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As an unprecedented European winter power crunch approaches, North America’s natural gas sector is rising from more than a decade-long slumber.
For the sector, a compelling supply demand equation is emerging which could set the foundations for a significant multi-year hydrocarbon cycle.
Europe’s energy woes
European winter is upon us and there are real fears that there won’t be enough gas to meet demand with current gas storage levels 25% below where they have historically been for this time of year.
To understand what’s happening right now in Europe you must consider the block’s key energy policies.
First, Europe is a large importer of fossil fuels, with most of its oil, natural gas and coal coming from overseas. Second, unlike many other countries, its power generation sector is fully deregulated, which is similar to what we have here in Australia.
Europe derives about 25% of its annual electricity supply from burning imported gas and coal. These two fuels perform a mission critical load balancing service – they fire up during periods of high demand which typically occur during the cold winter. So, being able to secure enough coal and gas for the winter is crucial for security of supply.
And that’s where European energy policy is surprisingly vulnerable.
An unfortunate consequence of the deregulated market design is that power plants do not have great visibility on future generation volume – only those that offer the lowest price get called to generate power during the next 24-hour window.
If you happen to be a relatively high-cost generator, like coal and gas, you can never be sure how much fuel you’ll need in future.
On top of this, Europe has got the worlds’ strictest decarbonisation targets, which aim to shut down most coal and gas generation by 2030 anyway.
So by design, the European power generation sector is dependent on the global spot market – Europe feeds on the global energy breadcrumbs if you like. For instance large LNG export projects and pipelines tend to leave about 10-15% of their volume for spot market, and that’s what usually ends up in European gas turbines.
It’s a system that works great when there is an abundance of seaborne energy supply globally – you get very competitive fuel – but it’s a very difficult operating environment when global fuel supply is tight.
The global supply conundrum
Since 2016 there has been chronic underinvestment in upstream (gas exploration, extraction & production), and finally when COVID hit, the upstream sector globally went into survival mode.
And as we now know, energy demand bounced back strongly. This left the marginal buyers of fuel, like European power generators, scrambling for supply.
Russia is widely discussed as the force that holds the cards to Europe’s gas woes, but Russia’s Gazprom (the largest natural gas company in the world) already supplies around 40% of Europe’s gas needs and increases in Gazprom’s output have already been taken by Turkey and China.
To be frank, Gazprom is selling its incremental capacity to the buyer who is willing to pay the most, and in doing so is diversifying its customer base.
The result of this? Europe has had little choice but to get gas from the spot market, which is why we’ve seen European gas prices rise more than 300% year to date, to all-time highs.
This has led to industrial demand rationing – for example around half of Europe’s nitrogen fertilizer producers have suspended operations.
The long-term solution
It is indeed, decarbonisation, perhaps the most significant investment super cycle of our generation and Europe is ahead of the rest of the world.
However, what we’re seeing now may be what many have underestimated – a mismatch between ever-increasing energy demand and insufficient supply, and a fundamental need for more investment, as we transition from fossil fuels to renewables.
Natural gas will be part of the solution as it has half the carbon emissions of thermal coal per unit of electricity produced – but the gas market will remain relatively tight over the next few years until major new LNG capacity comes online in 2024.
So who’s got gas?
The US is the world’s largest gas market with less than 10% currently exported and until recently there’s been little incentive for US natural gas producers to invest.
But this is changing.
The price arbitrage between the US’ $5/unit of gas and Europe’s $30/unit provides incentive to invest in production and export capacity given greater demand for gas globally as a transition fuel.
On our analysis we see US LNG export capacity increasing from 60mt p.a. to 120mt p.a. by 2025.
The Antipodes global portfolios and the Antipodes Global Shares (Quoted Managed Fund) (ASX: AGX1) portfolio have around 8% exposure to traditional energy with a bias towards companies that will benefit from an increase in demand for gas as we transition towards renewables.
Two key holdings are Coterra Energy (NYSE: CTRA) and Technip Energies (EPA: TE)
Coterra has around 5% of the US gas market with operations in the prolific Marcellus and Permian basins – and its production is extremely low cost, at below $2/unit.
Unlike many of its peers, Coterra has a very strong balance sheet meaning it is built to withstand downturns. It also means the company doesn’t have to hedge the gas price if it feels the price is too low – as was the case this year.
So Coterra is one of the few producers that will get the benefit of the move in spot US gas price from less than $3/unit to closer to $5 recently.
Further, it’s a shareholder friendly company, committed to paying out a minimum of 50% free cash flow, and with unhedged production going into 2022, the company is valued at around 5x spot free cashflows based on the 2022 forward curve.
Technip Energies is an engineering and technology business which designs and manages large energy projects – typically oil and gas-based projects like LNG plants, refineries and chemical plants.
It’s one of the largest players in onshore and offshore liquefaction plants having built more than 20% of today’s global operating LNG capacity.
Increasingly, Technip is the company of choice for oil majors bringing LNG capacity online – it’s been awarded the major Qatar based expansions. This leading market position came following industry consolidation, where many competitors entered bankruptcy through the downturn.
As handling and processing gas is second nature for Technip, it’s extremely well positioned to benefit from growth markets like hydrogen, carbon capture and storage, and sustainable chemistry like chemical recycling and biochemicals and fuels.
Today, these markets are only half the size of the existing LNG and downstream addressable markets, but they are growing quickly at around 5 – 15% p.a.
Technip is one of the few historical energy services companies that has a credible plan to transition to a greener economy. It has a backlog of €18b against €6b of annual revenue, with the backlog growing at a faster pace than revenues. It’s valued at 10x next year’s earnings.
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