Our Expectations for 2H2017 is Better than would be Expected

NATURAL GAS

Soft winter weather (warmer than normal) has not helped natural gas prices currently, nor the prospect for strong natural gas prices in 2H2017
However, due to declining production, storage levels have continued to remain below record levels seen last year

LNG IN KOREA

There was an article in the Central Daily News Agency (CDNA) of South Korea that predicted a large shortage of global LNG supply by some 2024 that would have a strong impact on pricing

In a related article, the CDNA is contending that India is set to renegotiate its contract with Cheniere Energy (LNG), also due to high pricing

POWER SECTOR

Given our natural gas outlook, it is natural that investors may think that our view on the power sector is negative; however, it is not, particularly given the developments at NRG Energy
We believe that the power sector is at the cusp of another paradigm shift in which unprofitable assets finally exit stage left (or right, we don’t care which as long as they do)

UTILITY AND INFRASTRUCTURE SECTORS

We believe that the flight to safety is over and a general migration towards a “risk-on” portfolio started in 1Q2017, which we expect to continue into 2018
Also, we expect interest rates to continue rising, which isn’t going to do any favors for the utility and infrastructure sectors in terms funding costs and comparative investment profile relative to fixed income instruments

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Power Company Privatization will Lead to Unintended Consequences

Lately there has been talk about privatizing power companies, including both CPN and NRG, and while we believe that the most rational course for these companies may be to go private – given the lack of “enthusiasm” for these names in the public markets – we are certain that the end result will not be either what the market expects nor what the regulators, politicians and, most of all, what the consumers desire
The assumptions we are making in our analysis are as follows:
Private equity (PE) investors are not unintelligent and will act in their own self-interest
Virtually all of the market (public and private) believe in the theory of “all else being equal”
Market forces move along least resistant path absent paradigm shift, typically externally imposed
As reserve margins dip below 12% market prices become more volatile and margins begin to expand at an accelerated rate
PE investors will be betting on the reduction of debt from internally generated free cash flow and asset sales, supplemented by cost reductions, to increase the equity value of its investments with the option value of changing market dynamics to further boost its rate of return
The first thing that PE investors are likely to do is to make the assumption that the underlying market forces and conditions don’t/can’t/won’t change for the foreseeable future
Based on these underlying assumption, PE investors will be able to figure out which plants they buy will remain profitable, which won’t and which are on the margin

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Supreme Court Stays Implementation of the Clean Power Plan; a New Plan May Already Be in the Works

On February 9, 2016, the Supreme Court of the US (SCOTUS), in a 5-4 verdict, stayed the implementation of the Clean Power Plan (CPP) until the DC Circuit Court could review the plan.

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The Myriad of Changes Are not Challenges, but Rather Opportunities

First time in almost 15 years, the electricity industry is facing rapid changes. Not since the separation of generation from transmission and distribution (T&D) businesses has the industry faced so many changes. Some of these include renewable portfolio standards (RPS), greenhouse gas (GHG) regulations, other regulatory and legislative changes, and the proliferation of distributed generation, energy storage, smart meters and smart grids, electric vehicles, and renewable power. Many view these changes as challenges and hurdles, but we believe that these changes should not be viewed as challenges, but opportunities, particularly for the utility sector and conditionally for the independent power producers (IPP).

Some of the more difficult issues involve RPS, and GHG regulations on the regulatory/legal side and the proliferation of distributed generation, renewable power, energy storage and electric vehicles from a commercial viewpoint. Many of these issues are interrelated and entangled and one change cannot be properly accommodated without integrating another change properly. From a high level, we believe that challenges encompassing these changes are as follows:

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Barring abnormal weather, we expect stronger commodity prices

NATURAL GAS
• As expected, due to mild weather, gas prices dipped below $3/MMBTU and continues to languish
• However, the strange turn in March weather has alleviated the downward pressure on gas prices
• Our forward-looking forecast on commodity prices does not consider the possibility of additional strange weather patterns occurring, i.e., we assume normal weather for the rest of 2017
• We believe that two factors will contribute to higher demand that will drive gas prices up in 2017 and 2018, which would keep gas prices mean-reverting above $3.50/MMBTU levels, in our view:
o Higher economic growth conditioned on reductions in both corporate and personal tax rates, and
o Accelerating liquefied natural gas (LNG) exports
• We believe that higher economic growth should eclipse the approximately 1.9% growth in supply (some 1.4BCF/Day) in 2017 projected by the EIA
o Our optimism wouldn’t be warranted under the economic environment of the last 6 years or so, which saw annual average economic growth of just above some 1.5%
o Our optimism is based on the expected accelerating economic activity brought on by the expectant reduction in corporate tax rates and enhanced by an expectant cut in personal income tax rates as well; we believe that these new economic and tax policies will create a positive virtuous economic cycle that would propel GDP growth beyond 3%, which should quickly absorb a 1.9% growth in natural gas supply, in our opinion

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