Broad energy sector performance was slightly negative for the quarter as concerns grew about the COVID-19 Delta variant’s impact on energy demand. Despite this, the recovery in energy demand is occurring faster than the recovery in supply. Global underinvestment resulting from COVID-19, ESG commitments, and energy transition is likely to keep markets tight for the foreseeable future.
The broader energy sector, as represented by the S&P Energy Select Sector® Index, finished the quarter ending September 30, 2021, in negative territory, returning -2.06%. OPEC+ producers continue to manage the market and shale producers remained disciplined, which led to rising commodity prices. Higher prices have spurred a revival of shale drilling in the Permian, America’s biggest oil field, where production is expected to return to pre-pandemic highs within weeks. The surge is being driven by private operators, rather than the publicly traded companies that fueled the previous booms. For 2021, the Energy Information Agency (EIA) forecasts production will end the year at 11.3 million barrels per day (b/d), up from 11.0 million b/d at the start of 2021. Stress on global power markets pulled on all available natural gas supplies, pushing prices to the highest levels in over a decade. This led to some switching to fuel oil for power generation which is expected to pull forward additional crude oil demand. Finally, as the quarter came to a close, oil surged higher as OPEC+ did not respond to higher demand and instead maintained plans to increase production by only 400,000 barrels per month.
Due to its low emission intensity relative to other dispatchable fuels, natural gas is being called on to fill gaps created by intermittent sources. The Energy Information Agency (EIA) estimates U.S. LNG exports exceeded a record high of 10 billion cubic feet per day (bcf/d) earlier this year. A few years ago, this number was zero. As demand surges for lower-cost U.S. natural gas there is a need for more LNG export terminals and additional natural gas pipeline infrastructure. In the northeast Marcellus Basin, pipeline infrastructure is constrained. LNG supply takes time to construct, but projects that do end up moving forward, such as Cheniere’s Corpus Christi stage 3, could have a greater visibility to signing long-term (20+ year) contracts.
Midstream energy fell during the quarter with the Tortoise North American Pipeline IndexSM returning -1.99%. From an energy infrastructure fundamental perspective, 2021 is among the steadiest years in recent memory with free cash flow and the return of capital to shareholders as the main focus. 2021 EBITDA expectations were revised higher based on increasing pipeline volumes as the economy reopened. On the cost side, companies kept capital expenditures lower and are using the excess cash flow to reduce debt with stock buybacks as a secondary and growing consideration. Seventeen midstream companies now maintain active equity buyback programs with MPLX leading the way, buying back stock worth $155 million per quarter.
On the legislative front, negotiations are ongoing related to President Biden’s infrastructure bill. Climate change legislation is expected to primarily come through the reconciliation process. It is likely that the bill will focus more on tax credits rather than more restrictive, comprehensive climate policies. While investors may assume this means tax incentives for renewable focused initiatives, we believe there will also be regulatory support for existing infrastructure. For example, the expansion of Section 45Q tax credit would incentivize more widespread carbon capture adoption for harder to abate sectors such as steel, cement, and chemicals. We believe taking a holistic view towards energy transition, with the understanding that fossil fuels will remain critical to the economy for decades, is the best approach to reduce emissions fastest. Finally on the regulatory front, Enbridge received positive news on its Line 3 pipeline project, and the pipeline is set to start moving volumes in the coming months.
The third quarter also saw further growth opportunities for energy infrastructure companies around energy transition. Energy transition projects support the longevity of existing assets and can support future growth of cash flow. Fuels including carbon (through carbon capture and sequestration), hydrogen, renewable diesel, and renewable natural gas all create a pathway to a lower carbon future.
An example of a new growth project announced during the quarter was between natural gas pipeline company, Williams, and wind farm developer, Orsted. The companies plan to leverage Orsted’s renewables and hydrogen expertise with Williams’ natural gas infrastructure and processing experience. Specifically, they’re looking at large-scale wind energy and electrolysis in Wyoming where Williams owns significant natural gas infrastructure. Williams believes its extensive energy infrastructure network is adaptable to further renewable energy storage and transport. This builds upon energy transition announcements from earlier in the year. Recall last quarter, a new growth project was announced with 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.
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 around 20% from pre-COVID levels. Natural gas liquids, unlike the refining sector, proved resilient despite challenges faced during the COVID-19 pandemic. Natural gas liquids (NGLs) 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.