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 40 | Jim Murchie | Who Benefits from the Growing Power Demands of AI, Reshoring, and EVs? | ROI Podcast
Electricity demand is poised to soar after decades of slow growth, driven by AI, reshoring, and EVs. Jim Murchie, CEO and portfolio manager at Energy Income Partners, unpacks how natural gas, nuclear power, and renewables will fuel this surge, as utilities scramble to keep up.
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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, president, portfolio Manager, ceo of Energy Income Partners. Jim and I are going to talk about some of the developments in the energy sector. There's a new administration, there's a surge of electricity demand, growth coming from artificial intelligence, a lot of other sources, but there's been some questions about whether that growth is actually going to materialize, especially with some of the new innovations that have been, or the competitive forces coming out of China, deepseek and others. Jim and I are going to cover all of that on this episode of the First Trust ROI podcast.
Ryan:Thanks for joining us. Well, jim, glad you were able to. We were able to arrange our busy schedules to do this. Once again, thank you for carving out some time for us. It's an eventful week. We're recording this on January 30th and earlier this week there was a pretty big sell-off in AI-related stocks, but also the energy sector also. You know, energy infrastructure anything that was that kind of had a whiff of the AI trade sold off. So I want to start there. I want to talk a little bit about electricity demand, especially its links to AI, and you know kind of that narrative that's been built. So, as you think about this, I mean, I guess the good place to start is is that link justified and what are some of the other ways that you think of or some of the other drivers for that demand growth for electricity?
Jim:Yeah, so the link is definitely justified. But the context is 20 years of essentially no electricity demand growth in the United States, and we saw demand growth last year for electricity of 2%. So the forecasts about electricity demand growing again are really no longer forecasts. They're really sort of starting to happen, and we've been training AI large language models for years now, but what everyone's talking about, of course, is still in the planning stages and probably not even under construction.
Jim:So the question is why did we have flat electricity demand for 20 years? And the answer is sort of you know a few things. The first is that you know the growth of electricity demand after World War II was, of course, population GDP and you know industrializing the world after World War II and then. But even in the residential sector, I mean, you went from houses with ice boxes to houses with refrigerators, washers and dryers, and then in the 70s and 80s, air conditioning, and then that all flattened out. And then we had these energy crises and then we worked on making all those machines more efficient. So you have that yellow sticker now when you go to shop for appliances you didn't have before the energy crisis, and so all of those efficiencies, including LED lights have now kind of worked their way through the system and you're now talking about maybe new appliances that are electric, which would be electric cars, and electric heat pumps replacing furnaces. Now those trends are much slower, but again it's a reversal of trends that contributed.
Jim:The other big contributor is the fact that industrial production and manufacturing in this country is also essentially flat for the last 20 years because of all of our offshoring. Well, as we know now, when you look at construction spending again from US Census Bureau data, the amount of construction spending for manufacturing plants has nearly tripled in the last three years. And of course, yes, that's the chips act, the bipartisan infrastructure, but it's also when you look at our imports from China. They're going down. So there is already this nascent reshoring.
Jim:And when you look at residential and commercial demand, for the last 20 years they were growing slowly, but they were offset by the loss of electricity demand in industrial. So now here we are and demand is already growing again. And so the question is, how big is AI as a part of that? Well, it's certainly something, but it doesn't take away from the fact that we're reshoring manufacturing anyway. We are doing more electrification in terms of vehicles and heat pumps and things like that. And, yes, forecasts now are for maybe one and a half percent a year growth all the way up to three and a half. And you don't get to the three and a half without the big AI demand. But you don't need any of that to have the one and a half percent.
Ryan:So do you think that it's? You know, I guess there's maybe the potential for overestimating the demand growth and underestimating where in that spectrum do you think we are now? I mean, are most people overestimating how much growth we're going to need or are they underestimating that?
Jim:Well, I think maybe the near-term peak for estimates of growth was a week ago, friday, and then come Monday morning, people were questioning those assumptions. At the end of the day, all of us on Wall Street are not experts in the amount of computing power and therefore electricity that's required for these large language models and this inferential software. So I don't claim to be an expert on that, but we are students of all the sources of demand for electricity and sort of why they've changed and the fact that even last year we've already seen some growth for the first time in 20 years.
Ryan:You talked about demand growth, and I think one of the interesting aspects of that is, if there's demand growth, you've got to actually increase production, right? That takes a long time, right? I mean it's not like you snap your fingers and all of a sudden you've got production online. You've got to actually add that capacity.
Jim:Where is that capacity projected to come from at this point? Yeah, so you're right. So the lead times on all this machinery is a long time. And forget the back order, which of course now is building up, where you can put the order in today and the machine won't show up for three years. And then of course you have to install it and build the buildings and all that kind of stuff. So the lead times are pretty long.
Jim:But the data on the industry's plans are pretty transparent. So whether you're a regulated utility or an independent merchant power producer, you kind of have to file every year with the Department of Energy and that shows up in what's known as the A60 report. So we have a spreadsheet on our computers of every single utility scale power plant going back to the 1920s when they closed, what's currently operating today and what the five-year plan is to add new capacity, by type, by location and the ones that are currently operating when they're going to retire. So when you look at that five-year plan, what you see is that we're adding 170 gigawatts of wind and solar, we're adding 300, sorry, 30, 35 gigawatts of natural gas, and you say, well, okay, we're not adding any nuclear because it's not really under construction. That takes eight years.
Jim:No one's going to build coal plants. In fact they're shutting them down. So the plan is to shut 50 gigawatts of coal. So the net capacity additions for the next five or six years is 150 gigawatts. But when you do the math wait a minute 150, but we're building 170. 115% of net capacity additions over the next five or six years is wind and solar, and 100% of the incremental demand is basically from the industrial and commercial sector that needs power 24-7, 365. So that's the setup. 100% of what we're adding is wind and solar, not a net basis, and 100% of what we're needing and wind and solar are obviously intermittent and 100% of what we need is 24-7 availability. And so that's the setup and that's kind of what has gotten the capital markets interested in how we're going to square that circle.
Ryan:Right. And then you hear deals announced like Constellation's deal to sell power to Microsoft by restarting the nuclear plant, Three Mile Island, the nuclear reactor and some other notable nuclear-related deals. Yeah, Is that kind of the direction that we're going? You said there's not anything in those spreadsheets about new nuclear power.
Jim:Yeah. So it's gotten attention for really good reason Because, again, regardless of what the math turns out to be, the amount of electricity required by what they call the hyperscalers, but let's call it big tech is significant, and they have two requirements of this commodity. So you mostly think of commodity, as every commodity is the same, whether it's an electron or an ingridium of aluminum, and all that matters is price. But at the end of the day, that commodity is used in a product or a system and performance matters. So the performance that matters to big tech is two things 24-7 availability and zero carbon. Remember, they've made zero carbon commitments to their shareholders and their customers.
Jim:And so, in the move towards electrifying the world's energy system in order to reduce pollution of all kinds and of course the environmentalists want that mostly to be carbon you say, geez, wouldn't it be nice if we had an always available zero carbon source of electricity? Oh, wait, a minute, we do. It's called nuclear power and we invented it 80 years ago. And you say, well, what's the problem? And you say, well, the problem is it's really expensive. The last nuclear power plant built in Georgia, which came on stream about a year ago after 10 years under construction, two and a half times over budget is going to need 15 to 20 cents a kilowatt hour to pay off. Now, put that in context the wholesale price of electricity in the United States is $0.05 a kilowatt hour. Okay, so the deals that have gotten everyone's attention is that Microsoft is paying Constellation a premium over that $0.05, like 2x. And the other deal that got everyone's attention, which is almost two years old now, was Amazon building a data center next to a nuclear power plant operated by a company called Talon in Berwick, pa. It's called the Susquehanna Nuclear Power Plant, and they were willing to pay a premium. We say, okay, that's interesting. We now have sort of a wholesale market sort of coach. Everybody gets to fly coach but a few people get to fly first class. They get food, they get the board first. It's the same flight but the performance is a little bit better. And so that willingness to pay by a very large purchaser of electricity has gotten everybody's attention in general and on nuclear in particular.
Jim:But the thing with nuclear that people have to remember is that while the new plants need 15, 20 cents a kilowatt hour to get a return on investment for the owner existing nuclear power plants, that capital is sunk, and for three and a half cents a kilowatt hour they are profitable at a five cent number. And so now everyone, all the investors, looked around and said, well, who owns the existing nuclear power? And those are the stocks that went up the most. The thing is, the difference between the Microsoft deal with Constellation is that it's affect extra capacity. It's a power plant that was shut down five or six years ago and so they're adding capacity to the system. They're adding zero carbon reliable power to the system. In the case of Susquehanna and Amazon, they were taking an existing power plant simply for their own needs. So that means that on the margin everybody else's reliability goes down if they're taking the most reliable system plant for themselves. And that is why the Federal Energy Regulatory Commission has put a stop on that deal for the time being. And so that kind of has thrown a wrench into how people, how investors, are deciding what premium they're going to pay for existing nuclear.
Jim:But as you suggest, I mean even some of the new what I would. They're almost venture capital, but they came public through the you know, the SPAC bubble where all this stuff was coming public. But these are really venture capital. I'm not sure they kind of belong in the public markets. For you know, for john q, investor um, but those have gotten, those have gotten a bid um as well. But again, it takes years to build these things, eight to ten years, and right now they're not economic if they're simply going to sell to the wholesale market okay.
Ryan:So you've got. You've got the intermittent renewal, uh renewables, you know the wind and solar um, so that can't supply that 24-7, 365 demand on the one hand. And then on the other hand, you've got nuclear, which would be great, but it takes a while, right, I mean? And we're racing to compete with China. We want to build and scale up the data centers and, you know, add new manufacturing capacity, and where does that leave us?
Jim:So it leaves us in delaying some of the closures of existing coal plants, delaying some of the closures of existing natural gas plants and accelerating, from that five-year plan, natural gas construction. Wind and solar are already being built as fast as they can, so forget that. They're intermittent. Those are the ones that are spread all across the countryside, right, they are the least energy dense source of electric power, and that means the more space you need, the more permits you get, the more nimbyism you get and the more new power transmission that you need. And that's hard to permit because think about all the property that you have to get a right of way across, and it's not just federal permitting, it's local permitting.
Jim:And so wind and solar are going as fast as they can and no one's going to build a new coal plant. It might delay the closing of an existing one Nuclear they're working on but it takes time. That leaves you with natural gas, and so that, to us, is how you're going to meet this incremental demand for the next five, six, seven years. It's really kind of you go through that spreadsheet, as we've been through a hundred times, you can't come up with an answer. And so now you're starting to see deals done with big tech and natural gas.
Ryan:So are you kind of alluding to? There was the big announcement that Meta made that they're going to spend like $10 billion on a data center in Louisiana.
Jim:Yeah, in the middle of nowhere in Louisiana. Now, some people would say that Louisiana is already in the middle of nowhere, but this is in the middle of nowhere in Louisiana and I think this is a really important deal and investors should be paying attention to this. Energy is going to build 2.2 gigawatts of power with three sort of 750 megawatt natural gas units and it's going to cost upwards of $3 billion to do that. To give you an idea of and this is for the $10 billion data center for Meta, but to put that 2.2 gigawatts in context, it's 17% of Louisiana demand today. That's how big this one data center is.
Jim:And you say, well, okay, I thought big tech wanted zero carbon. It's like, well, they're throwing in some solar panels, some batteries and some carbon capture to kind of burnish their zero carbon bona fides. But at the end of the day, these guys need power. They're running a business, and you say so. Why did they go to Louisiana? Why did they go to a vertically integrated utility?
Jim:People have this perception of utilities as run by a bunch of sort of you know, you know, dyed in the wool, old state management that you know doesn't know how to use a cell phone and that kind of stuff and it's just not the case. The vertically integrated utilities actually have an advantage here. First of all, they own all the wires in the state, all the transmission they own Inside of a state. When you want to build a new wire, the state gives you the right of eminent domain. Interstate power transmission under the Federal Power Act of 1920 did not grant right of eminent domain. If you're building an interstate power transmission line you got to go out and get the land yourself. The second thing is that, being a big utility, entergy is already a big customer of Siemens and GE, vernova and that kind of stuff. So they're farther up the waiting list on getting power demand.
Jim:The other thing that Louisiana is it's a business-friendly state.
Jim:They already have sort of a special tariff for large industrial customers.
Jim:They obviously don't have a problem with natural gas the way New England and California does, because oil and gas is the home team in Louisiana Sure.
Jim:Oil and gas is the home team in Louisiana Sure and you know you have a—and so if you need to build a new pipeline to these new power plants, then Entergy can write a 20-year contract, because the pipeline companies aren't going to build a pipeline without that 20-year contract and the merchant power guys don't really have the balance sheets or the shareholders willing for them to get into a 20-year commitment shareholders willing for them to get into a 20-year commitment. And so when you look at what Meta's looking for, they're looking for speed and one-stop shopping in a state that has natural gas availability, that has a business-friendly environment, that has a regulatory structure, has a vertically integrated utility, that operates on a cost-plus monopoly model, and it's basically everything they're looking for. And if there's so much more in that package for them than a single independent power producer operating in a state that may not be as friendly to natural gas as Louisiana is, so with that cost plus model.
Ryan:You know, are the normal consumers that energy is, as a utility, supplying power to. Are they the ones that end up paying for this deal with Meta, or does Meta have sort of a carve out? Or do they pay more? Is it distributed?
Jim:No See, I think that's what's making this deal. Have the other states sit up and take notice. And so this isn't the exact arithmetic. But think about a 17% increase in demand for electricity in your state and that some portion of the electricity costs that everybody pays to bring into their house is a fixed cost. Those fixed costs are now being divided by 17% more kilowatt hours. Now, that's not exactly the math, but that is directionally the math, and so the other thing that Meta did was they signed a 15-year contract. So, in spite of the fact that a vertically integrated utility is a cost plus model, they said if anything happens to our plans like, let's say, this deep seek thing said, we need a third less power than we thought. They're still on the hook for 15 years for all the capacity of those three generators, which is going to give the utility full cost recovery. And so it's very friendly to everyone else.
Jim:Go back two years when Talon says I'm going to take this one and a half gigawatt nuclear power plant in Berwick, pa, that's 24-7 availability and zero carbon, and I'm going to take it off the grid and use it for myself, and everyone else is saying wait a minute.
Jim:Not only are you making the grid less stable, but the people who use that electricity used to pay $140 million a year in transmission fees and we're going to lose that revenue. Now everyone's bill is going to go up and the reliability is going to go down. So you can see why the Federal Energy Regulatory Commission stepped in and said they kind of hit the red stop button. They said you know what? This is all happening too fast. We don't want to set the wrong precedent, but we're not seeing how this is good for everybody else. The Louisiana deal is good for everybody else and it's good for the utility whose stock price jumped on this, because now their earnings growth rate is going to go up, because that's they get. Remember, they get an allowed rate of return on invested capital. So the more invested capital they have, the faster their earnings grow.
Ryan:So you invest a lot in assets that are high quality assets focused on transmitting hydrocarbons, whether it's or electrons, or electrons, right. So natural gas pipelines how do they play into everything we're talking about?
Jim:Yeah. So they started getting a bid recently too and they sold off very hard on Monday because the investors have sort of figured this out for some of those companies. But there's no question that there is more pipe capacity that is needed for this additional investment in natural gas power generation. And when we start moving out of the world of electrons and in the world to pipelines, we are now sort of in the conventional oil and gas neighborhood and, as we talked about in our last podcast, that is a neighborhood run by companies that are on a very short leash with their shareholders with respect to capital spending. And the reason they're on a short leash is because they wasted so much capital during the shale boom and they drove their returns down pretty close to zero. Now the pipelines did much better. They're on a short leash is because they wasted so much capital during the shale boom and they drove their returns down pretty close to zero. Now the pipelines did much better because they're long-term contracts, they're regulated monopolies or natural monopolies.
Jim:But that shareholder culture of don't spend a dollar without my approval because the last 10 years you weren't getting good enough returns is as much a part of the pipeline industry as it is the oil and gas industry and so when you look at capital spending for pipelines, it has dramatically lagged the growth in natural gas demand and production in the United States and major systems. The biggest natural gas system in the United States and the second biggest in the world behind Gazprom, is the Transcontinental Natural Gas System owned by Williams. It runs from Texas and Louisiana all the way up to the New York City gate and that main trunk line is sold out. So the only way they can sell more gas is to build laterals in the Carolinas and places like that for these new natural gas-fired power plants for industry. Some of those are auto plants they're not all data centers and that allows them to grow their earnings even though their main asset is sold out. And when you look at the returns they're getting on those projects, they are twice what they were 10 years ago.
Ryan:So that added demand.
Jim:They're able to satisfy that by building more Building, more yeah, and so, yeah, so that capital spending will get 20-year contracts. And again, who is going to be able to sign those 20-year contracts? Vertically integrated utilities, because they can pass that cost and obligation along to all the rate payers. I mean, that's why we that's, you know, one of the reasons we have. You know, we have that model.
Ryan:You know you've. You've made a really interesting set of points when we've talked in the past about the difference between those vertically integrated utilities and some of the merchant power utilities. Can you maybe break that down a little bit for us, like, what's the difference between those two?
Jim:Yeah. So you have to kind of go back and look at the history of how we ended up here and again. When you look at the utility space, it's less than 3% of the S&P 500. It's two-thirds owned by retail investors. So the average institutional portfolio manager has less than 1% of utilities. So the subtleties that we're going to talk about is lost on 99% of them.
Jim:The folks that know the story I'm about to tell you can count on two hands and they're basically the research analysts in the world of utilities. But, as some of the listers may know, I mean research in general in the world of energy has been slashed in the last five to 10 years. But anyway, if you go back to the beginning of the utility industry, at the beginning of the 20th century, we were starting to build natural gas pipelines and electric power lines and the model that we chose really grew out of all the problems with railroads in the 1800s. And you say what were the problems with the railroads? Well, a railroad is a natural monopoly, just like poles and wires and pipes, and if you have one guy build one rail too many between Pittsburgh and Cleveland, all the rail operators go bankrupt. So we had massive financial distress as a result, horrible safety problems, all kinds of financial shenanigans, and that brought forth the very first regulatory agency in the United States, the Interstate Commerce Commission. And the very first regulator in railroads was actually Charles Francis Adams, the great grandson of John Adams from Massachusetts, and he made this observation that the rail lines with the lowest cost were the ones with the least competition. Because you have to think of cost, not just an operating cost but the debt and equity financing on building the railroad, and so if you had too many rails, you had too much cost and not enough volumes. That's just another way of describing a natural monopoly. So when we got to the turn of the 20th century we decided to try legal monopolies, and that way you only have one set of poles and wires running down the street, and so you avoid the duplication of capital, and you you basically run a cost plus model, so that that monopolist can't charge what he wants. You give someone a monopoly, you got to get two things in return you got to get an obligation to serve, because customers don't have another choice, and you have to limit what they can earn on their investment because you've granted them a monopoly, and so that takes the form of a cost plus revenue model. So you had your operating costs, your interest on debt, and you're allowed to return on equity and that's your revenue. It's literally upside down from every other business, and so that's how the business started off in the early 1900s and was cruising along fine until we got to the 1970s and 80s.
Jim:We're building out these nuclear power plants. We talk about what they cost. We had massive cost overruns. We're talking 5x. Well, in a cost plus system, those costs are passed along to everyone.
Jim:Industry is now looking at what they're paying for electricity. The wholesale price of electricity back then was six cents a kilowatt hour. Looking at what they're paying for electricity, the wholesale price of electricity back then was six cents a kilowatt hour. When I was at BP in the early 80s, my team was running economics on making our electricity, which we could do for three cents a kilowatt hour. Well, every industry was doing the same math and regulators realized what was going to happen. Big industry would get off. The fixed costs would be borne by a fewer and fewer and fewer number of customers. This was a negative feedback loop.
Jim:We had to deregulate the electric power portion of that vertically integrated model and we kept where the poles and wires of course really are a natural monopoly Generation, isn't? So that's when we started having independent power producers. Now some states decided that they didn't want their customers paying a highly volatile change in electricity price. Because you look at any commodity natural gas, oil, pork bellies, gold, aluminum, copper they cycle like crazy. They wanted to protect their customers from that, so they allowed their vertically integrated utilities to keep their power generation in that cost plus model. So today we have two side-by-side systems. We have deregulated markets in every state, but it's the state that decides whether or not the utility is allowed to have the power gen in a cost-plus model. And so today 50% of US electricity is generated by a cost-plus vertically integrated utility and 50% is generated by merchant power producers, generated by merchant power producers. And so a merchant power producer if he can sell electrons for more than they cost and make a profit, that's the only requirement on him. Just like if you deliver aluminum to London Metal Exchange, they don't say well, to do business here you have to come every Wednesday at 11 o'clock and sell us this amount of aluminum. That would be silly. That's not a deregulated market.
Jim:So one of the questions people get we went through the supply plan for the next five years and people say, well, wait a minute, if we need 24-7 electricity, why the hell is all the incremental supply coming from intermittent wind and solar? And the answer is because they're merchant producers and if they can sell their power on a 25-year contract at, say, four and a half cents or five cents, and it's costing them three even without subsidies, this is the misunderstood part. We are subsidizing these things, but in some areas the wind is so strong and the sun is so bright that with these subsidies they can sell electricity for zero and still get a cash-on-cash return. Take away all the the subsidies and there is still a big swath of the South for solar panels and a big swath of the center of the US where our wind corridor is from basically Minnesota down through Iowa to Oklahoma, the panhandle of Texas, where they can sell electricity for three or four cents a kilowatt hour and make a 10% cash on cash return.
Jim:You say, well, but it's not reliable. It's like that's not their problem. That's what a deregulated market is, and so that's what people have a hard time understanding. And people say, well, why did we deregulate? Well, that's $0.06 a kilowatt hour back in the early 1980s is still $0.06 a kilowatt hour. So adjusted for inflation, it's down 70%. So by that measure, deregulation was an overwhelming success and was absolutely the right thing to do.
Jim:But if the public wants reliable power, then some combination of their desire for that and regulators' desire to give them what they want, or politicians we have to figure out how to get reliable power without destroying the efficiency of a competitive market. And, as I say to people, if you think that's easy to do, then you haven't worked the problem. Because every time you step in with a constraint on the free market because that's what the public wants, you're going to lose a little bit of efficiency. And the public may say I'm fine with that, I just don't want the lights to go out. That is a tradeoff that the political process is designed to do. But that's why we have this hybrid system today, and it's just like Winston Churchill said about democracy it's the worst system, except for all the others.
Ryan:Right, there's a new administration. We're past inauguration day and the Trump administration has already pretty quickly began to issue a lot of executive orders and try to do a lot of different things. How does that impact the energy sector just kind of broadly, in your view?
Jim:Yeah. So you know, the executive orders are something people ought to read just one or two of just to get a feel for how they're written. And they've evolved from his first administration and the Biden's administration, because in those first executive orders every paragraph would start off with the phrase to the extent allowed by existing legislation and federal agency rules. We're going to do blah, blah, blah, blah, blah, and so, effectively, the context people have to put these executive orders in is the context of how the government works. And so the way the government works is Congress passes the laws, congress funds those laws and the executive branch executes those laws. It's not called the executive branch because the president is the CEO. It's called the executive branch because it exists to execute congressional intent. So we have over 400 federal agencies in the United States Now. After the Constitutional Convention in 1787, we had zero, but it's grown to over 400. And every single one of those agencies was created by and is funded by Congress, not the executive branch.
Jim:And why do those agencies exist? They exist to interpret, administer and enforce congressional intent in that legislation and they have to follow strict rules. So when there's new legislation, rules have to be promulgated, basically interpreting that legislation to the real world where businesses and people are going to have to work with the language in that legislation. To the real world where businesses and people are going to have to work with the language in that legislation. They can't simply just write those rules. They have to hold public hearings and then they draft the rules and they issue those and it's called a notice of proposed rulemaking and then people comment on that and it goes back and forth and back and forth. Because oh, that's a bureaucracy.
Jim:I think it's the most open and transparent democracy on the face of the planet. Everybody gets to weigh in. We ourselves have submitted expert testimony in two open hearings for the federal energy. Anybody can do that. It's not like you need a license, and so those processes and procedures define how those agencies can change their rules.
Jim:So when a new president comes in and says we're going to do this, this and this not so fast, okay, because the agency can't change its rules without holding hearings, now that doesn't stop presidents, this one or any other, and so if somebody doesn't like the change in the rule, then they sue and say you haven't followed the Administrative Procedures Act of 1946 because you didn't hold hearings on this, and it grinds the whole thing down. You didn't hold hearings on this and it grinds the whole thing down. But the president's power, I think and this is the irony of it actually comes into play, because there are over 400 federal agencies and there's just not enough watchdogs and so they can sort of issue rulings and issue sort of policy statements, and all those agencies start working a little bit differently. And, yes, there will be lawsuits, but they sometimes take years. So you saw like some of the judges issued injunctions, like when he said you know, we're not going to like fund any of these things, and the judge says, no, you can't do that, that's Congress Right, you know.
Jim:And then they rescinded that right and they rescinded it temporarily, but it's going to be adjudicated in the courts. And then Biden you in the courts and then Biden forgave all that student loan and people said it's the Congress, the executive spends the money, it doesn't authorize the money, and so that's the context people have to put this stuff in. But when you look at the executive orders for this administration, they're much more surgical in their drafting. Yes, there are policy statements, so there are three that relate to energy. One is unleashing American energy, the other one is unleashing the extraordinary natural resource potential of Alaska and the third one is declaring an energy emergency. So those are the three that relate directly to energy, and what's interesting about that one is that it actually references two pieces of legislation which have given the executive branch extraordinary powers. The first one is the Emergency Powers Act, and they say it's 1976, is the current one, but it was actually enabled all the way back during Woodrow Wilson's administration, prior to the US getting involved in World War I, because our ships were getting sunk by submarines, and so he needed executive powers to implement rules so that that didn't happen. And that legislation has been modified, and the last modification was 1976. It gives the president, certain powers there are still. I think in the history of it it was like 40 or 50 emergencies for specific things have been declared since Woodrow Wilson, and 20 of them are actually still active, and the oldest one is from 1979, and it relates to the confiscations of Iran's financial assets in the United States. It is still current. Wow, okay, it's a long emergency. It's a long emergency, but no one's objecting to that.
Jim:So let's put all of that detail in context, because clearly it's the policy of this administration to encourage energy production of all kinds oil, gas, coal, electricity generation, which is converting one energy form to another. You have to say, ok, what impact is that going to have on the industry? And when you read the orders, they are in effect attempting to relieve constraints on the industry right, permitting and things like that. But to believe that that's going to have an actual impact on supply, you have to believe that those things are the constraints. And, as it turns out, they're not. So, as we said on our last podcast from about a year ago, the real constraint on the oil and gas industry is actually the capital spending their shareholders are allowing them to do, and capital spending got cut 50% in the oil and gas industry during the Trump administration. Nothing to do with Trump. It happened to do with the cycle of shale. It just so happened that that happened between 2016 and 2020. And so when you look at the amount of drilling permits, for example, that Biden issued versus, you know, versus Trump, they were about the same.
Jim:But what is interesting, you go back and look at the offshore acreage that was put up for lease by the Trump administration and Trump won 2016 to 2020. Or 2017 to 2021. Versus Obama, it was two and a half X. So Obama made available roughly 60 million acres a year and Trump bumped that to like 150. And then you go back and look you say, well, okay, how many acres did the industry actually bid on? And the answer is less than 3 million in every year. And it didn't change under Trump because they have their capital budgets and that kind of stuff.
Jim:So the other thing is that, yes, the federal government has control over federal lands, but only 10 to 15 percent, depending on how you measure it, before or after royalties, etc. Only 10 to 15 percent of US oil and gas production is on federal lands. So it only affects that and if, for some reason, so forget the story I just told about offshore leasing. Imagine it was a constraint and it's not. And the industry spends more money in federal lands. They're just going to spend less money somewhere else because they're not going to change their capital budget as a result.
Jim:And then when you get to electricity, we've been through the numbers on demand exceeding supply and you say, well, what can the federal government do to help that? And I'm not sure they can, because all of those mechanisms that we just described were happening at the state level. We talked about the Meta, entergy deal and that is all within the state of Louisiana. And that's really the point of the story is that because it's all in one state, louisiana and Entergy can give Meta what it wants. The federal government has a hard time doing that. They just don't have jurisdiction. You say, well, they have jurisdiction on everything interstate. And you say that's right.
Jim:So if power transmission, interstate power transmission, you know, is a constraint, then permitting reform would help that.
Jim:But again, under the Federal Power Act of 1920, if you get a permit under, you know, under the Federal Power Act for an interstate power transmission line, it still doesn't come with them in a domain. Only the states can provide that and, at the end of the day, the reason we need so much new transmission is because of wind and solar. Remember, you can locate these natural gas plants and, in the future, new nuclear power plants right where the wires already exist. In fact, there's been a study done on the existing coal plants, not only the current ones that will close someday, but the ones that are already closed, and like three quarters of them are actually OK for a nuclear power plant, and so you just use all the infrastructure that's already there. So the funny thing about this is the one thing the federal government can do on the electricity side is improve permitting for transmission, which primarily helps the wind and solar, which, of course, this administration is against because the other administration was for it.
Ryan:So it sounds like a lot of it's just politics. It's really good theater.
Jim:I remember when Trump was doing all these executive orders in his first administration. I remember saying to people I said this is good theater and you watch. Whoever the next president is, they're going to do the exact same thing. And sure enough, biden did it in for oil and gas.
Jim:The general perception of the folks in the investment community that I talk to is that it is a constraint, that the industry is being held back and we will have more drilling. And the fact of the matter is that it's not the case. They say well, the industry says it is. The industry associations say that, but they are least common denominator mouthpieces and they're always talking about how government is the problem, because, God forbid they should ever admit their own mistakes. I mean, it wasn't the government drove their returns on capital from 10% to zero. It was them. But if they can blame someone else, they're going to do it, and so, of course, that's the narrative.
Jim:But when you talk to individual companies in one-on-one meetings and say, okay, mr CEO, are you going to raise your capital spending, and he's like absolutely not. And I'm running 14 rigs, there's no more rigs available. I'm going to keep the 14 I have and I'm not going to outbid the other guy just to get to 15 or 16, because it's just going to run the price up because they're not available. I'm going to stick at 14 rigs. And of course all the shareholders are like damn straight you are, because I'd be looking to change out the board if the answer to that question was anything other than what you said. So there's a big difference between what the industry associations say and what the politicians say versus what's actually going on on the ground.
Ryan:So this is kind of maybe a side topic, but all the capex that the energy sector did for that long period of time and they basically, you know to your point now they have much more discipline because they're forced to Are there any similarities when you look at, like, the amount of CapEx that's been done by or that's planned to be done and has been done by the technology sector? And some of these, you know, they're spending a ton, I know, and they're only raising their CapEx.
Jim:We had that conversation in the research group yesterday. Yeah, and I mean so for someone who works in commodity businesses right, that are capital intensive, capital discipline is everything. And so there's this report that I wrote when I was an analyst at Bernstein in the early 90s. That ricocheted around the industry and got to other industries and it was just something I noticed which is burned in my mind, that while Exxon was always the most expensive company in my coverage, they also had the best earnings growth, the best returns on capital. And I said they actually they're so frugal on capital. You know they give back like 40% of their cashflow and share buybacks. Why is it they grow more? And I said, well, let me look at what their return, their return on capital, is. Like you know, 10, 11%. It's interesting. I wonder what the other companies are. Oh, this company spends a lot of money. Their return on capital is three. And I said, okay, so I do all the companies.
Jim:I look at the capital spending as a percentage of cash flow versus the return on capital employed. And it was a scatterplot and it was an 85% correlation going from southwest to northeast and it was an inverse relationship the less capital you spent as a percentage of cash flow, the higher your returns. No-transcript these things. And then they have to cool the whole thing down because they get so hot and it needs all this power and all of a sudden they're going from basically code in a computer to physical machines that you're cramming electricity through, spending $25, $35 billion, and you just wonder is that going to create growth or they all have to do it to maintain market share? So now you don't think of it as growth spending. You think of it as sustaining capital and the returns. Now, I'm not a tech expert, but I have seen this play out in the capital-intensive industries that I've been investing in my whole career and that question is….
Ryan:And technology's never really been that capital-intensive industry. No, it's all human beings.
Jim:I mean, it's sort of like do you capitalize? Brian Westbury tells this great story. He says you see, capital spending and US industry goes down. He says but think about how we've shifted to a bunch of millennials sitting around developing an app. He says but think about how we've shifted to a bunch of millennials sitting around developing an app. He says I don't know what capital spending it takes to develop app. He says it's a case of Red Bull and 14 pizzas.
Jim:And it's a great line because it's human beings sitting at a keyboard who are just incredibly good at what they do. It's not concrete and steel and bulldozers and stuff like that is what you need to create the machines that we all use. They are making the machines we use smarter, but it's the machines that have the lower returns on capital. And so who knows? But there's no question. But being in a capital-int, you know I always get nervous when capital spending goes up and you say, well, but it's going up in these regulated utilities, it's like, yes, but that's the one place where they get a cost plus model. And you know, one of the and again the same, in effect, the same with the gas pipelines and one of the things that I think probably a frustration for some investors is that our industry is so siloed in terms of its expertise, just like every other. I mean, think about all the specialists we now have in medicine. Right, I mean specializations within specializations. The same is true on Wall Street, and so you've got fund managers out there that are experts in utilities and you have fund managers that are experts in pipelines. I mean they're really retreaded MLP funds. Basically, they say, well, no, it's not about MLPs, it's about pipelines. It's like well, it is now that the MLP thing didn't work out too well for you. When you have this industry responding to this demand through some combination of electricity and natural gas, you see that having the ability to invest across the space is an advantage for us.
Jim:One of the things we didn't mention, which is similar in vein to the Meta Entergy deal, was when Exxon had their annual analyst meeting last month. They announced that they're going to get into the electricity business. Of course, chevron copied them, and so I wrote a little blog on LinkedIn called the Exxon Electric Company, and people were saying this doesn't make any sense, they should stick to their knitting. I was going to say look, I believe that all these companies should stick to their knitting. But what is their knitting? It's getting natural gas out of the ground, processing it, shipping it through a pipeline, running it through rotating equipment. That's, you know the compressors that spin, you know anything that spins. That's a valve or a compressor or whatever is called rotating equipment.
Jim:Oil industry operates more than that than anybody, and they generate five megawatts of power for their own use anyway across all their facilities. So they actually know how to run electric power plants. So I actually think this is right within their area of expertise. But, more importantly, they're offering a vertically integrated solution, the same way Entergy is Now. Entergy doesn't produce natural gas. That's the only thing that they don't do. I mean, they don't do the pipelines either. So Exxon is saying we can build wires, and we haven't done that before. And you say, well, we'll contract it out, but that's the only thing we don't do. So you see this convergence of a vertically integrated solution, so that you're competitive in attracting these capital dollars that you're asking about.
Ryan:What about the renewable side of you know we talked a little bit about wind and solar and their subsidies going away. Is that going to have a big impact, do you think, at some point, on the deployment of those by those merchant power producers?
Jim:I think it will. I think what it does is it puts regulatory uncertainty in it, right. So remember, the onshore stuff is very low cost, the offshore stuff is not Okay. So we have a couple of sort of offshore projects One is sort of offshore Virginia, and those seem to be coming in sort of on budget because they did a good job of acquiring the acreage before it got expensive and acquiring the financing and all that kind of stuff.
Jim:In New England not so much. In New England, those wind farms were going to initially sell electricity for about seven or eight cents a kilowatt hour. Right, not quite the five cents of the wholesale market, but New England's a little more expensive anyway, because it's so far from everything that it wasn't that uncompetitive Go through COVID, go through supply chain things and that seven, eight cents became 15. And now people are backing away and the renewable developers said look, I can't honor the old contract, I'm going to have to pay the penalty to get out of it. Well, the only reason that those numbers are still 15 cents is because there's investment tax credits and the investment tax credits come in 10 percentage point bundles. The first 10 percentage point is domestic sourcing. The second one is fair labor pricing. The third one might be a disadvantaged community. Whatever, if you get all of them, you can get a 50% investment tax credit. So that's what they're trying to do in New England. They're trying to pancake every one of those things, check every one of those boxes.
Jim:Well, with a new administration that doesn't like offshore wind, it's going to be much harder to get all five of those 10 percentage points. So they're going to become even more stressed. And you got to remember the renewable developers who build those things are already under financial stress. They already have their shareholders breathing down their neck saying look, I don't care what the growth is, if it's not profitable, I'm not interested. And you've had cost overruns in New England. Get the heck out of there. And so that has been happening already for the last two years. You now put it in unfriendly administration and I think it throws even more uncertainty in the minds of the shareholders that are funding those operations.
Jim:So when you get to onshore those operations, so when you get to onshore, the recent data shows that even big tech is spending less. So 35% of all the onshore wind and solar there's no offshore solar of utility scale in the last 10 years has actually been funded by big tech. Remember, they have zero carbon and of course they have 24-7. But they have big energy groups that are trading electricity and swapping the intermittent for firm and that kind of stuff and that's a big operation. It's a desk with a whole bunch of people.
Jim:I meet the head of the energy group at all big tech at the Aspen Institute twice a year. These people know the energy markets, they're very sophisticated, spending on that is going down and their interest in nuclear is going way up and the nuclear thing, and so we get a lot of questions on the nuclear thing from investors, and one in particular I kind of. I really it really tickles me because it shows that investors really are willing to be long-term sometimes. And so the question takes the form of you know, we have some grandchildren of our wealthy investors. I know nuclear is a long way away, but there are some stocks we can put in junior's portfolio that in 20 or 30 years will be like Apple is today. You look back and say why didn't I buy it at a dollar a share? And our response to that is they're publicly traded but they're still venture capital.
Jim:We talked about what the costs are, but people ask, you know, wait a minute, but don't you think nuclear has a future? And the answer, my short answer to that is absolutely. But nuclear has three problems, and those three problems, in order probably of importance in terms of why nuclear power has not grown in the US, is cost. We talked about the cost, you know 15 to 20 cents a kilowatt hour. When the wholesale price is five, the risk of a meltdown. Everyone has Chernobyl, three Mile Island and Fukushima right back of their mind, and if you can get past those two things, you still have all the waste. And so when you look now, long term, we're not talking about the existing nuclear power plants. We're saying you know what is the investment case for these companies? The investment case is that their technologies are designed to address some or all of each of those three problems. And so when people say, yeah, small modular reactors, advanced reactors right, isn't that the same thing? It's like no, so let's take them one at a time.
Jim:The small modular reactors is a response to the cost. So we have today 94 nuclear power plants operating on roughly 50 locations, because most of them, there's two sitting there. In the last 10 years we've closed about 10 to 15, of which one of those is Three Mile Island, right, and there's a couple more. They're talking about restarting. So at our peak we've had, say, 100 power plants operating plus or minus 50 different unique designs. Now we're all the same technology, but they're all a little different size.
Jim:This is what the French did, right, they built the same unit. I think it's about 300 megawatts. They wanted 900 megawatts, they just put three of them. They wanted 1,200. They put four. They wanted 600. They put two. That's why nuclear power is 80% of their electricity.
Jim:So the small modular reactor is simply trying to get less construction in the field and more in a factory. So I was invested with a private equity guy building a hotel in Los Angeles that was manufactured. Each hotel room was built in a factory and put on the back of a truck. And you say, what does that mean? It's like well, it's a rectangle. Okay, the window is in, the framing is all there, the carpet is in, the drywall is in, the wallpaper is in the toilet, everything. The beds are in there, the linens are sitting on the bed. You stack these things together, you put on the siding. Literally, the housekeeper goes in and makes the bed. Everything is made in the factory that's. Compare that to a custom home in Beverly Hills. That's 25,000 square feet, where it's tough to get the permits. The neighbors don't want it to happen and it takes 10 years for the guy to build it and it's 50% over cost. That's an infield nuclear reactor and the hotel room is a small modular reactor. So that's what it's meant for. It takes advantage of the adoption curve, what's known as Wright's Law, and the more you make, the cheaper it gets.
Jim:So now we get to the meltdown thing, and meltdowns have happened. I mean, it's a scary thing, right. And the meltdown happens because the way you moderate that reaction fails, probably because of some pump I mean something that's a hundred-year-old technology fails and so the reaction starts running out of control. And because what everybody uses is water and the thing is at 300 plus degrees centigrade and water at that temperature is steam and it needs to be water, it's got to be under pressure. So your valves are failing, the thing is getting hotter and boom, it explodes. Not like gasoline explodes, it explodes because of the pressure of this. And so other technologies out there are using a moderator. That is not water, it is molten salt and it's not at pressure. So that's another technology that addresses the meltdown issue.
Jim:And then finally, you get to the nuclear waste. So one of the things I've been to a couple of nuclear conferences and all the nuclear guys love to quote this statistic they call the nuclear waste in the last 70 years around the world. And you put it in one spot it would be the size of a football field, four stories high, basically your average parking garage. And he says what other energy source can claim that about their emissions of any kind right Now? Having said that, we generate that waste because all the nuclear power plants in the world, effectively, are running a similar technology where they take uranium and they enrich it to 5%. So what does that mean? So naturally occurring uranium has two isotopes uranium-238 and uranium-235, which is seven-tenths of a percent.
Jim:So when you hear about enrichment, what is Iran doing? They're spinning these centrifuges. What they're doing is they're concentrating the uranium to get more uranium-235. Trading the uranium to get more uranium-235. That is the unstable isotope. So the bomb we dropped in Japan in August of 1945 was 95% uranium-235.
Jim:In a power plant it only needs to be 5% and so it gets used up. So you got to take out the whole thing and you say, well, what's the problem? It's used up. And it's like, no, there's all these neutrons kind of flying around and they create these isotopes of uranium and other atoms in there that are radioactive, that are going to last for 10,000 years. And you say, well, what do we do about that?
Jim:Well, there's another way to run a nuclear reaction, where you don't moderate the speed of the neutrons. You let them fly all over the place and they actually create as much fuel as they consume. So that's why they're called fast breeder reactors. They are fast neutron reactors, not slow neutron reactors. And you say, well, where does that technology stand? It's like, well, there's actually one commercial plant in France. It's not operating today, no-transcript. And that's why we don't have fast breeder reactors, because the world signed this nuclear non-proliferation treaty, because everyone's generating this weapons-grade plutonium.
Jim:The waste from a slow neutron reactor is toxic but it's not explosive. And so if you can have a small modular reactor that is not under pressure, that is using fast neutrons to consume the fuel and recycle the bad stuff to extinction, you've solved each of the three problems of nuclear. So that's why, when you go to a nuclear conference and you learn all this stuff, you say, wow, these guys really have got this figured out. And you say, well, if they've already built one in France, what's the problem? It's cost right. They built it because they had a waste problem. And even if that wasn't economic, the system as a whole was economic. And so it's now not just science, it's engineering. Can you engineer a machine that's working all the time, not breaking down and is cost effective, so it can be competitive in these deregulated electricity markets?
Ryan:So at conferences like that, I would imagine they do. But do they discuss any of the newer sort of like the fusion technology? Yeah, fusion gets in there too.
Jim:Yeah, my favorite comment about that is that's always going to be the energy source of the future. But one of the things you read is they say that the challenge is getting more energy out of that reaction that you put into it. Well, if you've ever seen a film of a hydrogen bomb going off, that isn't the problem. You can get way more energy out than you put in. You just have to have a controlled reaction, Right. So remember, we talked about how you control a fission reaction by moderating those neutrons, keeping the temperature right and all that kind of stuff. That's the problem is getting this thing hot enough literally the same temperature as the surface of the sun and controlling that temperature so the reaction doesn't run away.
Jim:And so, again, I don't like to bet against engineers and scientists, it's just a question of time. And there are these other things where the technology is sound. They have been built before. Granted, the only commercial one for the fast neutron reactor was in France. But the new technologies that Bill Gates is behind and some of these others Sam Altman is behind, these are valid technologies that have improved in the laboratory for decades, and the trick is now the engineering part of that where you can make these things commercial, and so it is very difficult not to be optimistic about the brainpower that exists on this planet, much less in this country, to be able to solve this problem. I think it's just a question of time.
Ryan:Well, that's a good point. It's a question of time and we I'm looking down at the clock have talked for over an hour.
Jim:I'm out of time.
Ryan:We are out of time, but I could talk for another hour. This is, as always, very interesting stuff, so thank you for carving out some time and joining us on the podcast once again, and thanks to all of you who have joined us once again for this episode of the First Trust ROI Podcast. We will see you next time.
