Recently, the International Energy Agency (IEA) published its World Energy Outlook 2021 (WEO) as a “guidebook” to COP26, the 26th United Nations Climate Change Conference, scheduled to take place from October 31 to November 12 in Glasgow, Scotland. Delayed a year due to COVID-19, participants of the 2015 Paris Agreement will finally update their climate action plans known as nationally determined contributions (NDCs). The noble goal is to reduce greenhouse gas (GHG) emissions and limit global warming to less than 2.0 degrees Celsius (preferably 1.5 degrees) from pre-industrial levels. Unfortunately, the emissions reduction targets set forth in the NDCs fall short of what is required to arrest global warming and, perhaps worse, countries are falling behind on their commitments. Global average temperatures have already risen by 1.1 degrees Celsius.
Here are our key takeaways from the WEO:
1. Not enough is being done. More than 50 countries, as wells the entire European Union, have pledged to meet net zero emissions targets. However, if all pledges are realized, global energy related CO2 emissions fall by just 40% by 2050 and the global average temperature rises 2.1 degrees Celsius above pre-industrial levels by 2100.
2. Participants are not complying with their commitments. Government policies in place and under development are insufficient to satisfy announced pledges. In addition, developed countries are currently about $20 billion short of their commitment to contribute $100 billion annually to emerging market and developing economies. Under the IEA’s, “Stated Policies Scenario,” annual emissions do not measurably decline, and global average temperatures hit 2.6 degrees Celsius above pre-industrial levels in 2100.
3. Fossil fuel demand continues to grow under the “Stated Policies Scenario,” but the big winner under any scenario is renewables. Oil demand levels off at 104 mb/d in the mid 2030s and then declines very slightly to 2050. Natural gas demand grows by approximately 25% from 2019 through 2050, while coal demand only falls by 27% over this period. Renewables generation nearly quadruples!
4. IEA’s Four Solutions for reaching Net Zero Emissions by 2050:
• Accelerate the transition to clean electrification, notably wind and solar, but nuclear as well
• Focus on energy efficiency such as in construction and behavioral changes (walk don’t drive)
• Cut methane emissions from fossil fuel operations
• Progress on clean energy innovation. Key technologies that show huge potential are in
batteries, hydrogen and carbon capture and sequestration
5. Invest more. The IEA estimates that in order to stay the path to net zero emissions, annual investment in clean energy projects and infrastructure will require a significant increase to about $4 trillion (70% of which needs to be spent in emerging market and developing economies) by 2030.
Investment ramifications of the IEA’s World Energy Outlook 2021
As we’ve written before, it’s clear that the train to net zero emissions has left the station. Almost under any scenario there will be tremendous growth in clean energy adoption, technology, and infrastructure. The challenge will be to pick the winners and avoid the inevitable train wreck, especially given lofty valuations. Our portfolios consist of companies that are market leaders in their sector, have a track record of success and disciplined financial plans to manage capital expansion.
Traditional energy companies can still strive during this energy evolution. It is indisputable that over the near-to-intermediate term, traditional energy such as oil, natural gas and coal will be vital to providing the world’s energy needs and for human welfare. The overarching question is when the inevitable decline will begin. It’s clear that it has already started for coal, the highest emitter of greenhouse gas. In our view, after reading the IEA’s recent outlook, the most likely scenario is that oil and gas will maintain a meaningful share of the energy mix for decades to come. Further, traditional energy companies will be part of the solution to limit GHG emissions, many already having established emission reduction targets. Midstream companies have infrastructure in place that can be utilized to facilitate the energy evolution.
Our portfolios consist of midstream energy companies that have embraced ESG and the transition to a cleaner energy future.
China and India Continue to Rely on Coal
The recent revival of coal demand driven by global energy price spikes and power shortages has added complexity to the COP26 backdrop. As the top two largest users of coal, China and India appear unlikely to meaningfully amend their pledges with the potential cost of hampering their economic growth and energy security. Coal accounts for approximately 70% and 60% of India and China’s total energy source, respectively. Despite having previously pledged to stop building coal plants abroad, China continues to add more coal capacity within its country. Their net construction of coal power capacity last year (i.e., 29.8 gigawatts) more than offset the net decrease of 17.2 gigawatts by the rest of the world, according to the Centre for Research on Energy and Clean Air.
Concluding thoughts: A practical approach to reducing emissions is essential and should improve human welfare. In other words, everyone is entitled to available and affordable energy. Electricity should be available 24/7. The recent surge in energy prices and shortages reminds us how essential energy is to our daily lives. Inflation is a regressive tax and hurts the people that are least equipped to absorb it. In order not to derail the net zero emissions train, consumers need to be onboard. Inflation that may lead to a recession may very well get people to hop off this train. Hence, it is critically important that we continue to invest in oil and gas to ensure that the net zero emissions train remains on track!
EIA Forecasts Robust Growth in Worldwide Energy Demand
Earlier this month, the U.S. Energy Information Administration (EIA) released its International Energy Outlook 2021 publication. The agency continues to expect a robust increase in worldwide energy consumption over the next 30 years driven by population and economic growth primarily in Asia (i.e., ~47% growth in demand from 601.5 quadrillion Btu in 2020 to 886.3 quadrillion Btu in 2050). Renewables are expected to account for 27% of total energy consumption by 2050, a notable step up from 15% in 2020. Although renewables’ market share steadily increases over this time frame, the EIA expects that petroleum and other liquid fuels will remain the world’s largest energy source at 28% of the total, down slightly from 30% in 2020. This view aligns with the IEA’s “Stated Policies Scenario,” as discussed earlier.
Source: EIA International Energy Outlook 2021
We believe that the EIA’s long-term outlook for growth in renewables may prove to be conservative, given that its reference case assumes the implementation of current laws and regulations as of May 2021, including existing climate law. For example, the agency projects energy-related CO2 emissions to notably increase approximately 25% (or at a 0.7% CAGR) to reach 42.8 billion metric tons in 2050 from 34.3 billion metric tons in 2020. This contradicts the current push for net-zero emissions by a growing global coalition (more than 130 countries have a target of reducing emissions to net zero by mid-century, the U.S. included). Additionally, the EIA expects electric vehicles (EV) to account only for 31% of the global light duty vehicle (LDV) fleet in 2050—this appears conservative given the EV penetration targets countries have set. China, the world’s largest auto market, is targeting 25% of new car sales to be EVs by 2025 and 50% by 2035; President Biden has a target of 50% by 2030 for the U.S. If EVs command a larger market share than the EIA forecast, this would imply a lower but still meaningful worldwide demand for petroleum, all else being equal. We note that the EIA’s reference case also assumes: (1) Oxford Economics’ GDP projections, with a global growth rate of 2.8% per year, (2) 2050 world oil price reaches $95 per barrel (2020 dollars); and (3) current technology trends continue.
Energy Regains Its Lead as Best Performing S&P Sector
The energy sector regained its top spot as the best performing S&P sector year-to date. It was the only one of the 11 S&P sectors with positive performance for September. Energy gained 9.3% that month (down 2.8% in the prior month) versus a loss of 4.8% for the S&P 500. Year-to-date, energy is up 38.4% (as of 9/30) versus 14.7% for the S&P 500. However, the energy sector is still down 13.3% from year end 2019. Driving energy’s strong year to date and September performance has been the surge in commodity prices. Utilities posted a 6.4% loss in September and appreciated just 1.7% year to date and is the worst performing S&P 500 sector thus far this year. However, clean energy stocks have done worse this year. The S&P Global Clean Energy Index (SPGTCED) dropped 7.1% in September and is down 23.0% for the year. But to be fair, clean energy stocks are up 99% over the past two years (9/30/19 – 9/30/21) compared to 45% for the S&P 500.
In September, SAM’s Infrastructure Portfolio outperformed the overall market and its benchmark with a 0.9% total return vs. the S&P 500’s total return of -4.7% (including dividends) and -.26% for its benchmark. On a year-to-date basis, SAM’s Infrastructure Portfolio’s total return of 24.7% compares favorably with the 15.9% and 18.0% return for the S&P 500 and its benchmark, respectively. Our new ESG Infrastructure Portfolio performed relatively well with a modest decline of 0.55% for September and, midway through October performance has been very good for the market and our portfolios.
Natural Gas is in Short Supply
The average price for front-month U.S. natural gas futures contracts in September was $5.11/MMBtu, the highest monthly average since February 2014. LNG spot and forward prices in Europe and Northern Asia ended September at record-high levels. The Japan/Korea (JKM) LNG spot price ended September at $31.10/MMBtu and the European natural gas benchmark (Title Transfer Facility or TTF) closed the month at $33.20. (EIA Short-Term Energy Outlook). The large price spreads between JKM and TTF relative to the U.S. Henry Hub price of just $5.87MMBtu have led to record U.S. LNG exports. Granted, the surge in prices may be partially due to global warming. For example, drought conditions in Latin America reduced hydropower capacity which is Latin America’s primary source of power. Natural gas inventory levels in Europe were below average due to a colder than normal winter. Hurricane Ida knocked out supplies from the U.S. Gulf of Mexico. In addition, demand for natural gas surged in China owing to disruptions in coal availability and the reopening of its economy. One can argue the actual impact of global warming, as does Steven E. Koonin in his book, “Unsettled: What Climate Science Tells Us, What it Doesn’t, and Why it Matters.” Regardless, the world should not take the availability of natural gas for granted. We have plenty of natural gas here in the U.S., but its availability will be constrained by bad policy that does not permit the timely construction/expansion of natural gas pipelines.
IN OUR VIEW: MULTI-YEAR UPCYCLE FOR ENERGY HAS BEGUN
We believe that inflation will be a bigger deal than conventional wisdom may suggest and may pressure corporate profits and ultimately the stock market. We believe surging oil and gas prices will stay elevated due to ongoing underinvestment. The energy sector is the best performing S&P 500 sector year-to-date and, may be at the beginning of a multi-year upcycle. In our view, the sector is becoming ESG-friendly, will be integral to the transition to a lower carbon future, and will generate significant free cash flow with which to provide growing dividends to shareholders.
Our recommendation is to overweight the energy sector for both income and as an inflation hedge.
Sam Partners’ Infrastructure 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 ~5.5% (as of 8.31.21) and growth potential of 3% to 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 ~ 3.5% (as of 8.31.21). In a world starved for yield, we
believe these Strategies offer a compelling value proposition.