Ep 69 | Jim Murchie | What Does AI Demand and a War in Iran Mean for Utilities and Energy? | ROI Podcast

Jim Murchie joins the podcast to break down how the war in Iran may impact the energy sector as well as the misunderstood relationship between AI data centers and consumer utility bills.

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Transcript

Welcome And Market Backdrop

Ryan 0:08

From the insatiable demand for electricity from AI data centers to an ongoing conflict in Iran, there's a lot happening in the energy sector. Today I'm joined by co-founder and portfolio manager at Energy Income Partners, Jim Murchy. Once again, Jim's gonna help me make sense of all these topics and others. Thanks for joining us on this episode of the First Trust ROI podcast. See, a lot lot of uh events happening in the energy sector and the utility sector. I was looking at the uh breakdown of market performance um maybe earlier this week or last week, and uh most of the S P 500 sectors were down. Well, the exceptions were basically the energy sector, the utilities sector, some of the boring consumer staples, um, some some you know some volatility, some rebounding in different sectors since then. But um obviously that can be traced back to uh some of the events that have taken place in the Middle East, particularly the war with Iran. Um and that's what's on everyone's mind. So uh, Jim, appreciate you coming to the podcast. But uh let's uh maybe let's start there.

Jim 1:14

Sure. Well, let's not forget that right before the uh the the attack on Iran, the the violence in the stock market was the massive sell-off of the enterprise software companies. Oh the sadness. That was that was that's you know, there's a lot of market cap there. Yeah. And remember, before the war started, everyone was talking about I want to own things that are physical where AI cannot disrupt them with software that's cheap to write. So anything made of concrete and steel basically fits into that category. So there was a rotation into those sectors that you described even before the war, because people were looking for refuge from those enterprise software stocks. Yeah. And then in fact, even the staples kind of kind of got overbought and then kind of drifted back, as did the utilities a little bit. And then there is another reason now for people to seek refuge. Trevor Burrus, Jr.

Ryan 2:07

Well, and and those sectors, I mean, utilities, um real estate, materials, um, energy make up such a small part of the S P 500, it's like they they're together, they're like half of the technology sector.

Jim 2:24

Trevor Burrus, Jr.: Yeah, the money doesn't fit. Yeah. Yeah. It's not a it's not a square peg and a round hole. It's uh it's a giant, giant peg trying to go into a small hole.

Ryan 2:32

I suppose if there is sort of a sustained rotation towards where value is, and it is those those sectors you mentioned, um that could have a pretty big impact on the potential to maybe expand those multiples.

Iran Risk And Oil Market Context

Jim 2:46

Aaron Powell Could be. They've already expanded, yeah. But um but on a relative basis, you know, the market really isn't down that much. Trevor Burrus, Jr. Yeah. People are so used to it going up every week that if you have a bad week, everybody's pulling their hair out. But in the big scheme of things, the market is very close to its all-time highs and trading at 22, 23 times earnings. So on a relative basis, these other sectors that have moved are still historically on a relative basis cheap. Trevor Burrus, Jr.

What Actually Causes Supply Shocks

Ryan 3:12

Okay. So I don't want to only focus on what's happening in Iran and its long-term impact on the energy markets, but I think that's the question everyone's having. So um I do want your perspective on um, you know, I think none of us knows how this plays out, when the war wraps up, how it wraps up, but I think you can probably make some guesses on what's going to be the longer-term impact, even when it does wrap up on the energy markets. So I'm curious what your perspective is, um, what the downstream impact might be.

Strategic Reserves And Price Limits

Jim 3:44

So I'm gonna start with Winston Churchill um and so and look farther back. So because he says the farther back you look, the far ahead, the farther ahead you can see. So um I am a lot older than I look, and I actually came to Wall Street in 1990, just three months before Iraq's attack and invasion of Kuwait. So even in that big event, which caused oil prices to just about double from kind of upper teens to $40, there really wasn't any interruption in oil prices. Um, you have to go all the way back to the Iranian Revolution and the ensuing Iran-Iraq war in 1979 and 80 to see actually a significant interruption in supply. And and back then, um, about 4 million barrels a day of capacity, both Iranian and Iraqi, was destroyed from military activity. They were offshore oil platforms, and they were pretty much just those platforms were destroyed. And that's when oil demand was 55 million barrels a day. So you're talking, you know, 7, 8, 9 percent of global demand. And people are like, oh, it's it's only 8 percent. We're having such a big price. Well, the oil industry is the original just-in-time inventory system. It's expensive to store. Remember, oil, the business of oil is just moving it from underground to the surface. It's it doesn't cost anything to store if you just leave it where it was formed 250 million years ago. So you bring it to the surface when you're ready to use it, and it's expensive to build tanks to hold it. So, you know, 7-8 percent disruption in supply is enormous. What's going on today, as everyone now knows, if they read the press, is 20 percent. We consume about 100 million barrels of oil a day on this planet, and about 20 of that 100 flows through the Strait of Hormuz. But nothing's really been destroyed. There was an attack a couple of days ago on a gas field. Uh remember, though, the field, you the field itself you can't harm. It's thousands of feet down in the ground. It's the production facilities of the surface that you damage. And they can take a long time to rebuild. But so far, this is just the blockage of a passageway, which could, depending on the nature of the ceasefire or whatever, end in 20, 24 hours. And so the the way the market is discounting this, both in the oil price and the stock prices, reflects the fact that this is not permanent damage to oil production facilities, and people kind of need to keep that in mind. In spite of the fact that this is the largest disruption in history, it's there's a you know, there's a temporary nature to it because the facilities haven't been destroyed.

Ryan 6:22

I'm curious, I haven't looked in a little while. Uh the strategic petroleum reserve, where is that at at this point? Has it begun to sort of be replenished and does that matter?

Jim 6:31

Aaron Powell Yeah, I think they were replenishing it slowly. I haven't looked at the numbers, but again, you're talking a hundred, you know, 135 million barrels out of the U.S., 400 million globally. So that's four days of supply. Um it's not like it's immaterial, but it's like the old joke about the the cab fleet, the taxicab fleet that always keeps one cab in reserve. And someone says, well, you know, I need a cab. Well, you know, they're all agile, so you have a cab in reserve. He says, well, yeah, we have one in reserve, and we'll send me that one. Well, then I won't have one in reserve. And so that's why the market actually didn't go down when the IEA announced that agreement. Um, because once you spend it, you can't spend it again. It's worth more having not spent it.

Ryan 7:13

Aaron Ross Powell Given that the Strait of Hormuz, um, let's say it does open up, um, where do oil prices go? And I mean, it still has a premium? Are we talking are we going back to $60, $70 oil, or does it stay at a premium for a long time?

Jim 7:28

Aaron Powell Well, remember, oil had dropped into the 50s because when Trump came into office, the you know, Saudi Arabia, they say as OPEC is really Saudi Arabia, says, you know, we're going to grow our product production. Um, and people are saying, why would you do that? The economy is slowing down. It's like, I think we now see why they were doing that. The idea that those two things were not linked, I think, is naive. I'm no conspiracy theorist, but this is this is how things work. And oh, by the way, the Chinese have been hoarding a million barrels a day, filling up their storage tanks. So maybe they're in on the joke too, meaning that you know they they they saw what was coming, or and even if they didn't, you're going to you know you're going to protect yourself against any kind of interruption. And so the issue is, let's say there's a ceasefire tomorrow. The question is what happens in the ensuing months and years unless you get a total capitulation of the things that Iran has done, which the two belligerents here want them to stop doing, you know, support Hezbollah Hamas and basically enriching uranium, um, to well beyond what you need for civil use. I mean, the the the uh enriched uranium they have is enriched and enrichment is a is a is an unfortunate word, it's concentrated. Okay, the uranium is concentrated in its percentage of uranium-235, which is the isotope that is fissile. It's the isotope that when you hit it with neutrons blows up. So the bomb that was dropped in Hiroshim was 95% uranium-235. There is no civil uh power plant in the world that uses uh uranium-enriched more than 5%. Iran has a supply of 60 percent enriched uranium. There is only one use for that. The idea that that's for civil is laughable on its face. And the only people who would believe that are people that don't know the math that I just described. So uh we don't know what the nature of the ceasefire is gonna be, but it is hard to imagine that the risk premium on oil goes back to zero the way it was called six months ago when oil was trading in the 50s, upper 50s. But it's hard to imagine. It's possible, but it's hard to imagine.

Ryan 9:51

So I'm gonna ask you to speculate again on another part of the uh sort of geopolitical energy equation, and that is Venezuela. Obviously, there's been some really impactful things that have happened there as well. Um how does that play into sort of the long-term supply of oil and gas um and sort of I guess restarting potentially their exports into the world markets? Is that uh how does that change the equation?

NGLs And Petrochemical Cost Advantage

Jim 10:15

Doesn't change it at all. And the reason is that the dollars spent in Venezuela are dollars that aren't spent somewhere else. So anytime the industry, and the industry does this a lot, you know, they say, well, the federal government needs to open these offshore um you know leases for us and they need to stop restricting us from doing this or that. And it's like, okay, that's fine. But if they do that, then you move your dollars there. You're not gonna spend more dollars, you're just gonna move them from somewhere else because the capital budgets of these companies are under very strict controls now because the shareholders revolted over the last six, seven, eight years because the industry wasted so much money on the shale boom that they have the management through the board of directors on a very short capital spending leash. And so the, you know, and look, Darren Woods was the only CEO who sort of was speaking truth to power in that in that meeting with the White House a few months ago. He said, look, it's uninvestable. You know, Venezuela confiscated, I think I can get these numbers right, $10 billion of assets from Conico Phillips and $2 billion of assets from Exxon. And if I were the CEO of Exxon, I'd say the same thing. You give me my $2 billion back, and then we'll talk. And until you have a legal system that protects my capital, why would I put my shareholders' capital in your country? Trevor Burrus, Jr.

Ryan 11:34

Let's say that there's a premium from concern about the risk and the in coming out of the Middle East energy. And um what's the impact on U.S. producers? You and I were speaking earlier about natural gas liquids. Um talk us through what the dynamics will be there.

Jim 11:52

Aaron Ross Powell The petrochemical industry uses different feedstocks to make ethylene, which is used to make polyethylene. Propylene used to make polypropylene, right? So everybody knows most of the plastic bags you use are polyethylene. Um, you know, some of the containers you you know use are polypropylene, et cetera, et cetera. That's um and they all come from hydrocarbons. The highest cost petrochemical feedstocks are ones that come out of a refinery that, if they're not used for petrochemicals, could be used to blend into gasoline or diesel, which is a much higher value. There are places in the world that produce so much natural gas that comes out of the ground with what are known as natural gas liquids, which is confusing because they're actually a gas at temperature, standard temperature and pressure, but you freeze this mix of molecules coming out of the ground, and the butane, which has four carbons, the propane, three carbons, and ethane with two carbons freezes or turns to liquid, leaving methane, which is what natural gas is, as a gas, and that's what goes to your house through the pipeline. So the alternative use of these molecules is their heat value, which is much lower than transportation fuel value. So the U.S. petrochemical system, located next to the most elaborate and extensive natural gas extraction facilities in the world, have a cost advantage versus the price setting mechanism for petrochemicals, which as it is in all commodities, is the high cost producer. Now, with oil prices having nearly doubled from six months ago, that cost advantage is much larger. And the petrochemical business was pretty much going through a massive sort of overbuild. And was it trough margins, petrochemical units were shutting back because there was too much capacity? And this had a small knock-on effect in our portfolio of the infrastructure companies that separate, transport, and store those natural gas liquids. And now you have this margin umbrella that is much larger than before. There is a supply interruption of some of those feedstocks coming out of the Persian Gulf, which then go to Asian petrochemical facilities. And these are, again, derivatives of oil from a refinery. And they are locked up in the Gulf. And once they get through, they'll be more expensive. So there is this knock-on effect for the U.S., which is a sort of a lower cost producer of these critical feedstocks. And you can't run the world without petrochemicals.

Ryan 14:44

For a non-energy analyst like myself, the difference between natural gas liquids and liquefied natural gas are completely different things, right?

Data Centers And Rising Power Bills

Jim 14:54

Trevor Burrus, yeah. Industries love to confuse people, but yeah. But liquefied natural gas is frozen methane. Yeah. And so the temperature that you need to lower it to turn it to a liquid so it fits on a ship is much lower than the temperature you need to extract ethane, propane, and butane. And remember, it doesn't even need to be cold, just it needs to be under pressure. So the propane tank sitting next to your grill, your gas grill is at 78 pounds. It's basically a bicycle tire's pressure at normal temperature turns propane to a liquid. It's very easy. And so we've had propane and butane uh tankers for decades, many decades. Um we have an international trade in ethane, which is more pressure, um, for not quite 20 years. And it comes out of the Gulf Coast and is shipped around the world. But that's a relatively new thing in the history of shipping natural gas liquids. So liquefied natural gas is a very large machine that really freezes this stuff to a very low temperature. And of course, once you put it on a ship, it starts to warm up. That's what those ships run on. Is as the natural gas goes from a liquid to a gas, they feed it through the engine room, and that's what drives the ship. And then when it gets to the other side, you know, they let it effectively evaporate, turn from a liquid to a gas. And then so you need a giant facility on the receiving end as well. Then it can go into the pipeline.

Ryan 16:27

I I want to talk now a little bit about uh what's going on in the U.S. in particular, but also around the world to some degree. And that is with respect to the build-out of data centers, the demand for more electricity, um, the impact of utilities and consumers yelling at those utilities because they see my electricity bill has gone up so much. Um so I guess maybe we can start with um is this in your opinion, do you do you see um the I guess maybe the politics surrounding that issue, but also the consumer complaints that I've heard about, you know, I don't want my utility bill to go uh up, so don't build that data center nearby. How is that going to play out?

Jim 17:16

Yeah. So so we've done so we've written two pieces that are on our website, Power Struggle 1 and Power Struggle 2. And the first one explains what goes into a residential rate for electricity. And the second one then analyzes our the market structure in the U.S., how we have two sort of side-by-side markets. So let me deal with the first one first. The average price of residential electricity in the United States is 17.5 cents. That's about what it was at the end of last year. Probably didn't quite average that for the whole year. That 17.5 cents is made up of three components. The cost of actually generating the electricity and delivering it to a market hub, that's 7.5 cents. Then moving a long distance to a metro center is two cents. Now, those that's called transmission, and those are those really tall wires that you see maybe in a railroad right-of-way or in their own right-of-way, way above the level of the trees. And that's two cents. And then the final eight cents is the last few miles. So let's call it the last mile of distribution. And that's where the lines are below trees, and that's where storms knock them down, and that's where all the overhead of a utility resides. That's where accounting and law and customer dispatch to get those repairmen out. Um and those repairmen, you know, are highly skilled. It's a very dangerous job. It used to be the most dangerous job until you go back many decades, but a lot of safety things have now made it not the most dangerous job, but it is a highly skilled job, and it's mostly guys. So it's very expensive, highly skilled guys driving around very expensive trucks. All of that hits in that eight cents of distribution. And so when you look at that 17 and a half cents over the last five, 10, 15 years, it's roughly up in line with inflation. Now, in the last two years, is it faster than inflation? Yes. But in the years before that it was less. So if you go back 10 or 15 years, that 17.5 cents is up in line with inflation. And when you look at the last 10 years, the 17 and a half cents used to be 13 cents 10 years ago. Okay. And so you say, well, okay, it's up four and a half cents. What's the makeup of the four and a half cents? You say, well, a penny of the four and a half cents is increase in generation, a half a penny is increase in transmission, and the remaining three cents, or two-thirds, is at the distribution level. So there's been a lot of debate about what has caused the prices to go up. And of course, the first thing he says is they're up with inflation. Of course, that doesn't make anybody feel better because they don't want any price to go up. And then you say, well, okay, but while the editorial pages are still full of opinions about how this type of generation or that type of generation is to blame, you could say, and it's not true, that 100% of the increase in generation and 100% of the increase in transmission, because some people are saying, oh, well, the wind and solar is so far away you need new wires. You say, that's fine. Let's just assume 100% of the increase in generation and transmission is solely due to bad generation choices. It would explain only one and a half of the four and a half cents. And so you say, okay, well, you know, why is the, you know, why is the other three cents there? You say, well, it's inflation. And that's that's really the only part of the system where you have labor costs. Because think about a nuclear power plant or natural gas plant. It's all capital and fuel and very few people. Transmission is like no people, and all the people, you know, not just the linemen, but all the staff positions, all of that hits there. And labor costs, including essentially health care and pension benefits, are up more than inflation. And so it makes sense. And then the 17.5 cents is an average for the country. There's a wide range around the average. And our piece showed this. There is a 95% correlation between the residential rate in each state and that state's cost of living index. 95% correlation. That doesn't leave a lot of room for any other explanations.

Ryan 21:50

That last part, the eight cents, the distribution part, went from five cents to eight cents. That's a pretty steep. That's like a 60% increase. Yeah. But over yeah, but over 10 years.

Jim 22:04

Now there's some other things in there, like you know, COVID bad debt. Yeah. That gets collected for the comp the people who pay from the people who can't afford to pay. Yeah. And so, you know, there are all kinds. So the utilities have, depending on the state and depending on the time, have acted as sort of a place to deliver sort of social benefits without having to raise taxes. And that's, you know, and so when your power generation costs were going down because of the shale revolution and because of how cheap wind and solar are, and you can say, yeah, they were subsidized, but they they're the cheapest form of electricity without subsidies. But even if they weren't, those subsidies aren't hitting the person paying the electricity. They're hitting the American taxpayer. And so you don't see that the two would be linked. Trevor Burrus, Jr.: They're not in your bill. Trevor Burrus, Jr.: They're not on your bill. And so, you know, the the you know, the other things that that that the states are doing, um, for example, rooftop solar is extremely expensive. In fact, it's the most expensive way of making electricity of any way we make it, because there's no scale to it. Utility scale solar is the cheapest, and rooftop solar is the most expensive. They literally anchor the cost range in the world of electricity generation. And what the what some states did was they allowed the people who put rooftop solar on to get a retail price for a wholesale product. Because those electrons don't go from your roof to your house, they go straight to the grid. So you're a home selling a wholesale product and you're getting a retail price for it. So if in places like New England, where the price isn't 17 cents, it's 25 or 28, you're getting 28 cents for something that in the wholesale market is only worth about seven. So that subsidy shows up there as well. And you say, well, that's not just distribution. You say, you're right. And that that's a policy that's expensive, but a lot of states have that policy, not just blue states, red states have that too. And so to separate all that out, you find that at the end of the day, it's the cost of living index is the best explainer. It's not the only explanation, but it you know, there's just a lot of political narratives that are always ready to go whenever the public is angry about something. And that's how politicians get elected. They're good at identifying the you know what's the cause, who's to blame, and what they're gonna do about it, and which is why you know you're gonna vote for them.

Ryan 24:49

Okay, so that residential solar example, I've always kind of wondered about this, but it does make sense. Like as the sun is giving me some power, I'm not using it all the time, so I've got to sell it back down to the grid. But um, I know Tesla makes these power walls where they're batteries. So um in my I live in New York, and I don't think I can even uh hook into the system if I take my solar panels, which I don't actually have, but if I were to hypothetically, and then store those electrons in the power wall from Tesla, um, wouldn't that be a way to kind of I don't know, make it more efficient over time? I guess maybe the costs are expensive still.

Jim 25:27

But yeah, people confuse efficiency with cost. Yeah. You know, and so whenever whenever you have people on either side of the debate talking about what you should or shouldn't do with energy policy, when they shift to dollars to BTU efficiency, it's because the dollar numbers aren't helping their argument. And I see this on both sides of the aisle. They say, oh, that's more expensive, why would you do it? And then you say, well, this is cheaper. It's like, oh no, but it but it has a low energy efficiency. It's like, well, okay, burning coal in China has a low energy efficiency relative to natural gas, but the coal is so cheap, it doesn't matter. Yeah. All that matters is the dollars or the yuan that they're paying. If it's less efficient, then fine. But that source of energy is so cheap that it offsets the lack of efficiency. That's that's what a that's what an open market does, is allocates things based on their cost, not based on some ratio of energy inputs and outputs.

Ryan 26:24

The other part of your um two pieces you mentioned, one of the things you wrote about was the difference between a vertically integrated utility and a deregulated utility. Would you take a minute and kind of break down those differences for us? Aaron Powell Yeah.

Jim 26:37

So you wouldn't call it a deregulated utility. It's good that you said that, because people use power generators or they refer to power generators and utility interchangeably, and they shouldn't. So a utility is a company. Trevor Burrus, Jr.: I'm good at giving the wrong nomenclature. But it's great. It's exactly why when you read about this, it's so confusing because the people who are writing about it aren't aren't sufficiently knowledgeable about the structure of the system. But um we have open competitive markets, in theory, everywhere in this country since the 1990s, and it took a couple of decades to be able to establish those. Because the poles and wires are all run by monopoly utilities. So when you s so in the beginning, 125 years ago, the entire electric system was regulated at the States, it granted a monopoly to a single company for a particular geography. And the way that system worked was you demanded in return for the monopoly from that company two things: an obligation to serve, because the customer doesn't have any choice. You have to serve them in safe, reliable service, and limits on what you can earn on your investment, because you've been granted a monopoly. So that's the social compact. And um, when you got to the 19 and and and the way you sorry, and the way you limit the return on investment is at a cost plus revenue model, right? So the revenue that that utility receives is the sum total of its operating costs, its interest on debt, and an allowed return on equity. So another way to say it is your total operating capital costs or your operating and financing costs, however you want to refer to it, you divide that by kilowatt hours, and that's what people pay on a per kilowatt hour basis. And it all worked fine until the 70s and 80s when we had these massive cost overruns for nuclear power plants. And so cost plus system, the cost got passed along. Now, some were disallowed because they thought the utilities weren't prudent. Um the problem was that very large factories could now make electricity cheaper than they were buying from the grid, and they were going to cut the cord. And that meant that the fixed costs of the system, very large percentage of the costs, were going to be borne by fewer customers. Now, smaller factories are self-generating and it's a negative feedback loop. So that's why at the federal level, we established competitive markets and all the rules that the monopoly poles and wires companies had to follow to not discriminate against competitors, independent power producers. But the states decided whether or not the legacy power generation in their legacy vertically integrated utility would either be kept in that cost plus model or kicked out, if you will, like kicked out of the nest to survive on its own in a competitive commodity market. So today, 15 states representing 42 percent of electricity demand in the United States operate under a deregulated or competitive model where prices are set on the margin, just like anything else. The high cost producer sets the price for all in commodities and in any any undifferentiated product for everybody else. Because if the if the high cost producer isn't remunerated for their costs, they don't operate and supply and demand don't balance. Okay, so this has been going on since the beginning of time. That's not a controversial observation or theory. The other 35 states representing 58% of power generation in the United States are states that allowed that legacy generation to be kept in the cost plus model. And so all those utilities are vertically integrated. And the way that works is as I described, you have a rev, a required revenue from your operating and capital cost, divide that by kilowatt hours, and that's what everybody pays. So there prices are set not on the margin, but on the average. And so when you look, and so that this is what our piece was called power struggle too, the when you look at the wholesale price of electricity as measured by what factories are paying, because they pay, so as I as I the numbers I gave before, um breaking down to 17 and a half cents, the average price of generation last year in the U.S. was seven and a half cents. These industrial users in the U.S. only pay eight and a half cents, only a penny more to deliver that electricity to their factory, whereas it's nine cents on average to a house. Big difference, right? So this is effectively the wholesale market. And when you look at the trend of prices for industrial users over the last, say, ten years, you want to go back before COVID, you can see in the last three years, now that demand is growing faster than supply, we've had a 30 percent increase in those industrial prices in the deregulated states and zero increase in the vertically integrated states. And so once you separate those two, it shouldn't be a surprise to anyone that in a competitive commodity market, when demand goes up faster than supply, the price goes up. That's not a stop the presses moment. That's what it if if I said oil demand was going to start rising faster than supply, everybody, I mean, even a sixth grader would tell you that means prices are gonna go up. Okay? But when you separate the two systems and look at the price, you know, the price, the recent price history, you'll see that the vertically integrated guys, you know, because their costs were laid down over the last three or four decades, they haven't changed. And in fact, what happens when you add demand to the vertically integrated states, yeah, you have to add a little supply. But depending on how that state forces the new demand to contribute to existing overheads, you can actually have prices go down. And so in our piece, we showed uh we showed a slide that a utility that operates in Indiana has now shown their investors that had like five, four lines, I think, on the graph. They say, look, if we get no data centers, no new growth in demand, you're gonna see an inflationary increase in residential rates. But if we have sort of a low, medium, and high amount of data centers, the more data centers we have, the more the price will go down. Because remember the math, it's total cost divided by kilowatt hours used. And so that denominator can very well grow faster than incremental cost to the numerator. So there's two completely different outcomes and two completely different incentive structures. In a competitive market, the people who are providing electricity, these are big lumpy machines, a gigawatt or two gigawatts at a time, they had one plant, and these higher margins in that area could just disappear. I mean, that's what happened with shale. Volumes went up, but margins went down by more. And so you actually lost money buying the oil producers. And in a vertically integrated market, the people who are supplying electricity don't have to worry about that. They're going to get cost recovery. And since they can only grow their earnings by growing their capital base, upon which they earn that allowed return on equity, they're incentivized by their shareholders. And from a supply reliability standpoint, they are encouraged by their public utility commissions to put capital on the ground. Not inefficiently, not to waste it, but to make sure there's a cushion and to make sure that that state, if it's New England doesn't want to do this, California doesn't want to do this, but most of the other states want to attract this data center business. And so they want those utilities to make the extra generation available. And they would like to see an outcome which they can be in charge of, depending on how much of the existing overheads are contributed to by the new factory and the new data center coming in, they can actually see customer prices go down.

Overbuild Risk And Power Purchase Deals

Ryan 34:32

Aaron Powell Do you think that it seems like there would be some concern that you're going to overbuild your capacity? I mean, we've seen that with other technologies time and time again. Sure. I just the only thing I've seen so far is like, where we're going to need more and more electricity. Now we're going to need more. Now we're going to need more. Absolutely. Trevor Burrus, I haven't seen the other side, but is that a risk?

Jim 34:52

So it's definitely a risk. And it's why the merchant power producers in the U.S. that operate in those 15 states are reluctant to add capacity because their shareholders don't want them to. So the capital activity you've seen is mergers, because it's cheaper to buy an existing competitor than it is to build new capacity. And the customers essentially have told them if you're going to build new capacity, you have to get a long-term contract with kind of a fixed margin. So what people may not realize is that all the wind, the utility scale wind and solar that's been built in this country in the last two decades is on long-term contract. No one is building a wind farm on spec. And so, you know, and you could say, well, maybe big tech does big tech has has built effectively a third of the utility scale wind and solar in this country for themselves. But in effect, the way it works is they get a long-term contract for that power that is sold to the utility, and then they buy their electricity where they need it because they're not locating their data centers in the middle of a window.

Ryan 35:58

Are those virtual power purchase agreements?

Jim 36:00

Is that what that is? Trevor Burrus, Yeah. They're just called power purchase agreements. And yeah.

Ryan 36:03

But they're not necessarily using that electricity. Trevor Burrus, Jr. Absolutely. It's all fungible. Trevor Burrus, Jr.: Because it's fungible. Yeah.

Jim 36:09

Yeah. So they're going to put their data center in the best place it makes sense to put the data center, and they're going to put the wind and the solar where it's windy and sunny, which of course that's that's exactly what they ought to do. Yes. Yeah. But there's no question that their zero carbon commitments are going to take longer to achieve now because you're taking this detour through all this all this natural gas fire generation.

Ryan 36:34

I think I've asked you this before, but uh curious if you have any insights on uh you mentioned nuclear plants take you know 10, 15 years to do a one of the big ones, like the one that was in Georgia. Yeah. Um but you know, everyone's talking uh about the small modular nuclear reactors. Um any any thoughts there? Uh are we what five years out, ten years out?

Jim 36:55

Yeah, two years out. Probably not five. Um so the we actually, you know, the the biggest buyer of small modular reactors is the U.S. Navy. I mean I I I may I may get these numbers wrong by one or two, but we have 87 nuclear reactors in the Navy, 10 aircraft carriers. Um because we have 10 aircraft carriers, and only seven or eight are operating at one time, the others are in dry dock. We have 10. And we have 77 atomic submarines. So that's you guys, you get to 87. Um and so they're there. They they know how to build them. But remember, while cost matters to the military, saving lives matters more, right? And so the Department of Defense um has been a great driver of technology throughout history because of the preciousness of life versus versus a dollar. Um But there are three problems with nuclear power, which is why we've only built a couple of plants in the last 20 or 30 years. And the first one, of course, is cost. Uh the second one is risk of a meltdown, because it's happened three times, if you want to say it's you know, it's Chernobyl, Three Mile Island in Fukushima. Um, and then what do you do with the waste? Those are the three problems, and all the technologies that you're hearing about address are trying to address each of the three. So small module reactors is addressing the fact that in the U.S. we generate uh just under 100 gigawatts a day, or sorry, gigawatts of nuclear power spread across 51 locations. And what you find at each of those locations is there tends to be two units of a gigawatt each. So sort of, you know, two times 50 is 100. That's for the that's the rough math. And and those 50 locations all have a slightly different design. You know, the technology is essentially the same, but if it's a different size in a different location, there's all this stuff you have to do out in the field. It's the difference between a custom home and a manufactured home, right? And so, you know, they even like some of these hotels they're building now, the rooms are actually manufactured in a factory and delivered on a truck. And because a hotel doesn't have to be an architectural masterpiece, it's just a box, they put that thing in right next to the other one. And what you find, and I was in a I was thinking about being an investor in one of these things, inside that box, the wallpaper, the carpet, the furniture, the plumbing is all in the room. And the linens are folded on the bed. No exaggeration. So all of that happens in a factory because it's cheaper to do that. A small modular reactor is trying to get at that sort of repetitive, you know, it's what Adam Smith said about the specialization of labor, right? You just do the same thing over and over again, you get better and better, it gets cheaper and cheaper. Better economies of scale. Yeah. And then on the meltdown, you know, the issue with the meltdown is that all of the reactors use water to kind of conduct the heat away from the reactor and to what they call moderate the neutrons. And it slows the neutrons down, actually. If you slow them down completely, the reaction stops. If they go too fast, you don't get enough of a reaction. Actually, slowing them down to a certain speed actually increases their effectiveness, which is why you only have to concentrate the uranium to 3 or 5 percent, because you slow those neutrons down, they tend to have a higher hit rate. Um, but it's 330 degrees centigrade, which of course would be steam and not water, and steam doesn't slow the neutrons down, only water does. So when something goes wrong, it explodes. And then now radiation is getting everywhere. So you can use a moderator that is like liquid sodium that is not under pressure. So they're addressing that. And then the waste is to use a fast neutron reactor. And you say, well, I thought fast neutron reactors don't work. You say, well, if you concentrate the uranium to more like 20 or 25 or 30 percent, there's enough uranium-235 for those neutrons to hit. And that gets the reaction going. Now those fast neutrons hit uranium-238, the stable isotope, and in a two-step process turns it into plutonium. It makes more fuel than it uses. So remember, the first bomb in 1945 was 95% concentrated uranium-235. The second bomb was plutonium. And that had to be manufactured in a plant at a plant in Washington state, actually, that's still there. Not operating, but still there. And so that's that breeder reactor actually makes more fuel. And in the only time we've ever had a commercial breed reactor was in France. And it's called the Super Helix. And it hasn't been running for a while because it's old now and they haven't built another one, but they took all their waste from their conventional reactors and ran it in the superhelix, which is a fast neutron reactor, and it just it's they just processed to extinction. So you can address all three. The technology exists. What's been missing is the economics. And now comes big tech, where speed to market matters more than cost, and the Department of Defense, with Trump writing executive orders saying you are going to have this number of new reactors operating by these dates. It's sort of rather than say, I'd like you to work on this, you know, it's like I'm going to put a man on the moon and return him slavely to Earth inside the decade. Is there anything about that that's not clear? Right? Okay. A guy up and back before the 1970s. And we got it done. And so uh so you combine Department of Defense, uh need for always available electricity, um, and big tech's love of technology and free cash flow, and you can see that you know, in the long term, there's probably the best chance for a nuclear renaissance than we've had in the last 30 years. I don't say it's going to happen, but the probabilities are much higher than they were just five years ago.

Ryan 42:33

Aaron Powell Devil's advocate, why don't they just use what they're using on those atomic submarines and just commercialize that?

Jim 42:40

Trevor Burrus, Jr. Yeah. So those submarines are using 95% enriched uranium. Oh, and the reason they're doing that.

Ryan 42:46

Because you can't have that floating around. Yeah.

Jim 42:47

So in a in a conventional nuclear reactor, you have to refuel the thing every three years. Because when only 5% is uranium-235, you use it up actually pretty quick, and you got to take the fuel out and put in new. And so Admiral Rickover, who was the one who was behind the nuclearization of the of the U.S. Navy, is like, look, these things need to be always available. This is a Cold War, right? I'm not sure I can take this thing out of service. We could just be at war with the Russians at any time. And so, you know, you have got literally decades of fuel sitting in that thing. So you don't have to take it out and refuel it. Eventually you do, and you got to dry dock the thing once in a while, but that was the idea behind that. And plus they had something that worked, and he and its speed to market was important in the Cold War, just like it is in AI. And so that's why we have that's that's why they're 95% enriched. And so that means you would have civilian users of weapons grade, you know, enriched uranium. Trevor Burrus, Jr.: Yeah. That seems like a bad idea. Yeah, it's yeah. Seems like there's a war that's happening.

Ryan 43:46

There's a war that's ongoing right now as a result of the right.

Jim 43:49

Which is why, like I said before, why why it's ridiculous on his face that Iran, who has you know admitted to sixty percent enriched uranium, says it's for civilian purposes.

Ryan 43:58

Okay. Well, I think we have solved all the world's problems here in terms of the energy market. My takeaway is that the data centers aren't necessarily going to blow up everyone's utility bills.

Jim 44:13

No, they're not the bad guys. I mean just think about a cost plus model. It's total cost divided by kilowatt hours. And you have the ability. Now again, there are differences between states. Some states are so eager for this business that they're not asking the data centers to contribute to existing overheads. So when we think about that 17.5 cents average residential rate, by my calculations, 80% of that 17.5 cents is fixed costs. Only two, you know, two cents or 20, sorry, 20% of that, three and a half, whatever, four cents is variable cost, which would be the fuel to make it, the natural gas and the coal and the uranium, whatever it is, to make it. And so I talk to different utilities and it's like, okay, what are you doing in your state? And one of them, I won't say who, said, you know, we want them to pay their fair share. And it's like, okay, this is uh I live in the world of numbers, not in the land of nouns and adjectives. So let's what does fair even mean? Well they're going to pay all the costs that they incur. And it's like, well, okay, that means there's no contribution to existing overheads. And so they're not doing anything to grow that they're growing the denominator, but that denominator is not absorbing any of the overheads that everyone else has been paying to keep the system going. These data centers want to use that system. They want to use the massive inertia of that system for quality voltage, for quality frequency, and backup if their own unit goes down, right? Because you have this diverse that's what networks are. They're a diversified connection of all these different sources and that's why they want to be on the grid. And so you're not going to charge them some portion of existing overheads? That doesn't seem right to me. But just like everything else, the states are competing for that business and they will do different things. And some will say no, you are going to contribute X percent to these costs that are not being incurred but of you, but our state won't welcome you unless you're willing to do that. And from my discussions with these folks, again, all the the the senior energy buyers at all the big tech go to the Aspen Institute Energy Week, which is twice a year, which we participate in. And there's not one of them that says, you know, the heck with that, we're not we're not going to we're only going to pay our fair share. They are much more sympathetic to the public's, you know, reaction to them than people, I think, than people are giving them credit for. They're not looking to pick a fight. They're looking for a home where they're welcome and they're going to get high quality power and if it costs an extra two cents a kilowatt hour, they're not going to admit this in a negotiation, but the answer is that's fine.

Book Picks And Final Thoughts

Ryan 46:50

Yeah. They want quality power and they want to be able to deploy this quickly, right? They don't want to fight for a long time and you get what you pay for. All right Jim well we are coming up on the uh hour mark. Time flies by once again and uh appreciate you coming on and sharing your knowledge. I I will give you my final question that I have the last few times. I don't know if you'll be prepared for it or not, but that is what are you reading these days? Anything that you would recommend viewers of the podcast check out?

Jim 47:16

Let's see. One category of books that I think people would find interesting is Progressive Scolding Progressives about the bureaucratic administrative state. Okay? Which is why you like it already. Yeah. Which is why actually like shrinking the administrative state is actually a bipartisan issue. And there's three books. Everyone's probably familiar with Abundance written by Ezra Klein who's a New York Times writer. Trevor Burrus Yep he made the rounds and that's fine. I mean the first paragraph almost lost me but you got to gut through it and and and listen to it. The second one is it's called Why Nothing Works by a guy named Mark Dunkelman. And what he does is he takes you through sort of the history of the growth of the administrative state and just sort of identifies the problems of creating centralized power to solve a real problem. But having endowed that new government agency with power, we have to shackle it so that it doesn't get out of control. And that that challenge is sort of the you know is sort of the essence of the problem. And one and one final book in this area is a woman a writer is she's Joan Williams and she wrote this book called Outclassed. And what she does is she identifies sort of the the sort of the two sides of all these debates in the country not between liberals and conservatives but and not by race, but by class. And she says if you understand that you'll understand sort of the politics sort of recently administrative state was certainly one of the things that the you know the whole doge thing when the Trump administration just started Yeah it's hard PR it's hard the last time we had and Brian Westbury talks about this a lot the last time we had true deregulation started actually in the Carter administration and was continued under Reagan. It was actually it was actually a progressive agenda item first and Reagan was smart enough to sort of to kind of hawk it and make it his own but a guy named Alfred Kahn who was really the the architect of deregulating energy, transportation and telecommunications. And that was the and it was an enormous effort of deconstructing legislation that created these things and replacing it with something better. And simply going in and firing people doesn't accomplish that. It needs legislative treatment because all these 426 federal agencies are create were created by and are funded by Congress. They reside in the executive branch but that's not who creates them or has the power to get rid of them. Only Congress can do that. And so that is why it's hard to do.

Ryan 50:09

All right well that's a good place to leave it. Jim thanks for joining us we'll look forward to doing this again sometime soon. Always enjoy it. And thanks to all of you as well for joining us on this episode of the First Trust ROI podcast. We'll see you next time.