Iurii Garmash
Amidst the Ukraine War and the ensuing chaos in the energy markets, there was another potentially pivotal development in energy this summer. On the last day of June, the Supreme Court handed down West Virginia v EPA and struck down the Clean Power Plan. The vote fell cleanly along party lines, with all six Republican justices in the majority and all three Democratic justices dissenting.
West Virginia was one of 27 states in the litigation, but it’s an appropriate choice of representative in the headline name as West Virginia is the home of much of the coal production the case was launched to save. But while the natural gas industry (NYSEARCA:UNG) certainly does have reason to cheer, the oil industry will probably be more or less indifferent. And companies like Peabody (BTU) and Arch (ARCH) will soon find this case is nothing but a lump of coal (sorry, couldn’t resist) in their stocking. WV v EPA will, however, prove to be a major catalyst for the gas industry in the years to come, if indeed the Republican victory over the last Democratic climate plan is answered by the Democrats with a new one.
Long-Term Fundamentals Only
One quick note: this article will examine this new decision through the prism of the long-term fundamentals of various companies. Right now, with the Ukraine War still raging, obviously gas, oil and coal are all spiking – gas prices are at 14-year highs and actually threatening to break back into double digits, which is not a sentence I thought I would ever write again – and there is money to be made from the energy sector pretty much all over.
You certainly could – and many are – write articles about the short-term movements in the gas markets. However, it would be difficult to write about the short-term implications of the Court’s decision since, as I will, show, there almost certainly aren’t any. The decision does, however, have significant long-term implications, by which time the war will probably be over, one way or the other. So the elephant in the room is the Ukraine War, but I largely intend to ignore it.
Minimal Short-Term Impact
There are a few reasons the decision probably has minimal short-term implications.
Cancelling A Forgotten Plan
It’s worth noting that the Clean Power Plan was never going to be implemented anyway. It was proposed by the Obama Administration, withdrawn by the Trump Administration before it could be implemented, and has not been reintroduced by the Biden Administration, who told the Court they’re not planning on doing so. So the Court literally ruled against implementing a plan no one was planning on implementing.
The Game’s Already Been Called
Even if the CPP had been implemented, it would have required … precisely nothing. When CPP was announced Obama triumphantly declared he had struck a major blow for the climate by requiring US power sector carbon emissions to fall 32% below 2005 levels by 2030. As I said, the CPP never went into effect. And yet, carbon emissions in 2019, the last pre-COVID year, were already 33% below 2005 levels. In fact, emissions economy-wide are getting close to 1990 levels, the benchmark used in the now-defunct Kyoto Protocol.
Carbon Profiles
The reason for this is, of course, the explosion of natural gas and renewables, courtesy of shale drilling and plunging costs for solar panels. Even natural gas, the fossil fuel ugly duckling of the clean energy bunch, in 2020 produced roughly 60% less carbon per kWh than coal, and thanks to shale there is even more natural gas growth than renewables growth in the market. Altogether, gas’s higher market share but smaller carbon savings means that gas and renewables have split credit for the 33% savings almost exactly evenly.
Scoring An Own Goal
With West Virginia bringing this challenge on behalf of coal and, to a much lesser extent, gas interests, one would think that the victory would set off cheers of joy in coal executive suites. Gas executives should indeed be celebrating, but if I were a coal executive, I’d be wondering if I’d have been better off losing.
Spoken with no trace of irony
First, the ruling was not nearly as sweeping as it could have been. This is an investing article, not a legal one, so very briefly and considerably oversimplified:
There had been considerable speculation before the ruling was handed down that the Court might take the opportunity to completely overturn the Chevron doctrine, the pivotal constitutional precedent that allows agencies like the EPA to make rules like the Clean Power Plan without Congress voting on each rule itself. Under Chevron, Congress simply sets a general objective (keep the environment clean, police the drug market for dangerous products, prevent fraud in securities investing) and also any restrictions on the way the objective is pursued, ie., things they don’t want the agency to do. Within those restrictions, the agency has very broad power to decide for itself how to proceed, as long as its chosen course is reasonably related to the objective outlined.
The doctrine is increasingly criticized by conservative legal scholars, and overturning it could have crippled the EPA’s ability to pursue any carbon restriction regulations now or at any time in the future. That would have been a very big deal, especially for coal.
Instead, the Court made a relatively minor decision when it struck down the CPP on another ground, ironically known as the “major questions doctrine.” This doctrine essentially says that even Chevron doesn’t allow an agency to make sweeping economic changes above a certain level without explicit Congressional approval, if it is seeking to regulate something it has never regulated in the past, and regulate it in a way it has never regulated anything else.
Leaving The Door Ajar
In so doing, the Court left open the possibility that the EPA might still use Chevron and its rule-making authority to pass significant carbon restrictions down the road, provided they are better tailored and a little more similar to the ways the EPA has regulated other pollutants in the past. Ironically, that is likely to be very bad for coal, the protection of whose industry is a big part of the reason why West Virginia went to court in the first place.
Under the CPP, or a similar plan just like it which the EPA can now no longer pursue, aggregate standards were set and then each state was left to implement them, with direct federal oversight existing only as a backup that no state was likely to risk happening. This meant that as long as some percentage of coal plants closed, others could stay open, because the EPA was only setting an overall target.
That looks very different from the traditional EPA regulation method, which the Court has now said the next carbon plan must bear more resemblance to. Usually, the EPA uses its powers to simply require every power plant to adopt the “best available control technology” which produces more benefits than costs to society, even if that emissions control technology will completely wipe out profits at the plant. And it applies these standards, most of the time, to every plant in the country simultaneously.
That means that in order to set a standard that has any impact on climate and coal use at all, the EPA might well have to adopt rules that threaten the viability of (almost) all coal plants.
No More Special Favors?
What’s more, the second go-round might be less solicitous of coal, in particular, than the CPP was. The Clean Power Plan was going to allow coal plants to emit almost twice as much carbon per-rata as natural gas. While coal plants were still going to have to cut more in absolute terms, the CPP allowed them to maintain a considerable crutch against one of natural gas’s biggest weapons, its lower carbon profile.
Even oil plants, of which there are hardly any left, were given a break, since the Clean Power Plan allowed emissions of 160 pounds per million BTUs (1 million BTUs produces about 293 kWh of electricity) from oil or other petroleum liquids but only 120 pounds per mmBTU for natural gas.
But there aren’t enough oil plants left for that to really matter. Coal, however, is another story. There is still real market share for gas/renewables to take from coal. The next plan might preserve a similar “coal support system,” but then again it might not. And if it doesn’t, any sort of “flat-rate” approach will almost certainly mark the end of coal’s ability to compete in any meaningful fashion.
Gas’s Relentless Advance
This is, therefore, quite an own goal coal seems to have scored, and given the limits on how much renewable capacity can be installed at any one time, oil and gas stocks are likely to be considerable beneficiaries – along with renewable companies like First Solar (FSLR) and SunPower (SPWR) of course.
But renewables ability to benefit may be limited, at least for a while. A series of trade disputes have weakened imports and caused a 55% decline in renewable energy projects over the past few months. The future course of these disputes is unclear. But assuming that renewables will not be capable of filling the entire gap when a new climate plan is handed down – and President Biden has promised there will be a new climate plan – natural gas is the natural replacement.
Natural Gas Safe From Reductions
As for a new climate regulation’s threat to gas itself, it is almost minimal. Regardless of whether natural gas benefits from the new rule or not – and I believe it will – circumstances make it all but impossible for it to be seriously hurt.
Although its common knowledge that coal is more carbon-intensive than natural gas, the sheer scale of the disparity still surprises some investors. In 2021, coal accounted for 59% of all power-sector carbon emissions despite representing under 22% of total power produced.
Meanwhile, natural gas has seen its share of power generation increase from 17% to over 38% since 2003, but it still represents only 40% of power-sector emissions. Taking account of the fact that total power-sector emissions are already down 1/3 from 2005 levels, emissions could fall to 73% below 2005 levels without taking a single natural gas plant offline, if every coal plant were to be turned off.
And if renewables don’t grow fast enough to make that feasible, so much the better: gas will fill the void. Indeed, the most likely outcome now of any renewed regulations, formulated under the more traditional “point-source” regulatory scheme, is to further increase the disparity in competitiveness between coal- and gas-fired plants, especially if the next regulation, unlike CPP, offers absolutely no respite to coal and insists that its plants meet the same standard as gas ones.
In other words, by leaving carbon regulation possibilities open, the Court signals to us that the market may have been underpricing the risk of further regulation that will slant the field further away from coal and towards natural gas, despite coal’s putative “win” at the Supreme Court.
Playing The New Hand: Picking Stocks
So, in brief, the Court decision did nothing that wasn’t already expected, and even if it had by some miracle come out in favor of the CPP (and the Biden Administration had decided to reimplement it) the oil & gas industry wouldn’t have had to do anything to come into compliance with it they’re not already doing.
But the Democratic Party and, according to polls, the vast majority of the voting public still want more done on climate change, so it seems likely that something more will be demanded in the future. When it is, the structure of those regulations is likely to be something a good deal closer to command-and-control style regulation than the more market-based systems regulators – and economists – have come to prefer in recent decades.
Such controls, while they will probably still demand something of natural gas as well in terms of cleanup, could very well all but put the final nail in the coffin of coal-fired power generation in the US, and thereby be a net gain for natural gas even if additional spending on emissions control is required.
So how to play it? Broadly speaking, there are three major classes of oil/gas producers: pure-play gas stocks who produce dry gas or wet gas with relatively small liquids percentages; super majors, like Exxon Mobil (XOM) and Chevron (CVX); and shale mini-majors like Pioneer (PXD) and Devon Energy (DVN) who produce so-called “associated gas” as a byproduct of their shale oil operations, which are also environmentally challenged and are seen by some as benefiting from the ruling as well.
Shale Oil Mini-Majors
The oil shale mini-majors, which also include Occidental (OXY) and EOG Resources (EOG), are the easiest to dismiss. In the first place, the perception that the Court’s ruling may benefit oil as much as gas by clipping the EPA’s wings is almost certainly wrong. And they simply aren’t gas producers to the same extent; again, they produce gas only as a byproduct.
While any ruling that trims the EPA’s carbon-fighting power is probably good for oil stocks as well as gas stocks, oil producers are unlikely to benefit to the same extent since the primary tools the government regularly uses to fight transportation emissions, where most oil is burned, come from the Department of Transportation, not the EPA. These are also on much more solid legal footing since they can be justified on national-security as well as environmental grounds and, unlike the EPA’s “creative” approach, are explicitly authorized by law.
Another concern is that because oil is so much more easily traded across the globe than gas, it spiked much higher than natural gas in the US after the war started and has now been falling back. In Europe, for the same reasons, the reverse is true – natural gas there is trading at a record 188 euros per MWh, close to $100 per thousand cubic feet! But unless oil has another surge in it – unlikely, since oil is widely seen as already having spiked high enough to reach demand-destruction levels – the effects of settling oil prices and falling gasoline demand could easily swamp any associated gas benefits.
Supermajors
The supermajors, which also include BP (BP) and Shell (SHEL), are more interesting, since they regularly produce large amounts of gas to turn into chemicals and other products. My concern here is that these are large, geographically distributed producers with production all over the globe. What we are discussing now is a uniquely American change in regulatory posture, so the supers are going to see the benefit over a proportionally smaller share of their operations.
Again, this logic would be somewhat different if you thought that the decision had also changed the outlook for oil, the more globally traded commodity. But I simply don’t think that’s the case.
Pure Plays: EQT and Antero
I see this decision as benefiting primarily the pure-play gas producers. They have the greatest exposure to the only fossil fuel that is likely to see a substantial benefit from the Court’s relatively narrow ruling. EQT Corporation (EQT) and Antero Resources (AR) are both interesting, although since they’ve spiked so high already, investors may want to await a dip before entering.
Southwestern (SWN) is a little less interesting to me, only because its relative strength to peers is in its proximity to LNG exports through the Haynesville shale. Exports are not going to benefit from this ruling like domestic consumption is likely to.
Potential Risks To This Thesis
One potential fly in this ointment is if the new climate program is so strict that even the 70% below 2005 that shuttering coal gets doesn’t satisfy it. At some point natural gas will become the only further carbon reduction game in town. But most agree that that cannot be done without producing extreme dislocations that even the Democrats don’t want to risk.
Also remember that the Court’s ruling affects only federal law; states are still free to set far more stringent standards. Democratic voters in blue states are already pressing to do exactly that; California wants to hit net-zero no later than 2045. Obviously, that will have real implications for natural gas use in that state.
Another risk to this thesis is if renewable rebounds faster than expected and does indeed sweep up so much of coal’s former space that there isn’t much room for new gas. A two-year tariff reprieve is in the works, though I question if that is sufficient, and before this whole mess blew up there were projections that renewables and nuclear could march to 50% of total electricity production as early as 2027.
Due Diligence Still Required
Because this was such a broad examination of a nationwide decision, there was relatively little time to devote to the individual companies. Even more so than usual, investors should remember to do their own due diligence on any of these investments as we’ve focused on the EPA Court ruling to the exclusion of some of the other factors more unique to each company.
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