After a brief detour, today we resume our Gas Infrastructure Series. We’ll take a look at one of the three key drivers of future earnings growth for energy infrastructure companies.
Focus will be on those with exposure to Permian and Gulf Coast dynamics. We’ll use this framework to underpin our bull case for gas infrastructure stocks in the long-term.
Today we discuss: The Political Backdrop
We’ve already covered:
LT Driver: The Fundamental Case: The Pivot to Electric Vehicles
LT Driver: The Fundamental Case: The Great Gas Debottlenecking
Today we cover:
LT Driver: The Political Backdrop
What we’ve yet to cover:
Deep Dives for TRGP, WMB, EPD, ET, LNG
Let’s get to exploring!
Economics is Law
High commodity prices are no mystery – as we’ve discussed previously, one major driver is the powerful Green Rhetoric constraining supply-side expansions *without* addressing demand and *without* replacing the supply with alternative energy sources fast enough.
Result: higher input costs for manufacturing goods, where margins are so thin that costs must be passed down to consumers to maintain profitability (and stay in business!).
Lets briefly get into the economic viability of a new venture.
If a new venture isn’t economically viable – then tech advancements leading to cost reductions and widespread adoption of the product will be hindered. External labor, capital, and research is only drawn to profitable ventures.
Subsidies and regulation can provide some support and attract capital in the short term. Their ability to drive long-term progress, however, is ultimately contingent upon the economic viability of the venture.
Inorganic market intervention can only take things so far.
We talk about this delicate dance between subsidized technology and eventual adoption in our piece about China’s impressive Electric Vehicle adoption.
Subsidies were key in kicking off progress, but it was only through threading the policy needle and aligning incentives across multiple parties that China could finally ween off subsidies in 2023 - after 13 years.
There were several moments where efforts to scale economically were nearly scrapped entirely due to failure to adopt EVs on both the supply-side (manufacturers wouldn’t make the switch) and demand-side (consumers didn’t want a 100-mile range vehicle with no charging infrastructure!)
Massive continuous subsidies for certain infrastructure inherently limited by the laws of physics cannot be sustainable. It leads to shortages, rationing and austerity measures, the ultimate recipe for entrenched inflation and societal destabilization (see: inefficiencies of the Soviet Union command economy).
Luckily in the case of EVs, battery tech and advancements in infrastructure led to the new technology being able to stand on its own. All those subsidies were not spent in vain.
It may be helpful to extrapolate a simplified hypothetical to see how subsidized infrastructure, whose advancements are limited by the laws of physics (we’ll cover this in a future post) could eventually lead to market inefficiencies - and societal destabilization.
Imagine a Scenario where…
A normal 5% of your take-home pay is used to fuel your fossil-powered travels. This comes at the expense of rising CO2 concentrations, which could lead to a global catastrophe. No one wants that.
New subsidies have been implemented by the federal government. Now you can opt for cleaner methods of travel and still pay 5% your take-home for it. You spend the same amount of money, AND you get to save the world? We adopt this cleaner tech. No brainer.
Eventually..
Subsidies wean off as state and federal debt obligations soar.
All of a sudden, 10% of your take-home pay is directed towards clean travelling, then 20%, then 30%..
Saving the world no longer appeals to you. You’d like to save yourself and your family first. Now that significant personal sacrifice is involved you begin to question your beliefs. You become enraged over the hard-earned capital being siphoned from you due to adopting this cleaner tech.
Multiply this sentiment by hundreds of millions, and it becomes clear how this all unravels.
This is why we believe a reversal of the current environmental subsidy and regulation narrative is inevitable.
It simply isn’t sustainable – neither economically nor socially.
By the time the narrative reversal occurs however, the world would be in a vastly different state than it is today. Centralized control over energy production and distribution, lower quality of life from higher living costs, universal basic income, and migration to lower energy-cost regions are some potential scenarios that could play out.
However, one scenario is inevitable..
The ongoing Net Zero by 2050 narrative will continue to cut off supply-side expansions while demand for the energy-dense hydrocarbons continues to rise globally, leading to perpetually elevated fossil fuel prices.
This is the main driver underpinning our thesis for a multi-year Commodity Supercycle.
Energy Market Dislocations Abound
Until policymakers and the public recognize the importance of energy abundance and affordability, there will continue to be massive dislocations across energy markets. We believe the value of natural gas assets that are currently on the ground will increase substantially as the narrative of fossil fuel demonization continues.
Here’s why we focus on infrastructure, like pipelines, storage facilities, processing plants, fractionators etc.
Once an asset is built and in operation, especially in energy infrastructure, it becomes exponentially difficult to implement regulations. Many businesses and citizens grow to rely on the new asset, directly supporting the livelihoods of many. After several years of construction, the asset becomes difficult to retrofit or alter. Any regulations that could disrupt operations of the midstream asset would have an immediate adverse impact on everything that grew to rely upon it.
Regulation is being imposed on new energy infrastructure assets so that they do not get to the point of consumer reliance. This is why we focus on infrastructure – the value of the assets already in service will only continue to increase as it gets increasingly more difficult to build new assets.
Infrastructure constraints, regulatory uncertainty, and rising energy security are some of the main contributors to the future increase in value of natural gas infrastructure assets
1. New Infrastructure Construction Driving Legacy Asset Demand
There are many examples of last-mile energy infrastructure assets that never crossed the operational finish line due to regulation. Keystone XL is the most famous example, followed by the Mountain Valley Pipeline (MVP), the PennEast Pipeline, and many others.
MVP was originally announced in 2014 with a target completion date of 2018. The massive 2 bcf/d pipe would provided the much-needed takeaway capacity out of one of the most prolific natural gas basins in the world – the Appalachia Basin. The pipe would have connections to other infrastructure assets and connect to demand centers in Mid-Atlantic, Southeast, and Gulf Coast, all of which are experiencing higher natural gas demand from either coal plant retirements or increasing international demand.
In 2023, the pipeline remains unfinished despite being over 90% complete for several years not. Its status has been in constant regulatory limbo. Environmental groups, landowners, U.S. Fish and Wildlife Service, Virginia Department of Environmental Quality and many others have vehemently opposed the completion of the pipeline’s final leg.
This led to billions of dollars in cost overruns. The increasing difficulty of building energy infrastructure inherently raises the value of those already on the ground.
KMI 0.00%↑ , WMB 0.00%↑ , and ET 0.00%↑ are some companies that have significant natural gas infrastructure assets in the Appalachia region. Pipeline transportation services have become increasingly more valuable as producers look to secure longer-term contracts for capacity takeaway. Those with spot capacity available also enjoy capturing the arbitrage between regions lacking natural gas supplies and Appalachia gas hubs, which are flush with gas and trade relatively cheaper to other hubs.
Regulatory constraints for new energy infrastructure assets ultimately lead to higher value for legacy energy infrastructure assets, as demand for the hydrocarbons continues to grow with little options to serve as an outlet to reach these demand centers. This leads to market dislocations, the frequency of which only increases as more anti-free market policies come into play.
2. Regulatory Uncertainty Driving Infrastructure Demand
No one wants to invest in an asset that has a 10+ year payback period when they don’t even know if legislation would deem those assets obsolete. A good example of this is the constant threat to ban drilling in certain parts of the U.S. Why spent $ millions in such an uncertain regulatory environment?
A direct quote from E&P management in December 2022:
“Geopolitical risk, economic uncertainty, material and/or labor shortages and an administration that is hostile to the industry have made it difficult to project what the next 12 to 18 months will be like for the upstream sector.”
Companies would rather maintain operations rather than invest in growth. Coupled with the steep decline rates of shale, lower levels of production growth is inevitable. This will lead to higher-for-longer fossil fuel prices, particularly natural gas as the influx of demand from The Great Gas Debottlenecking on the Gulf Coast will come into full force by mid-late 2024.
Infrastructure companies with assets positioned for this trend are set to benefit as demand for their transportation, processing, and fractionation services increases alongside commodity prices.
3. Energy Security Driving Infrastructure Demand
The invasion of Ukraine by Russia on February 24th drastically altered the global commodity trading landscape. It led to a brief period of spikes in various commodities, though as we talked about here, “Putin’s Price Hike” was only a partial contributor to overall fossil fuel price increases.
Regardless, the impact of the invasion sent a shockwave throughout the world, upending commodity markets everywhere. Supply chains were re-routed and re-established, leading to severe market dislocations that impacted people individually.
This is leading to nations putting energy security front and center, which is one of the key aspects of the current de-globalization trend.
This de-globalization will come at the expense of higher energy and commodity prices, but will be more advantageous in an era of rising geopolitical instability.
There are countless pieces out there discussing the importance of energy affordability and abundance on a fundamental level. We talk about the First Principles here. Lyn Alden has some great insight on the topic, as well the partners at Goehring & Rozencwajg.
In short, Energy affordability + abundance leads to:
→ higher energy consumption per capita
→ more energy spent on innovation and tech advancements
→ higher GDP per capita
→ greater levels of happiness (higher quality of life)
Nations will have to balance their willingness to do whatever it takes to achieve Net Zero by 2050 with increasing energy supply to avoid reverting to pre-Industrial Revolution means. Energy Security measures will only make the shift more difficult, as higher commodity prices will be exacerbated by increased manufacturing of the energy and commodity-intensive solar and wind infrastructure.
There’s no doubt that companies with exposure to energy production and transportation are set to benefit greatly from this political trend
Wrapping Up
Legislation and ESG narratives will surely dictate the flow of labor, capital, and research towards renewable and emissions-reducing infrastructure. However, economics will be the deciding factor for their eventual adoption in the long-run. Given physical limitations, commodity-intensities, energy generation inefficiencies, and overreliance on a handful of countries for key renewable materials, subsidies are unlikely to lead to organic economic viability.
Dislocations will arise - as we’ve witnessed in Europe, California and other parts of the world - and force investors to deploy capital to more reliable and sustainable energy infrastructure.
The Political Drivers driving value to natural gas infrastructure assets - and consequently the stocks associated with them - can be attributed to increasing fossil fuel legislation and restrictive capital. This has the unintended consequence of driving regulatory uncertainties, a severe lack of infrastructure projects, and a growing need for energy security.