2018 Industry Update: Economic growth should favor commodities-driven businesses in 2018

Warmer than normal winter:
Weak gas prices:
However, 4Q2017 and 1Q2018 power gross profit could be better than expectations:
Similarly, we’d expect natural gas infrastructure businesses to perform well for 4Q2017 and 1Q2018:
We expect economic growth to surpass 4% for 2018:
Strong economic performance should lead to strong power sector performance:
Commensurately, we expect natural gas infrastructure businesses to perform well:
Adjusted for seasonality, we expect natural gas prices to creep up throughout 2018 and, given normal weather, we’d expect natural gas prices to average at or just below $3.50 for 2018 with an exit price of some $3.65-$3.75:
Conclusion: Going into 2018, we believe that natural gas prices will stage a moderate recovery, but power margins should do better benefiting from accelerating economic activity. Individually, we continue to like… . However, the real star may be … . Among the utility names, we like … due to their growth prospects. We also look for … to outperform as … .

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GOP Tax Bill is win for utilities, power, infrastructure, and customers

GOP Tax Bill (GOPTB) looks to be positive for industries and companies in our coverage universe
Key aspects of GOPTB that affect our coverage industries and companies include, but not limited to:
21% corporate tax rate would be expected to reduce deferred income tax liability by some 40%
Interest expense deductibility capped at 30% of EBITDA for 2018-2021 and to 30% of EBIT after
100% investment deduction, except for utilities that would continue to deduct 100% interest
Preservation of existing investment tax credits (ITC) and production tax credits (PTC)
Repatriation of profits tax at 15.5% for cash and equivalent and 8% for non-liquid assets
Base-erosion & Anti-abuse Tax (BEAT) not impactful: If payments to foreign affiliates are 3% or more of a large company’s tax deductions then BEAT is imposed. We do not view this as relevant to companies that we cover, given 100% of PTC would be allowed to offset up to 80% of BEAT
AES Corp. faces large disqualification of interest expense deductibility but given its $3.7B in NOLs, we do not believe this to be an immediate issue; AES has time to remedy the situation:
NRG Energy shouldn’t have any issues with interest expense deductibility:
Exelon Corp. isn’t expected to have any problems with interest expense deductibility:
Cheniere Energy, oddly enough, shouldn’t have any problems with interest expense deductibility:
BKH, CNP, DUK, EIX, PCG, PNM, SRE should not have any issues with interest expense deductibility but may be able to use 100% investment deductibility to create win-win:
We note that the inability to deduct interest expense is limited to $0.21/$1 of lost deductibility
Loss of interest expense deduction could lead to some unexpected corporate behavior

Conclusion: Net effect of GOPTB looks to be positive, more so if utility holding companies are permitted to use non-utility subs to take advantage of the 100% capital investment deduction

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Share buybacks do not create value and the notion that a company can invest in its own stock is nonsense

Ever since I graduated business school – which was a long time ago – I’ve been having discussions and arguments as to whether or not share buybacks (SBB) create value. Despite the fact that many impartial studies have demonstrated and many mathematical proofs have been proffered that SBB don’t create value, astonishingly people continue to emphatically argue that SBB create value. This is not to say that SBB cannot be used to return truly unused capital back to shareholders, but we believe that SBB should be an action of last resort. Regardless, the conclusion: SBB cannot and, therefore, do not create shareholder value.
Even CEOs and CFOs of many companies can’t seem to bring themselves to stop SBB despite all of the evidence that companies cannot create value by buying back their own shares. And, even when it is demonstrated to these managements that there are far better ways to utilize the cash, managements still have reservations about ending their SBB program.
Therefore, I’m hoping that I can end this resistance to ending SBB through this editorial tutorial. The following lists arguments that we’ve encountered for why SBB create value for shareholders:
1) The P/E argument: SBB reduce share count, which increases EPS, and given the same multiple, the stock price must go up;
2) Investing in the company’s own stock creates value for shareholders: Companies can buy their stock at a low price and sell it at a higher price, which creates value;
3) Higher ROE means higher valuation: By reducing the amount of equity on the balance sheet, this raises the ROE on the returns from company projects, for which investors give the stock a higher valuation; and
4) Excess cash returned: This point is about returning excess cash to investors not about shareholder value.

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Letter to FERC outlining our thoughts on how to redesign wholesale power market pricing mechanism

For years, I have been advocating for a wholesale change in how power is priced in the wholesale electricity markets. And, I wish to be heard on this matter, because I believe that my views are not only intelligent and cogent, but also on-point to a future grid that is both reliable and resilient.

From my perspective, there are five main issues that must be resolved to maintain a grid that is both reliable and resilient for the long-term:
Renewable power disruption of wholesale power pricing
Proper compensation of reliability and resiliency characteristics of generation
No regression to “cost-of-service” rates
No “freebies” to businesses
Redesign must be based on market principals

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Summary and analysis of the 187 page DOE report titled “Staff Report to the Secretary on Electricity Markets and Reliability” dated August 2017 and summary and analysis of the 6 page PJM report titled “Energy Price Formation and Valuing Flexibility” dated June 15, 2017

DOE report titled “Staff Report to the Secretary on Electricity Markets and Reliability” dated August 2017, and
Summary of the 6 page PJM report titled “Energy Price Formation and Valuing Flexibility” dated June 15, 2017

Following are some of the highlights:

Changing circumstances are challenging current reliability:
Energy efficiency is done:
Retired plants were mostly baseload-type plants:
Grid operators must place and are placing increasing premium on flexible resources
More focus on resiliency is needed:
Current wholesale pricing inadequate for modern grid:
Cooperation between power and pipeline sectors is becoming crucial to reliability and resiliency, especially in winter,
Four issues that threaten grid reliability due to forced early retirements:

Our conclusion: While we believe that the DOE Report is critical to understanding the evolving electricity market, we believe that there are a number of issues that may be challenged:

Natural gas isn’t the main culprit for plant closures, in our opinion
Market forces are enough:
While DOE is concerned about natural gas price spikes, we’re not:
Decoupling of economic output and power demand is not solely a function of efficiency, in our opinion:

We were disappointed by the fact that the DOE did not incorporate analysis from potential accelerated economic activity, which we expect that we believe will accelerate demand

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As expected, the EPA repealed the Clean Power Plan (CPP); asks industry to help write a new regulation

CPP repealed: As expected, the Administrator of the US Environmental Protection Agency (EPA), Mr. Scott Pruitt, repealed the Obama-era CPP regulation aimed at forcing generators to reduce CO2 emissions by 32% from 2005 levels by 2030
CPP was like forcing car manufacturers to pay Tesla: The only way to achieve the CPP objective would have been for coal-fired generators to buy Renewable Energy Credits (REC) to offset CO2 emissions from its own plants, which is tantamount to subsidizing competitors’ generation

This would be equivalent to car manufacturers paying Tesla $X/car for every non-electric car that they sell to the consumers

EPA asks the industry for help in writing new regulations but what could be recommended? This was not expected. Regardless, we would expect that any proposed recommendations would involve inside-the-fence solutions
Conclusion: We are not surprised at the repeal of CPP; however, we are somewhat puzzled by the EPA’s request of the power industry to help it write new regulations regarding CO2.

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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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EIX, SRE, PCG: Preliminary Decision from ALJ on CA IOU’s Cost of Capital Proceeding is Largely in Tact with Two Relatively Benign Changes to the Settlement

On May 10, 2017, two assigned Administrative Law Judges (ALJ) issued a proposed decision (PD) in the cost of capital (COC) proceeding pending final decision (FD) by the California Public Utility Commission (CPUC)
The PD upholds the settlement agreement but for the following two modifications that was submitted by Southern California Edison (SCE), PG&E (PGE), San Diego Gas & Electric (SDG&E), and Southern California Gas (SCG) – all four combines (CA-IOUs) – CPUC Office of Ratepayer Advocates, and The Utility Reform Network on February 7, 2017
Instead of requiring the next COC application in two years to April 22, 2019 for 2020, the PD would require the next COC application to be filed on March 22, 2018 for 2019
The PD left open the possibility of reducing PG&E’s return on equity until recommendations made by the NorthStar Consulting Group which are adopted by the CPUC are implemented in the second phase of the CPUC’s safety culture investigation
The earliest the CPUC would promulgate a FD is June 15, 2017

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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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