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

26:24And it's hard for us to count on the choice to shut off contracted cargos where there's some Japanese utility counterparty who has 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 Haynesville wells. The very closely known parameters of rock where we know it to be very productive. And so Expand, We think it's far and away the biggest winner. Uniquely expand is CEO list right now.

27:05There was some turnover in the year. They're going through a search. The stock has plummeted over the last six months as a part of that search. And it's trading at 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. The stock has dropped. The assets have not changed. it has some of the highest quality rock in the country. 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.

27:42It'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. 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'd be solar, to less extent wind, hydro. Well, solar assets, which are growing meaningfully, they've been 90 % of the interconnect key 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 marginal plant taking fuel where the price is increasing is rising, while the sun costs the same.

28:30We think there are some companies positioned very well for margin expansion for no incremental capital costs. 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. Clearaway 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 of our discussions in the past, residential solar, which has been suffering from really the first removal of tax incentives to install residential solar since like the late seventies, 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.

29:20to 6 p.m. once gas gets really tight in the electricity markets, what you pay for electricity 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 surprising winners, do you think, in all of this? What about nuclear?

29:54What about Westinghouse or places like this? What we're talking about is a complex dynamic system where there'll be choices to consume 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've spent a fair amount of time as well in the nuclear ecosystem.

30:28To us, large-scale nukes are the only solution that makes sense, which point us primarily to the AP1000 Westinghouse units that... Don't those take like five years to build or something? More than that, but at least they have a story past and very brief history. we built two nuclear reactor units in 30 years in the U.S., Vogel III and IV. Around that time, we also tried to build one in South Carolina called VC 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, especially in the back of Fukushima in 2011, up in Chernobyl, through Mile Island, for three decades, nuclear engineers and scientists and companies moved away from nuclear.

31:14And 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. Regulated utilities, hyperscalers, regulators should all align around that goal. But because people don't really believe that gas is in short supply as the decade goes along.

31:56They don't believe in the problem. They don't like the solution. They need to be convinced of the problem. And the country has a history of building pipelines to solve problems that exist today, not problems that will exist in five or 10 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 this just never touches the system? Many of the SMRs are still science experiments.

32:26The NRC and the U.S. government are actually doing a fair number of things to break down the barriers to bringing those and 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 181000. 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.

33:04I think a third of those are modeled after the AP1000. 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 businesses yet in terms of SMRs. Large scale versus small probably wins in our mind. The two companies most levered to that would be Cameco, which owns 49%, Brookfield 51%. You'll probably find that the US 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.

33:46And when the Westinghouse comes public, and it's deeply undervalued within Cameco 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 and lots of dollar content in the AP1000 as well. Who 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.

34:19As electricity prices rise, you start to think about the trade-off. 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 nimbyism 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 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.

34:59Please 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. BYOG 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. 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.

35:33Another 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 bust. In the early 2000s, 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 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.

36:11What 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 planned. Bloom Energy, they've been topical recently because of other things that folks are talking about, the rare earths they use in their manufacture, for instance. 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 the scarcity that we see.

36:49So those are two 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 2029, 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 just may not make sense to use gas for power generation for new or incremental assets after a certain point.

37:30It seems like sort of like this whole memory shortage thing that we're going through right now that hyperscalers 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 this and he said, well, this sounds like DRAM two years ago, slowly at first and then all at once. The lack of investment in capacity expansion is going to come up to bite us. And I think that's where the analog starts.

37:59When 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 hyperscalers, right now, energy is budgeted to be about 10 % of their cost. Depreciation is the highest memory and other things factor 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, 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 CapEx, it takes into account cost of fuel.

38:44Everybody who are making decisions in this moment are using the forward curve for natural gas, which is flat, a little backward, a little contagible, mostly flat out to the 2030s in the mid threes. 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 in entropic or elsewhere? For us, we're just focused on modeling objectively. When you plug in this computer, this compute and this power gen source here and there, how exactly does it pull on the system of companies that we focus on?

39:19If 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 costs three bucks, 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? What is this most sensitive to such that it might 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.

39:53So 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 in the ground associated with it. why can't Permian productivity just fix problems? So our base case model already accounts for the seven plus billion cubic feet a day 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 now and 2030, we would know about it because of the regulatory processes and the time it takes to build these pipes.

40:35So 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 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 aplenty again.

41:13That's why it was at$55 a barrel before the Iran conflict. In order to make more Permian natural gas, you also have to be incentivized to make more Permian oil. And those incentives didn't exist until they're on. In order to produce a lot more Permian gas than even these seven plus BCFA 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. 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.

41:55And 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 folks We're 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.

42:32And 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, 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.

43:04Real-time limits, automatic rules, zero firefighting. Try it at ramp.com slash invest. As your business grows, Vanta scales with you, automating compliance and giving you a single source of truth for security and risk. Learn more at vanta.com slash invest. The best AI and software companies from OpenAI to Cursor to Perplexity use WorkOS to become enterprise ready overnight, not in months. Visit WorkOS.com to skip the unglamorous infrastructure work and focus on your product. Ridgeline offers one unified platform that automates away the complexity across portfolio accounting, reconciliation, reporting, trading, compliance, and more all at scale.

43:42Schedule 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.ai slash invest. If you were a czar for a day and you had to decide everything that gets started and to solve this problem, what are all the things that you would do to most solve and mitigate this? If I were the US government, I would find a way to build entirely from beginning to end two to four AP1000 nuclear reactors.

44:21That 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 China, like build 30 of them. Currently, there are 10 to 20 envisioned by the US government through different groups in terms of nuclear reactions come on, but no one wants to be first. I think we're close to a few stepping forward. But if the US 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.

45:00That 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 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.

45:39And so that's why it brings me to the nuclear solution as maybe the most viable long-term. 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. It 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 your bill. I would incentivize people to study your state's rules 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.

46:20That 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? 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 to 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.

46:52One is Canada has limited storage. It's about a silver TCF, about a fourth of the U.S. storage. 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 US Midwest, the MISO power market, and then wheel it around MISO, PJM, SPP, ERCOT, and try to satisfy this demand because I really don't want to see demand slow. So I really don't want to see consumers' bills go up. What are the implications of this for the rest of the world?

47:30Well, the U.S. has become the leading provider of natural gas with our exports going from virtually zero to starting in the teens. And now we're at 15 BCF a day. That'll be 35. Many countries in the world are building gas generating 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 deliverers of gas to Europe, for instance, and then we filled 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.

48:14You probably impact Europe meaningfully, and they're left with a trade-off 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 consumer again with some of the outages in the least. 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.

48:59Anything 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 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.

49:49The 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 genset. 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 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.

50:42It's been surprising that enough folks haven't put pen to paper to then start contracting gas to make sure they have supply certainty. 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. You're going to start to see a knife fight to secure natural gas physical in 28 like we really haven't seen before.

51:18And it's been surprising we haven't really seen any of this yet because 28, 29, 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 that really may not happen until 2035, maybe that's been surprising, especially as it relates to you got expand trading at four times EBITDA, low to mid-teens, free cash flow yield on a gasp forward 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.

52:02But 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. 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?

52:43What 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. 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.

53:20That 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 hyperscalers and for the buyers of Simple Cycle and CCGT large-scale plants, but especially for fuel cells. We are very cynical whether you can deploy fuel cells at scale because there isn't the gas in the system to power those 24-7, 365. 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 base load gen, that only pulls forward and is additive to the convexity that I described.

54:07CEOs and partners on projects, whether you are the E &C company trading at 25 times cash flow, which is a historically high multiple for a 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 your and diversify your business so that you're not entirely beholden to natural gas generating asset build. For hyperscalers, I know memory has been a pain point.

54:52Natural gas could be 20, 30, or 40 % of their cost of doing business at a time when they're supposed to be reaching escape velocity with profitability. Performance per watt is probably a 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 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.

55:34Matt, 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. Thanks so much for your time. If you enjoyed this episode, visit Colossus.com. You'll find every episode of this podcast complete with hand edited transcripts.

56:04You 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.

56:56Thank you. risk. Learn more at vanta.com slash invest. The best AI and software companies from open AI to cursor to perplexity use WorkOS to become enterprise ready overnight, not in months. Visit workos.com to skip the unglamorous infrastructure work and focus on your product. Ridgeline is redefining asset management technology as a true partner, not just a software vendor. They've helped firms 5x in scale, enabling faster growth, smarter operations, and a competitive edge. Visit ridgelineapps.com to see what they can unlock for your firm. Every investment firm is unique and generic AI doesn't understand your process.

57:31Rogo 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.ai slash invest.