poised to Outperform Growth After Years of Underperformance
Source: FTSE Russell
• Improving narrative.
- Although fund flows into energy and the midstream sector remains muted, we believe that the negative narrative may be changing.
- Global energy crises, inflation, and companies more forcefully demonstrating their commitments to reducing emissions may soften the rhetoric against traditional energy companies. Momentum investors are likely to hop onboard stocks that are outperforming. - Larry Fink, CEO of BlackRock, the world’s largest asset manager with US $10 trillion in assets under management, had favorable comments in his annual letter to CEOs regarding the role of fossil fuels in the energy transition. To quote, “...to ensure continuity of affordable energy supplies during the transition, traditional fossil fuels like natural gas will play an important role both for power generation and heating in certain regions, as well as for the production of hydrogen.”
How to Invest in Clean Energy Stocks
As we’ve noted on numerous occasions now, the clean energy train has left the station. Renewable energy, wind and solar, are growing rapidly. Government support for and private investment in new technologies such as hydrogen and carbon capture and sequestration (CCS) should lead to commercialization and wide adoption by the end of the decade and years to come. As noted in our commentary below, the headwinds for clean energy stocks are lofty valuations and rising interest rates. Given our outlook, our near-term strategy to participate in the exciting clean energy megatrend is as follows:
We maintain a balanced portfolio approach and plan to limit our holdings in clean energy stocks that have substantial earnings growth potential but are not yet profitable or cash breakeven, to no more than 20% of our portfolio.
• Invest in YieldCos. These companies generate stable and growing income from providing wind and solar power to utilities under long term purchase power agreements. Dividend growth among these companies range from 5% to as high as 15%.
• Invest in Utilities. In our opinion, utilities that can grow earnings and dividends by 5-8% through investing in clean power, infrastructure modernization, and have set net zero emissions targets can generate attractive total returns (yield plus growth).
• Invest in midstream companies that have embraced the energy transition. Like our utility investments, these companies are also investing in clean energy technologies, albeit in a measured way that includes setting emissions targets.
Interest Rates Weigh on Clean Energy Performance
In 2021, clean energy stocks (as measured by the S&P Global Clean Energy Index) significantly underperformed the energy sector and the broader market (i.e., -24% vs. +48% and +27%, respectively). We attribute last year’s pullback in clean energy primarily to three factors:
1. The rapid step-up in interest rates last year. Higher rates result in a higher cost of capital/lower discounted cash flow for these companies. The correlation between the S&P Global Clean Energy Index and the 10-year Treasury yield was notably higher in 2021 than it was in 2020 (i.e., -0.61 vs. -0.08). We believe the Index’s strong performance in 2020 was driven more by the heightened interest and growth in ESG Investing and less by low interest rates. As illustrated by the chart below, clean-energy ETF assets under management (AUM) increased to $22.3B in January 2021, up almost five-fold from $4.7B in December 2019. Although AUM continued to increase in 2021 (i.e., $25.3B as of November 2021), the pace of growth had significantly slowed. Some funds had witnessed outflows by year end.
Clean-Energy ETF Assets Under Management
Source: Bloomberg LP
2. The perception that global and U.S. actions to address climate change and the transition to net zero may take longer than expected (e.g., results of COP26 and stalling of Biden’s Build Back Better Plan). This could delay investments in new technologies such as hydrogen and CCS that rely on government incentives/subsidies to be economic during the development phase as costs decline over time.
3. A correction in frothy valuations. The S&P Global Clean Energy Index posted a gain of 138% in 2020. In general, clean energy companies do not expect to generate positive cash flow/earnings in the near-term. Often, their potential growth prospects are tied to emerging technologies and unproven markets, which makes stock valuation a challenging exercise.
We believe that these temporary setbacks in the sector will not derail the clean energy train.
SAM’s Infrastructure Income Portfolio Outperforms in 2021
SAM’s Infrastructure Income Portfolio performed well in its first full year, outpacing both its benchmark and the S&P 500. Our Portfolio generated a total return of 31.0% (gross) and 29.7% (net of fees) compared to the 20.0% return for its customized benchmark and 28.7% (dividends reinvested) for the S&P 500. Our strategy to overweight midstream energy paid off, and more than offset tepid results in utilities and clean energy.
The S&P 500 Energy sector was the best performer of the eleven S&P 500 sectors in 2021 with a total return of 54.4%. The upstream oil and gas sector, which is sensitive to oil and gas prices, outperformed the midstream sector, which relies predominantly on fee-based revenues. Oil prices (WTI) finished the year at $75.21 per barrel, up 55% and natural gas prices (Henry Hub) closed the year at $3.73 per MMBtu. Both subsectors are generating free cash flow, have paid off debt, and have attractive yields. The S&P Energy sector yields 3.7% while the midstream energy sector (AMNA) yields 6.5%. Utilities were the worst performing S&P 500 sector and generated a return of 17.7%. The Philadelphia Utility Index (UTY) posted a return of 18.2%. The S&P Global Clean Energy Index (SPGTCED) lost 23.1%, reversing only a portion of its 2020 gain.
In December, SAM’s Infrastructure Portfolio produced a return of 1.8% compared to 4.5% for the S&P 500 and outperformed its customized benchmark, which increased by just 0.63%. The Alerian Midstream Energy Index (AMNA) and the Philadelphia Stock Exchange Utility Index (UTY) posted returns of 1.1% and 9.3%, respectively, last month. SAM’s nascent ESG infrastructure Portfolio generated a total return of -2.2% in December. Our holdings in midstream, utilities, and YieldCos more than offset the 9% decline in the S&P Clean Energy Index.
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 ~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.