Episode 7: Energy

• Disclosures (0:00 – 0:35)
• Host introduction (0:35 – 0:47)
• Episode introduction (0:47-1.05)
• Introduction of the episode’s guest: Gregory Padilla, CFA (1:05 – 3:01)
• Energy Transition, decarbonization and electrification (3:01 – 6:20)
• Natural gas in the fight against the climate change (6:20 – 8:19)
• Investing in the energy space (8:19 – 9.42)
• Challenges around transitioning into clean sources of energy (9:42 – 11:31)
• Achieving decarbonization goals (11:31 – 13:25)
• Societal challenges around mining (13:25 – 14.03)
• How investing in the energy sector fits in the Aristotle Capital process (14:03 – 18:01)
• Greg’s research visit to Guyana (18:01 – 22:26)
• Aristotle Capital mosaic theory approach in research (22:26 – 23:36)
• Conclusion (23:36 – 24:49)
  

Aristotle Introduction: The term Aristotle is used to represent a family of affiliates, which is comprised of Aristotle Capital Management, Aristotle Capital Boston, Aristotle Credit Partners, Aristotle Atlantic Partners, and Aristotle Pacific Capital, which collectively operate under a unified platform known as Aristotle. Each firm is an independent investment advisor, registered under the Investment Advisors Act of 1940 as amended.

Catalina Llinás: Hello, everyone. Thank you for joining us for our podcast series, the Power of Patience. My name is Catalina Llinás, Co-Chief Investment Officer of Aristotle Capital, and I will be your host today.

On today’s episode, we’re going to talk about the energy sector, and for that we have Greg Padilla, Portfolio Manager at Aristotle Capital, joining us. Hi, Greg. It’s great having you here. Thank you for joining.

Gregory Padilla: Thank you, Catalina. Good to be with you.

Catalina Llinás: Before we start, would you like to say a few words about yourself?

Gregory Padilla: Sure. I’ll give you a little bit of my background at Aristotle and how it pertains to the energy sector. I’ll give you the short version of the long version. Coming out of high school, I actually thought I was going to be a professional golfer, attended Arizona State on a golf scholarship. I majored in finance as I wanted to be able to manage all the money I was going to make on tour. Obviously, that didn’t pan out, but my senior year I convinced my finance professor to start a class on investing. The final project was to read three investment books and lay out our investment philosophy. Some of you might be familiar with these books. We read Burton Malkiel’s A Random Walk Down Wall Street, we read Robert Hagstrom’s The Warren Buffett Way, and Motley Fool’s Rule Makers, Rule Breakers.

It was that point in my life, reading these investment books, that I was really hooked on investing. Went back to business school for my MBA and began my career at a subsidiary of Nuveen Investments that was focused on global equity investing. I started my career as a utility and energy analyst and then began managing money in 2008, which as you can imagine, was quite an interesting time to get the trial by fire. I’m incredibly grateful for the opportunities I got early in my career.

After a successful run at Nuveen and a brief stint in the hedge fund world, I joined Aristotle Capital in January of 2014. Now in my 10th year managing our global equity strategy, sixth year co-managing our US strategy. And while my responsibilities are much broader now, the energy sector is near and dear to my heart. I’ve been following it closely for just about two decades.

Catalina Llinás: And hopefully, you’re still playing some golf?

Gregory Padilla: Not much between work and my 13 and 11-year-old daughters and other family obligations. It’s tough, but I still get out there and have fun with my friends.

Catalina Llinás: Well, we’re glad that didn’t pan out. Let’s just dive into the topic. Let’s talk about energy and perhaps let’s start with the topic that seems to be on the news of the day and everyone’s mind, which is the energy transition. I would love to hear your perspectives on decarbonization, electrification. Maybe let’s start with that.

Gregory Padilla: Yeah, definitely. Obviously, it’s happening. The transition is happening, but the point I’d like to make is it’s going to take a lot longer than anyone imagines, and that’s really due to the scale and scope of the transition. Little historical context, the world has really had two changes ever, really, in the leading source of energy. The first was in 1900 when we went from burning wood to burning coal, and then more recently in 1960 from primarily using coal to oil.

The transition we’re going through now is going from oil as our primary energy source and other fossil fuels to really more of electrification. That’s something that is incredibly complex. Obviously, electric vehicles come top of mind for a lot of people. And to put that to scale, the world consumes roughly a hundred million barrels per day of oil. I’m going to repeat that to make a point because just to fathom that a hundred million barrels per day, it’s just enormous. Half of that goes to the transport sector for driving vehicles. And then just focusing on that area, you can imagine the complexities of we got to get people in the electric vehicles. Today, only about 6% of new car sales are electric vehicles.

Catalina Llinás: Is that in the world or developed economies?

Gregory Padilla: That is in the United States last year, where we can get accurate data, but you can use it as a… That’s kind of a high point. There are certain parts of Northern Europe where EV penetration’s higher, but kind of broadly you can think of it as low single digits. Still very low. When you have electric vehicles, you need electric charging infrastructure. When you have the charging infrastructure, you need your power generation not to be heavy fossil fuels, particularly coal. You need it to be more lower emission-intensive sources of power generation or ideally wind and solar. And we’ll talk about that in a little bit.

And then one other area that I’d point out the challenge when you look at what Europe’s going through right now. In the US, about 15% of natural gas consumption comes from the residential sector, so 15% in the US. In Europe, it’s 40% of the natural gas consumption in the residential sector. A lot of that is from gas boilers heating homes. Right now, Europe’s going through the transition from these natural gas boilers to electric heat pumps.

Catalina Llinás: On that.. Oh, sorry, go ahead.

Gregory Padilla: No, I was just going to say… I mean, it’s wonderful. We need to go there, but imagine the complexities of ripping up the infrastructure in someone’s home. I mean it’s really…I mean go down to a home improvement project you have when you want to replace a sink or a stove and multiply that across the country with the complexities of getting electricity to the right spots, getting natural gas lines pulled out. It’s incredibly complex and it’s going to take time.

Catalina Llinás: Those boilers, from my years in Europe, you get the warmth… Looks like little stoves on the wall and they get warm with hot water.

Gregory Padilla: Exactly.

Catalina Llinás: Versus here in the US, where you get these big holes in the walls that blow warm air, right?

Greg Padilla: Yes. It’s a good simple way to think about it. Exactly.

Catalina Llinás: When we talk about natural gas, it’s interesting because people that think about protecting the environment tend to say or we hear that if you want to protect the environment and if you want to fight climate change, you should be against natural gas. Yet, it seems that natural gas is really part of the solution to fighting climate change. What are your thoughts on that?

Gregory Padilla: Yeah, most definitely. It’s a good point. That is the misperception specifically about natural gas. Natural gas replacing coal power is the single largest source of decarbonization. Just to kind of put that in context, if you replace one BCF a day of the equivalent of coal power with natural gas power, you’re taking 30 million tons per annum of CO2 emissions out of the air. That’s the equivalent of removing 6 million vehicles from the road each day as far as the CO2 that they put out, so it’s incredibly impactful.

As you rightly point out, a lot of people say you either love the environment or you love natural gas. I don’t think that’s the right way to think about it. I think gas plays an important role as a bridge fuel, and while we would love to be 100% renewables tomorrow, it’s just not practical.

The US has been a leader on this front. If you go back to 2006, about 16, 17 years ago, 50% of our power consumption came from coal. So we’re getting half our power from coal. Today, that’s 20%. So significant reduction in coal. What did we replace that with? First and foremost, gas. The mix of natural gas went from 20 to 40 and then the balance was from renewables.

Again, we all would love wind and solar to be the primary source of replacing coal, but there are practical constraints to that. The US has been a leader and now we need the rest of the world to make that similar conversion, particularly with foreign coal. What’s going to replace that is going to be LNG, liquified natural gas. That’s really going to be an important bridge fuel for particularly developing economies.

Catalina Llinás: When it comes to investing in this sector, do you then say, “Well, this is the place to go because LNG is a requirement to continue on this transition, therefore let’s invest in some of this interesting business”? Or how does the team think about it and what are we investing in?

Gregory Padilla: Yeah. Again, just to take a step back, we’re not making a top-down call and saying, “This is what I see the future playing out. Let’s go invest in LNG.” It’s really from the bottom up, focusing on the energy companies, understanding the evolving dynamics within these industries. What we’ve come to the conclusion is that natural gas will play a key role in the transition, which makes us comfortable when we’re looking at various energy companies.

There’s really probably only a handful of energy companies in the world that would meet our quality criteria. And I’ll mention two of which that we own in various strategies. We own the French company, TotalEnergies, in our international and global strategy. They are, among other things, the largest exporter of LNG from the United States. And then in our US strategy, we also own a company called Coterra, and Coterra is a leading producer of natural gas from Appalachia, the northeast of the United States. Those are two well-run, well-managed companies in our opinion, and we’re happy to hold them in the portfolio on behalf of our clients.

Catalina Llinás: You mentioned wind and solar and how it would be great if the world could transition to that, but there are some challenges. Right? We have storage issues, battery transmission challenges. How do you see that playing out and is that something we are invested in?

Gregory Padilla: Yeah, another great point. I think it really comes down to the utility sector driving the pace of electrification and the transition. Because when you put out wind farms and solar panels, they’re obviously not located centrally in cities, particularly the ones in massive scale outside of rooftop solar. You have to have significant investment in transmission lines. It requires significant investment in transformers when not all of us live in densecities and drive electric vehicles. When everyone’s home at night plugging in their cars, that puts enormous stress on the grid and you need upgrades and transformers, et cetera.

The utility industry is really going to be driving that pace of innovation and adoption. It’s a tremendous opportunity. In our US strategy, we own two fully regulated utilities that we believe are located in reasonable regulatory jurisdictions. One of them is Atmos Energy, and Atmos is the largest natural gas-only distribution company in the US. And we also own Xcel, and Xcel is an integrated electric utility and they’re really leading the clean energy transition in our view. Geographic location is great for utility scale, wind, and solar phasing out of coal. It’s really what you look for in utility that you want to own for the long term.

Catalina Llinás: We haven’t owned many utilities over the years and we do have members of the team that spend a lot of time looking at the sector. Perhaps this is a great podcast for the future where we can talk a little bit more in-depth about the utilities, but let’s talk a little bit about… When we began the podcast, you mentioned that decarbonization, the transition was monumental. So perhaps you can highlight some of the challenges that the world is facing as this takes place.

Gregory Padilla: I think it’s really the realities of the transition in what we need. To achieve the decarbonization goals that have been broadly set out… Take copper for example. To achieve the goals that the industry would like as far as this decarbonization, it requires roughly, and this comes from various industry sources in mining companies, about $250 billion of investment in copper when you look by 2030. And when you look at what’s in the pipeline today, it’s only about 50 billion. That just frames for you what the ramp up that we need. Copper’s critical in wind turbines, solar panels, energy storage, electric vehicles, the batteries, and the motors.

We currently have no investments in the metal miners, but I think it’s something that society needs to acknowledge. Mining isn’t something that a lot of people want to support or endorse, but it’s just a practical reality that the transition needs reliable supplies of copper, rares, nickel, lithium, cobalt. All of these things need to obviously be done responsibly, but that’s going to be a huge challenge for the industry.

And then another one, very sadly, the atrocities in Ukraine really reminded us of the importance of reliable and affordable sources of energy. You look back at Europe and they were on the cusp of a massive energy crisis. It was avoided from a warm winter and shutdowns in China that redirected LNG cargoes to Europe, but it really kind of was eye-opening for society to take kind of a step back and reassess the balance of the pace of this energy transition with the other impacts on society.

Catalina Llinás: And when you say that it’s hard to accept for society that we will need to do a lot more mining, is it because of some of the social challenges where these minerals are found?

Gregory Padilla: Yeah, and the environmental. I think mining’s probably in the bullseye of the challenges in the environmental and societal challenges that the investment community is dealing with today. Again, I think in an ideal world, we’d love the idea of never having to mine for anything again, but I think it’s important to kind of frame the discussion a bit and be pragmatic about, “Okay, if we do need copper and we do need these rare earths, let’s have the companies that are doing it in an environmentally friendly and in a sustainable way.”

Catalina Llinás: Okay, let’s take a step back and talk about the Aristotle Capital process. You start by focusing on high-quality businesses. The question we get is how does a sector like energy fit with that quality criteria? It’s capital intensive. It’s cyclical. It’s regulated. How does that work?

Gregory Padilla: Yeah. We own some home building companies and financial companies and isn’t as similar, but I think in energy in particular… It’s a question we get asked if you’re a quality first investor, “How does energy get through that quality hurdle?” And it really gets back to how we look at things. It’s a pragmatic approach to quality and we’re looking at it two-dimensionally. We’re looking at the dimension of the company and we’re looking at the dimension of the industry. And most definitely, as youarticulated very well, the energy industry broadly is capital intensive, cyclical, and regulated, and those do put it in the category of what I would consider an average at best and more likely below average business.

But there are certain companies we believe are phenomenal companies, low-cost producers, long life asset base. They’re developing these resources in a responsible way. They have management teams that we believe are proven over various market cycles with good balance sheets and disciplined capital allocation. Those are the companies that we would focus on. As I mentioned earlier, there’s probably a handful in the world that get through our quality criteria. We’re always obviously looking for new ones, but it is a pretty tough hurdle to get through.

And then broadly, looking at the industry in general, we’re really at an inflection point, in my opinion. The industries finally focused on profitable growth and return of capital. I think back to my early years in this industry in 2006, it was really about, “How many acres do you have? What am I willing to pay a dollar per acre?” Nobody cared about cash flow or free cash flow. It was really more of a sum of the parts in EV. These companies were burning through cash and never generating free cash flow.

Not that dissimilar to what was going on recently in the cloud and software space. Right? You had all of these companies that were burning through cash, but they traded on a number of eyeballs or a number of clicks and the markets kind of changed and cooled on them as well and really demanding profitable growth.

Back to the energy sector, the refining industry was really the first to make this transition. It started in 2010. You had a wave of consolidation. You had the divestiture of many refineries by the majors. You had a wave of good management teams that came in that were disciplined capital allocators focused on returning cash to shareholders. You look back at the footprints that have been laid over the last decade with this new kind of industry structure, and the businesses have been very strong. When you look at the oil and gas companies, they’re now making this transition and they’re trying to optimize, if you will, how they return that cash to shareholders.

Do you do it through buybacks? Do you do it through dividends? Special dividends? Variable dividends? Again, these companies are generating a ton of cash trading, as an industry, roughly 10% free cash flow yield and returning 50% to shareholders… 50% to 100%, I should say, to shareholders. There’s tremendous opportunity there from the investment side. And particularly in a world where people are looking for reliable sources of income, potentially inflation protection, I think that the energy sector is a place where you can really find that today.

Catalina Llinás: Perhaps it’s fair to say that the quality of the sector in general… And we look, of course, at individual companies, but the quality has improved over time and maybe some of that perception is no longer accurate.

Gregory Padilla: Exactly. Again, I’m hesitant to paint a broad brush because we definitely wouldn’t endorse that, but I think in general, the industry’s improving. And in general, we’re really laser-focused on what we think are the best companies within that improving industry. And that can create a potentially fertile environment for investment.

Catalina Llinás: Thank you for that. I have, of course, worked with you for many, many years and I have heard about your very amazing research visits and trips, and you’ve talked about visiting LNG facilities in Qatar and Northern Iraq. You’ve been to Vietnam and you’ve been in the oil sands of Canada and Alberta. Most recently, just a couple of weeks ago, you went to Guyana. I would love for you to tell the audience about your latest trip to Guyana. And first, start with, where is this country? I remember from my days in high school learning geography that there were three Guyanas, and so maybe tell us a little bit about that and what you learned as it pertains to energy.

Gregory Padilla: Yeah. The ability to travel the world and visit some of the most interesting and emerging countries in particular is really a privilege of my job. As you pointed out, most recently I got back from a trip to Guyana. And just to kind of frame it, if you close your eyes and kind of visualize South America, Guyana’s on the northeast coast that borders Venezuela on the west. It borders Suriname on the east, and even Brazil stretches that far north, so Brazil is its southern neighbor. The country was originally settled in the 1600s by the Dutch, taken over by the British in early 1800s. And for most of the last 300 years, the primary source of industry in Guyana was sugar and rum.

Catalina Llinás: So there’s been discoveries?

Gregory Padilla: Yes, they had. Getting back to the reason I’m down there, it’s not to drink the rum, it’s to visit their massive oil development. In 2015, there was a massive offshore oil discovery by ExxonMobil. They’d been drilling in the country for over 20 years. They had drilled 40 dry holes, but that’s part of the oil business. They hit a massive discovery in 2015 and getting a little bit in the weeds, but it is quite interesting. The working hypothesis down there was an analog to the Gulf of Mexico here in the United States, where you drill on the shelf, the oil migrated up to the shelf, and you would start your drilling on the shelf. They drilled a ton of dry holes.

Well, what happened was the oil got trapped offshore in deeper water in what they call stratographic traps. Think of that as just a less porous sediment where the oil migrates up and it can no longer permeate this barrier. It’s basically mud that trapped the oil and offshore in about 6,000 feet of water. They had a massive oil discovery. They’ve continued to have further discoveries and Guyana, again, has the potential to be one of the largest oil-producing smaller countries in the world today. You can almost think of it as potentially being a Kuwait in 10 years or an Abu Dhabi in 10 to 20 years. It’s really quite exciting.

Our trip down there, we met with the president, President Ali and Vice President Jagdeo. We met with the US Ambassador Sarah-Ann Lynch and we met with Exxon and Hess who are the owner-operators. We met with Noble who’s the drilling contractor. SBM, they’re the contractor for the floating production and storage ship, which is essentially the offshore floating vehicle that’s processing all of this oil. And we visited the onshore bases. A lot of the conversation down there, getting back to the responsible development of hydrocarbons, is this is going to be transformational for the country. A lot of it was really understanding how they’re managing that. They need significant investments in infrastructure, roads, bridges, electric grids.

I think the most dangerous part about my trip was the 4:00 AM drive from my hotel to the airport. Six of us in a van on a one-lane road with a semi-trucks whizzing by us at 60 miles an hour. They need to invest in infrastructure. They’re committed to invest in education, they’re committed to invest in healthcare. They’re doing a partnership with Mount Sinai, which as you can imagine, the US companies involved down there are really helping facilitate that. It’s great for the people of Guyana. This has the potential to cut their electricity bills in half and give them opportunities that they never would’ve had without the development of these resources.

Lastly, I’d finish that these will be some of the lowest carbon-intensive barrels in the world. And instead of flaring the associated natural gas, they’re going to be piping it on shore. The country, instead of burning fuel oil. The transition grid is very weak down there. Instead of burning fuel oil, they can burn clean natural gas and cut their electricity bills in half. It’s going to be fascinating to watch. It was an eye-opening trip for me and it’s all about just trying to better understand businesses and industries every single day. When we wake up every day, that’s goal number one for us, and finding new ideas and investing is kind of second to that.

Catalina Llinás: We do talk a lot in Aristotle Capital about the mosaic theory. We learn a little bit. Little by little, we put a puzzle together, a mosaic. Maybe with all the trips you’ve taken over the years, the decades, how does that build up? How does that allow you to better understand? And perhaps we’re not making an investment on anything that you necessarily visited years back, but how does that help with the way you conduct research as you look at your career and all of this research and visits and meeting the people? Maybe tell us a little bit about that.

Gregory Padilla: Our process is incredibly iterative. It’s all about learning every single day and layering on knowledge. I think when you contrast our approach with perhaps some more short-term focused investors that are looking for a stock pick or a trade or whatnot… For us, again, it’s getting back to trying to understand these businesses and industries as good as anyone, making well-educated decisions, choosing good management teams, and trips like this is part of layering the knowledge on. I come back eyes wide open, not thinking that there’s no risk in these areas, but that incremental knowledge helps us be aware of any potential risks and it also gives us a deeper understanding of those industries.

Catalina Llinás: Well, thank you. This was very interesting. Maybe if we were going to sum up what we talked about today or a conclusion, we can say that, yes, we will continue to transition. The transition to decarbonization is taking place. We’re moving to an era where a lot of power will be generated by electricity, but this is going to take a long time, and oil and gas are still going to be part of the equation. Then how can we continue to understand businesses that are getting this oil and gas in more friendly ways as it turns to the environment? Anything you would like to close with?

Gregory Padilla: No, I think that was perfect, Catalina. Thank you for having me today.

Catalina Llinás: Thank you, everyone.

Well, that brings us to the end of this episode. Thank you, Greg, for joining us today. And thank you all for listening to the Power of Patience. We hope you enjoy the podcast.

To learn more about Aristotle, please visit www.aristotlecap.com or follow the link in the show notes. If you enjoyed the show, please rate and review us on Spotify and Apple Podcast. On behalf of Aristotle, this is Catalina Llinás. Thank you for listening.

For additional disclosures please refer to www.aristotlecap.com.