Despite some challenges, infrastructure investment is essential across the US.

The upcoming November election has dominated the US media headlines, with the contest expected to be tight. Anecdotal conversations with management teams at the time indicated domestic concerns mirror international concerns – whether either President Joe Biden or Donald Trump were fit for office, and the impact their policies could have on economic progress, as well as the clean energy transition. President Biden has since announced he will not run for a second term, and the Democrats have nominated Kamala Harris as the party primary to run against Donald Trump.

While the Democrats are focused on supporting the energy transition and supporting working class jobs through the continued onshoring of select industries back to the US, Donald Trump is focused on supporting the exploration and production of traditional fossil fuels, reducing regulation and red tape, and extending tax cuts he implemented in his first term. Tax rate reductions are scheduled to expire in 2025, but it is widely expected that Trump will fully extend the tax cuts he previously implemented, while his election opponent in Kamala Harris will also extend components of the reductions, both putting upward pressure on budget deficits and inflation.

In terms of trade restrictions, the Democrats are likely to maintain tariffs on select Chinese goods and support the onshoring of manufacturing back to the US. Trump has communicated the more aggressive position for a universal tariff of 10 per cent on all imports, and 60 per cent on Chinese goods. The economic impacts of this could cause stagflation for the US economy, a real fear among economists.

Turbo charged load demand to favour infrastructure

For the first time in decades, many electric utility companies expect rising power needs, driven by several factors including population growth, on-shored manufacturing, especially from technology companies supported by the US Chips Act, and electrification in the transport, space heating and the oil/gas industries. Data centre demands and the rising energy needs of artificial intelligence (AI) is also a recurring theme.

Questions centre around whether utilities maintain their guidance of growing earnings at 4 to 8 per cent a year, or whether increased load demand will push this higher. The resounding feedback we hear from utility management teams is that increased load demand growth is expected to support the investment proposition of utilities, not change it. Companies are more likely to hit the higher end (or just above) their earnings growth guidance ranges but are unlikely to significantly change their long term guidance to the market.

Management teams are cautious about data centre energy demand. It is felt that some communicated demand from big tech companies developing data centres such as Amazon, Meta, Microsoft and Google may not eventuate. If utilities make investments to facilitate that expected load, and it doesn’t eventuate, the cost of that investment would be spread over the remaining customer base, negatively impacting affordability of regular residential customers. This is a major concern for both regulators and utility companies.

The impact of environmental policy on utilities led energy transition

Donald Trump has also communicated that he intends to repeal Biden’s Inflation Reduction Act (IRA) which supports renewable energy sources, and electric vehicles (EVs) through tax credits. Commentators suggest he may only repeal components of the bill such as support for EVs.

Trump has instead communicated the intention to support drilling for traditional fossil fuels in oil and gas, potentially through streamlining the permitting process for drilling and pipeline development. This would be supportive of investment in midstream infrastructure companies which transport oil/gas from production wells to demand centres. Gas pipelines are perceived as central to supporting the intermittency of renewables in the energy transition process.

This policy changes by Trump could be detrimental to companies investing in the clean energy generation, as well as the electric utility sector. Most electric utility management teams have communicated a desire and ability to deliver their generation plans under either the Democrats or Republicans in government. This is based on focusing on the economic benefits of renewable generation for customers, and delivering in line with state based legislative mandates.

The need for asset replacement and hardening to support reliability and safety

Reliability is potentially the key focus of legislators and regulators across the US. Ensuring electricity and gas supply is not only essential for business operations, and therefore economic growth, its demanded by all customers and therefore a sensitive political issue. Regulators demand reliability performance of electric and gas utilities, and are supportive of investment to facilitate it. Companies are replacing aging infrastructure, as well as adopting modern technology to support maintaining/improving reliability in ever increasingly difficult environmental conditions.

Reliability and safety investment for utilities is focused on replacing ageing assets, but also hardening the network against the increasing frequency and ferocity of natural disasters, such as wildfires and tropical storms. This is to ensure that electricity networks don’t ignite fires, causing massive legal liabilities for companies, and to reduce damage and network interruptions in the case of tropical storms. Over recent years wildfire liabilities have forced at least one utility into bankruptcy, causing significant disruption in the delivery of service to their customers, and wiping out shareholder value.

With increasing demand for baseload power generation through gas, and increasing concerns around energy reliability, the environmental focus on reducing gas utilisation has subsided. Gas utility management teams have outlined anecdotal evidence from discussions with regulators that they understood that gas networks would be around for decades, and the investment in them will be maintained for the foreseeable future. Importantly, regulators across US states still largely support the replacement and modernisation of gas networks, to ensure safety and reliability for customers.

Allocating to assets in the region

As the markets wrestle with the timing and magnitude of interest rate cuts, this will no doubt feed into US infrastructure valuations over the second half of 2024 and into 2025. The fear that politically motivated fiscal policy could ignite inflation and put upward pressure on interest rates again is a risk to valuations. In addition, markets currently believe there is roughly a 50 per cent probability that the US economy encounters a recession. The earnings resiliency of infrastructure stocks would be appreciated by investors as compared to other sectors if a recessionary scenario plays out.

Despite some challenges, infrastructure investment is essential across the US. This investment should support consistent, predictable earnings growth for investors over the long term, with the defensive qualities of infrastructure likely being favoured by investors.

By Peter Aquilina, portfolio manager – sustainability

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What are the long-term prospects for natural gas and midstream infrastructure assets as an investment opportunity?

While the speed of ultimate decarbonisation remains unclear, there appears to be a real opportunity for multi-decade investment as every country moves towards a cleaner environment.

In this article, Peter Aquilina (Senior Investment Analyst and Head of ESG) analyses what the global Net Zero goal means for natural gas demand in the long term; and discusses how 4D analyses and values oil/gas midstream assets, considering both the risk and opportunity as we move towards Net Zero.

1. Paris Agreement commitments

The headline goal of the Paris Agreement is to limit global temperature increases to well below 2°C, preferably to 1.5°C, compared to pre-industrial levels. To achieve this goal, parties to the Agreement aim to reach global peaking of greenhouse gas (GHGs) emissions as soon as possible, so as to achieve a balance between anthropogenic emissions by sources and removals by sinks of GHGs^[1] in the second half of the century. Broadly speaking, signatories to the Paris Agreement are looking for Net Zero emissions by 2050.

As of November 2021, 193 states and the European Union are parties to the Paris Agreement (a further four countries are signatories, but are yet to ratify the agreement). These parties to the Paris Agreement cover approximately 98% of the world’s human-made emissions – a depiction is shown below.

Many countries outlined their current Net Zero plans at the recent UN Climate Change Conference (UNCCC) in Glasgow (GOP26) in late 2021. Within these plans, most countries also outlined interim decarbonisation commitments for 2030. These interim targets are intended to provide a more tangible medium-term target for countries to establish detailed plans and to indicate the pace of GHG emissions reduction.

Albeit the pace of decarbonisation between now and 2050 is still unclear, there seems to be widespread political support to achieve Net Zero. This will no doubt create a strong push to decarbonise economies globally, providing opportunities and risks for investors, especially for certain infrastructure sub sectors, such as midstream oil/gas.

The rest of this article looks at how 4D balances this opportunity with risk for this sector in particular.

2. Balancing conflicting challenges

With roughly 25% of all global emissions coming from electricity generation alone, it’s clear the energy sector is central to achieving a Net Zero goal. However, this goal cannot be viewed in isolation, and energy market participants must balance carbon reduction strategies with other social obligations.

In summary, we believe there are three main targeted outcomes for energy market participants as they seek balance between energy transition, political goals, and customer satisfaction:

1. Power needs to be affordable to customers.
2. The delivery of power needs to be reliable and consistent.
3. GHG emissions need to be removed or offset in the shortest time possible.

An additional consideration is to support economic growth, predominantly through employment and investment. The balancing of these factors may vary depending on the perspective of the individual or government. However, these three (or four) targets are typically prescribed by all energy market participants and stakeholders.

3. Benefits of natural gas to energy markets

Natural gas has inherent qualities which support the above targets of affordability, reliability and GHG reduction.

• Versatility: natural gas power generators can technically be turned on and off quickly as compared to other baseload power sources such as nuclear and coal. This makes peaking gas generators a strong compliment to support renewable power generation and ensure ongoing security of supply.
• Storable: natural gas can be stored in underground salt caverns in large volumes for long periods of time, which also makes it a strong complement for renewables.
• Transportable: natural gas can be transported within existing pipeline infrastructure, or can be converted into liquid by cooling to -162 degrees Celsius and transported by ship/rail, even internationally.
• Plentiful: natural gas is relatively plentiful and available in many geographic locations, with the International Energy Agency (IEA) estimating that there are enough recoverable resources to last around 230 years.
• Affordable: according to Lazard investment^[2] bank research, the most efficient gas fuelled power generator has an all-in cost (as measured by Least Cost of Energy (LCOE)) of between US$44 – US$73 / MWh, which is the lowest of fossil fuels (coal generation between US$65 – US$159 / MWh);
• Cleaner: burning natural gas results in fewer emissions of nearly all types of air pollutants than burning other fossil fuels. Natural gas generation releases about 117 pounds of CO2 million British thermal units (MMBtu) equivalent compared with more than 200 pounds of CO2 per MMBtu for coal, and more than 160 pounds per MMBtu for distillate fuel oil^[3].

The above attributes make natural gas an important transitory energy fuel in maintaining reliability and affordability for customers as the world transitions away from GHGs. It is on this basis that we expect to see significant ongoing global demand for natural gas and the assets that transport it.

4. Long-term prospects for natural gas

Forecasts of the pace of GHG emissions reduction, and demand for natural gas in the long term, can be fraught with error and/or bias. A number of stakeholder groups have commissioned their own studies and forecasts from various consultants, which may cynically have a pre-determined goal that needs to be supported by the analysis. It is impossible to determine which, if any, forecast will be correct, and it is often difficult to understand if any particular forecast has inherent bias assumed within it.

Based on the views and forecasts of independent industry agencies and energy consultants, we are confident that natural gas will have a role to play in the energy mix in the very long term. Based on our review of a number of forecasts and studies, we are of the view that:

• Achieving Net Zero emissions AND maintaining global temperature increases to 1.5°C by 2050 is becoming optimistic, if not unrealistic, due to the limited progress in setting and/or achieving national short/medium-term decarbonisation targets.
• There could be some decline in natural gas demand by 2050, although the magnitude varies widely between decarbonisation forecasts. A more aggressive, yet reputable Net Zero scenario developed by the International Energy Agency (IEA) implies a 39% reduction in volume demand compared to 2020, while others assume very little demand erosion.
• There is unlikely to be a significant reduction in natural gas demand by 2030.

5.  What does this mean for the long-term prospects of the midstream sector?

At 4D Infrastructure, we define the ‘midstream’ sector as the infrastructure used in the transportation, storage, extraction and refining of natural gas, natural gas liquids (NGLs) and crude oil. Midstream is the ‘glue’ between upstream E&P and downstream distribution.

With the transportation of oil and gas remaining the core business of midstream companies for the reasons discussed above, we see a longer ongoing demand profile for those transporting gas. However, there are also potential future opportunities for companies to re-use (and re-purpose) their assets and expertise in a Net Zero world. The expertise of midstream management teams in managing energy infrastructure is easily transferable to no/low carbon fuels. In addition, the prominent position of terminals in industrial hubs and pipeline assets in connecting demand centres provides a good basis for utilisation for low/no carbon fuels such as hydrogen, CO2 from CCUS, renewable natural gas (RNG), and other biofuels.

Taking all of the above into consideration, we believe the core business for the midstream sector in transporting oil/gas is almost certain to be maintained through the period to 2030. Further to that, even assuming aggressive decarbonisation scenarios, there is still likely to be utilisation of select midstream assets in 2050 and beyond. Beyond this, there is the opportunity for companies to reposition their business and re-use their assets and skills for low/no carbon fuels. Midstream assets connected to oil/gas basins with economic and geographic competitive advantages, and to demand centres (domestic and international), are likely to be heavily utilised in the long term. This doesn’t consider the potential for assets to be repurposed to carry low/no carbon fuels such as hydrogen, CO2 from CCUS, renewable natural gas (RNG) and other sustainable biofuels.

6. Investing in midstream gas assets

We believe that midstream companies satisfy our definition of infrastructure, although their specific characteristics could put them more at risk of being stranded in the very long term (>2050) under some aggressive Net Zero scenarios. However, even under aggressive decarbonisation scenarios, midstream companies with strategically placed assets connecting the lowest breakeven cost, natural gas basins are likely to be heavily utilised in 2050 and beyond.

Some of the due diligence and valuation considerations we adopt in selecting the best midstream names in the sector and valuing them appropriately include:

• Adopting a base case in valuation models assuming that Net Zero is achieved to some degree by 2050: global temperature growth is maintained at or below 2°C.
• Strong preference for midstream companies that operate in natural gas directed basins: natural gas is often a by-product of exploration & production (E&P) companies drilling for crude oil. The decision around continued production is based on the economic value of crude, so this production is often cut when the economics for crude production are not satisfied.
• Adopt conservative assumptions: only incorporate growth assumptions for contractual price uplifts and associated with development projects that have been secured by management. Do not include any market growth associated with long-term forecasts.
• Not valuing ‘blue sky’ opportunities: opportunities for midstream companies to re-purpose assets for utilisation with low/no carbon fuels is only in its infancy, and although a great opportunity, it is not currently being significantly valued in our models.
• Conservative terminal value assumptions: acknowledging the uncertainty for growth associated with any fossil fuels beyond 2050, and its impact on earnings of midstream assets, we adopt conservative terminal value assumptions.
• Scenario analysis: run scenario analysis within models to determine the impact on valuations under a number of different decarbonisation trajectories.
• Due diligence for competitive advantages: develop a strong understanding of the competitive advantages of the various gas supply basins and which are likely to continue to be economic for E&P producers in a potential low demand, low price environment. This provides confidence in utilisation post 2030, as gas prices potentially decline in line with reduced demand. Alternatively, we look to understand which arterial pipelines are likely to be utilised in connecting demand centres and export terminals in the long term. Interconnection of assets from the wellhead to demand centres and export terminals ensures utilisation throughout the value chain.
• Quality assessment: we undertake a detailed quality assessment, which incorporates an assessment of the quality and competitive advantages of company assets (point above), but also contractual defensiveness, ability to transition the business model into low/no carbon fuels, management quality, and financing position. This all provides insight into the sustainability of the business model.

7. Conclusion

There is significant uncertainty as to whether the globe will be able to maintain global temperature increases to ‘well below’ 2°C in line with the Paris Agreement. Despite the communicated target of most countries, the challenges to achieving this goal are great.

Irrespective of the world’s long-term carbon trajectory, most industry forecasts assume that natural gas has a role to play in the long-term global energy mix. Even assuming aggressive GHG reductions are achieved, and the globe is able to maintain temperature increases to below 2°C, natural gas volumes are still expected to be significant in the longer term. This is because 1) developing nations will still likely utilise natural gas after 2050 for energy production, and 2) natural gas will be used in combination with CCUS, carbon sinks and in the creation of blue hydrogen. Therefore, based on the continued demand for natural gas, the business model of midstream infrastructure names focused on processing and transporting natural gas is likely to be maintained. There is further potential upside from repurposing midstream assets for use with hydrogen, CCUS, RNG, biofuels and other renewable fuels, which many companies are starting to explore.

We at 4D adopt a cautious approach to investing in midstream oil/gas companies. We undertake significant due diligence regarding the quality of companies and their competitive advantages in the processing and delivery of natural gas. We also adopt conservative base case assumptions with regard to growth and terminal values, and undertake scenario analysis to understand the breadth of potential valuation outcomes. They also must adhere to strict ESG standards and stack up against their infrastructure peers on an overall quality basis. In doing this, we believe the investment proposition of specific midstream names is attractive.

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References:
[1] GHG sinks refers to human-made efforts to remove carbon from the atmosphere and offset a portion of carbon emissions. This can include technologies such as carbon capture as well as nature-based solutions such as reforestation and afforestation.
[2] Lazard’s Levelized Cost of Energy Analysis—Version 14.0, October 2020
[3] Natural gas explained, U.S. Energy Information Administration

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Tasneef joins 4D from Crowe Howarth where he was senior analyst in its corporate finance team, advising corporate and private equity clients on M&A, capital raising and divestments. He has also worked as a fund data analyst at Morningstar.

Peter joined 4D in March and has over 10 years’ experience in infrastructure asset management in Australia and Europe. He was most recently with Lazard Australia in the financial advisory division, where he advised corporates and governments on a number of M&A transactions and strategic reviews. Peter also worked for a number of years in London for First State Investments and JP Morgan Asset Management.

Sarah Shaw, global portfolio manager and chief investment officer at 4D, said the two appointments mean the 4D investment team is now fully resourced and positioned for future growth.

“Infrastructure as an asset class has huge potential, due to a number of powerful macro forces at play which will compel new, improved and expanded infrastructure around the world.

“Global listed infrastructure’s very attractive investment attributes will make it an important part of the financing solution to the world’s infrastructure needs and, we believe, see it continue to grow and prosper over the longer-term.

“With the appointment of two experienced and skilled analysts, in Tasneef and Peter, we now have a team that will allow us to further expand our offering and ensure we can meet the ongoing demand from investors for high-yielding, stable investment options,” Ms Shaw said.

The 4D team now has six investment professionals, following the departure of Michael Morrison late last year.

For the last six months, the 4D Global Infrastructure Fund has returned 21.86%*, significantly outperforming its benchmark, the OECD G7 Inflation Index + 5.5%, which returned 3.61% over the same period.

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