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Energy Smuggling Good

This will be the least popular idea I have shared in almost three decades of stock research. As always, I have no idea what will happen next. That’s why I love this endless work. The only thing I know for certain is that curiosity beats conviction. I have never witnessed a more agreed upon conclusion – that the energy sector is unsustainable at best, and almost completely un-investable. As a portfolio manager I am delighted to be in lonely positions on the other side of that crowded trade. What’s even better for more people, I am curious if improved solutions for better climate aren’t hiding where the convinced crowds would never consider.


Capital will always flow to where it is treated best around the world. Energy companies underperformed the rest of the stock market for over a decade. They made their own terrible investments, over-produced supply and drowned themselves in debt. Then the ESG movement created public pressure to eliminate even one good word said about traditional energy sources, and are forcing institutional funds to sell all energy shares or be fired.


Energy supplies growth. These three words do not make up that popular acronym, but instead provide a bunch of facts instead. But even the crowds of ESG protestors need to take a hot shower at some point. To be clear, I am a dad of five young kids (with zero time for politics) who wants the cleanest and brightest future for all of our families. We have big problems to solve. Better than any new regulation or tax, capitalism will always reward the best problem solvers. That’s why I know there will be wonderful new innovations and technologies developed.


I am wondering if the most unimaginable possibility offers the greatest upside to the environment and investors – improving the use of traditional energy. After all, who better to know where the biggest challenges to solve are, than the industry with the blueprints to the problems?!


We will take a tour of one of those remarkable solutions right around the corner from the loudest critics who are not being taught how capitalism works (which may be no accident, so the value of their tuition isn’t examined more closely). I’m not an engineer or environmental scientist. I will let the example of what is possible speak for itself, when we look at the potential of energy supplying growth to better power plants in just a moment.


What I do know is when a group of stocks is unusually appealing. Never in my career have I studied a better setup than certain energy stocks, made possible by the most crowded conviction that they are doomed. We will look at those facts underneath uninformed opinions.


The Crowds Have Spoken, Loudly



Harvard students filed a complaint in 2021, with the Massachusetts attorney general, in an attempt to force the university to sell its estimated $838 million invested in energy companies.



Harvard’s endowment fund is the nation’s largest. Many others follow the lead of the supposed “smart money” here. The forced selling has been relentless. Most stock investors know that trouble will soon find any industry where buying is done without asking any questions or doing any valuation math. It should make sense then, that an unusually attractive opportunity can be created by just the opposite.



The silliest of all ESG arguments is that cutting access to capital will change behaviors. Large energy companies have no problems finding money. As a matter of fact, they can be so reckless with issuing shares and debt they can destroy themselves just fine on their own. They do it all the time.


Energy companies have bankrupted themselves before with no help from investor restrictions, actually just the opposite. Equity poured into shale projects that never produced cash flow, and destroyed capital chasing expensive projects.


The shale boom was a great lesson in geology and terrible math. The projects produced energy but not free cash flow. Investors were ignoring simple back of the envelope math on how much more expensive these projects were, and how much faster they depleted. More cash was flared than gas.


Then a great thing happened, as it always does on the other side of conviction - weaker hands get eliminated. Speculative projects were cancelled. Excess capacity was taken out. Balance sheets were cleaned up. Management renewed their focus on stakeholders. All while demand never budged. Investors exited the sector at the worst time.




Energy Demand is Profoundly Underestimated


Anybody who wishes to replace petrochemicals underestimates how much of the world’s manufacturing, materials, and supply chains would be erased.


96%+ of all manufactured goods are directly helped by petrochemical industry.

99%+ of pharmaceutical feedstocks and/or reagents come from petrochemicals.


Grasping at plastic straws of products to outlaw is missing the bigger opportunities. Zoom out from our first-world problems and remember close to 700 million people still do not have electricity. THAT’S where our focus, and a clue at the end of this post, makes me most excited about truly helping the environment.


The rest of the world can’t all get solar panels or wind turbines (where it’s not always sunny or windy anyhow). Solar panels and wind turbines account for less than 5% of global energy consumption, and each are manufactured using fossil fuels. In order to compensate for inconsistent wind or solar output, U.S. utilities are forced to use oil and gas burning reciprocating diesel engines. Three times as many of these units have been added to the grid since 2000, as in the 50 years prior to that.



Energy Supply is Historically Under-owned


The amount of oil and natural gas discoveries around the world fell to a 75-year low in 2021 as a result of years of cutting exploration budgets. In the last year alone, new discoveries plummeted 61%.




Capital will go where it is treated best currently, which can leave wide open uncrowded fields of opportunity.


In addition to the big public energy companies cutting back exploration, the private markets dried up for new supply. Banks stopped making loans for energy projects. In the past three years alone the number of energy focused private-equity funds dropped from 29 firms with $90 billion, down to 9 with $22 billion (accd. to RBC Capital Markets research). In 2015, approximately $50 billion new capital was raised by private-equity energy funds. In 2021, less than $3 billion was raised. “There is nobody left, everybody is kind of gone,” said the CIO of one of those nine left standing.


So, we still need a lot of energy and we stopped looking for more of it. What did we think was going to happen to energy prices?



Sticking to the Math


By comparison, investors have been putting $3 billion into alternative energy funds…per day. According to data compiled by Scott Patterson, assets in funds focused on the environment are now over $2 trillion, more than tripling in three years. Additionally, more than $5 billion worth of bonds and loans to support green initiatives are being issued, on average, each day.


Wood Mackenzie estimates at least $50 trillion will need to be invested in alternative energy sources to meet the goals of the Paris climate accord by 2050. 579 new environmental mutual funds and ETFs were just launched in one year.


Burton Malkiel authored the book “A Random Walk Down Wall Street,” an investment classic, now in its 12th edition. For 28 years, he was a Director at Vanguard. He is Professor Emeritus at Princeton. He is Chief Investment Officer at Wealthfront.


Malkiel says, “I’m skeptical about ESG for the following reasons. The idea that is touted with ESG investing is that you can do well financially by doing good. What I worry about is that some of the largest ESG funds and ETFs may do neither. The rating agencies can’t even agree on what ESG is. The correlation between raters is as low as 0.4.”


Personally, I am excited about a few of the innovations that will come from alternative energy. But I am afraid a shockingly large amount of that cash will be incinerated along the way, invested in more stories than facts. As a portfolio manager, I will stick to the math that has never looked better for energy companies when compared to more popular ideas.




It has been estimated that even if there was 100x growth in the number of electric vehicles - to 400 million on the roads by 2040 – that would only displace five percent of global oil demand.


I am not opposed to Tesla, just bad math. I am certain there will be even more disruptive new technologies we can’t even dream of now. That’s the beauty of capitalism, the greatest problem solver the world has ever known. Just remember, those fast-growing clean technology companies need data centers to help pump through gushers of digital data. For every $1 billion spent on data centers, that leads to $7 billion in electricity consumed over two decades. Global spending on data centers is more than $100 billion a year and rising.



Energy Companies Have Never Been More Efficient


“The best customer service is if the customer doesn’t need to call you, doesn’t need to talk to you. It just works.” -Jeff Bezos



Let me give you just one example from our research of how tremendously conservative energy companies are now, for the benefit of their stakeholders. The green lines below are where they are extremely profitable and generate enormous free cash flow: $50 crude oil & $2.50 natural gas.


The best energy companies are making their operations more efficient than ever, applying more conservative math on expectations than ever before, and share a clear desire to reward stakeholders with extra free cash flow – dividends are poised to rise considerably from here. The top two holdings in our dividend growth strategy paid a combined $2.21 per share in dividends in 2019. Those same two dividends climbed to $11.44 per share in 2021.


Over those same three years, the average price of crude oil was only $58 and natural gas was $3. The free cash flow that can be generated by the best operators with those prices now considerably higher, can lead to dividend growth unlike anything I have seen in my three-decade career as a portfolio manager. And, all of this happening while these companies have never been more under-owned by investors. It’s the best math setup of risk vs. reward I’ve witnessed.



Energy Use Could Be Dramatically More Efficient


As I am writing this post, I am on a flight where first-class seats are separated by a tiny curtain about 2x3 feet. That may provide about the same difference in climate for the few rows up front as any new U.S. regulation on domestic energy use.



What we should focus our best and brightest ideas on is how to deliver our better energy technology for more efficient solutions to the rest of the world, to make real climate change improvements. U.S. Energy production and consumption is by far and away the cleanest in the world and getting better every day. THAT is the fact to invest in financially and environmentally.


Remember our Harvard protestors? Their dorm’s HVAC system was quietly humming in the background, with better ideas hiding in plain sight. Quiet improvement is ignored by the convinced narratives, so allow me to share the facts and uncrowded potential for more.


This is the District Energy Facility, just built to power Harvard University. The very first building on its new Allston campus, it is perfectly located for the expanding the School of Engineering & Applied Sciences. The architects of the building won many awards, including “Metropolis Planet Positive” given to the most creative projects that benefit the most people and the planet. It needs natural gas to work.



One of my favorite deep dive researchers, who is very interested in the environment, is prolific author Michael Lewis. About this new building he noted, “With its sophisticated network of interlocking technologies, it can respond instantly to shifts in the demand for electricity. During off-peak hours, it can store up cheap energy by chilling water in an immense 1.3-million-gallon tank. At the same time, the excess heat thrown off by the chilling process is captured and used for heating buildings. The increase in energy efficiency is enormous.”


To disclose a bias, I was not smart enough to attend Harvard University and I have never attended any protest on any topic. It has proven far more profitable to remain curious than ever convinced. I have found the biggest profits are earned by problem solvers. The biggest upside here will be better U.S. solutions for traditional energy smuggling good (the uncrowded ESG) around the world.