Invest Like the Best with Patrick O'Shaughnessy - Matthew Smith — Natural Gas: The Next Bottleneck - [Invest Like the Best, EP.483]

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Starting point is 00:01:11 Hello and welcome, everyone. I'm Patrick O'Shaughnessy and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, stories, and strategies that will help you better invest both your time and your money. If you enjoy these conversations and want to go deeper, check out Colossus, our quarterly publication with in-depth profiles of the people-shaping business and investing. You can find Colossus, along with all of our podcasts at Colossus.com. Patrick O'Shaughnessy is the CEO of Positive Sum. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of Positive Sum. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions.

Starting point is 00:01:51 Clients of Positive Sum may maintain positions in the securities discussed in this podcast. To learn more, visit PSUM. Our guest today is Matthew Smith. He's been on the show before many years ago, and I always love talking to him about energy markets where he's worked for 20 years. He's the founder and CIO of Chronometer Partners, which invests in energy, industrial, materials, power, and utilities, and related infrastructure. He and his team have modeled nearly every natural gas well pipeline and processing asset in the United States. He's reached the conclusion that most of the market does not share. Starting in 2008, AI data centers and LNG exports will need more gas than the country can produce and deliver.

Starting point is 00:02:34 By his math, the U.S. could exhaust its working natural gas storage by 2030 and could lead to a true energy crisis. In his words, the upside risk to prices becomes unbounded and convex. We talk about why this was set in motion long before AI arrived, why the U.S. can't just turn off exports, who wins and loses among producers, nuclear, solar, and hyperscalers, and what he sees as the only long-term solution. please enjoy my great conversation with Matthew Smith. So Matt, the last time we did this was, I think, during COVID, kind of crazy that it's been six years. I've always loved talking to you about energy markets. You've been working in this space for 20 years.

Starting point is 00:03:11 You're about as encyclopedic on this stuff as anyone I've ever met. But you've also been acutely studying the current energy situation in the U.S., rebuilding in a way that you'll describe from the well-level up, a picture of what's happening, especially as AI. is creating all this new demand through data centers, et cetera, of what is going on over the last 18 months of concerted effort. You've reached a fascinating and somewhat scary conclusion. I'd love me to just start with a conclusion, and then we're going to talk through how you came to this conclusion, who the winners might be, the losers might be, what's to be done about it. But before we get deep into all the component parts, just tell us what you found after 18 months of study. We are headed into a place where we see an historic deficit in natural gas.

Starting point is 00:03:56 supply available in the United States, which does pretend some pretty serious consequences. Natural gas, which is over 40% of U.S. power generation, is imminently going to become the most important fuel in the country, it's overtaking petroleum, given the amount that we use now for generation. Our work suggests that 26, 27, natural gas is appropriately supplied, but as we get into 28 and you plug in this compute and you assign gas to very specific assets as that are plugged in as well and you continue to export LNG as we're planning to do with known projects we start to eat into our working gas storage which is the nexus of supply and demand in the country I think we will come to the conclusion that the upside risk compress the natural gas is both unbounded and

Starting point is 00:04:48 convex. And so where you will feel at the most securely will be electricity prices in 28, 29, 2030 based on our work. How much of this is just attributable to data centers, like just purely we're building a lot more data centers. That's just for AI. Is it that simple or is there something else going on as well? The die was cast long before AI compute came to the scene. If I may set the stage a little bit. U.S. gas was plentiful, starting in about 2010, when Shale started to really change, come to the scene and change things. We had been importing natural gas to satisfy consumption on top of what we produced domestically. Shale started to be very productive, surprised at the upside, and became this abundant force. And as natural gas became more abundant,

Starting point is 00:05:34 we started to export, starting with Sheneer. We've gone from that early Sheneer exporting to today. We're exporting about 15 BCF a day of nameplate, U.S. export capacity. Now that 15 billion could bequeed is on a base of about 110 to 112 BCF a day of natural gas production in the U.S. So if you think about it, it's become about 12 to 15 percent of the U.S. daily ability to supply the market we're exporting. As this abundance continued, more and more facilities, projects have been announced. As of today, we're scheduled to export up to 35 BCF a day by the end of 2030. And in that case, the dye has been mostly cast to build an NLNG project. you need various approvals. They're project financed. You cite and permit many years in advance.

Starting point is 00:06:22 Most of these projects that get you from 15 or 16 BC up day to nameplate to 35 are well on their way. And so that's the primary incremental demand driver in the country over the last 10 years and will be at least for the next five. We had moderate population growth during the tens and teens into the 2020s. We went through a period of stagnating electricity demand. You had energy efficiency and some other things driving down electricity demand. Well, you had more demand for gas-driven generation. But it's really been in the recent past where compute has started to pull incrementally. But before that, you had LNG as the main driver demand.

Starting point is 00:07:03 Now, let's put those together. I just shared that we're going to go from about 15 to 35 BCF a day of incremental LNG exports. And after evaluating every producing gas well and the entire pipeline and processing and gathering system, we have the capacity to add about 20 BCF a day of gas production, even without AI compute. We had sources and uses matched between our ability to deliver new natural gas from Appalachia, Haynesville, Permian, and that which is supposed to leave the door through LNG. Now in our AI compute. There's so many different power generating ideas in order to power compute, time to power,

Starting point is 00:07:42 that folks talk about so much. It sort of goes from the large-scale, most efficient assets, which are GE-Fernova combined cycle all the way down through the distributed generation assets, which will call fuel cells. We will add Worsesila-Oij or Caterpillar or solar turbines. There are various local field level behind the meter assets. Those assets are also relevant. We have had to assign with an outside partner probabilities to all that stuff. All of this stuff. And so what we've gone about doing is we will start with our base case, which is we'll call it P50, everything with the probability of 50% or more, 50% being they have some approvals. They have usually a PPA, someone planning to buy power from them

Starting point is 00:08:23 under contract. You know, they usually have some sort of interconnection agreement or they're in process with the interconnection agreement. Those are the assets we've taken seriously in our base case. And so we'll call that the P50 level. And when you do that, it's about 5 BCF a day. we think of very credible incremental natural gas demand associated with mostly AI compute. Now, importantly, there are multiples of what we are considering serious in our base case that have been proposed that will consume natural gas. Every solution today, a six-series Bloom Energy latest-gen-fuel cell will take 150 million cubic feet of data gas per gigawatt. The market has been assigning a high probability on them obtaining two gigawatts a year of productivity or of manufacturing capacity.

Starting point is 00:09:13 And that's likely to ramp to five gigawatts. There isn't the gas for that unless you take it from something else. In the extreme case, how high does that number get? If you start to move it down, it's a P30 or P0, that number can more than double and be 12 to 15 BCF a day by the early 2030s if unmitigated. One naive way to approach this is to say, like, this doesn't sound like that big of a deal. Like, 12 new in the extreme case, just shut off the exports. Like, who cares? We didn't export natural gas for a long time.

Starting point is 00:09:43 People domestically are not going to tolerate skyrocketing energy prices, especially when they think, like, the simple solution to this is just like, stop shipping it out of the country. They just use it for ourselves. Why is the solution not just like shut off exports? It's more complicated in that contract law. There are rules. There are really good reasons why we're exporting. And these projects have, you know, there's tens of billions of project financing and contracts attached to or associated with these LNG projects. And as the U.S. will be about a third of global gas supply in several years, our allies and other FTA and increasingly non-FTA countries are reliant on U.S.

Starting point is 00:10:23 Free trade agreement. So the answer is that it's both, because it's a third of the global supply, that's really important for the rest of the world. and domestically, there's just contracts and investments. And it could be stopped, but it'd be very complicated. Yeah, let's step back for a moment. You have to have a starting place for a base case, which is typically starts with signed contracts. You know, what are the words on the page say? What's allowed or what's not allowed?

Starting point is 00:10:46 When we set out to build the firm, we've had about 16 plus months to start to model almost every asset at a time at the atomic level. Along the way, there are numerous constraints and rules and regulations. and contracts. When we set out to build this, it was about acknowledging those constraints for what they are, assuming that contract law would be followed. And then as we go through and build all of this, we can flex up and down based on the choice to send less LNG out of our terminals, for instance, or slow AI compute growth, which is one of a solution which we're not really willing to propose because we know that there's insatiable demand. And so it's not

Starting point is 00:11:29 popular to say slow AI compute growth, but to the extent that would happen, that would be another lever to reduce the pole or strain we expect in the system as the decade goes long. I'm just going to try to ask really simple questions here because so it's not to minimize it, it's your view that in the bad to worst case scenarios, like this is like a full-blown crisis. This is not like a small thing. This is like the story in the country. So I want to make sure like the whole reason we're going into all this detail is like in this scenario, it's really, really bad and it's it's really bad primarily I guess through prices that maybe you can continue to articulate why we don't necessarily want this specific outcome and what we can do about it but help me

Starting point is 00:12:07 understand like underneath the United States right now or North America there's a certain amount of gas just like objectively I'm trying to understand like how much of this is that we are literally going to run out of the gas that's under the ground versus it's just a problem of how quickly we can find out where it is get it out economically process it story transmit it, use it, et cetera. Like, those seem like two separate problems, like literally just how much there is and then what we can do with it and about it. And so is any element of this problem, like there's just literally not enough of it?

Starting point is 00:12:38 Starting with it, we'll call it resource in the ground. There's tremendous data availability. We can measure where we are in the exploitation of most of the major gas-producing basins. Appalachia, which is primarily the Marcellus, plus the Utica, the Haynesville, which is a key swing basin, and then, of course, the Permian, and the Let's percent the Eagle for these are oil-directed plays where the decision to drill and produce is driven by oil and gas is a byproduct. So in each of these plays, there are some stacked pay or zones

Starting point is 00:13:09 where well penetrations output can be measured with a lot of data. What that allows us to do when you digitized the acreage controlled by each one of these companies with polygon shapes that uses a bunch of Latin longs to drop in and associate a well with an area that's controlled, you can figure out what's left. And the reality is there is gas, and we've, as a part of our analysis, produce the gas that is logically captured and can be produced from wells from existing acreage positions of all these companies. And so there is gas.

Starting point is 00:13:45 We're assuming it gets developed here. That's how you get to our 20 BCF a day of growth. but there are other constraints. It's unbelievably cool that we can like literally know at this precision what is underneath the ground, often deep underneath the ground and hard to reach places. It's a technology story, right? That would be fun to tell sometime. But it doesn't sound like the actual problem is like we are literally running out of

Starting point is 00:14:06 the stuff underneath the ground. We've also had a history of just finding new stuff that we didn't know existed before. So it sounds like the problem is more our ability to serve the demand in this kind of time frame, not that we're literally going to like run out of the resource over the next 20 years. So it's a little more complicated than that. We get through most of the existing captured inventory of companies in the next four or five years. And so if you think about you bring on a new well, it has a decline rate.

Starting point is 00:14:35 And each well as it's stacked on an existing company-wide portfolio decline, and a lot of these companies decline curves are maturing some. And so they don't have to- Pretty steep in natural gas, right? It's steep initially natural gas, but, you know, expand and EQT and others have such mature portfolios, the replacement is less costly today than it would have been five years ago. So when you stack all of these wells based on existing acreage up on these companies, assuming they're going to drill optimally based on the forward curve, which is depressed, and we'll talk about that,

Starting point is 00:15:02 you get to this 132, 128, 130, 132 BCF a day of maximum deliverability. So we are assuming that all of these companies develop the rest of their acreage. But that's a flow metric, not a stock metric. That's a flow metric. What is possible when you use known well performance parameters to maximize production before you get to midstream and other surface level constraints, which we'll talk about? There's resource. We are depleting the known resource.

Starting point is 00:15:33 If you were to assume prices go up meaningfully, you may unlock additional basins that are legacy known basins. We know a lot about most of the rock in the U.S. there are other known gas basins, but they're uneconomic. And furthermore, there is an infrastructure to really accelerate drilling and activity in those basins to solve this. The constraints are multifold. So the first constraint is the rock. We have the ability we think to get to 128 to 132 BCF.

Starting point is 00:16:01 I started in our highest estimate, which is 132 BCF as a starting place because that's how you solve the LNG exports we've committed to. We will take the under on that, but that's where you can get to. A common pushback, as we have gone through this, is there's plenty of resource available to us in the Permian. There's plenty of resource in Appalachia. A number of companies describe themselves as having a lot more inventory of wells to drill than we can justify with the facts. And I'll just leave it at that. But when folks meet with companies, they should ask to understand exact engineered locations on a map. Where do they have not just the ability to produce, but plan.

Starting point is 00:16:41 to have infrastructure on the surface to allow it to flow, for instance, and the ability within financial parameters to invest and produce. The resource in the ground, we're fairly far along and understanding it. We've accounted for all of the major productive basins in the country, and I do not think we're likely to be surprised by some new major shale find. At this point, knowledge of those things are pretty mature. To say it back, there's a lot of resource, but at this rate, we're depleting the known resources quite quickly. We are advanced in depleting the known resources, especially as to move to the next layer, which is infrastructure.

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Starting point is 00:18:35 running on Ridge Line's unified platform. If you're serious about your firm's AI strategy, Ridgeline should be part of that conversation. You can request a demo at ridgeline.aI. There's a bigger, longer term question about, is this just a parenthetical period of time between 2010 and now when we were a wash in gas? Prior to that, we really weren't. And maybe after this, we really won't be. Let's talk now about, okay, we get gas out of the ground. It still has to go, get processed and transmitted and used.

Starting point is 00:19:06 What are the most important rate limiters in that part of the equation? In some cases, it's processing the natural gas flows to the surface with natural gas liquids embedded there in. In some cases, there's sulfur or nitrogen that has to be dealt with. In some cases, it comes with oil, and so you have to have surface level infrastructure to produce the oil, which is different. Gas primarily has to be produced into a pipeline system, and there's a certain spec on regular pipelines. That's 1,010,030 BTU is the spec. So you have to remove enough of these other hydrocarbons. carbons to get it to pipeline spec to be able to produce it into the system, to be consumed by

Starting point is 00:19:45 folks downstream. So processing is the first major constraint. There are a couple of basins with a little bit of extra processing. We'll fill it up pretty quickly. We do not have processing yet to get to our assumed 20 BCF production target that's necessary. But processing would be something it takes two or three years to build at the midpoint. We generally know what processing investments are being made and projects have been announced by Permian processors or by Appalachian processors. We know where the materials and liquids handling throughput capacity will be in 27, 28 at least. You really would need to, in the near term, even to get to our 20 BCF of incremental gas production, we're willing to estimate you need to have more processing built.

Starting point is 00:20:31 Build stuff now. Point one. Build it now. Imminally. Gathering small dam at a pipe gathering is what takes it from the wellhead to processing or pipeline system. there is a fair amount of disclosure around processing systems being expanded and built. And we would posit we have put all those on a map on top of every one of these wells at their Latin longs

Starting point is 00:20:49 in order to grow even a fraction of where we must have natural gas production go in the U.S. Gathering has to be invested in very materially over the next imminently to get to the place where we can achieve, you know, 130 Bs of Day of Production in the U.S. The last one is interstate gas pipeline system. And this is where I come back to your answer on LNG, lots of rules and regulations around these things. Pipelines are monopolies, for the most part. Local distribution companies that deliver gas to your stove, those are monopolies or oligopolis. In the last 10 or 12 years, we've really built one interstate gas pipeline. That was Mountain Valley pipeline connecting appellation to Mid-Atlantic.

Starting point is 00:21:31 The various environmental permitting the regime changes been made very difficult to build interstate gas pipelines. This administration, this is an apolitical economy, this administration has been trying to reduce the barriers to building interstate gas pipes. We've started to see some more progress to that end. There is an urgency to build more connectivity, to wheel gas around the country, to serve this incremental AI compute load. Before we keep going through this sequence here, can you just say what you think the state will be, let's assume that like there's roughly inertia in the system. And like nobody listens to this, nobody does anything. A lot of people listen to this and have ideas. But what is going to happen in the world?

Starting point is 00:22:13 What will the state of the world be like in 2030 if none of this starts getting addressed sooner than later? What's your best guess as to what it looks like? There is a tremendous inertia around natural gas being the primary fuel to power AI. Semi analysis, for instance, leader in many respects. They've done excellent work on everything up to the, power source and they're behind the meter BTM load forecasts generation and load forecasts where they match. They do everything up to the point where they don't assess where the gas will come from. And so the market has been focused on understanding the power shortage and trying to solve that.

Starting point is 00:22:56 Generation generally, power generation, which could be solar and batteries, wind, nuclear, whether large scale or small module reactors, SMRs or natural gas, Natural gas is well supplied today, 26 and 27. And the result is that nobody is investing in gas. In fact, EQT is shutting in natural gas right now because they think it'll be more valuable later. The rig count, the things that we can see real time to figure out if the market is onto this tightness in 2020 and 30, it's not apparent today. And so it's perpetuating this view that most Americans have, which is there's plain natural gas. Because for 15 years, it's all we've been taught.

Starting point is 00:23:35 And so there's a. complacency that's developed. And we think that complacency is going to take us right up to the point where it's too late. So we do think the die has been cast, where gas, which is currently $3.50, $3.60, going out to 26, 27, in 28, the curve is flat. 20, 20, 30, the curve is flat because people believe the gas is abundant. That's despite all these AI compute announcements, despite what all of the companies are doing for their investments, gas has lulled everybody to sleep. But what happens is these structural things start to fall in place in 27, 28, and we start to draw meaningfully in the middle of 28, early 28, on the gas system like we've never drawn before.

Starting point is 00:24:19 And as we look at 28, 29, 2030, we start to cut into the U.S. working gas storage, which is about 4 TCF total gas storage. There's kind of a range of high and low for that storage seasonally as we draw in summer, winter and then build in the shorter months in the spring and fall. When you get to the middle of 2028, we start to break very materially below in a historical way where gas available in storage has ever been before. And by 2029, we drop below all known historical storage evidence. And by 2030, we get pretty close to where we think satiris paribus gas storage looks very, very low. And at that point in time, because it's not happened before.

Starting point is 00:25:07 We're forced to look at where has gas price gone during shortages. Well, we can look at Russia, Ukraine. The gas went to $8, $9, $10 in MCF because we send a lot more externally to Europe. We've seen various weather anomalies, polar vortex in 14, December of 22. And those prices have gone to $6 or $8 or $10. But those have been transitory. And what we're talking about are structural drivers of demand against a known possible production of gas and they don't match up.

Starting point is 00:25:40 You pull in a very historic way, starting in 28, to the point where the deficit gets really convex and unbounded. Meaning that gas prices could be 20 or something like this? I would hesitate to even put a price target on it, but at $8 or $10, we think you potentially shut off some of the U.S. exports, their spot cargoes, and they are leaving the border to capture uplift in Europe or elsewhere. Those spot cargoes may not be lifted in that gas is left in the system. And we've tried to account for that in our model, but the spot cargos alone can't solve this. You would have to get into shutting off contracted cargoes, leaving our border via

Starting point is 00:26:21 LNG, to really start to mitigate some of this. And it's hard for us to count on the choice to shut off contracted cargoes where there's some Japanese utility counterparty who is counted on it for its provision of electricity. In crazy convex outcomes like this, can you tick through who you think the biggest winners and losers are? There are some clear natural gas producer winners. Expand Energy is probably at the top of that list. They probably control 70% of remaining core Hainesville wells.

Starting point is 00:26:53 The very closely known parameters of rock where we know it to be very productive. And so expand, we think is far and away the biggest winner. uniquely expand his CEO list right now. There was some turnover in the year that are going through a search. The stock has plummeted over the last six months as a part of that search. And it's trading it four times EBITDA on a forward curve where no one believes what I'm telling you to be the case, even though we think modeling the facts gets you to a much higher gas price.

Starting point is 00:27:26 The stock has dropped. The assets have not changed. It has some of the highest quality rock in the country. Like highest quality upstream company in Appalachia is probably range. Range has significant room to grow production and materially grow returns to investors. So those would be the upstream companies. It's not going to be obvious in the first pass through this equation for most, but natural gas sets as the marginal fuel for the next in line power generating asset in each power market.

Starting point is 00:27:53 As natural gas goes, power prices go in the country. And so if you think about the dispatch curve of different, generating assets in the country, there are some where the fuel is free. That would be solar, to less extent wind, hydro. Well, solar assets, which are growing meaningfully, they've been 90% of the interconnect to you with batteries in the last 10 years in terms of new assets coming on other than gas. Solar assets stand to benefit from a windfall where electricity prices are going up because the margin of plant taking fuel where the price is increasing is rising, while sun costs the same. We think there are some companies positioned very well for margin expansion for no incremental capital costs.

Starting point is 00:28:37 XPLR, tickers XIFR, formerly Nextera Yield Co, which is an interesting set of assets. They have a windfall coming in the latter part of the decade because they mark their PPAs to market at much higher values without any CAPEX. Clearway energy would be another one similar circumstance. And so solar assets at the utility scale, especially stand to win, maybe more interestingly as it relates to some, some of our discussions the past, residential solar, which has been suffering from really the first removal of tax incentives to install residential solar since like the late 70s, residential solar assets are really one of the only ways to protect yourself from what's going to happen during the time of 10 a.m. to 6 p.m. once gas gets really tight in the electricity markets, what you pay for electricity

Starting point is 00:29:25 at your house. So we think residential solar grows exponentially from here, even without tax incentives. For the first time, it's very economic with where electricity prices are likely to go to install solar, especially when it accompanies batteries, which make the electricity much more available around the clock. I think it's important to say you're an investor, like, you have money behind this work. Beyond those two categories, are there any other, like, surprising winners, do you think, in all of this? Like, what about nuclear? What about, like, Westinghouse or places? like this. What we're talking about is a complex dynamic system where there will be choices to consume

Starting point is 00:30:01 electricity or not at different times. And as I go through this, I want to make sure I acknowledge that there's no silver bullet solution for what I described as a convex situation with natural gas and therefore electricity prices as the decade closes. And there's no bridge fuel other than solar and wind because currently natural gas is the only flex fuel to get us to when we can bring on nuclear. We have spent a fair amount of time as well in the nuclear ecosystem. To us, large-scale nukes are the only solution that makes sense,

Starting point is 00:30:33 which point us primarily to the AP-1,000 Westinghouse units that... Don't those take, like, five years to builders and move out? More than that, but at least they have a story passed. And very brief history, we've built two nuclear reactor units in 30 years in the U.S., Vogel 3 and 4. Around that time, we also tried to build one in South Carolina called V.C. Summer, another nuclear project at the time, nearly bankrupted Scana, which was later pushed into the arms and the project was shut down. The muscle memory from trying to build large-scale nuke,

Starting point is 00:31:03 especially in the back of Fukushima in 2011, Chernobyl through My Island, for three decades, nuclear engineers and scientists and companies moved away from nuclear. And then the Vogel 3 and 4 experiment where it costs, you know, three times as much and took 15 years, I think, from birth to commercial service. That's the recent memory of these nuclear units. But if you go out to the 2030s, what I'm describing in terms of gas deficit only gets worse in 31, 32, and beyond. And so in our mind, the only viable solution is to build large-scale nuclear as fast as possible, which would mean it needs to come on in 2033 or 2034, which is as soon as it can come on. Regular utilities, hyperscalers, regulators should all align around that goal. But because, it's a lot of the goal, but because,

Starting point is 00:31:51 Because people don't really believe that gas is in short supply as the decade goes along. They don't believe in the problem. They don't like the solution. They need to be convinced to the problem. And the country has a history of building pipelines to solve problems that exist today, not problems that it will exist in five or ten years. And so we're trying to get out ahead and see where the puck's going. And where it's going is we are going to need large-scale nuclear by 2033, 2034. You don't think SMRs can be a solution where you use smaller reactors to power individual data centers behind the meter and to see.

Starting point is 00:32:21 this never touches the system? Many of the SMRs are still science experiments. The NRC and the U.S. government are actually doing a fair number of things to break down the barriers to bringing those to see if they work or not and what the cost will be and whether they can be scaled or not. But many of these SMR companies are not set up to manufacture and truly scale for the solution that's needed to solve this problem, which is tens of gigawatts as you go into the 2030s. That points us to these 18,000.

Starting point is 00:32:48 So since Vogel 4 came on, and Vogel 4, experienced very material improvements from Vogel 3 in Georgia. Today, China is building 39 plus or minus nuclear reactors. 34 of them are one gigawatt plus. I think a third of those are modeled after the AP 1,000. We know a lot more today about building large-scale nukes than we did when these mistakes were made. So large-scale to us where it can be commercialized on a known timeline and where the costs are probably better than where we don't even know if we can scale the business. businesses yet in terms of SMRs, large scale versus small, probably wins in our mind. The two companies most lever to that would be Camaco, which owns 49%, Brookfield, 51%.

Starting point is 00:33:31 You'll probably find that the U.S. government, I think, agrees with what I'm describing. They seem to really be lining up and trying to facilitate commitments and early procurement, which will de-risk some of the supply chain, which will help put timelines on this. And when the Westinghouse comes public and it's deeply undervalued within Camaco today, So that's an interesting one. BWXT, which is a super interesting company, they're the primary supplier of nuclear for the U.S. Navy. They significantly benefit from the coming nuclear cycle as well

Starting point is 00:34:02 and lots of dollar content in the APN,000. What are the big losers, do you think, in this future? Well, sadly, the biggest losers of this would be the U.S. consumer. To the point where you take what I'm saying, and if we're even partially right, electricity prices rise, which you can see some of on the forward curves in these different markets. as electricity prices rise, you start to think about the trade-off,

Starting point is 00:34:23 are we going to export natural gas to foreign buyers? Are we going to use it for AI compute? Or are we going to try to keep consumer electricity price bills? It's an awful trade-off. I think it will probably start to contribute more to the public dialogue, the nimbism that we're seeing already pop up in some places. We think AI is tremendously transformational. We're not anti-AI, but it consumes a lot of,

Starting point is 00:34:49 of power. And we need to really focus on the 2030 to 2035 period. And the U.S. consumer is probably going to pay the bill in the meantime. Please note that most of the solutions being proposed by the government are to consume more gas because everybody believes it's plentiful. Bring your own generator or generation. B.YOG is a thing today. That's what the hyperscalers are being asked to do to cite their data center in a certain Latin long. Well, that means more gas, not less. And so every time you read a press release from Bloom or from... Think more gas. Think more gas.

Starting point is 00:35:25 And you can use the energy efficiency of each one of those units and understand exactly how much more incremental gas beyond the base case that I just shared is dangerously tight. Another loser, and I want to be respectful, but some of the biggest winners so far, at least in the stock market, have been the manufacturers of gas turbines or distributed power gen sets. And when you think about those companies, It's been somewhat boom and busts in the early 2000s.

Starting point is 00:35:51 There was a boom to build as many gas plants as we could. The capacity was overbuilt, and the industry really languished for a long time until now. And you've had just a tremendous profitability and equity returns come from these companies over the last two years. But as you look at 2028, 2029, most of them are adding more capacity, again, just like they did in the early 2000s. What kinds of companies are these? Caterpillar is, I think they're doubling their solar turbine capacity between now and the end of 29. which I would judge is just at the exact wrong time when people may be questioning whether they even want to deploy those assets because the gas is much more expensive than they plant. Bloom Energy, they've been topical recently because of other things that folks are talking about, the rare risks they use in their manufacture, for instance.

Starting point is 00:36:34 But for us, we don't think that Bloom Energy's assets at two gigawatts or more will be able to get natural gas in competition with all of the other assets that are being deployed that will consume gas, given that. the scarcity that we see. So those are two, we'll call it manufacturers of distributed generation or BTM generation that we think are probably more poorly positioned than investors appreciate. It really doesn't make sense to us beyond 20, 29, 2030 to build large-scale natural gas generation until we ramp up production meaningfully. And you can make sure we have the security of deliverability of supply of gas that's consistent with our model. We could see orders slow very meaningfully for natural gas generating assets, even at large scale as 26 progresses. And those could be some of the losers would be it.

Starting point is 00:37:25 It just may not make sense to use gas for power generation for new or incremental assets after a certain point. It seems like sort of like this whole memory shortage thing that we're going through right now, that hypers might also be in trouble here if this is a key input to what they're doing. Do you think that's a big problem for them? So as we've been socializing this a little bit, trying to learn more and have people poke holes, I've shared this with one of your recent guests. And he listened to say, well, this sounds like DRAM two years ago, slowly at first and then all at once.

Starting point is 00:37:52 The lack of investment in capacity expansion is going to come up to bite us. And I think that's where the analog starts. When we think about the way this plays out and other analogs, that's probably the best one. And when we think about the cost of the hypers, right now energy is budgeted to be about 10% of their cost. Depreciation is the highest memory and other things factored into that as well. but energy's total cost of energy is supposed to be about 10%. If you plug in all of this compute and it's gas powered, and we think gas could double or triple structurally,

Starting point is 00:38:28 even without weather, it could end up being 20 or 30% of the cost of compute by 2029. We do think it becomes a much more material issue. Now, the levelized cost of energy, LCOE, as it's referred to, takes into account capax. It takes into account cost of fuel. Everybody who are making, decisions in this moment are using the forward curve for natural gas, which is flat, a little

Starting point is 00:38:51 backward, a little contained, mostly flat out to the 2030s in the mid-3s. That is a very attractive, low-cost fuel for the hyperscalers to commit to when they're focused on solving everything else. Like, how do I get compute in place to manifest in this revenue growth inthropic or elsewhere? For us, we're just focused on modeling objectively. When you plug in this computer, this compute, in this power gen source here and there, how exactly does it pull on the system of companies that we focus on? If you were forced to play devil's advocate in all of this and come up with the set of circumstances such that this is all much ado about nothing, and we're sitting here in 2030 and gas cost three bucks,

Starting point is 00:39:32 what do you think is the most likely reason? Is it data center power requirements are much lower because we make performance breakthroughs or AI demand isn't what we think it's going to be? Like, what is this most sensitive to, such that my people? be wrong. So after we did most of our work, we went on a bit of a listening tour to target conversations with who we think are maybe the subject matter experts in that thing. So energy storage or hyperscaler compute deployment and energy consumption and the common pushbacks, which we've spent a lot of time understanding are Permian oil play. Oil is high. Permian has lots of gas

Starting point is 00:40:08 in the ground associated with it. Why can't Permian productivity just fixed problem. So our base case model already accounts for the seven plus billion cubic feet today of pipelines that are already being built or developed that come on between 26 and 2030. If there were a new gas pipeline that would come on between 90 and 2030, we would know about it because of the regulatory processes and the time it takes to build these pipes. So we've mitigated the risk of being surprised by the Permian by moving into the midstream to understand the bottleneck constraints. So beyond the deliverability of the resource or the gas in the ground itself, how much can actually get to market and either leave via LNG export terminals or be consumed in

Starting point is 00:40:54 Texas or nearby, we've already included that in our base case model. And so that will be one of the pushbacks is there's plenty of gas in the Permian. But I would posit this may be controversial. There was plenty of oil in the world before the Iran conflict surfaced. Eventually there will be oil a plenty again. That's why it was a $55 a barrel before the Iran conflict. In order to make more permeant natural gas, you also have to be incentivized to make more permanent oil. And those incentives didn't exist until Iran. In order to produce a lot more permine gas than even these seven plus BCF pipelines being built that we're already modeling, you'd need much, much higher oil for longer, which only exacerbates this consumer crisis that we are concerned about.

Starting point is 00:41:40 So we don't think the Permian solves the problem. And then the other one is, well, you can locate a bunch of behind-the-meter local Permian power generation, which is happening. But we are modeling what has been announced and proposed. And if it's going to consume local Permian gas, that means it's not going to make it into the pipeline downstream. We can accommodate that with our model. In any case, we always try to think about technologies that can disrupt, change structurally the need and consumption of natural gas. And so it often leads us to focus on battery technologies. There's sodium and other battery technologies that are currently not commercial, but

Starting point is 00:42:19 in development. People getting a bit more enthusiastic about. The vast majority of economic battery deployment today is lithium ion. It has a fairly fast discharge cycle. Those are being deployed in earnest across the system. And yes, we are also modeling known battery deployments as a part of modeling this generating system across all fuel types. a step function battery technology change could be something that would affect you,

Starting point is 00:42:43 but that would affect some of these pieces that I described, winners and losers in meaningful ways. It would be a watershed moment that I would welcome because it would solve a problem that we're pretty concerned about. Your finance team isn't losing money on big mistakes. It's leaking through a thousand tiny decisions nobody's watching. Ramp puts guardrails on spending before it happens, real-time limits, automatic rules, zero firefighting.

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Starting point is 00:43:38 reconciliation, reporting, trading, compliance, and more all at scale. Schedule a demo at ridgeline.ai. Every investment firm is unique and generic AI doesn't understand your process. Rogo does. It's an AI platform built specifically for Wall Street, connected to your data, understanding your process, and producing real outputs. Check them out at rogo.a.i slash invest. If you were a czar for a day and you guys just decide everything that gets started

Starting point is 00:44:04 and to solve this problem, what are all the things that you would do? to most solve and mitigate this? If I were the U.S. government, I would find a way to build entirely from beginning to end two to four AP 1,000 nuclear reactors. That would de-risk the supply chain. It would invite in and really open up doors to folks who want to see somebody do it first before they do it. With the hopes that, like, we get more trying to, like, build 30 of them.

Starting point is 00:44:37 Currently, there are 10 to 20 envisioned by the U.S. government through different groups in terms of nuclear reactors come on, but no one wants to be first. I think we're close to a few stepping forward, but if the U.S. just said, hey, we have $260 billion to spend at the loan program office now, the EDF, it's $260 billion, I think, to spend by the end of 28. We need to build four nukes with this. That would de-risk this materially, and I think you would see a jumpstart the nuclear equation. energy and resource availability, egress, and knowledge, we think are the biggest bottlenecks to

Starting point is 00:45:14 productivity and deploying all this incredible technology that America has really been the leader of developing. When we set up our firm and started building a team, things are happening pretty quickly in AI, and especially with regard to power. So we didn't set out to understand the now. It's important to understand now, but we set out to understand where the puck is going. and where it's going looks like it will meaningfully diminish growth if not dealt with. And so that's why it brings me to the nuclear solution as maybe the most viable long term.

Starting point is 00:45:46 My comments on solar are probably the most important thing that I would do. I think everybody should get a solar system on their houses. It won't be perfect. It will deliver electricity when there's sun out. I may not deliver electricity when it's cloudy, but it's a way to protect yourself from very high peak power prices from 10 a.m. until 6 p.m., which are the biggest part of your bill. I would incentivize people to study your state's rules

Starting point is 00:46:09 and try to put incentives in place to really, really start to grow residential solar faster than what's been kind of a stagnating industry the last year after some incentives removed. That would be one place to be reinvigorating solar incentives because they're going to be needed in a few years. Can we build like a giant pipeline from Canada or something, try to tap our neighbors to help us solve this problem?

Starting point is 00:46:31 Canada is an interesting partner of ours. They have the capability of delivering about 11 or 12 BCF, usually in January, periodically. And there are meaningful pipelines from Canada, the U.S. But largely, it's seasonal and it helps us solve winter, but otherwise there are net imports most of the year. But we're not really set up to take from Canada year round. There are a few reasons for that. One is Canada has limited storage. It's about silver TCAF, about a fourth of the U.S. storage.

Starting point is 00:46:58 If I think about this on a three to five-year plus basis, Canada, by far has the deepest and richest resource of economic gas in the ground, but it's been trapped behind pipe. I would build a one to two BCF a day, at least pipe into the U.S. Midwest, the MISO power market, and then wheel it around MISO, PJM, SPP, or COT, and try to satisfy this demand because I really don't want to see demand slow. I really don't want to see consumers' bills go up. What are the implications of this for the rest of the world? Well, the U.S. has become the leading provider of natural gas with our exports going from virtually zero to starting the teens and now we're 15 BCF a day that'll be 35. Many countries in the world are building gas generating

Starting point is 00:47:46 assets that are dependent on our delivery of that gas to them. And so lots of political conflict related tensions or bottlenecks today or Russia Ukraine, Russia used to be one of the biggest delivers of gas to Europe, for instance, and that we fill the gap. To the extent we cannot deliver our 30 to 35 or more BCF a day of gas to the global consumer, rebalancing will be required. You probably impact Europe meaningfully, and they're left with a tradeoff of taking Russian gas or much, much higher cost, U.S. gas, because they can't produce it there domestically themselves enough to satisfy their need. Asia is a large consumer, the largest consumer until Russia, Ukraine, of U.S. natural gas, and they probably will be, at some point, the largest

Starting point is 00:48:34 consumer again with some of the outages in the Middle East. We potentially hurt important allies at a time where we really want them to be allies if we can't send them the gas they need. And so it is pretty important that we don't curtail LNG, although that will certainly be one of the levers as we go out to the late decade that we will be forced to think about to deal with rising electricity prices in the country. Anything that we haven't talked about that has surprised you in this year and a half long analysis of trying to understand state of things and where we're going, obviously we've covered the big conclusion, which is scary and hard to deal with even if we start acting now. Anything else that surprised you either in your work or in people's reaction to it as you've started to share it? Really for the last two or three years, the phenomenon where CEOs, CFOs of companies, all of whom have worked.

Starting point is 00:49:29 really been asked by their investors or their products lend themselves well to deploying products to capture AI compute rent. What CEOs have said versus what is possible from the system, I think is an interesting study that will happen over time. The amount of capital made available to companies to make investments that are really short-sighted in the context of our work, like the incremental distributed natural gas gen set. It's an inefficient, high heat rate or high cost inefficient asset that really should only serve as backup generation in any context outside of this fast time-to-power setting

Starting point is 00:50:13 where AI compute needs the power now. Over four or five years, those assets may not even run. And so you've had tens of billions flow into these distributed power assets, all of which are short and will consume natural gas. And we really haven't seen anybody, including firms we really respect, question at any point whether there will be enough gas and what the cost will be when the time comes. It's been surprising that enough folks haven't put pen to paper to then start contracting gas to make sure they have supply certainty.

Starting point is 00:50:52 We haven't seen more financial contracting. 28 is somewhat illiquid. This is why we really haven't seen the forward curve move, and we think that's where the action starts. As soon as utilities turn the page and start to really hedge or buy gas in 28, and we start to see all these natural gas generating companies start to think about securing supply.

Starting point is 00:51:12 You're going to start to see a knife fight to secure natural gas physical in 28 like we really haven't seen before. And it's been surprising we haven't really seen any of this yet because 2829 the physical market tightens materially, depending on where you are. And the amount of money that's gone into unproven, untested, and the amount of capital being raised for things

Starting point is 00:51:35 that really may not happen until 2035, maybe. That's been surprising, especially as it relates to, you got expand trading it four times EBITDA, low to mid-teens, free cash-reield on a gas-before curve that is complacent to all of the objective things that we already know are likely to get plugged in. People are not really willing to look past summer heat or a slight outage in an LNG facility right now. But in six months, we start to see these companies roll forward to look at 28. You can start to see the forward curve really move up materially.

Starting point is 00:52:12 And investors are not willing to look past near-term, appropriately supplied gas market, but they're willing to pay for something in 2035 that is totally untested or unproven. It's been surprising the assumptions and the inconsistency across sectors and industries we follow. So maybe in closing, what would be like the healthy challenge to pose to anyone out there whose business has as an input directly or indirectly energy prices? How would you encourage those CEOs? What questions do they ask of themselves or their business? Make sure when your assets are deployed that you understand exactly what the source of your natural gas will be.

Starting point is 00:52:54 Make sure you have physical supply locked up and that you understand your counterparties and what will likely be very meaningful counterparty risk in two or three years. And counterparty risk isn't something we've really talked about during the last couple of years in the AI boom. But when it comes to parties being long and short, something that is moving a lot, Imagine being short memory a year ago or 18 months ago and finding out all of a sudden your short memory. That is what this natural gas market looks like to us, not two years out, but six plus months out. And making sure you understand the physical provisioning of gas for your assets is important for the hypers and for the buyers of Simple Cycle and CCT large-scale plants, but especially for fuel cells.

Starting point is 00:53:41 we are very cynical whether you can deploy fuel cells at scale because there isn't the gas in the system to power those 24-7365. And so therefore we treat them in our base case that I described as backup gen. To the extent you were to deploy fuel cells as baseload gen, that's only pulls forward and is additive to the convexity that I described. CEOs and partners on projects, whether you are the E&C company trading it 25 times cash flow, which is a historically high multiple for an engineering construction firm, and your main business is building natural gas plants. And we may not be able to build or deploy more gas plants at a certain point in 2029, 2030, because gas is much more expensive and you may have regulators asking questions, the focus for you should be on how do you do a creative M&A to backfill

Starting point is 00:54:41 your and diversify your business so that you're not entirely beholden to natural gas generating asset build. For hypers, I know memory has been a pain point. Natural gas could be 20, 30 or 40% of their cost of doing business at a time when, you know, they're supposed to be reaching escape velocity with profitability. Performance per watt is probably a kind of compute metric that we're going to care more and more about. I would say that the questions or the challenges for each industry of companies is a little bit different, but it's all focused on making sure you're managing risk and you understand exactly when your plans play out, how it can go wrong, which in this case means what if gas

Starting point is 00:55:21 is not 350, but 10 or more? What happens if physical gas is questioned? What happens when consumers and therefore regulators start to ask questions? Matt, I love talking about the energy system with you. This was an especially fun one on the back of so much of your work. So fascinating and interesting, I hope as the U.S. has been very good at doing historically that lots of people listen and start to imagine solutions and also create the right amount of urgency to get those solutions in place and that we emerge from this more resilient, more capable, more efficient, all these things.

Starting point is 00:55:56 Thanks a much of your time. If you enjoyed this episode, visit colossus.com. You'll find every episode of this podcast complete with hand edit. the transcripts. You can also subscribe to Colossus our quarterly print, digital, and private audio publication featuring in-depth profiles of the founders, investors, and companies that we admire most. Learn more at colossus.com slash subscribe. You know how small advantages compound over time. That's true in investing and just as true in how you run your company. Your spending system is your capital allocation strategy. Ramp makes it smarter by default, better data, better decisions,

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Invest Like the Best with Patrick O'Shaughnessy - Matthew Smith — Natural Gas: The Next Bottleneck - [Invest Like the Best, EP.483]

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