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THE UPSIDE CASE FOR PIPELINES – PART 2

 * Simon Lack, Portfolio Manager
 * January 12, 2022
 * 5 minute read

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As we noted last week, the world doesn’t need another anodyne “2022 Outlook”. So
we’ve put together a set of upside scenarios that are plausible but not
consensus.

Last week we published The Upside Case For Pipelines – Part 1. This examined
factors unrelated to commodity prices that could provide the sector a boost.
This blog post considers what might boost oil and gas prices, which would likely
provide a lift to the sector.

They fall into four categories – cyclical, geopolitical, Covid and the energy
transition.

1) Cyclical factors that are bullish

Reduced growth capex has become a positive habit for the energy industry.
Depletion of oil and gas wells is 2-4% of production – meaning that the industry
needs to invest in that much new supply just to stay even. Crude oil demand has
obviously been volatile over the past couple of years, but looks likely to reach
new record levels over the next couple of years, driven by growth in emerging
economies. The industry seems poorly positioned to meet this extra demand.



Capex is down 2/3rds from its 2014 peak, and the industry shows little
inclination to boost it in spite of high prices and entreaties from the
Administration. RBN Energy expanded on this theme in September (see Where Has
All The Capex Gone? E&P Investment Down Despite Rising Prices And Cash Flows).



Global oil inventories have been drawing down since early last year, leaving
little excess available. Moreover, OPEC countries are producing well within
their stated capacity, which leads some to suspect that their actual maximum
production capability is less.



The story is similar with natural gas, except that global demand is more clearly
rising. Because transportation costs are relatively high, regional prices vary
substantially. TTF futures, the European natural gas futures benchmark, are
priced at the equivalent of $26 per Thousand Cubic Feet (MCF) for January 2023,
lower than the $29 equivalent price of the front month January 2022. US prices
are one seventh of this, so the prospects for continued growth in shipments of
US Liquified Natural Gas (LNG) to Europe and Asia look good.



Against this positive backdrop for prices, it’s worth remembering that oil
services companies shrank payrolls in response to the drop in capex, so even if
spending did ramp up it would take time for the industry to rehire and retrain.

Lastly, economies around the world have been improving their energy efficiency.
The US is no exception. Adjusted for inflation, it takes 60% less energy per $
of GDP output than was the case in the 1970s. Therefore, energy prices have a
smaller impact on the economy today, making it better able to withstand higher
energy prices than in the past.



2) Geopolitical factors that might surprise

The middle east remains one of the less stable regions of the world. A fifth of
the world’s crude and an increasing amount of natural gas pass through the
Strait of Hormuz. Although it’s unlikely Iran could ever cause more than a
temporary disruption to supplies, the threat remains, along with the possibility
of conflict breaking out elsewhere. The world has very little spare capacity, so
is vulnerable to surprises here. A failure in the Iran negotiations over nuclear
weapons would keep Iranian oil mostly off the world market.

Russia’s growing military threat to Ukraine is another flashpoint where armed
conflict could disrupt supplies of Russian natural gas to western Europe.
Nordstream 2, the controversial natural gas pipeline from Russia to Germany, is
completed but not yet operational pending German and EU regulatory approval.
Conflict in Ukraine might delay its start indefinitely – likely a factor behind
the elevated price of January ‘23 TTF natural gas futures noted above.

3) Covid loses its ability to disrupt

The Omicron variant is highly infectious and milder than preceding variants. It
is causing far fewer hospitalizations and research shows why it’s causing less
severe illness (see Studies Suggest Why Omicron Is Less Severe: It Spares the
Lungs).

Economic disruption from Covid has come mostly from the mitigation steps
countries have taken to curb its spread. In the near term, Omicron’s fast rate
of spread is likely to drive global supply disruptions in a more synchronized
matter. Former FDA Commissioner Dr Scott Gottlieb has become a widely followed
resource on covid, and he expects in 2022 we will “…go from a pandemic into a
more endemic phase,” as countries learn to live with Covid without noticeable
disruption.

As the world opens up, energy demand will increase especially in Asia where many
borders have remained partially or fully closed. International air travel
remains the one weak point in liquids consumption, and a rebound could push
crude prices higher. We’ve already seen prices reach $80 recently without these
sources of extra demand.

4) Energy transition

So far there’s little sign that renewables are reducing the world’s demand for
oil, gas and coal. Higher prices for fossil fuels remain inevitable if consumers
are to switch to other forms of energy. The failure of COP26 in Glasgow may lead
to renewed unilateral efforts by policymakers to reduce emissions. Curbing coal
remains the obvious target – consumption limits or wider use of carbon taxes
would drive demand for natural gas as the closest substitute, and to a lesser
extent crude oil.

New Year’s Day brought an encouraging report that the EU will classify nuclear
power and, in certain cases, natural gas as “green” energy. The requirements for
natural gas include that it’s being used to replace coal, and that its emissions
are no higher than 270g per Kilowatt Hour (KWh). Natural gas emits 180g per KWh,
so even allowing for conversion losses this ought to be an achievable benchmark.

Assuming the news report is comfirmed, EU endorsement of natural gas as part of
the energy transition solution is a long term very postive development for the
natural gas industry. It will likely add momentum to emerging economies and
perhaps even the US to adopt a similar approach. It should be supportive of
natural gas demand and correspondingly negative for coal.

The energy crisis of 2021, which exposed some countries’ overly hasty embrace of
renewables, showed that traditional sources of energy are vulnerable to sudden
price jumps.

Any of the factors above or some in combination could drive oil and gas prices
higher, potentially much higher, which would support already improving sentiment
in the energy sector.

We have three funds that seek to profit from this environment:

Energy Mutual Fund
Energy ETF
Inflation Fund

Please see important Legal Disclosures.

The post The Upside Case For Pipelines – Part 2 appeared first on SL-Advisors.

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SIMON LACK, PORTFOLIO MANAGER

Simon Lack is Founder and Managing Partner of SL Advisors, LLC. Mr. Lack is
Portfolio Manager of an energy and infrastructure fund at Catalyst Capital
Advisors LLC. Mr. Lack’s experience includes: Managing Director, JPMorgan Global
Trading Division and CEO, JPMorgan Incubator Funds. Mr. Lack has authored The
Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True
(January 2012) and Bonds Are Not Forever: The Crisis Facing Fixed Income
Investors (September 2013).

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‹›


LATEST POSTS

THE UPSIDE CASE FOR PIPELINES – PART 2

January 12, 2022 3:37 pm | Simon Lack, Portfolio Manager

Last week we published The Upside Case For Pipelines – Part 1. This examined
factors unrelated to commodity prices that could provide the sector a boost.
This blog post considers what might boost oil and gas prices, which would likely
provide a lift to the sector. Read more



WHY IRON ORE PRICES MEAN MORE THAN YOU THINK

January 5, 2022 9:40 am | Jacob Shapiro

If you were a commodities-focused investor and had success over the last decade,
iron probably had something to do with your performance. Indeed, according to
this chart from S&P Global Platts below, iron ore futures "drastically"
outperformed most other metals and mining equities since 2015. Read more



THE UPSIDE CASE FOR PIPELINES – PART 1

January 4, 2022 8:50 am | Simon Lack, Portfolio Manager

Part 1 of a two-part look at what could create upside surprises for midstream
energy infrastructure. The downside is well understood and was experienced in
full force quite recently. On March 18, 2020 the Alerian MLP Index (AMZIX)
closed down 67% for the year. The broad-based American Energy Independence Index
(AEITR) was marginally better at down 63%. There’s no plausible downside
scenario that can beat that for a live ammunition drill. Within 19 months the
two indices had rebounded 220% and 264% respectively. Read more



INFLATION’S UPSIDE RISK

December 20, 2021 1:08 pm | Simon Lack, Portfolio Manager

The media referred to the Fed’s “hawkish pivot” following Wednesday’s revised
dot plot and faster taper. More accurate is that chair Jay Powell confirmed that
the FOMC was following the market’s earlier revisions to the rate outlook.
Eurodollar futures traders and the Fed are once more synchronized over the next
couple of years in looking for the Fed Funds rate to reach around 1.5%.
Forecasts diverge beyond that, with fixed income traders comfortable that rates
will peak, whereas FOMC members expect continued increases. When it comes to
forecasting even their own actions, history shows the Fed has much to be humble
about. Read more



WHEAT PRICES CRITICAL FOR 2022

December 17, 2021 8:44 am | Jacob Shapiro

Since launching our ambitious series on commodities, we have spent a significant
amount of time on energy. That's with good reason: according to the latest
reading of the U.S. Consumer Price Index that has markets jittery and the
Federal Reserve dreaming of interest rates, energy prices are up 33 percent,
compared to 6.8 percent for all goods. But if energy prices have spiked
suddenly, hiding in plain sight of the global inflation story are food prices,
which have steadily increased since May 2020, when pandemic-related economic
shutdowns started impacting agricultural supply chains. Read more






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