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.
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.
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.