Energy Transition Pathway: Investment Risks, Rewards and Unintended Consequences

Stewart: Welcome to another edition of the InsuranceAUM.com podcast. I'm Stewart Foley, I'll be your host. Thanks for joining us. It's great to have you back. Today's topic is energy transition pathway, investment risks, rewards, and unintended consequences. And we're joined today by Stu Porter, who's the founder of Denham Capital. Stu, thanks for being on.

Stuart: Thanks for having me.

Stewart: We normally do icebreakers on the front end, but your background is so interesting. I'd like to kind of get into it if we can, because you started 15 on the floor at the Merck, right?

Stuart: Chicago Board of Trade, in the corn pit at the Chicago Board of Trade.

Stewart: So tell me about that. I mean, I realize it was a different time then, I get it, but how does that happen?

Stuart: Yeah. I got a job from a baseball coach / family friend Dan Huber, who was a legendary guy at Cargill, and I kept that job all the way through 15 years old through college and then went to go work for what became their financial markets department, which has spun off some great investment management firms. But that financial markets department at the time took the concepts of commodity arbitrage, cash and carry, locate geographic arbitrages, and they applied it to the financial world.

And I showed up in 1987, they had, I think the United Airlines crash, meaning the financial crash. But I showed up and there was actually at that point free money lying around in terms of index arbitrage, warrant arbitrage. And so I began as a runner in the grain world, but when I showed up on my first day at work, I was really showed up in the intersection between the commodity world and the financial world developing.

Stewart: That had to be a crazy time.

Stuart: And so that was my start. Yeah, it was nuts. I probably didn't realize it at the time, but I walked into an opportunity set that didn't last forever, but was certainly opportunistic at that time to understand how you apply the world of commodity arbitrage, which existed for 80 years prior to that, to financial markets that were just starting.

Stewart: And then you ended up at the Goldman desk on the floor. Right?

Stuart: I actually had a brief stop in between, which was I went back to Chicago to get my Master's at University of Chicago, and I had an interesting discussion with my dad riding the train from Barrington to Chicago, and I said, "My brother's going to be a neurosurgeon and you've saved some money for both of us to go to graduate school. It's going to take him 11 years before he gets out of his residency and he's not going to pay you back. But if you let me go to the Board of Trade with my graduate school money you saved, I'll trade and I'll pay you back at the end and you'll be much happier." Fortunately, I was able to pay him back for graduate school.

Stewart: I love that. And it's great to meet a fellow University of Chicago School of Business GSB grad, right? Yeah. And that's so cool. And so what happens then? So you've founded Denham Capital, you are a leading energy and resource focused global private equity firm, and you're also doing private credit with your new partner Aflac, right? So how do you go from on the floor? I know you had a couple of very important stops.

Stuart: I was at the Harvard Endowment for just under a decade and while at the Harvard Endowment I was there and as I said, we were looking at financial markets and opportunities and commodities world is somewhat arbed out, to be honest with you. And so I kind of started thinking what is our edge? And this is really something that relates to this podcast is if your edge is having a long-term ability to invest and not have to be swayed by the markets. The edge that we had at the Harvard Endowment, or at least I had because I certainly didn't have an edge in understanding where oil prices were going or grains were going, but I had long-term capital.

So I started spending a lot of time looking at opportunities in the energy space that were long-term on the power side, on the natural gas side. We ended up doing a deal where we figured out that we could buy proven producing reserves at kind of a low teens discount rate and we got all these undrilled locations and natural gas for free and no one ever thought natural gas prices would go up. So we looked at it as like buying cashflow and then getting free upside. So back to my kind of trading roots is I got free optionality, and once I saw that free optionality, we had to go then find partners on the operating side. And so I transitioned from trying to figure out markets versus trying to figure out long-term assets that we could hold.

And then we ended up owning a couple of things that were really interesting. We ended up being one of the original investors in energy transfer after Enron had blown up. Energy transfer became an opportunity for some very savvy operators. And then we also ended up rolling up, and this is where we really got on the sustainable side, but we ended up doing a roll-up of district heating and cooling units. And what we understood there was predictable cashflow, but also because of their CapEx installed base, we basically viewed ourselves in several cities that we were the cheapest source of heat or chilled water.

And so we basically made our transition from trying to predict what markets would do to basically owning stable cash flows that had optionality either in the case of the gas world being able to drill more locations or in the case of district heating and cooling, add more customers.

Stewart: And so as it stands today in my notes, you have four dominant themes that you're focused on over the next several decades.

Stuart: Yeah.

Stewart: Can you talk about them?

Stuart: Yeah. And let me start with, because this is an energy transition discussion, and let me start with for energy transition to really happen, you need, I believe, or for any transition to happen, it needs to be cheaper and as reliable. Everything else follows suit. Now, there may be a minority of adopters that adopt hydrogen early because of customer demand, but in the long run, if we want things to change, you got to make it cheaper, more reliable, and that's kind of where we stand in renewables today.

And so our four big themes, and we're now talking to our investors about these four themes around the world, start with the following. One is the US and whoever put together the Inflation Reduction Act did a very good job by the way, except for naming it because they should have called it the Energy Defense Act. The US is becoming the leader in low cost clean energy production both on the production side and I should say the manufacturing side.

And that's theme number one. And that's why we're seeing a lot of capital come to the US focused on developing solar, solar and battery wind, offshore wind, which is still not as cheap as fossil fuels, but you're seeing it just happen in droves. It's almost like the real estate business.

The second theme, and I think this is a very nuanced theme for the people that are listening to the podcast, is I firmly believe there's just too much capital and talent focused on the way that we both consume and produce energy and are energy efficient, that we are going to have a lot more things to invest in that are beyond solar, wind, battery storage and renewables. And we're seeing it by the day and some it's around the edges. And one of those examples I would say right now is if you want to make a bet with me, I would tell you that I think we're going to see a total transition in the way that we comfort cool or the way that HVAC works because there are technologies that are coming out of places like the US Department of Energy Labs that look at things like how do we recycle heat to basically desorb humidity? And I think that's a major opportunity that's going to be significantly deployed over time. So that's my second theme. My second theme is we're just at the front end, kind of second inning of different areas in sustainable infrastructure to invest due to the technology breakthroughs. And this isn't turning water into wine or seaweed into oil, these are engineering breakthroughs that will allow us to invest and allow capital markets to invest over the long term around sustainable cash flows. That's number two.

Number three, which is probably the most relevant to this call is just like private credit has become a huge factor in investors' portfolios, sustainable infrastructure private credit, I think will become a staple to investors' portfolios. The reason being is you have lower loss ratios, higher recoveries, lots of duration because these are long life assets. And if you break out the fundamental part of, say solar for instance, if you look at that, there's some value to having a zero marginal cost input, the sun, when someone else has already spent all the CapEx. And so I think that as investors look at the analogs to what's going on in private credit and how it's filled that role in the LBO world, they're going to look at this and they're going to say “This is an opportunity, especially for investment grade buyers or the higher end of low investment grade that really checks a lot of boxes.” And the most important box probably is it's low correlation to the overall economy, and so they're not taking a lot of the same risks that are existing. I think the danger, just to digress a second for that, is that people are going to look at absolute yields instead of risk adjusted yields. And I think you have to look at loss ratios, recovery, just the fundamentals of the asset correlation. And to me, I would rather own investment grade or just below investment grade sustainable infrastructure credit three hundred or four hundred basis points less than, let's say something five times levered in the private credit side.

The last point maybe isn't as relevant, but it's something for people to think about, which is I'm really concerned about where we're going to get the minerals to continue on the decarbonization path. If you look at what's going on on the mining side, we have a mining business, if you look at what's going on on that side, it's a very difficult business, by the way, because of geographies, because of geology and the geology perspective, think about a manufacturing plant that moves incrementally every day, but I think it's something that the US government has taken a look at, but we're so far behind executing a plan that protects the supply chain around it that I think that we really need to think about that. And so owning assets that basically think about tin. People don't probably think about tin every day, but it's the soldering mechanism that we use for all of our electronics. You think about heavy rare earths, that's in the news quite a bit. We're building the largest, or we're commissioning the largest heavy rare earth mine outside of China that produces the lightest magnets that are key to electric motors. And so while we have, I think done an A-plus job on the Inflation Reduction Act, or as I like to call it the Energy Defense Act, I think it has to incorporate the whole supply chain.

So my four big themes are number one, US becomes the low cost clean energy producer in the world and the rest of the world is chasing it, trying to copy it. Number two is that we are just at the front end of a series of opportunities to invest across sustainable infrastructure that go much further than just utility or commercial-based solar wind battery. Number three is private credit is going to be a hallmark staple in people's portfolios in sustainable infrastructure because of the benefits I mentioned earlier. And then fourth, you got to look out because I think there are supply chain issues in the mining sector that we have yet to really begun to understand.

I mean, if you look at the supply / demand scenarios for, and this isn't just lithium and battery metals, this is copper, this is metallurgical coal which you use for steel. We're just not seeing the investment nor the opportunities that are going to deliver on the demands from decarbonization.

Stewart: That's really interesting and thanks for going through it. I really appreciate that. So you've recently formed a partnership with Aflac. I kind of referenced it a moment ago. What are your views about the evolution of growing partnerships with alternative asset managers and insurance companies?

Stuart: I think there's three buckets, and we've been thinking a lot around, Warren Buffet was pretty smart to build an insurance company around an investment business. And then you have Apollo, their ownership of Athene, and then you have some others, but I think there's three buckets.

There's the alternative asset manager buys another insurer and then therefore manages those insurance assets, which we've seen happen in a large scale. I think that's a hard one to pull off for a smaller asset manager. The second one is a partnership where there's this partnership like ours with Aflac, where they have a minority equity stake in our sustainable infrastructure business. They see everything we do. We talk to them all the time about the deals we're looking at, they have views on it, and we build effectively alpha, if you will, around our ability to be on the ground, both on the equity and the debt side. And actually be creative and move quickly both in the investment grade just below investment grade base.

So those partnerships I think are going to continue to develop. And then the third is just the flip side of it was something maybe more like what MassMutual has where they buy an asset manager and that partnership grows and a lot of the growth of that asset manager accrues to the benefit of an insurance company. So three buckets, and I think they all can work. There's different horses for different courses, and I think we're going to see more of it though. I think we're going to see, we're seeing more of it now where insurers who have lots of capital to deploy are looking for partners in our specific area to help them deploy capital effectively in the sustainable infrastructure credit space.

Stewart: That makes total sense to me too. You spun off your oil and gas private equity business into a new entity called Trace Capital Management. Can you talk a little bit about your thought process there?

Stuart: There were a couple of reasons for it, and some of it are somewhat qualitative. I think for us, we had investors who really wanted us to, for instance, sign net-zero agreements. And as I looked at our ethos, I didn't see how we could say with a straight face, "Yes, we're going to sign one by 2050," but really having no idea how we're going to sign it. So the first thing we did was really kind of confront the realities of there are investors, large investors of ours, who want us to sign agreements that we didn't know if we could live up to.

The second element was, look, I believe we're going to need all energy through this transition until we can scale cheaper and more reliable. We don't know what that end date is. And so for the guys and gals on the team at Trace Capital, this was an opportunity for them to make hay. I'll tell you, I only hear stories about people spinning out partnerships, but myself and the guy who runs it basically did it over a cocktail napkin and figured out a model that works for them and works for us. We still have an economic ownership, but it declines over time and they get to go out and basically focus on an area which is hard to raise capital, but man, the returns look very good in that area.

Then the other thing I would tell you, which is just kind of an aside, is as we went out and talked about this, we had investors from let's say blue states who said, "Thank God you're out of the oil and gas business." And then we had investors from red states who said, "Why are you getting out of the oil and gas business?" And so it's simmered down but the political charge nature of all this is really still going on. Now some of them say, "Don't talk to me, don't ever bring a renewable fund to my door." And by the same token, you have the same thing on the fossil fuel side. And I think it's natural when you have political environments, but I think the danger that we all have, if there's one thing that I'm concerned about beyond my comment on enough minerals, is we need to have active discourse about how we get through the energy transition.

If I take a steel plant and I'm able to reduce carbon and we know we need steel, that's a real benefit. And if you think about the biggest benefit of all is gas, natural gas. We thought we had 50 years of expensive natural gas left in the United States. Turns out that because of George Mitchell and some other shale pioneers, we have 300+ years of very cheap natural gas on a relative basis, and that gas displaced coal.

So these decisions aren't ‘zero carbon or bust’. I think they are, how do I think about... I think we can all say no one likes pollution. I think we can all say, at least I think we can say, we think the scientific evidence about climate change is real. Even if we're wrong, I wouldn't want to make the bet on the other side. And so how do we get there in a realistic way? The unintended consequences, part of my theme when I've been around is look what's happening in oil and gas prices. You're having 60% of the cashflow that's generated by public companies going back to shareholders. So we're not getting reinvestment, even though there's reinvestment opportunities. If you look at metallurgical coal, which gets mixed in thermal coal, there's literally no financing, no insurance, and no equity for new met coal. But guess what? We're still going to be producing steel and it's not going to all come from scrap.

So my one larger concern is a societal concern is we need to have these really, really difficult discussions around how do we get there and what are the things that we have trade-offs we have to make? And if it becomes, yeah, I can't invest in this because it doesn't fit exactly in this box, and I think this is important for insurance companies, then they're going to miss out on returns, diversification, but more importantly, we're going to have all sorts of unintended consequences like the cost of fuel going up, the cost of steel going up, which is going to harm probably some of the poorest people in the world.

Stewart: Yeah, that's very well said, and thank you for that. So what would be your advice to an insurance company, both as a direct investor and an allocator, as they build exposure to sustainable infrastructure?

Stuart: So I think number one, they should be building or partnering to build a skillset internally. Because just like real estate, just like buyouts or general infrastructure, not all deals are the same. We've got all the blood, sweat and tears to show you of what's worked. We've had to battle with construction companies. We had to battle with turbine suppliers. Every battery project is different than the next. So I would suggest that number one, this is going to become an important diversifier in their portfolio in large scale, whether it be on the credit side or in small scale on the equity side for insurance companies. So build that competency that the same competency they have here, either through partnership or internally to basically execute on this because this is not a 5-year, 10-year opportunity. It's a multi-decade energy transition. It's a multi-decade opportunity.

And look beyond what may be going on now and think about, hey, if we turn over all the HVAC in the United States, commercial HVAC, what does that mean for our real estate business? Is there an opportunity there? How can I think about that? Or if you think about mobility, how are people going to finance or how are we thinking about financing charging stations? Can it be infrastructure light?

And then on the credit side also, this is the danger that I think is people say, I've seen this a little bit, which is, "Well, on the private credit side, I get my extra return from people that are lending to the bio world." And there is three hundred, four hundred basis points on that, but there's a lot more leverage, a lot more cyclicality. And so again, I would rather own high, below investment grade infrastructure credit, sustainable infrastructure credit, than I would something that's super levered that has lots of cyclicality to it.

But then again, my number one point for the insurance companies is if you're investing directly, make sure you have the partnership or the talent to evaluate every deal or you develop that talent because in the next 30 years, this is going to look like real estate, in my opinion. It's going to be that important to people's portfolios.

Stewart: All right. What conversations does the investment community, the insurance investment community need to have about decarbonization? Do you think that it's wise to eliminate fossil fuel from an investment mandate, just as an example?

Stuart: Yeah. I mean, I have a very strong view that there are nuances in these discussions both from a climate perspective and an investment perspective, and then they kind of act like a teeter-totter. If you go one way and say we're not doing anything in fossil fuels which are needed, then what happens is under-investment leads to higher prices and higher prices mean that you missed out on return. So I think there has to be this nuanced discussion about how do we balance our views on climate and our constituents' views in many cases on climate, and how do we balance that against building a portfolio? I mean, going back to my days at the Harvard Endowment, people were really against oil and gas and the endowment world really led the private equity in oil and gas.

And that discussion has now been crushed, with the exception of a handful of endowments, but have been crushed. And then the knock-on effects were hurt returns at the bottom of the fossil fuels market or for some of the endowments, hurt cashflow. And the other is prices went up. So I think the discussions have to be balanced with what are our social commitments and what are we trying to do in terms of building out a portfolio? And I think that's a real important discussion that sometimes it's easy to say, "You know what? Let's not invest in oil and gas because..." Or "Let's not invest in something else because it has a little bit of carbon." I mean the world is not that binary. And by the same token, we are looking at a period of time where I think that renewables are cheaper than combined cycle gas turbines. And now the US government on solar and wind has given you both development effectively, we should talk a little bit about that, but development credit and that development credit effectively can be up to 40% of your project.

If you look at the cost of solar manufacturing with the incentives in the IRA as proposed, the US could be the lowest provider of solar panels. Today we import 85% of our solar panels. And so again, I use the word Energy Defense Act, and I think it's appropriate because if you think about what's going on here, there was a wake-up in re-shoring of supply chain and the place where we can be squeezed the most is energy, certainly on the renewable energy side. And we're also intersecting at a time when the cost of solar is down 90% since 2010, wind's down about 60%. And so you're going to see Adam Smith's magic hand at work over the next several decades with a push from tax credits from the US.

And the other thing I would mention on that, the important part of what's going on in the Inflation Reduction Act, and by the way, I should have said this from the beginning, in my lifetime I never thought I would be talking about fiscal policy during an investment discussion, but it's quite important here. And if you look through the view of energy defense versus more fiscal policy, you probably have a different view. But the key component here is that these tax credits are uncapped and transferable. So when the US government came out on this, they said over the next 10 years, it's going to be $390 billion of public capital, put a two and a half times public to private multiplier on there, you get to a trillion and two. Well now you probably have a hundred billion of battery manufacturing plants, and it looks like it's going to be $1.2 trillion of, effectively, tax credits and incentives. That's $1.2 trillion of public capital. And then 2.5x multiplier probably gets you north of $3 trillion of capital.

And so we're in this situation where there's a ton of wind behind energy transition in the United States. And the other thing I think that we should also talk about a little bit is what's the rest of the world going to do? Because I think if you saw the first volley from the rest of the world, they thought, well, this is a violation of, this is effectively a trade war. And essentially what has happened, the Europeans and the Canadians and the Australians and the developed market is come on to say, "You know what? We can't beat them. Let's join them. Let's come up with our own policies that are as effective in driving energy transition."

The last part I would say is I do think there is a danger that we leave the fastest growing consumers of energy behind, which is the emerging world. And part of that is there just isn't the incentives to go into the emerging economies and build like there used to be. It'll still happen, but you'll need the incentives.

Stewart: Very helpful. I've learned a lot today, plus I feel like I made a friend out of the deal that we've got Barrington commonality, so that's win-win. I've got one more question for you. Actually, two, you can take your choice or if you're the baller I think you are you're going to take them both. Ready?

Stuart: Okay.

Stewart: All right.

Stuart: Let's go.

Stewart: Best piece of advice you've ever gotten and who would you most like to have lunch with alive or dead?

Stuart: All right, best piece of advice I have gotten is from my dad taking the train from Barrington downtown to Chicago. And he had this great way of taking complicated topics and simplifying them. I was in eighth grade, and he said, "You have three curves in your career. You have your learning curve, your earnings curve, and your network curve, and your proficiency was on the vertical axis and time on the horizontal axis." And he said, "Don't worry about your earnings curve." He said, "A lot of people worry about that, that'll come over time, but I can tell you late in life, it doesn't really matter that much. Worry about building your network curve because that will steepen your learning curve and you'll continue to grow."

And so we, I think, at Denham have really tried to kind of make that a science and constantly meet new people. I would tell you almost everything good that's happened to me has been something I call planned serendipity. Which is I worked on the network, I worked on meeting people, and all of a sudden they came into my life in a positive way. And I think that network curve is something that maybe even today we really need to think about more because not because of, oh, I'm going to get something of out of it, but there's mutual beneficial things that happen as you meet more people, as you have more discussions, share ideas, combine ideas, et cetera.

Stewart: That's great advice. And who would you most, you can choose up to three people, who would you most like to have lunch or dinner with alive or dead?

Stuart: That's a really, really interesting question. Everybody I think would say Jesus Christ, that's a Christian. And so that one I think is one. The other one would for sure be MJ because I'm a Chicagoan, so Michael Jordan would be -

Stewart: There you go. Absolutely.

Stuart: ... at the top of my list. And a side note, I've lived in Boston for 25 years and I stayed a Chicago fan across everything while my kids watch Boston teams win 18 championships.

Stewart: I can relate.

Stuart: Last one, it would probably be my dad's dad because I never met him. He died before I grew up. He started a brewery in Davenport, Iowa. He had a rubber company, both had good times and bad times, and he had to be resilient through all of those. And then he died of a heart attack when my dad was 19 years old. So I never even had a chance to meet a guy who I'm sure that part of my life was developed by. So I think that would be quite interesting.

Stewart: Very cool. It has been my pleasure to have you on.

Stuart: Yeah, I look forward to grabbing lunch in Barrington.

Stewart: Absolutely. Today's topic has been energy transition pathways, investment risk, rewards, and unintended consequences. We've been joined by Stu Porter, who's the founder of Denham Capital. Stu, thanks for joining us. Thanks for taking the time.

Stuart: Yeah, appreciate it.

Stewart: I had a great time, and thanks for listening. If you have ideas for podcasts, please shoot us a note at podcast@insuranceaum.com. You can rate us, like us and review us on Apple Podcast, Spotify, or wherever you listen to your favorite shows. My name's Stewart Foley, and this is the insuranceAUM.com podcast.

The InsuranceAUM.com podcast is available on