February 28, 2020 in Articles & Newsletters | by Chris Pate

FOURTH QUARTER 2019

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2019 Q4 Letter-fukushimav2In Western’s 2012 Q2 letter we discussed a few historic natural disasters (notably, the 1900 Galveston hurricane) that acted as “black swan” events to alter the course of history around their geographic location. One question posed in the letter revolved around whether the 2011 Fukushima nuclear reactor meltdown in Japan – precipitated by a historically devastating earthquake and the resulting tsunami – would have long-term ramifications across the global power generation industry. Only a year out from the disaster, the extent of long-term damage to the global psyche regarding nuclear power was not yet knowable. Today, almost nine years later, the answer is very clear. Short of some unknown catalyst occurring in the future and changing the current arc of history yet again, nuclear power generation is not long for this world.

While the 2011 meltdown of several reactors within the Fukushima Daiichi Nuclear Power Plant might turn out to represent the final nail in the coffin for atomic energy’s role within our power grid, the far more important black eye for nuclear power occurred in 1986. Over the course of roughly 90 minutes in the middle of the night on April 26, reactor No. 4 at the Chernobyl Nuclear Power Plant near Pripyat in the former Soviet Union (today’s northern Ukraine) went from producing stable power to exploding in an uncontrolled blast that would prove to be the worst nuclear accident in history. The details surrounding Chernobyl’s disaster make for a fascinating story, and HBO’s recent documentary series Chernobyl is a realistic retelling of the hours and days and years surrounding the event. Suffice it to say that natural disaster was not involved. Design flaws and an escalating series of human errors sealed Chernobyl’s fate that night.

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The first nuclear power plant to be connected to a power grid opened in the Soviet Union in 1954. Sixty-five years later there are about 450 reactors operating around the world. Not coincidentally, the construction and startup of nuclear facilities peaked in 1986, the same year Chernobyl blew up, and has been in steep decline since. Due to the dearth of new facilities coming on line, almost two thirds of the world’s reactors are now over 30 years old. Since it is generally accepted that the useful life of a nuclear facility is about 60 years, the world’s total supply of nuclear reactors should only drop over time.

Ronald Reagan once said that all the waste produced in a year from a nuclear power plant can be stored under a desk. And that statement is basically true. Nuclear power has proven to be one of the cleanest forms of energy, and certainly the form in which we can harness the most power in the most demand-friendly way – i.e., whenever we want it, as opposed to when the wind blows or when the sun is out. The problem with nuclear energy is not what happens when things go right, but rather what happens when things go wrong. In what has become a classic line from Steven Spielberg’s film Jurassic Park, Jeff Goldblum’s character points out a similar flaw with the concept of dinosaur theme parks by noting that “if the Pirates of the Caribbean (ride) breaks down, the pirates don’t eat the tourists.” If a natural gas-fired power plant breaks, we don’t have power. At the very worst, a contained explosion occurs. But if the local nuclear plant breaks, untold numbers of nearby residents could be subject to radiation poisoning, thousands of square miles of land could be rendered permanently unusable, and radiation containment efforts could end up practically bankrupting a major country. We know this because it happened in 1986.

Those readers who were around in 1979 remember the near-meltdown that occurred at Three Mile Island in Pennsylvania – the only major nuclear energy incident on U.S. soil. Since then, and as the risks of nuclear plant failure have slowly become more clear over the decades, safety and maintenance protocol expansion has resulted in skyrocketing operational costs. While Unit 2 at Three Mile Island (the unit that almost melted down) has been shuttered since the 1979 incident, Unit 1 continued to produce power until it was closed by its owner, Exelon, in September 2019. Exelon’s Senior Vice President Brian Hanson noted that the reason for its closure is unprofitability due to increased competition from natural gas- fired power plants in the vicinity, which are being powered by low-cost gas from the region’s Marcellus shale. While the fatal flaw with nuclear power likely ends up being the outsized risk of catastrophe, nuclear generation units are being removed from the grid more quickly because the economics do not make sense in the current environment.

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Multiple forces are also at play within other power markets. For instance, solar and wind power have been subsidized by various governments over the past two decades, and coal power has gone out of favor both in the U.S. and abroad as pollution concerns grow. These types of external non-economic factors will push and pull at each other over time as consumer and government interests change. Concurrently, the unit economics of power generation/distribution exert a powerful gravitational pull toward the cheapest socially acceptable source of electricity.

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2019 Q4 Letter-electricity-generationAs a percentage of total electricity generated globally, nuclear energy peaked sometime around the year 2000 and coal peaked around 2010. Today natural gas provides about one third of total U.S. electricity and continues to gobble market share globally as coal and nuclear power stall out. But gas’ reign as the largest power source figures to be short-lived as well, and most estimates predict that the combination of solar and wind power will overtake natural gas as a global energy source by 2030, a mere decade from now. When one considers that wood was mankind’s primary energy/ fuel source for a few thousand years, these timeframes appear incredibly short in the context of human existence. Technological advancement is unrelenting in this way.

Does this mean that oil and gas production are going away soon? That depends on the definition of soon. Wall Street’s newfound focus on positive cash flow within the oil patch has put a temporary lid on production, which we believe to be a bullish data point in oil and gas over the medium term – the next decade or two. But it is likely that the role of oil and gas in the economy over a longer timeframe – say, 40-60 years – will begin to be relegated to industries such as plastics and specialty manufacturing, rather than comprising the primary feedstock for transportation and electricity as is the case in 2020.

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The institutional investment world is now publicly grappling with what its role should be when it comes to imposing Environmental, Social and Governance (ESG) mandates on its underlying investment managers. One might read the following quotes and surmise that they were penned by a 2020 presidential candidate. In fact, they were published in January 2020 as part of an open letter to his fellow global executives by BlackRock CEO Larry Fink. BlackRock is the world’s largest money manager with assets of nearly $7 trillion:

“Over the next few years, one of the most important questions we will face is the scale and scope of government action on climate change, which will generally define the speed with which we move to a low- carbon economy. This challenge cannot be solved without a coordinated, international response from governments, aligned with the goals of the Paris Agreement. Under any scenario, the energy transition will still take decades. Despite recent rapid advances, the technology does not yet exist to cost-effectively replace many of today’s essential uses of hydrocarbons. We need to be mindful of the economic, scientific, social and political realities of the energy transition…While government must lead the way in this transition, companies and investors also have a meaningful role to play…We believe that when a company is not effectively addressing a material issue, its directors should be held accountable… Where we feel companies and boards are not producing effective sustainability disclosures or implementing frameworks for managing these issues, we will hold board members accountable. Given the groundwork we have already laid engaging on disclosure, and the growing investment risks surrounding sustainability, we will be increasingly disposed to vote against management and board directors when companies are not making sufficient progress on sustainability-related disclosures and the business practices and plans underlying them.”

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As such views shift from being outliers and become the consensus, a clear picture emerges that massive fund flows will be headed toward renewable energy and other social/environmental mandates in the coming years. Rather than opining on the merits this trend, our primary job is to 1) recognize it, and 2) react appropriately when it comes to our client portfolios. Renewable energy assets themselves will see a tidal wave of capital inflows, but less obvious beneficiaries exist. Power-related infrastructure (the electricity network to support not only current power generation/ distribution but also what comes next), and the services necessary to build and maintain this infrastructure, comprise one industry that we believe will stand to benefit. Others exist as well and will eventually see their way into our portfolios. We continue to diligently seek out the most appropriate uses for our clients’ hard-earned family treasure.

About The Author

Chris Pate is Managing Director of the True North Fort Worth office. His duties include managing the firm’s Fort Worth presence and sourcing/evaluating investment opportunities for clients of the firm.

Chris previously spent eight years managing the investment activities for Western. His responsibilities included oversight of both public markets and private investments within Western’s investment advisory operations, including equities, fixed income, alternatives, and hard assets.

Before joining Western, Chris spent 11 years at Q Investments, a $2.5 billion (as of 2011) Fort
Worth multi-strategy hedge fund founded in 1994. He graduated Cum Laude from Texas Wesleyan University in May 2000 with a Bachelor of Business Administration in Finance and Economics.

Chris Pate

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