December 2022 – Commentary from Dan Pickering

Traditional Energy Commentary

A grinding finish to 2022. The S&P500 fell -5.8% (-18.1% YTD). Energy was an outperformer but still down in absolute terms. Diversified Energy dropped -3.5% (S&P 1500 Energy, S15ENRS) with subsector performance as follows – Oilfield Services +1.0% (OIH), Midstream -4.7% (AMZ), and Upstream/E&P -10.0% (XOP). Clean energy dropped -6.0% (ICLN). Crude oil was essentially unchanged at -0.4% (~$80.26/bbl), while gas was walloped -35.4% (~$4.50/mcf)⁽¹⁾.

Our “November” writeup was only a few weeks ago and captured most of the relevant near-term issues. A few things worth noting:

• Natural gas has been a disaster
• US NYMEX front month has fallen to ~$3.30/mcf as this commentary goes to press on 1/18/23. What the #$*#@ happened? Europe jammed price to fill storage and avoid a winter calamity. Winter weather then turned very warm, causing Netherlands Title Transfer Facility pricing to tank further, closing the year at €74/MWh or -76% from the summer highs. US natural gas prices followed a similar trend. Front month NYMEX gas was pulled up to ~$9.70/mcf in August and subsequently pushed down by Europe’s collapse and our own warm weather, falling -63% from the peak.
• Damning with faint praise, gassy stocks have done better than the commodity – since the August 22^nd US gas peak, an equally-weighted basket of Appalachia-heavy gas stocks has fallen “only” -30.7% (including slight offset from dividends) through 1/18/23 (EQT, Antero and Range Resources). Lest we celebrate, gassy stocks have been awful relative to oily stocks (+3.0% total return average for Pioneer, Diamondback and Devon), relative to front month WTI (-11.9%) and relative to the S&P500 (-4.4%).
• We wouldn’t dare to try and call the timing or magnitude of a near-term bottom in natty. Given rising well costs and higher costs of capital (rising rates), US drilling economics will likely dictate a slowdown in drilling activity with prices in the $3.50/mcf area. European gas will catch a bid by summer as structural supply dynamics will once again require a scramble to prepare for Winter 2023.
• Gassy stocks still look cheap and are discounting somewhere between $3-$3.25/mcf. Washed out? Perhaps. While we don’t want to be too negative given the structural demand picture (Energy Security, LNG, etc), this falling knife doesn’t feel worth catching right now. It feels good to be Switzerland – an interested but currently neutral party.

• Everybody’s favorite horror movie - Tesla
• When the world’s richest man is at the helm of one of the most watched companies which is disrupting a big business, people tend to pay attention.
• Tesla’s high flying stock price has come back to earth – falling from over $400/share to the current ~$120 level. This is part a sympathy trade with the overall technology stock correction, part TSLA-specific on a slight Q4 order miss and part self-inflicted wound by Elon Musk (Twitter acquisition, sale of $40B of Tesla stock).
• We’ve had a lot of respect for the Tesla product after being an early owner of the Model S. The stock has always been a bit of a mystery given its cultish status and outlandish valuation. The recent retrenchment brings the name into “time to pay attention” territory for the first time in years. Street 2024 consensus estimates are in the $6-$6.50/share neighborhood, putting the stock below 20x P/E for the first time. The 2024 S&P500 P/E is 14x for 10% expected eps growth. TSLA is now ~20x 2024 P/E for 27% expected eps growth (using GAAP consensus estimates).
• We still wouldn’t call Tesla a cheap stock, but it’s become an interesting stock. Sentiment is awful. The popular press has turned from fawning sycophants to knife-wielding doubters. Twitter has been a terrible distraction for Elon and for Tesla investors, particularly as it has spurred massive insider sales of Tesla stock to fund Musk’s acquisition. We feel the drama will inevitably ebb. The company recently announced an expansion to its Austin facility, the rumor mill is talking about an Asian facility in Indonesia and there is an analyst day scheduled for March. We’ve recently watched Netflix tank and then double. Meta tanked and has subsequently rallied 60%+. Tesla has tanked….and we’re interested.

The stock market will be consumed during 2023 with interest rates and economic health. Energy will trade with beta around these themes. Should oil crack $70 or energy stocks have a meaningful swoon, we’ll be stepping up as our conviction remains high in a ThreePeat for energy outperformance.

Decarbonization / Energy Transition Commentary (Included Quarterly)

Encompassing Q4 2022, this is the inaugural decarbonization / energy transition commentary.  Choppy is the best description.  For Q4, the S&P500 gained +7.5% with some wild gyrations along the way.  At +4.2% for Q4, the iShares Global Clean Energy ETF (ICLN) lagged the broad market, while conventional energy outperformed at +22.1% (S&P1500 Energy Index, S15ENRS). ⁽¹⁾

The overarching clean energy macro continues to be one of the globe’s adamant commitment to lowering carbon emissions and the resulting tsunami of public, private and government capital inflows.  For the past several years, we have called “Energy Transition” a megatrend.  This is based on the vast capital that will be expended (forecasts for $150+ trillion between now and 2050) and widespread support for decarbonization from governments, individuals, institutional investors and large corporations.  Nothing during 2022 swayed that narrative, cementing in our minds the secular nature of the energy transition.

Decarbonization is manifesting in government policy (particularly Europe and the recent US Inflation Reduction Act), widespread media attention on climate change, dramatic capital formation (“everybody” has a clean energy fund or has bumped their portfolio allocation) and significant attention from public companies across various industries (conventional energy, industrials, renewables, etc.)

The challenge now is making money or, to be more specific, making acceptable risk-adjusted returns.  The excitement of energy transition led to massive valuations on early-stage companies across electric vehicles, battery storage, hydrogen and other energy transition and decarbonization verticals.  Subsequent carnage has been meaningful, with many public companies having seen their stock prices fall 50-90% over the past 12-18 months.  Established renewables such as wind and solar have seen asset-level returns compressed to single digits.

It is our belief that we are in a shaking out period, where decarbonization stocks are 1) in the doghouse given how awful they have been and 2) tied to the sentiment of technology stocks at least as much as “energy”.  Meanwhile, companies making meaningful progress can be great performers and/or consolidation candidates.

One need to look no further than Archaea Energy (symbol LFG), a producer of renewable natural gas from landfills, to illustrate this point.  Archaea announced a going public SPAC combination in April 2021, closed the SPAC transaction on September 15, 2021 and was acquired by BP in 2022 (announcement October 17^th, closing December 28^th).  Archaea returned +160% ($10 IPO to $26/share takeout) while the ICLN returned -5.0%.⁽¹⁾

Finding companies like Archaea isn’t easy.  It takes a combination of favorable subsector dynamics, favorable company-specific dynamics and a management team that can execute.  From a subsector perspective, we favor themes that have some combination of 1) current commercial profitability, 2) improving financials with visibility to relatively near/intermediate-term profitability, 3) positive catalysts or 4) inexpensive valuations.

Today, we are most interested in the following themes on the long side:

• Energy storage – In a world that is aggressively adding renewable energy generation, there is a rapidly growing need for storing intermittently-created power.  Whether this is via conventional battery technology, new battery technology, grid-scale storage, microgrids, or equipment and services, the world needs more capacity.
• Carbon capture – We are believers that reaching NetZero is essentially impossible if the only mechanism is by eliminating CO2 creation.  Our globe is hooked on carbon-intensive industries and can’t/won’t wean itself fast enough.  Abatement of carbon must be part of the answer.  Particularly after the US Inflation Reduction Act dramatically increased 45Q tax credits, CCUS (Carbon Capture, Utilization and Storage) economics are now attractive.
• Enabling commodities – Low carbon technologies require commodity inputs, some of which are in relatively tight supply.  Rare earth minerals are frequently cited as gating items in the production of electric vehicles, wind turbines and solar panels.  However, even well-known commodities like copper are already in relatively tight supply, before we’ve seen the expected decarbonization-driven surge in demand.
• Decarbonization equipment and services – There will be many successes and failures in decarbonization technologies.  There will be booms and busts.  We like the idea of owning technology-agnostic equipment suppliers and services providers who get paid regardless of the point in the cycle. Of course, healthy customers are always best.  But at this point in the cycle, there are many customers with flush balance sheets spending aggressively to capture mindshare and market share.
• Special situations – There are always companies that don’t fit nicely into specific subsectors.  They have a unique business model, a funky niche or some other characteristic that makes them interesting.

Today, we are avoiding the following themes or consider them short candidates:

• Electric vehicle industry – We are big believers in the ongoing adoption of electric vehicles – in the United States and globally.  EVs have lower carbon footprints and lower fuel costs.  Although current US models are quite expensive, over the next decade, average EV costs will decline to the point their total cost of ownership will be at parity/below gasoline vehicles.  Legislation is pushing for EV phase-in’s while it pushes for the phase-out of internal combustion engine vehicles.  HOWEVER, the EV industry is massively fragmented following the SPAC wave which brought dozens of EV-centric companies into the public market.  All are vying with the incumbent automakers to capture enough market share to survive.  Almost all will fail.  History repeats itself - there were hundreds of car companies created through the 1950’s.  All but a few failed.  Of the new entrants, we expect Tesla to make it.  Probably Rivian.  Maybe one other.
• Hydrogen – Even with post-IRA US government subsidies of $3/kg, hydrogen is still a long way from economic.  Major industrial companies are allocating R&D and pilot money toward hydrogen projects.  Hydrogen will likely follow in the footsteps of wind and solar, gradually coming down the cost curve thanks to massive subsidies and many low/negative return investments.  Commercial success is too far away to be excited about the public companies in the space.
• Wind & solar – Blasphemy!  Wind and solar will see the biggest capital allocation of all decarbonization technologies.  Installed capacity will grow dramatically over the next decade.  So why be gunshy?  On a risk-adjusted basis, the sheer quantum of capital being deployed argues that returns are being competed to unattractive risk-adjusted levels.  Government and socially-driven capital is willing to own renewable power for 6-8% unlevered returns.  And those returns assume nothing goes wrong from an execution perspective over the next 10-20 years.  Many projects are one event (such as the Texas winter storm Uri) away from being breakeven.  No thank you.

Things change fast.  Our views above could change quickly depending on market conditions and subsector valuation.

Overall, we expect the general trajectory of the Energy Transition to be up and to the right.  A secular trend.  Within that trend, we’ve already seen dramatic volatility and expect this to continue until the winning pathways to decarbonization are identified, which will probably take 5-10 years.  Exciting, nerve-wracking and worthwhile.  We look forward to providing future quarterly updates – it won’t be boring!

Please remember the PEP organization is standing by to help – whether it be investment exposure, capital needs, energy market intelligence or help with a specific problem. As always, we appreciate your interest and welcome your questions.

1. Source: Bloomberg

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