Tortoise Talk 1Q2021

Energy 4/23/2021
Download as PDF

The broader energy sector, as represented by the S&P Energy Select Sector® Index, had a strong first quarter, returning 30.7%. The vaccine-driven rally drove the energy sector to finish the quarter as the best performing S&P 500 sector. As positive cases decline and mobility increases, global oil demand could reach pre-pandemic levels over the next 12 months, a far-fetched thought one year ago.

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 to keep the markets balanced through April. Overall adherence to the production cut agreement remained strong in the first quarter, leading to inventory draws which are expected to continue throughout 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 million barrels per day (b/d), essentially unchanged from the fourth quarter estimate.

Similar to oil, improving demand and stable production has created a constructive long-term natural gas environment. Cold weather in Asia increased demand from Europe for U.S liquefied natural gas (LNG) exports during the winter months. In fact, during the first quarter of 2021, the EIA estimates U.S. LNG exports exceeded 10 billion cubic feet per day (bcf/d). Domestically, the U.S. market remains structurally undersupplied as producers have remained disciplined, associated natural gas production has continued to decline, and global LNG demand has strengthened. Rising U.S. energy exports of natural gas are expected to positively affect the U.S. trade deficit. Natural gas has continued to provide a cleaner burning fuel source and along with renewables, will ultimately help reduce global CO2 emissions as they take market share from coal.

Energy infrastructure

Midstream energy also had a strong first quarter with the Tortoise North American Pipeline IndexSM returning 18.3% and the Tortoise MLP Index® returning 21.3%. Improved fundamentals coupled with higher energy demand, continued OPEC+ restraint, a post-pandemic recovery, and supportive monetary and fiscal policies are helping drive positive sentiment for energy infrastructure stocks. Rising GDP forecasts should lead to increased energy demand and volumes flowing through pipelines. GDP forecasts are rising with Cornerstone Macro forecasting a 9% real U.S. GDP growth in 2021, the strongest growth since 1959. Globally, ISI expects 8% real GDP growth in China. Thus the two largest economies in the world, the U.S. and China, could both grow by at least 8% year-over-year in 2021.

2021 GDP forecast

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

Despite what will likely be a noisy first quarter of earnings due to supply interruptions from Texas Winter Storm Uri, we expect midstream companies to keep their full year guidance intact. Offsetting the weakness was an improvement in commodity prices, which may allow companies to leverage excess pipeline capacity across their systems. Specifically, natural gas liquids fundamentals have remained robust, which should lead to continued volume growth. Earnings and distribution announcements have highlighted the stability of the midstream business model as free cash flow generation has continued to ramp. Companies have been reducing capital expenditures and using the excess cash flow to reduce debt, with stock buybacks as a secondary and growing consideration. There are now 15 midstream companies with active buyback programs, with approximately $300 million being bought back in 4Q 2020.

Winter Storm Uri was another reminder of the critical role energy infrastructure plays in delivering energy to end users. All generation sources suffered from reduced uptime due to a multitude of factors. Texas oil and gas producers’ biggest obstacle to delivering the fuel during February’s historic freeze was power outages rather than frigid temperatures. Pipelines, in some cases, suffered from rolling statewide blackouts. Moving forward, we expect the industry to explore additional winterization investments in energy and power infrastructure, improved resource planning, and increased investment in reliability and dispatchable power. The grid needs reliability and dispatchable generation must be ready to go.

While the Presidential Inauguration in January created headline risks for the energy sector, we continue to believe the consensus path forward for the Biden Administration is focused on getting Americans back to work with supportive policies versus policies aimed at opposing the oil and gas industry or destroying jobs. Actions taken by the Biden Administration have been more “bark than bite” in our view. In his first few months, President Biden stopped short of declaring a Climate Emergency, which would have given him executive power over export restrictions, tariff controls or emergency rulemaking. His pausing of new leases on Federal lands has had a very minimal impact as producers hold backlogs of permits on already leased land, and the Army Core of Engineers (ACE), a branch of the executive branch, has punted any decision on shutting down the controversial Dakota Access Pipeline (DAPL).

The predominant theme around Biden’s energy plan is to address climate change and create substantial job opportunities for Americans. Climate change and related opportunities for the overall economy was one of the four pillars of the convention platform, integrated into an overall vision of revitalization of America. We are keeping a close eye on policy guidelines. The tight margin in both houses of congress likely forces legislation using the reconciliation process, which we would expect to tilt legislation towards tax credit policy rather than more restrictive, comprehensive climate policies. We expect market economics to dictate the trajectory of future energy supply and demand.

Finally, the first quarter witnessed energy infrastructure companies advance ESG efforts to meet modern energy initiatives. During the quarter, we saw governance improvements with many MLPs now having publicly elected boards, midstream companies Kinder Morgan, Energy Transfer, and Williams Companies forming sustainable development groups, and formal carbon reduction targets being established by ESG leaders MPLX and Williams. Last quarter, we discussed how pipeline infrastructure could be repurposed to transport hydrogen. During the first quarter of 2021, we saw increased discussion on carbon capture. We believe achieving a carbon-neutral future will take a comprehensive approach, including carbon capture. Carbon can either be captured directly from the atmosphere or in higher concentrations directly from point sources, such as industrial exhaust. Existing U.S. CO2 pipeline infrastructure should be critical to accommodate growing volumes and we believe more infrastructure will need to be built to transport the carbon. During the quarter, Valero Energy announced a partnership with the Navigator Energy Services to build out a new carbon capture pipeline system in the midwest. The proposed system plans to transport liquefied carbon dioxide through the pipeline, for delivery into a central sequestration facility contemplated to be in south-central Illinois.

Within the downstream portion of the energy value chain, the refining sector remains among the most challenged sectors due to the COVID-19 pandemic. Refinery utilization has recovered from the depths of the economic contraction in 2020 but has remained below 2019 levels. In a sign of the times, permanent refinery closures have helped balance the market from a supply and demand perspective while new renewable diesel projects are being announced to extend the useful life of refining assets and associated logistics. From a U.S. refined product demand standpoint, we believe gasoline and diesel will continue to inch towards pre-COVID levels during 2021 while a slower recovery should be expected in jet fuel. That being said, more americans are traveling and American Airlines recently announced April ticket sales have hit 90% of pre-pandemic levels. Natural gas liquids, unlike the refining sector, has proved resilient despite challenges faced during the COVID-19 pandemic. 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.

Sustainable infrastructure

The clean energy sector experienced a somewhat expected correction following the strong rally observed in the fourth quarter of 2020. At the same time, several factors conspired to force the sector to pause in its secular progress. First and foremost, the final eight weeks of 2020 was an exceptional period of performance. We believe a meaningful part of that rally involved investor enthusiasm leading to inflows for the clean energy sector following the Biden Presidential victory, given his purposeful commitment to address climate change concerns and broader infrastructure investment stimulus objectives. This carried through to the surprise Senate sweep in Georgia, thereby delivering a narrow legislative mandate for at least two years.

Following that event, the S&P Global Clean Energy Index announced plans to substantially expand its number of constituents which created volatility in the sector (given the related ETF flows). The final details of the index restructuring were announced early April with full implementation by April 16, 2021. We see this event as a transitory issue but note that passive strategy reallocations and activity in the growing ‘clean’ space have to be monitored for price performance influence.

Lastly, BP bid very aggressively in England’s most recent offshore seabed leases for future offshore windfarm development, raising fear of cut-throat competition from oil and gas companies that could confiscate returns going forward. Competition has definitely intensified but, at the same time, the opportunity keeps increasing. In offshore wind, for instance, the new U.S. administration has committed to expanding offshore wind capacity to 30GW by 2030. Also, Scotland came up with its rules for seabed offshore leases applying a leasing price cap at a much lower level than BP’s bid.

On the positive side, the quarter witnessed fundamental developments that should carry the sector for years to come. First, the Biden administration released its infrastructure plan which should be very supportive to our investment universe given long-term tax incentives for renewables and batteries, and ambitious growth plans in offshore wind and transmission infrastructure. We believe that the measures related to renewables are not controversial and look forward to these becoming law later this year.

Second, the Canada Supreme Court confirmed the legality of a federal carbon price which should be positive for renewables relative to fossil fuel generation. It is worth noting that European carbon prices continued to rise and reached a new all-time high in the quarter.

Concluding thoughts

While the energy transition will take time to play out, midstream management teams continue to provide details on the role they expect their companies to play in the transition. As the world continues to demand more energy and less carbon, we believe midstream companies will view the energy transition opportunistically. Renewables and natural gas are more economic than coal in generating electricity and will likely continue to take market share, while crude oil will likely remain the predominant fuel source in the transportation sector for the near future.

Over the coming months, we are looking forward to strong impetus for the renewables universe as the U.S. hosts a Climate Summit with the political leaders of 40 countries, the EU Commission issues a revised Emission Trading Scheme Directive in June to reflect the EU’s more ambitious 2030 emissions reduction targets, and then the UK hosts COP26 in November. We see reasons to be optimistic about the prospects for renewables not only because more countries are translating their net-zero targets into renewables capacity additions, but also because we are seeing more corporates driving their supply chains to decarbonize and the leading players have high conviction that green hydrogen can become a competitive option by 2025.

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 MLP Index® is a float-adjusted, capitalization-weighted index of energy MLPs. 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 500® Index is an unmanaged, market-value weighted index of stocks that is widely regarded as the standard for measuring large-cap U.S. stock market performance. 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. The Alerian Midstream Energy Index is a broad-based composite of North American energy infrastructure companies. The capped, float-adjusted, capitalization-weighted index, whose constituents earn the majority of their cash flow from midstream activities involving energy commodities, is disseminated real-time on a price-return basis (AMNA) and on a total-return basis (AMNAX).

Tortoise North American Pipeline IndexSM and Tortoise MLP Index® (the “Indices”) are 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 Indices are 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”).

It is not possible to invest directly in an index.