Tortoise Talk 2Q2021

Energy 7/28/2021
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The broader energy sector, as represented by the S&P Energy Select Sector® Index, finished the quarter ending June 30, 2021 in positive territory, returning 11.11%. Energy markets and commodity prices continue to experience a significant turnaround year propelled by the vaccine-driven rally since last November. As positive cases decline and mobility increases, the International Energy Agency (IEA) now expects world consumption will once again reach 100 million barrels a day (pre-pandemic levels) in the second half of 2022 as developed economies bring the virus under control.

Commodity backdrop

The Organization of Petroleum Exporting Countries (OPEC) and their Non-OPEC partners (OPEC+) remained supportive of global crude oil markets in extending deep production cuts. Overall adherence to the production cut agreement remained strong in the first half of 2021 and U.S. crude inventories normalized following a 140 MMb surge in 2020, driven by pandemic related demand destruction. Inventory draws are expected to continue throughout the second half of 2021. Domestically, producers’ capital discipline remained during the quarter keeping a lid on U.S. production as management teams focused on higher free cash flow generation and return of capital to shareholders. For 2021, the Energy Information Agency (EIA) forecasts production will average 11.1 million barrels per day (b/d), essentially unchanged from the first quarter estimate. In 2022, the U.S. is expected to grow production as OPEC members, including Iran, will be needed to produce at full levels to prevent inventories from declining further.

Similar to crude oil, disciplined producers and strong global demand created a constructive long-term natural gas environment. At the onset of the pandemic, natural gas storage increased significantly, approximately 60%, between March and June of 2020. Since the end of June 2020, the U.S. natural gas market collectively withdrew from storage, implying a structurally undersupplied market. During the first half of 2021, the EIA estimates for U.S. LNG exports exceeded 10 billion cubic feet per day (bcf/d). Despite higher prices, the U.S. market demand is being driven from LNG sales to Europe and Asia and exports to Mexico. Rising U.S. energy exports of natural gas are expected to positively affect the U.S. trade deficit. Natural gas continues to provide a cleaner burning fuel source and along with renewables, will ultimately help reduce global CO2 emissions as natural gas takes market share from coal.

Energy infrastructure

Midstream energy scored its third consecutive strong quarter with the Tortoise North American Pipeline IndexSM returning 13.23%. The 2021 first quarter earnings reporting period was one of the strongest for the group in recent memory. The two main drivers were the benefits from Texas winter storm Uri and increased revisions of 2021 estimated EBITDA driven by higher volume expectations due to the economy reopening. Midstream companies generated approximately $4 billion in additional EBITDA from the Texas winter storm Uri as companies supplied the market with much needed natural gas and power as prices spiked, with Kinder Morgan and Energy Transfer being the biggest beneficiaries. 2021 EBITDA expectations were also revised higher based on increasing activity through the second half of the year. Volumes are being driven primarily by increased drilling activity from private producers with public E&Ps showing capital restraint. On the cost side, companies kept capital expenditures lower and are using excess cash flow to reduce debt, with stock buybacks as a secondary and growing consideration.

While the Presidential Inauguration in January created headline risks for the energy sector, actions taken by the Biden Administration in the first few months are more “bark than bite” in our view. Though political and regulatory risks remain, the second quarter provided many positive outcomes supportive of energy infrastructure. The Dakota Access Pipeline (DAPL) remained operational following a positive ruling from the Judge who initially ruled the pipeline was in violation of its easement. Enbridge received a positive ruling from the Minnesota Court of Appeals on its Line 3 pipeline project, after years of regulatory pushback. Finally, after initially pausing new leases on federal lands, statements and action taken by the Biden administration show a willingness to continue granting drilling leases on federal lands.

The second quarter also bore fruit to further growth opportunities for energy infrastructure companies around energy transition. Energy transition projects support the longevity of existing assets and can support future growth in cash flow. Drop-in fuels including carbon (through carbon capture and sequestration), hydrogen, renewable diesel, and renewable natural gas all create a pathway to a lower carbon future (see graph below) with minimal capital expenditure. An example of a new growth project announced during the quarter was TC Energy (TRP) and Pembina (PPL) developing a Carbon Capture and Sequestration (CCS) system in Canada, including the retrofitting of some existing pipelines. Repurposing existing pipelines significantly reduces the capital expenditures versus building a new pipeline. Pipeline utilization can also increase, which should be supportive of higher tariff rates for midstream companies.

Market share in CO2 reductions: IEA SDS

Source: U.S. - Cornerstone Macro Forecast and China - ISI Forecast

As the market becomes more demanding of lower carbon intensity and increased transparency on climate impact for energy products, energy companies are prioritizing ESG and climate reporting. As an example, the largest LNG export company in the U.S, Cheniere Energy, announced a collaboration with producers and academic institutions to monitor and verify emissions from production wells. Cheniere plans to provide Carbon Emissions Tags to customers beginning in 2022 to help track emissions. While the energy transition will take time to play out, we believe companies with existing infrastructure and pipeline construction expertise maintain a significant competitive advantage over newcomers. Even Canada’s largest oil sands producers announced unprecedented alliance to achieve net zero greenhouse gas emissions by 2050. The alliance will be anchored by a major carbon capture, utilization and storage (CCUS) pipeline connected to a carbon sequestration hub.

As the world economy reopens, our strategies are positioned for a reflation around increased energy demand. The focus continues to be on companies with strong balance sheets and exposure to the most competitive basins for hydrocarbon production, including the Permian and Marcellus basins. We also continue to emphasize export infrastructure, both liquefied natural gas (LNG) and liquefied petroleum gas (LPG).

The downstream portion of the energy value chain continues its recovery from the COVID-19 pandemic. U.S. demand largely normalized with gasoline and distillate demand roughly in-line with 2019 levels and jet demand down just 20%. Natural gas liquids, unlike the refining sector, proved resilient despite challenges faced during the COVID-19 pandemic. NGL prices are elevated on favorable fundamentals and recovering demand. Strength can be seen in LPGs (liquid petroleum gases) where demand is driven by global population growth and improvements in living standards in Asia, notably in China and India.

Renewable energy

The first half of the year was turbulent for renewable energy due to a reflation rotation and concerns about inflationary impacts on renewable project returns along with more aggressive bidding for renewable project sites by oil and gas companies. We saw meaningful equity price corrections across many of the ‘champions’ of the broader space, following a banner year in 2020 (see chart below).

2021 1H performance shows a quite different picture to 2020

Source: Bloomberg

Many of the headwinds impacting the first quarter continued into the second quarter, particularly the reflation trade, which delivered stark underperformance of structural growth versus value cyclicals, and the continuing underperformance of pure-play renewables stocks. An additional headwind that grew in significance during the second quarter was strength in commodity and freight pricing which threatened to squeeze renewable equipment supplier margins and renewable developer returns. Many of the pricing framework agreements for renewable equipment had already been set, as well as some power purchase agreements for renewable developers. The ability to pass through higher raw material costs is likely to be challenging. Ongoing strength in polysilicon, steel and copper prices added to the string of uncertainties surrounding the renewable equipment and renewable developers that investors contemplated during the first half of the year. Given the fact that in many regions renewable power purchase agreements are already attractively priced relative to prevailing spot and forward electricity prices, renewable developers should have the ability to enforce pricing power and to defend new project returns by stabilizing and/or increasing power purchase agreement pricing for new renewables projects.

From a macro perspective, inflationary impulses may peak around the middle of this year. Moving into the second half of 2021 and beyond, a potential normalization of inflation and policy support should result in a more benign backdrop for the renewable sector. Many policy drivers due in the second half of this year which should re-focus attention on the energy transition: the European Commission will release new emissions reduction targets for various industries in July; US infrastructure stimulus is on the agenda for H2 (and should include various tax credits and incentives for renewable technologies such as wind, solar and battery storage and incentives for electric vehicles as well as building efficiency); and the COP26 climate summit in November will encourage more ambitious decarbonization targets from governments and corporates.

Concluding thoughts

As people continue to receive vaccinations and the economy opens due to increased mobility, we see positive momentum across the essential assets in which we invest. Increased travel is positive for energy demand that impacts the entire energy value chain. Renewable energy stocks slowed down during the first half of the year with a few headwinds, but mostly pulling back from an extremely strong 2020. We are optimistic about essential assets and our strategies for the remainder of 2021 and beyond.

This commentary contains certain statements that may include “forward-looking statements.” All statements, other than statements of historical fact, included herein are “forward-looking statements.” Although Tortoise believes that the expectations reflected in these forward-looking statements are reasonable, they do involve assumptions, risks and uncertainties, and these expectations may prove to be incorrect, Actual events could differ materially from those anticipated in these forward-looking statements as a result

of a variety of factors. You should not place undue reliance on these forward-looking statements, which speak only as of the date of this publication. Tortoise does not assume a duty to update these forward-looking statements. The views and opinions in this

commentary are as of the date of publication and are subject to change. This material should not be relied upon as investment or tax advice and is not intended to predict or depict performance of any investment. This publication is provided for information only and shall not constitute an offer to sell or a solicitation of an offer to buy any securities.

The Tortoise North American Pipeline IndexSM is a float-adjusted, capitalization-weighted index of pipeline companies (MLPs, corporations, LLCs) domiciled in the U.S. or Canada. The S&P Energy Select Sector® Index is a modified market capitalization-based index of S&P 500 companies in the energy sector involved in the development or production of energy products.

Tortoise North American Pipeline IndexSM (the Index) is the property of Tortoise Index Solutions, LLC, which has contracted with S&P Opco, LLC (a subsidiary of S&P Dow Jones Indices) to calculate and maintain the Indices. The Index is not sponsored by S&P Dow Jones Indices or its affiliates or its third party licensors (collectively, “S&P Dow Jones Indices”). S&P Dow Jones Indices will not be liable for any errors or omission in calculating the Indices. “Calculated by S&P Dow Jones Indices” and its related stylized mark(s) are service marks of S&P Dow Jones Indices and have been licensed for use by Tortoise Index Solutions, LLC and its affiliates. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC (“SPFS”), and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”).

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