May 8, 2017
Interviewed by: Privcap
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TPG: Investing in the Energy ‘Bottleneck’

The coming deregulation of the US energy industry will set off a private capital investment wave that will finally address the massive infrastructure “bottleneck” of the oil and gas market, say two market veterans. Also discussed: How to assess the accelerating productivity of fracking, the changed outlook for renewable assets and potential “black swan” events that will dramatically alter the energy landscape.

The coming deregulation of the US energy industry will set off a private capital investment wave that will finally address the massive infrastructure “bottleneck” of the oil and gas market, say two market veterans. Also discussed: How to assess the accelerating productivity of fracking, the changed outlook for renewable assets and potential “black swan” events that will dramatically alter the energy landscape.

Investing in the Energy “Bottleneck”

David Snow, Privcap:
Today, we’re joined by Joe Brusuelas, Chief Economist of RSM, and Chris Ortega, who leads the energy investment practice at TPG Capital. Gentlemen, welcome to Privcap. Thanks for being here. We’re talking about the energy sector and the important changes taking place there that will have an impact on the U.S. economy and which present an investment opportunity. I’m fascinated to hear both of your views on that. Why don’t we set the stage on how you track important macro changes in the energy market or in the U.S. economy that might affect the energy market? Joe, what indicators do you follow that you think are most important in really understanding what’s going on?

Joe Brusuelas, RSM:
I think the first thing to recognize right now is that, given the current macro outlook, energy really is in many ways the only game in town. And I look at the energy market in two ways: first, I’m looking at the deregulation that’s going on in Washington right now. During the Obama era, there were 3,000 regulations that were put in place that carried a dead weight loss of around $872 billion. That’s enormous. And what’s interesting is that the energy sector bore about two-thirds of that cost. It was only 439 regulations put on the energy sector, but they were so broad and sweeping that it created an enormous dead weight across the entire sector, which we now see coming back to life.

Second, I’m obviously looking at inventory. We’ve seen the inventory build quite dramatically here. I think we’re just north of 9.1 million barrels per day and, given the fact that Saudi Aramco is going to issue an equity offering over the next couple months, we really do see a fairly large increase in supply.

Chris Ortega, TPG Capital:
What we really try to spend our time on is what’s happening to the marginal cost for the incremental barrel. And that, more than anything else, just as much as if you look in whether it be internet or other industries, is a technology-driven story.

What we’re really focused on is what’s the marginal cost for each additional barrel? That’s really been the story of the shale revolution in the U.S. And one of our big conclusions is that we’re just still in the middle innings, so there’s a lot more to come.

Snow: How do you track rate of change? What are some indications from the oil field that, to you, indicate that production is getting more and more efficient?

Ortega: If you were to look at some of the historic indicators, people would look at things like rig count, for example. In the mid-2000s, we hit 2,000 rigs. Right now, we’re up a bit above 800. And…what that suggests to us is that’s no longer the right indicator. What we’re really looking for more than anything else is the efficiency that comes back from dollars spent. And the amazing place where we are today is we’re growing our oil production. We’re growing our gas production with one-third of the rigs we had seven or eight years ago.

So, what we really spend our time on is looking at the efficiency of each one of those wells being drilled. For every dollar you put in the ground, how many barrels of oil or molecules of gas are you getting out?

Snow: Joe, you clearly are looking very carefully at trends taking place in the U.S.—regulatory trends and some supply trends. What is going on around the world by way of either demand or geopolitical events that you think will make the biggest impact on the energy sector?

Brusuelas: I think the number-one thing this year is a rebound in global demand—that we are seeing the global economy actually accelerate. We will be well above 3% for the year and we could reach 4%, which of course is a very good narrative in terms of overarching demand. If you just take a look at the global economy and you think that, if the global economy just performs at its current level—which has been somewhat disappointing, not something outstanding—we’re going to see an increase in demand. We’re going to have to increase extraction and supply and that’s a good story. When you link that back here to the U.S., you need to think about our energy distribution infrastructure, putting in the pipelines to move oil and natural gas. Right now, we have bottlenecks all over the place. But with the deregulation that’s already in place and to come, I would expect that to ease in coming years, which of course presents an enormous opportunity for the United States.

One little unknown statistic: who do we export our oil to? Who’s our number-one purchaser? Most people would say Canada. It was for many years, but now it’s China. We’re in a different global economy.

Ortega: I think the LNG space is another interesting part, because you are starting to see the U.S. really become that incremental supplier in the market. And it’s at a time where other areas like Australia (which folks thought was going to have a lot of LNG going forward) is right now in a deficit from a domestic perspective, in terms of being able to supply their local power plants with gas and coal. So, I do think you’ll continue to see LNG grow going forward. It will be a bit more though in a step function, because we are putting all that infrastructure on what Joe’s talking about in terms of getting these new LNG trains coming out.

Brusuelas: Let me add something to that, because this is really important on the domestic infrastructure front. The simple act of just reducing the regulation has unleashed the internal dynamics of capitalism in the energy sector. I want to say this. There’s no public money being spent on construction of the North American energy infrastructure right now. This is all private sector money and this is a really interesting dynamic during a very rough transition into a new administration and a new Congress.

Ortega: I think the other nuance that we’ll just have to continue to work through is that, in a lot of these areas as well, it’s state regulation. So, when you look at oil and gas development in particular in places like Oklahoma, Texas and Louisiana, it’s much more at the state level than at the federal level. Similarly, when you go to some of the power regulations, for example, you’ll see a changing of the guard at the federal level to Joe’s point. But California, for example, will continue to have some pretty rigorous renewable standards that they’re going to push forward as well.

Snow: Chris, as the head of the energy group at TPG Capital, what are some other really interesting investment themes that you’ve come up with that you think are going to work over the next three to five years?

Ortega: One of the things we’re huge believers of is that you need to understand the headline. But if you’re investing in the energy headline, you’re too late. So we really spend our time saying, “What’s the secondary or tertiary derivative of something that we see in the marketplace, but where there may be a bit more pricing inefficiency?” in order to be able to play. One of those themes, certainly, is consolidation. What we’ve seen, over the last five or six years in particular, is a number of private equity-backed companies go public, whether it be on the upstream side or the midstream side. But, frankly, they’re having a more challenging ability right now to grow, even though it’s a pretty attractive time to potentially consolidate in the marketplace.

Where we really start to focus is on the downstream side. So, if you have more volume growth overall, that means that your refineries, your pet-chem facilities, your fertilizer plants, your ammonia plants—all of them—will be having higher utilizations than you’ve ever had before. Also, it’s an opportunity for more pet-chem facilities to come to market.

And we’re probably not going to be the guys to build those pet-chem facilities, but we love looking at businesses that service that.

Snow: Why don’t we talk about the renewable space? Joe, presumably many of the regulatory rollbacks ahead will have to do with rolling back some of the incentives that have been put in place to support renewable energy. What’s the outlook for renewable energy with a different regulatory framework?

Brusuelas: I think it’s somewhat diminished, right? If you’re going to take away the subsidies, it means it’s going to be a longer bridge to the point where renewables really play a much larger role. Now, I happen to actually think that’s a good thing, because it means when we get there, it will be sustainable and it will be less of a drag on overall public debt.

Ortega: We’re starting to get a bit more interested today, though, partly because—just on an economic basis—given the technological gains that we’ve seen on the solar side in particular, we’re not cost competitive yet. But we’re getting closer. Also, certainly with the Trump election this past November, the administration coming in, a lot of those historic names within the renewable space have really decreased in value materially as well. So, from a value perspective, it’s a time where we’re taking another look to see what else is there.

Snow: Joe, it’s impossible to know exactly what all the policy outcomes are going to be in Washington, but what are you following most closely that you think will be a pretty big deal if it comes to pass?

Brusuelas: All right, what I’m looking at most closely is [whether] the border tax be put into place. What that means is that we’re going to abolish corporate income tax and we’re going to substitute a value-added tax with depreciation for wages, which will create about $1.2 trillion in revenues over 10 years. I actually think that one of the major drivers on whether this becomes law or not is how imported oil is treated in terms of the border tax. Now, if we throw 20% tax on imported oil, that’s going to cause problems for refineries, right? Over time, I think they’ll be okay because the reduction in corporate taxes really supports the oil industry.

However, due to the policy sensitivity, one gets the sense after spending a lot of time in Washington that, if there is a border tax, we’re going to have to phase it in over three to five years. And there may be special treatment for imported oil to reduce the sensitivity of the pass-through effect to consumers downstream. I think that’s something to watch over the next six months.

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