First Trust ROI Podcast
On the ROI podcast, we discuss some of the most important questions facing investment professionals today, ranging from macroeconomic views, to perspectives on the equity and fixed income markets, to insights on practice management. We aim to cut through the noise, examine the data, and provide fresh insights to investment professionals as they help their clients find better ways to invest…seeking to generate attractive returns on their investments.
First Trust ROI Podcast
Ep 50 | Jim Murchie | New Developments in the Race for More Electricity | ROI Podcast
Jim Murchie explains recent developments in the energy sector, including growing, bipartisan demand for nuclear power and why the non-cyclical energy industry is “an island in a sea of chaos”.
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Hi, welcome to this episode of the First Trust ROI podcast. I'm Ryan Isakainen, etf strategist at First Trust. Today, I'm joined by Jim Murchie, ceo, co-founder and co-portfolio manager at Energy Income Partners. Jim and I are going to discuss the increased demand for electricity capacity in light of artificial intelligence, reshoring, of manufacturing, cryptocurrencies, electric vehicles and other areas of electrical demand, and what the impact might be on the energy sector, specifically that non-cyclical part of the sector. Thanks for joining us on this episode, that non-cyclical part of the sector. Thanks for joining us on this episode. So, jim, before you got into the investment side of the energy sector, you did spend some time at British.
Jim:Petroleum. Is that right, correct? Yeah, I had an eight-year career there, seven different jobs, seven different jobs, seven different jobs. Yeah, that was actually kind of my problem with. Well, I actually went to go work for the Standard Oil Company of Ohio in 1982. They were majority owned by BP. Okay, so what happened was BP had Alaska and Standard Oil had just refining and marketing. And so they said here's the deal We'll give you Alaska, you give us 55% of your company. So it was the deal of the century for Standard Oil of Ohio. It is where John D Rockefeller was based, in Cleveland. So when they broke up the trust, they gave him this tiny little piece in Ohio, I think, just to stick it to him. And so I had seven different assignments in refining and marketing and petrochemicals staff and mine jobs.
Ryan:So that probably gives you an edge in understanding the industry now that you're having for years have been on the investment side, yeah, and the the other folks at EIP are really sick and tired of listening to my stories from the old days.
Jim:But that's exactly what Bernstein thought. Bernstein hired their analysts from industry for that reason yeah and uh, it's you know, and they figured that they could teach you how to do the financial analysis, but they couldn't teach you what you would learn actually working in the industry.
Ryan:So then you went to. Did you go right from BP to?
Jim:Sanford Bernstein. I went right to Sanford Bernstein and from there two years at Julian Robertson's Tiger Management and then after that ran a a long short hedge fund in the world of energy and basic materials and commodities and things like equities, commodities, derivatives.
Ryan:Okay, so that you've got a really kind of unique background with both the energy sector and as an analyst and all these other other roles, what's kind of the like. As an analyst, what's the key takeaway? That applies to what you're doing now.
Jim:You know, the thing is, all three of the portfolio managers at EIP had their industry experience, kind of in the oil and gas part of the business, I had so many different jobs and the I had so many different jobs and the other two had so many different jobs that we touched a lot on the pipelines and the power sector as well. What we like to say is you know, we grew up in the cyclical sort of bad investment neighborhood of the energy ecosystem and we're able to get out, and so the transition of going from industry to managing money was the transition of going to the part of the business that really was not a good shareholder investment, to the part that is. And while I sensed that when I was at BP, it was really when I got to Bernstein analyzing these companies, their lack of earnings growth, the high variability of their earnings, their low returns on capital that it was like. You know, this is not a place this isn't Microsoft and Google where you just own the companies for the next 20 years because their earnings growth isn't there and it's highly variable, which makes planning their businesses very difficult. It makes capital allocation and the efficient allocation of that capital, which would result in a high return on capital just wasn't there. It was a complete lack of capital spending discipline.
Jim:And so one of the pieces I did, the research pieces I did you could say it was sort of a seminal piece for me that other people at Bernstein and then around the industry copied was I noticed this correlation between capital spending as a percentage of cash flow and returns on capital. In fact it was an 85% correlation. And people said, oh okay, so the more you spend, the more you grow. No, it was the opposite correlation. And people said, oh okay, so the more you spend, the more you grow. No, it was the opposite. So Exxon had the highest returns on capital and reinvested the smallest portion of their cash flow. And so when you would talk to the companies, they didn't really understand this either. But it occurred to me that the companies are good at ranking their projects. You know everyone can run a spreadsheet and the farther down that list they go, the lower their returns. So you do your best projects first and your worst projects last. So the more you spend, the lower your returns. It's almost tautological, and other analysts in other industries kind of took that analysis and found similar correlations.
Jim:Now, you wouldn't find that in tech, for example, but for mature, cyclical businesses it definitely was the case.
Jim:And so, when you look at how energy infrastructure operates, not only are the earnings stable, but the dividend payout ratios are higher.
Jim:And if you think about it, if you've been given a monopoly, let's say, to run an entire electric area, right, and demand is only growing 1% or 2% a year, and you're earning a 10% return on equity, if you reinvested all of that money, you would grow your capital base 10%. Well, who would do that? There's no competitor to steal market share from and demand's only growing 0%, 1% or 2%. So why would you do that? And so there is an inherent capital discipline that comes from a monopoly business that can't steal market share and knows that if it's simply plowed back in all of its cash flow, or like the s p 500, which has a payout ratio today, I think, 27 or 28, so you know, reinvesting 75 of your of your operating cash flow means you're growing your asset base much faster than you're growing your business. So it's two very important elements you get when you get to the world of non-cyclical energy infrastructure that isn't present in the rest of the industry.
Ryan:So you said something interesting there, growing at 1% or 2%. But that actually leads us into another thing I wanted to discuss with you, and that is the apparent inflection higher for the growth in electricity demand. Yeah, to what?
Jim:three, three and a half percent, something like that, that's the high end of the range, but we're already growing at one and a half, coming off of 20 years of zero growth. And so, again, being an investor wanting to cover our downside, we have this discussion with investors that says, look, let's understand how we went from zero to the one and a half that we've been at for the last two or three years and to understand that you got to understand why you were zero for 20 years. And it was really two reasons. The first is the offshoring of manufacturing, which everybody knows about. Manufacturing output in this country didn't fall, it just went sideways while the economy grew right Because we outsourced it to China, southeast Asia and other places, and so electricity demand there didn't grow. In fact it shrank.
Jim:For the second reason, which is everything that uses electricity today, whether it's light bulbs, air conditioners, electric pumps, washers, dryers, dishwashers they use 70 to 80% less electricity than 30 years ago. Every refrigerator at Home Depot, that energy star rating. I think the improvements today are minuscule and I'm not even sure they're worth the dollars. They save energy, but you may be spending a hundred extra dollars to save maybe $50 of energy over the life of the machine. I mean, I don't know that, those are the numbers, but we're clearly getting to diminishing marginal returns. But, more importantly, we've turned over in the last 30 years the highly inefficient stuff that predates the run-up in energy prices in the 1970s and 80s which triggered all of that, and so you have now a reversal of those things right.
Jim:So now we're electrifying more things. It'd be electric vehicles, not so much in this country, but it's happening. It's just happening slower than people had forecast and you have this migration towards heat pumps, not in Wisconsin, but sort of in the moderate temperate areas in the wintertime. And then, obviously, manufacturing is reshoring. I mean, construction spending on factories has tripled in the last three years, and you folks work with Richard Bernstein and he has been telling people about this for a while. He saw this coming a long time ago and it's a function of a lot of things coming together cheaper energy, a strategic need to reshore, that kind of thing. So that gets you to one and a half percent. The AI data centers gets you another one or two percentage points, depending on what forecasts you listen to.
Ryan:So I would imagine that people watching that are listening to the podcast now are saying, okay, that's boring one exactly two two and a half three percent.
Jim:I know india grew 65 percent last quarterover-year sales, and so it's only large when you compare it to being flat for 20 years an industry that's used to flat for 20 years and what the actual five-year plan is for the industry. So all of the folks in the electric power industry, mostly utilities have to file with their states every year a five-year plan. They call it an integrated resource plan, but they also have to file it with the Department of Energy. So we in the industry know exactly what plants have existed in the country, when they closed the existing ones, when they plan to close and when the new ones that are planned are coming on. And so if you're going to grow at one and a half percent, you need 130 gigawatts of power over the next five years.
Jim:If everything you're building is what the industry calls dispatchable with an eye um, as opposed to dispatchable where you chop somebody's head off um, so dispatchable is natural gas, coal and and nuclear right, you can turn it on, you can turn it off.
Jim:That's opposed to intermittent, which is wind and solar. Now if everything we're providing is coming from wind and solar, we'd be more like 225 gigawatts, not quite double. So, as it turns out, we are in fact adding 150 gigawatts at the low end of the range. So, as it turns out, we are in fact adding 150 gigawatts at the low end of the range, but that's made up of 170 gigawatts of wind and solar minus 20 gigawatts of dispatchable. Now we're growing natural gas, but we're shrinking coal, and so we are not adding enough by a long shot in the five-year plan. Now, if electricity wasn't growing, we probably would just continue doing what we've been doing for the last 12, 13 years, which is closing coal-fired generation at a rate of about 5, 5.5% a year and replacing it witha roughly 50-50 mix of natural gas and wind and solar, and so the plan for the next five years is perfectly consistent with what we've been doing for the last 10 to 15. But what's different from the last 10 to 15 is demand is growing. Now.
Ryan:So you're not just replacing with 0% growth some of the coal with maybe wind and solar that have lower utilization rates, but maybe it all is okay.
Jim:Yeah, that's right, yeah, and so and so now the folks worried about the reliability of the system, and that would be at the state, regional and federal level. They all have varying degrees of responsibility. I think the primary responsibility is with state regulated utilities, because they have what's known as an obligation to serve, and that means safe and reliable power. We don't have regional authorities everywhere in the country and the federal government has some powers, but no one can make anyone build a power plant. All they can do is encourage it and ask you if there's one currently in existence that's not profitable. They can say you got to run this thing and we'll compensate you for your costs.
Jim:But the folks who are looking at this unfolding situation for the next five years see that dispatchable power will continue to decline. I mean, natural gas is growing, nuclear is not, but coal continues to decline. And you say, well, okay, what does the industry think growth is going to be? We're currently at one and a half. Well, the industry thinks growth is going to be about two and a half percent a year. And the way they look at the reliability equation is they look at the peak demand for the year in the US, which is July or August and we're talking like the peak day or two days or something like that, and that's because it's hot and people need to turn their air conditioning to share out.
Jim:Now below the Mason-Dixon line. They have a peak in the wintertime too because they have so many heat pumps, but up north it's mostly natural gas and in the northeast fuel oil, so electricity isn't peaking them the way it is south of the mason dixon line. And so they compare that peak demand to the amount of electricity available from dispatchable sources and you say well, wouldn't they include wind and solar? It's like, well, wind and solar have an average utilization rate of, you know, 22, 23, 24% combined, something like that. You know wind is higher than solar, but that's an average. If for some reason it's hot, you know, and it's at night when people want to run their air conditioners and it's not windy and in fact when you look at wind speeds in the United States they dip in the summertime then you can't depend on it, even though some of it's going to be there. And so when you graph out peak demand with a two and a half percent growth rate and the continued decline of dispatchable, those lines cross in about three years.
Ryan:And that is not a good thing. If you want to if you have an obligation to provide that power right.
Jim:You have an obligation to provide that power right, have an obligation for that power, and so that's again. So that's where the state regulated utilities um come in, because, with the obligation to serve, they're the ones who have been primarily building natural gas turbines to back up the wind and solar who are being, who have almost entirely been built by merchant power providers.
Ryan:Right, yeah, break down the difference between those two.
Jim:So we started the industry off in a vertically integrated cost plus system and the choice was whether or not we let companies do that or governments do that. So if you look at water and sewer God I'm going to get this wrong, wrong. But like 92% of sewer and 75 to 80% of water in the United States is provided by municipalities and regional districts. There is some investor owned water and sewer, but it is very small. In the world of electric power it is. Those numbers are the opposite. 85% is provided by investor-owned utilities and those utilities are granted a monopoly in return for an obligation to serve.
Jim:So as one utility executive said to Walmart once, every time you put in a wind farm or a solar farm, it's another natural gas power plant that I have to put in to back it up. And he gets cost recovery on that because he's operating under a cost plus system, because he's been granted a monopoly, which means that there is no competition. So he has to serve customers don't have an alternative. And um, he has to agree that utility has to agree to limits on what they're allowed to earn. He said well, how do you manage that?
Jim:You say it's a cost plus system. They have their operating costs, their interest on their debt and then an allowed return on equity and that is their allowed revenue. Divide that by kilowatt hours. That's what everybody pays. So you can see why the utilities under the cost plus model have been the ones building natural gas to back up the intermittency of wind and solar. And now essentially what's happening is people are saying, well, I guess that's okay, but you got to either build more because we have demand growth or stop shutting down these coal plants one or the other, or both. But we need more dispatchable power because demand is growing.
Ryan:So do you expect that will need to happen in the next few years? Maybe delay some of the shutdowns of coal and some natural gas plants are going to shut down as well, right?
Jim:Yeah, so a five-year plant has 35 gigawatts of natural gas planned, but that's roughly an addition of 50 and a closure of 15. So those will probably be delayed. The five-year plant has 55 gigawatts of coal, so think about how big that is. I mean we're building net 150, right, but without those coal plants we would have been building 200. And some of those coal plant planned retirements have already started to be postponed and that's already happened at the state level where utilities have said you know, you got to get another five years out of these things because we see what's happening. We don't have enough dispatchable power.
Jim:There are regional authorities, one in the Northeast that goes by the initials PJM, which stands for Pennsylvania, jersey, maryland.
Jim:They issued an order to keep a one and a half gigawatt coal plant, you know, like five miles outside baltimore, to keep it running.
Jim:And then we've had an executive order from the white house, um, essentially saying look, we're going to make sure that these coal plants don't close if we need them, and that power already exists under the federal Power Act of 1920. So if people want to look it up, it's section 202C. It's been in the Federal Power Act for 105 years and what you find with these executive orders is there's really no new law being issued. It's really a statement of policy and emphasis on the part of the executive branch using existing laws and existing agency rules. So there are these backstops that are kicking in, and I think that, regardless of what growth comes from the AI data centers, it has shined a light on this situation where the cushion between dispatchable available power and peak demand is starting to erode and, if you believe the industry's modest growth of 2.5% a year for the next five years, that margin disappears, and so it's like you can only build this stuff so fast, so let's make sure we don't close the stuff we already have.
Ryan:You know, one of the things that I think has surprised a lot of, maybe, strategists over the last couple of years has been the fact that earnings growth estimates have really increased more than historically, at least over the last 20 years for utilities. Why is that?
Jim:happening. So there's a big mix change that's gone on in utilities. So again, in the beginning they were all vertically integrated, cost plus, and after World War II there was a lot of growth in everything, demand for everything, and that all slowed down as the economy matured and became more service oriented. As Alan Greenspan famously said, gdp gets lighter every year, and lighter means less energy as well. And then we went through this deregulation of electric power generation where the federal government made sure that there were open, competitive markets. That was difficult to do because the poles and the wires are all still controlled by the state regulated utilities. And history tells us if people can manipulate a market and favor their own source of supply, if they control the infrastructure, they're going to do it. And so those rules took almost 20 years to put in place. So we started with allowing people to build their own power plants, but the price they got was some economic calculation of avoided cost because there was no wholesale market. And there was no wholesale market because they hadn't established the rules of how you're going to use the poles and wires. Electricity isn't like coal you can't like dump it into a truck or on a rail car and take it to wherever you want, it needs a wire, and so all of all of that took a long time.
Jim:And so when you get to the beginning of the 1990s, you have this deregulation of the electric power generation part of the business. Government don't have a wholesale market in my state, but what they can say is my vertically integrated utility in Florida or my vertically integrated utility in Georgia, I want you to keep that power generation in the cost plus system. Why? Because we don't want happening to the electric power system what happened to the railroads in the 1800s, which was just a wild west boom bust business. We know that cyclical commodity businesses come with. You know, booms and busts, bankruptcies and all kinds of things, lack of reliability, lack of safety and we don't want that happening. And so today you have half the power generated by these, these cost plus utilities, and half generated by the merchants. Now, a merchant power producer doesn't have an obligation to serve, and so, as I said before, most of the wind and solar were generated by those guys. So that's how we got to the situation we have today.
Ryan:Is there a difference in projected or realized earnings growth over the last couple years or going forward a couple years between the merchant power and the regulated?
Jim:Yeah, so the merchant power guys are highly cyclical and the electric power market has gotten tighter. So their earnings are doing really well now and the stocks have done really well. In fact some of these guys are up 200% in the last year and a half or so. Meanwhile, what's happened in the sort of the vertically integrated utilities is the character of their earnings has become less cyclical over time because they have divested that merchant power along with their energy trading desks think Enron along with their overseas investments think Enron and they're getting back to their sort of more simple model. And so the first phase was watching all these earnings become cyclical because of deregulation, because there were so many utilities in states that said, nope, your electric power is going to be a free market, cyclical business now, and they added energy training and all that. Then they start getting rid of that stuff and the earnings become less cyclical, but they're only growing 2% or 3% a year.
Jim:So you have this perception out there that, oh, utilities are bond substitutes because they don't really grow. That was true on average. But that 3% was a mix between companies whose earnings were still falling because of bad execution and ones that were growing at high single digits. So when you look at the utility space on average. Now that mix change, combined with this need for new electricity, has brought that growth rate from three or 4% 10 years ago, five years ago, to closer to seven or eight on average. And if seven or eight's the average, you know there's folks that are still four and five but there's folks that are nine and 10.
Ryan:I also wanted to ask you about natural gas specifically and some of the pipelines, and there's been some news recently. You and I were chatting about this yesterday with the state of New York and the Trump administration, I think, had pushed pause on some of their offshore wind operations. And then Kathy Hochul and Donald Trump got together and made a deal. Yeah, and I'm probably oversimplifying, but it was basically a trade of okay, you can put a natural gas pipeline in in exchange for going forward with the wind project.
Jim:Yeah, I think that's pretty much the deal. I mean, you know, at the end of the day, that was the federal government saying look, all of New England is suffering for lack of energy. So New England is a net importer of all kinds of energy because they just don't have any on their own. You know the Marcellus Shale is close in pennsylvania but it's not in new england. Um, so they don't have natural gas production. Um, you know, and you know, they only have two nuclear power plants left, and so they are a net importer.
Jim:And, um, you know, you can't run the whole system on renewables. And the other thing is offshore wind is five times more expensive than onshore wind just because of all the equipment it takes to put it out there, and so, and the other thing is, the current president just hates offshore wind. I mean, just he not recently, like people that know him, like this goes back decades, right, it's like I don't want to look out on the beach and see those things. Basically is kind of what is where he comes from, and I you'd be hard-pressed to find people that don't agree with them well, there's a reason for nimbias.
Jim:There's a reason for nimbias.
Jim:Nobody wants to see yeah so so anyway, so what they, so what the trump administration did, was they pulled the same trick that the sierra club pulled on the pipelines by saying you know, I'm looking at your permits and you haven't really filled them out exactly right, so we're going to stop this project. And um, and they York says, okay, what do you want? It's like, well, let's reinvigorate these two pipelines that you shut down the Constitution pipeline, which comes from the Marcellus Shale into New York and then connects to some other pipelines that would feed the rest of New England, and then a pipeline that actually runs from New Jersey across a little bit of the Atlantic Ocean to Long Island and that's called Northeast Supply Enhancement. Now they call it Nessie, and so that's kind of the deal.
Jim:Now the question is whether or not those pipelines get built. So Williams Company is the company that owns those two projects and they're looking into kind of getting the permitting going again. But here's the thing you can't build a pipeline. Well, you can, but Williams isn't going to do it and I don't think any other pipeline companies are going to do it.
Jim:You don't build a pipeline on spec you do it on the back of a 20-year contract. So the original Constitution pipeline had contracts from the producers Now producers generally, not the ones that backstop natural gas pipelines. 80% of the capacity on natural gas pipelines is reserved generally by the users which are the utilities, either electric utility or natural gas utility. So it's not clear whether or not those producers want to sign up again when it's indicated an interest and it's not clear whether the utilities in New England want to sign up for Constitution. There is one utility that would sign up for the Northeast supply enhancement and that one is deemed the more likely of the two to go through.
Ryan:As you said, there is a need to increase dispatchable energy, though. So I would think that would be. I know the politics to increase dispatchable energy though.
Jim:Yes, so I would think that would be-.
Jim:I know the politics in New England are rough, though. I mean the governor of Connecticut, in his State of the State, addressed energy, because rising electricity bills has become pretty much the number one political issue in Connecticut and the rest of New England and he's a Democrat in a blue state and he used the expression all of the above and was just widely criticized from the left side of the aisle for uttering those words, because the folks on the left side think that that's a dog whistle for fossil fuels. But he is frustrated with the cost of offshore wind at 17 cents a kilowatt hour and they have chosen not to participate in any of the projects going forward. Well, they have one that's already in the bag, but going forward. They were offered to participate in a wind project that's mostly contracted with Massachusetts and a little bit of Rhode Island and they actually chose not to do that. And I think the reason was because that 17 cent per kilowatt hour when the wholesale price of electricity in New England is between five and seven cents, I think.
Ryan:I think the governor just thought you know, that's just, that's not a good look the politics of energy never ceases to amaze me, and one of the interesting things that's happened just the last couple of years has been the renewable energy commitments that especially technology companies have made has butted up against their need for electricity right.
Jim:Yeah, so about a third of all the utility scale wind and solar that built in this country in the last 10 or 15 years has been built by the four big tech companies and you for walmart in there too, because walmart's actually the largest buyer of electricity in the united states. Yeah, um, and and there, and I and I, um, we attend the aspen institute energy environmental roundtable twice a year, sort of invitation. Only about 60 to 80 people and the head energy buyers of big tech are always there, they're sponsors, so they're always there, and they are are remarkably sophisticated energy buyers and they have to be sophisticated because they have 24-7 requirements and the wind and the solar of course that they're building isn't 24-7. So they're out there in the market backstopping the intermittency with purchase contracts on the grid. So they call that firming and shaping the power of. You know it's just sort of a euphemism for backstopping, and so they're very sophisticated about doing that.
Jim:But, as you say, now you know if the ability to go out into the wholesale market and buy all the electricity you want when there was plenty of surplus capacity and electricity demand wasn't growing, that situation has changed and so now they're expressing this willingness to go with natural gas, while at the same time having discussions with carbon capture and sequestration of that natural gas. Or as Facebook did with their deal with Louisiana vertically integrated utility that goes by the name of Entergy. They signed a deal about six months ago for 2.2 gigawatts of gas fire generation to feed a $10 billion data center in Louisiana. But their investment Meta's investment will include batteries and some wind and solar I think primarily solar as well. So they still have these zero carbon commitments to their shareholders and their customers. But they also have a commitment to their shareholders to be competitive in this space race for AI, and speed to market is critical.
Ryan:Yeah, in their eyes.
Jim:I mean, I'm not an expert.
Ryan:I just saw, I think this morning, that Meta had signed a deal with Constellation for nuclear up in Illinois.
Jim:Yeah, that's right. So let's talk about nuclear a little bit. We have 18%, we can call it 20. 20% of US electricity comes from nuclear. That compares to 10% for the globe. And we finished one new nuclear power plant a year ago. But other than that we basically haven't built nuclear for 20 years. And so you have these plants that are getting old and it costs money to kind of shut them down and refurbish them.
Jim:Now the state of Illinois was one of a handful of states that said we don't want to lose the zero carbon. So they put in they called them zero emissions credits to make it sound like they're more agnostic, saying well, we'll give these credits to anyone who's zero carbon and dispatchable. Well, there's not much geothermal there. So pretty much it was a nuclear subsidy so that those things wouldn't shut down. That was followed by the way at the federal government under the IRA, to provide a rising floor rising with inflation floor for the price a nuclear power plant could get for selling its electricity in the wholesale market, in an attempt to make sure their costs were covered. So the Illinois program expires in a few years, I think in the end of 2027. And so the meta deal is going to extend the life of that nuclear power plant. The federal subsidies will sunset eventually too, but that's not until 2032 or whatever. But what they're making this sound like is that, even though this plant is currently running, the meta deal keeps it going, that, all else equal, this plant would have shut in a couple of years.
Jim:I'm not sure that's true, but you can see what Big Tech is doing. They are reaching for this always available zero carbon source and trying to avoid the problem that happened with the first deal like this that was announced a little over a year ago and that's between Amazon and another merchant power producer called Talon and that is being held up by the Federal Energy Regulatory Commission because they're saying wait a minute, this is an existing resource. It's 1.6 gigawatts total. It's in Susquehanna. It's a Susquehanna nuclear power plant in Berg, pennsylvania, and you know, in fact the company built a shell for a total. It's in Susquehanna. It's a Susquehanna nuclear power plant in Bourke, pennsylvania, and in fact the company built a shell for a data center. They didn't put chips in it or anything.
Jim:And Amazon comes along and says we'll buy that and we're a couple of hundred yards away and we'll use your power. And the Federal Energy Regulatory Commission said we're going to hit the red stop button on this because it concerns us that you're taking this highly reliable asset for yourself, which, all else equal, makes the rest of the grid less stable. We want to study this. So that analysis, that testimony, those studies are still kind of filtering in, but you can understand from a public policy perspective. If big tech starts hogging all the nuclear to themselves, all else equal, it makes the rest of the grid less reliable. The real solution is to build more dispatchable power and if people want to insist on zero carbon, they can build the natural gas with carbon capture or we can get going on nuclear.
Ryan:I'm not sure how much you've uh studied the illinois uh deal with constellation, but isn't that potentially going to run into the same issue taking that power off the good?
Jim:but you could tell, you could tell in the, in the um, in the language, in the press release this morning. Um, because it was first thing this morning, they came out and um basically saying hey, this plant was dead until, not until're not taking anything off the grid.
Ryan:It was dead anyway.
Jim:Yeah, that's exactly right. So the word additionality is the word people throw around. So Microsoft is doing a deal with another merchant power producer to restart the unit at Three Mile Island that didn't melt down, or almost melt down, in 1979. And it had closed I'm going to get this wrong say three to five years ago, and they're paying that company 12 cents a kilowatt hour remember. The wholesale price is six, twice the wholesale market to compensate them for the costs. And 12 cents is cheaper than a brand new nuclear power plant. The one that was just finished last year in Georgia needs close to 20 cents a kilowatt hour to recover its costs.
Ryan:Okay, so nuclear. There was also a series of I think four executive orders that the president just issued.
Jim:I want to back up a second and say that what seems to be apparent without much disagreement is that nuclear, being pro-nuclear, is a bipartisan issue. So you saw this under the biden administration, where they passed the advanced act, and the advanced act addressed a number of the impediments for nuclear. Like you know, you gotta, you gotta try these new technologies, you gotta permit them faster. You know, uh, if someone's gonna do the old technology, you gotta permit it faster, that kind of thing. And then, with this administration comes in and says that's, that's, that's still too wishy-washy. I'm going to go into the NRC and I'm going to start firing people. I'm going to start replacing them with people that are going to be oriented towards getting this stuff built, because their current criteria is zero radiation. Okay, well, you walk out on a sunny day, you're getting bombarded by radiation and their standard is actually less radiation than that. And so that language is actually in the executive order. So it's four executive orders that are addressing what they perceive to be the constraints. So the first is the permitting thing, the second is the financing right. So think about that nuclear power plant in Georgia that got built. They're in a vertically integrated cost plus utility. So at a point the public utility commission cut them off and Southern Company had to eat those. But the rest the public is eating. So if you want a merchant power producer, you know to try to sell electricity into a six cent market, obviously the price has to come in a lot less than 15 to 20 cents a kilowatt hour, or they have to do a bilateral deal, the way Microsoft is doing. And so the trick is to get those costs down, and the only way you do that is with adoption, and you got a chicken and egg problem because no one wants to be first with a massive cost overrun. So in these executive orders the president is actually ordering the Department of Defense to come up with a new technology and the new technologies have been used for decades. Right, but actually put one in place at a US lower 48 installation in the next two and a half years. Like get it the next two and a half years. Like get it built in two and a half years, just one, but get it done, stop talking about it. Put a man on the moon, return him safely to Earth inside the decade, kind of a thing. They also then have said we want to have 10 nuclear power plants under construction by 2030. Figure out how to do that. So by putting the power of the purse of the Defense Department behind it and then actually going into the Nuclear Regulatory Commission and saying the incentives you're operating under are gumming up the works. They really are taking an aggressive step towards this.
Jim:And some people said, hey, let's not forget about the safety. I think everyone would agree with that, but I think this is the natural evolution of the situation we're in, where a significant part of the customer still wants zero carbon, but everybody wants always available and nuclear power solves both. We invented the technology and now we're falling behind on the implementation. So it isn't the physics, it's the engineering and the economics, and so the only reason and that's us, that's just human beings and how we interact with each other, how we permit things, how we argue about things and not get stuff done. And so the president's executive orders and under this administration and the Advance ActANCE Act under the prior administration, which had bipartisan support, are an attempt to sort of say wait a minute. We are falling behind in a technology that we invented. Economics matters. The only way we're going to bring the cost down is the adoption curve, so we've got to start building these things at scale.
Ryan:It's really ironic to me that you can't get bipartisan agreement on anything Just about, especially in the energy sector.
Jim:It's so polarized. It is.
Ryan:If you would have told me five years ago that nuclear power was going to be the bipartisan agreed on energy source. I would have thought you were crazy.
Jim:No, that's right. The other bipartisan thing in energy is and it's moot now because everything's going on with tariffs but but was actually having a border adjustment tax on carbon? Because the environmentalists say, hey look, the biggest problem are countries like India and China that keep building coal plants right and left and that is, you know, the largest single source of carbon emissions and we should tax them for it. In fact, everyone agrees that the best way to deal with an externality like pollution is to tax it out of existence and then let the free market come up with the most efficient way of getting rid of it. And while everyone agrees on that, no one seemed ever to be able to pass a carbon tax legislation, and in part that was because we're just going to tax ourselves and those guys. We're just making our energy more expensive.
Jim:So that's why people, including George Shultz and James Baker, who served under Ronald Reagan they formed this thing called the Global Climate Initiative, and I mean 15 years ago they were saying, no, you need a carbon tax and a border adjustment tax. And they're not liberals. They're just saying, no, you need a carbon tax and a border adjustment tax. And they're not liberals. They're just saying this is the way to address this problem. Let the market figure it out, but tax it. So there's bipartisan support for that.
Ryan:But obviously given everything that's going on with tariffs, that's you know.
Jim:I don't think that'll bubble to the surface anytime soon, but the nuclear thing is bipartisan. And the public? By the way, the public is now 61, 62% in favor of nuclear. Yeah, and then you go back five or 10 years. It was 61, 62% against Public opinion has definitely shifted.
Ryan:In fact, I remember it wasn't that long ago. In upstate New York there's a nuclear power plant in Oswego, New York.
Jim:Yeah, it's the one that they kept.
Ryan:Yeah, they closed the one. You 35 miles from manhattan and they kept that one. Yeah, and, but they were going to shut that down, yeah, and, and then well because it was uneconomic.
Jim:Yeah, of course, yeah, yeah, and so now? So now it's economic and you know, and as you know, in those areas there's not a lot of employment and so you know, shutting a plant like that has a big social impact as well.
Ryan:Absolutely Okay shifting gears a bit, because we get questions all the time about the price of oil, the price of natural gas and how that impacts the non-cyclical part of the industry, and that's really what you focus on yeah that's right. So you know. The price of oil and natural gas is down when we're recording this, maybe 10% or 15% this year. What impact does that have on the non-cyclical part of the industry?
Jim:Yeah, so non-cyclical per se, it has virtually no impact In the longer term. If you run a transportation infrastructure, you want the thing that you're shipping to be competitive, want the thing that you're shipping to be competitive, so you don't want high oil and gas prices, just in the simple economic theory that people would use alternatives and that means they'd be using other infrastructure to deliver other sources of energy that you're losing market share to. But there is this sentiment that when oil and gas prices go down, that you need less infrastructure, that well, no one's going to drill, so they're not going to use your pipelines. Sentiment that when oil and gas prices go down, that you need less infrastructure um, that well, no one's going to drill, so they're not going to use your pipelines. Well, it's sort of like well, the pipelines have to be used because people heat their homes with natural gas and drives their cars with gasoline, so the demand in fact, doesn't go down. Um, and so you see a sympathetic move in the stock prices of pipeline companies.
Jim:Um, but the earnings are for our companies anyway, are as stable as they can be. In fact, during the time when oil prices corrected from bubble territory in 2014 at $110 a barrel, overcorrected to $30 and then settled back at their cost, which 10 years ago was, say, $50 or $60 a barrel. The earnings in our portfolio actually were flat to slightly up over that time, where, when the S&P energy sector dominated by names like Exxon and Chevron and the oil service companies and the independent oil and gas producers, the earnings for that part of the S&P 500 was down 83% in two years and the earnings in our portfolio were essentially flat.
Ryan:So here's maybe an oversimplification, but if earnings don't decline but prices do, that seems like an opportunity.
Jim:Yeah, absolutely. I mean, the SEC doesn't let us do it anymore. They don't like this line. But we show a line of the earnings of our portfolio over time and then the price of the portfolio to tell the clients is like, look, it's not like somebody knows something. They actually don't know anything. They don't know what we know, which is the earnings on our portfolio are stable and they're still growing. In fact, the earnings on our portfolio grew right through the global financial crisis as well, but the stocks? Obviously there was a liquidity crisis and I had clients saying, well, somebody must know something. And it's like, well, I don't think they know more than us. We've been investing in these companies for so long and, sure enough, with the benefit of hindsight, the earnings on our portfolio went up low single digits over that time, when the earnings for the S&P 500 fell almost 40%. So people confuse. People have this belief that the market is efficient in absorbing information and translating into stock prices, and it's just not true. I mean, that example tells you that it's not true.
Ryan:Yeah, all right, I want to circle back to something that we said we were talking about early on in the conversation, and that is the plans to add power capacity in the US and you know we made the point that it's mostly renewables the Pacific at China, and the amount of electrical capacity that they have added over the last 15 years, it's pretty staggering. It's a staggering comparison, and you and I were talking yesterday. It was something like 430 gigawatts of capacity just last year and we have something like 1.3 total in the US. So do we need to be really ramping up the capacity in order to compete?
Jim:You know this is I think from an economic growth standpoint you know, we know we're already short right. The market is already responding in various ways to this shortfall. There is a little bit of a price signal coming through for the merchant guys. There's clearly a reliability signal coming through for the vertically integrated utilities and the carrot of demand from AI, data centers and the carrot of I'm going to bring jobs and economic growth to your state has the states and their partner vertically integrated utilities. Even though they're monopolies, they're competing against each other because those monopolies are at the state level. So Missouri is competing with Louisiana, which is competing with Texas, which is competing with Oklahoma, and Arkansas and Illinois. So there is competition. And you do see the capital spending plans of the vertically integrated utilities keep ramping up. Every quarter that goes by there's another announcement that their capital spending for power generation is going up.
Jim:The question is whether or not from a geopolitical strategic, if we're adding enough. I don't know the answer to that question, but if that answer is yes, that is where the government has to step in and say I know there's no price signal for this, because there's no market for geopolitical strategic supremacy, any more than there was to put Neil Armstrong on the moon. So the government has to step in and say this is a strategic imperative and I think, through trial and error, the Advance Act under Biden, the executive orders now under this administration. If that doesn't do it, expect more executive orders and expect legislation. Remember, the executive can only do so much. Only Congress can pass the laws and only Congress can allocate the tax dollars. And so if which it seems to me people are coming to the conclusion that this is a strategic imperative for the United States, because you cannot afford to not have enough electricity to be at the cutting edge of AI, and all of that means for any kind of military conflict that we have to do this now. And if the market doesn't respond, then there will be even more incentives. And Trump's executive orders are definitely a step in that direction. But again, it doesn't come with the power of the purse. Only Congress has that. And again, being that this is bipartisan, you know, I see this.
Jim:For years I have been saying if you want nuclear to come back, you have to have an Apollo program approach, because if it's strategic imperative, price signal isn't there for for the, for independent people to do it right. So nasa said if you build me a rocket that takes neil armstrong to the moon with you know, computer chips that are light enough for me to get, because vacuum tubes are heavy. If you build it, I will buy it from you and that's the situation here. In fact, that executive order said you're going to build an advanced reactor at a defense base or location and have it operating in two and a half years. You're going to do what you can to get private industry to have 10 under construction in five years.
Jim:You're now starting to take steps of actual commitments to actual numbers. As before, it's like we're going to encourage it's all adjectives, no numbers. We're starting to actual numbers. As before, it's like we're going to encourage it's all adjectives, no numbers. We're starting to see numbers now and the real weight would be if Congress passes legislation that has numbers in it. We have a strategic objective to have so much reliable power, zero carbon, if they want it, nuclear, whatever because it's a strategic imperative.
Ryan:So do we then run the risk that there's overcapacity? No question, and maybe that's further down the road. Is that a Always is.
Jim:But I mean, this investment theme of electricity demand driven by AI is not the first investment theme to visit the energy ecosystem in the last 15 or 20 years. Remember peak oil supply, right, and then we had shale, right. So it's like, well, I guess we didn't have the, I guess we haven't reached the peak, because there's all this stuff in shale, you know, which is where actually 95% of the hydrocarbons still are. They're still in the rock, where it was formed, where the hydrocarbons were formed from rotting plants and animals. And then then you know, so then we have, you know, an oil price boom because everything's running out of oil. And then the shale comes. We have an oil price bust and then people say, well, you know what? It wasn't peak oil supply, we had to worry. We have peak oil demand now because renewables are just taking over and we have an energy transition. And then we have a clean energy boom and then we have a clean energy bust. And it's like you know, it's one thing after another and in a cyclical look.
Jim:Energy is a cyclical commodity business. The regulated pipelines and power utilities are an island in that sea of chaos, but as, on average, it's a cyclical commodity business, strong price signal is going to be needed to get people to build stuff, and that price signal is exactly right, not a little bit, too much, not a little. You know, too little would be the first time in commodity price history that that happened. So they don't build enough, the pricing will be there until they build too much. And then of course and these things take three or four years to build, so once you start it you can't stop it, and then you go on the, then you go the other and remember there's this risk for these data centers where they come up with chips that use a significantly less amount of electricity to do the same number of calculations, and so that's always a risk. So that's why, for us, we stay with the cost.
Jim:Plus guys, that was a risk in the whole shale build out. Plus guys, that was a risk in the whole shale build out. There's tons of cyclical businesses, obviously oil and gas production, but the processing of that, before the stuff can even be put into the pipeline, that processing activity actually splits the revenue with the producer. So people were calling that infrastructure. I suppose you look at it, looks like infrastructure, but the revenue stream was exactly the same as the company who was pulling the oil and gas out of the ground. You were just splitting it with them. So that was obviously highly cyclical got overbuilt and when oil prices fell and natural gas prices fell, their share of that revenue fell as well and we had a number of bankruptcies and consolidation and everything. And that was where people who thought that the word energy infrastructure was a sufficiently safe adjective they found out that a significant part of businesses that were kind of loose in using that word had the exact same cyclical exposure as Exxon.
Ryan:Just because it's marketed as infrastructure doesn't mean that it's not cyclical.
Jim:And when you have this with investment, people say I want real assets or hard assets or infrastructure in my portfolio, and it's like those are broad adjectives and I understand what people are getting at. They want something that seems like a natural monopoly, something that will have sort of inflation protection and something that is an essential service, like a road or a bridge or an airport or a pipeline. That is an essential service, like a road or a bridge or an airport or a pipeline. But it doesn't mean that there aren't a lot of pieces of that business within the technical adjective of infrastructure that are highly cyclical and are going to hurt your performance. And that's kind of what happened during the shale boom. People thought they were buying infrastructure. Well, it might've been infrastructure, but it was cyclical.
Ryan:Well, jim, the time has flown by. Once again, you're right, believe it or not. We're coming up against the hard stop time here, yep, but again, appreciate it. There's a lot of people wondering how to navigate the energy ecosystem, so these podcast chats are enormously helpful. Thank you for joining us once again.
Jim:Yeah, thanks for having us again. Yeah, we'll do this again soon. Great, yeah, no thanks. We'll continue to be sort of chickens and avoid the risks and do our best to stay out of trouble, as we have for the last 22 years and, thanks to First, trust, has been our distribution partner for nearly two decades now. It's been a great partnership.
Ryan:All right. Well, thanks again, and thanks to all of you for joining us on this episode of the First Trust RY podcast. We'll see you next time.
