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Finding Winners in the Hydrogen Hype

We focus on quality companies in an environment where investors are engaging in rank speculation.

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There is a great opportunity for hydrogen to decarbonize power generation, a major source of global greenhouse gas emissions. This has generated significant interest among governments around the world. For example, the U.S. Department of Energy recently launched an initiative to reduce the cost of renewable hydrogen by 80% to $1 per kilogram by 2030. Indeed, consensus expectations are for the hydrogen market to grow between 5 and 8 times larger than today’s by 2050. This bright outlook ignores our concerns about costs, infrastructure, and regulation, however.

Even if hydrogen costs decline to meet consensus expectations of $1.50-$2/kilogram (or $11-$15/mmBtu), we would also need carbon taxes well above consensus expectations to make the economics truly work. Despite this, investor enthusiasm for hydrogen stocks has exploded over the past year, with many clean energy exchange-traded funds up several hundred percent and substantial investor interest in pure-play hydrogen companies such as Plug Power (PLUG) and FuelCell Energy (FCEL). Given the nascent nature of the hydrogen market, we view these increases more speculative than considered. Investors can do better. We forecast numerous opportunities for high-quality companies to participate in the developing hydrogen market across a variety of sectors--industrials, utilities, basic materials, and energy--in the United States and Europe.

Our Top Picks Embrace Quality and Solid Hydrogen Upside

Our criteria reveal a number of compelling ideas offering measured exposure to the hydrogen opportunity. Our analysts have culled these ideas carefully to highlight only the industries and companies with above-average hydrogen exposure. Gas-oriented midstream companies offer a great combination of hydrogen opportunity and attractive valuation, with Kinder Morgan (KMI), Cheniere Energy (LNG), Williams (WMB), and Enterprise Products Partners (EPD) standing out. Two of these--Cheniere Energy and Enterprise Products Partners (a master limited partnership)--have wide economic moats. Other picks include Alstom (ALO) and Johnson Matthey (JMAT), which offer greater exposure to hydrogen; they have narrow moats. We also think the industrial gas companies (Air Liquide (AI), Air Products (APD), and Linde (LIN)) are worth considering, as all three have narrow moats and score strongly on our criteria.

Looking across our criteria, we think it is interesting that none of our analysts yet assess the space as offering the potential for improvement in a company’s competitive advantages, or economic moats. Our economic moats are underpinned by moat sources, including cost advantage and efficient scale. Given the hydrogen industry’s focus on costs, it’s possible that an emerging moat source could be a cost advantage. Also, with the number of utilities on our list, we think efficient scale could also apply, particularly if the space moves toward developing highly local hydrogen clusters located near renewable power sources and protected by regulatory monopolies.

What’s the Appeal of Hydrogen?

Plans by the European Union and other countries to aggressively pursue hydrogen development look aggressive to say the least. Current EU plans envision 40 gigawatts of electrolysis plants to produce hydrogen, whereas the world’s largest plant, in Japan, is just 10 megawatts, and total global capacity is around 100 megawatts. Hydrogen is especially promising as an avenue to decarbonize economies and enable the storage of renewable power; it has an energy content of about 50,000 British thermal units per pound compared with natural gas’ 20,000 and takes up less storage space than a similar amount of gas.

Virtually all hydrogen today is gray hydrogen, using natural gas as feedstock. The goal of these investments is to shift the production process to rely more on green hydrogen, which is produced from renewable sources (wind, solar, water), and blue hydrogen, produced with fossil fuels but offset by carbon-capture efforts elsewhere. Using carbon-free nuclear power could also extend the lives of U.S. nuclear power plants. These efforts would offer significant savings. Early markets that governments are targeting include refiners and nitrogen fertilizer markets, which already use gray hydrogen, but also the heavy transport and steel industries, which are very difficult to decarbonize with just electrification.

Why Are Governments So Interested in Hydrogen?

Government investment in hydrogen is enormous. Beyond their announced intentions to pursue investments and supportive regulations, European governments have also pursued partnerships. Germany has agreed with Morocco to take green hydrogen produced in the latter country and is looking for a similar arrangement with Australia. These deals demonstrate the advantages of producing hydrogen in sun-rich regions; they also allow for better management of any long-term hydrogen storage. The rationale for this shift is clear: Hydrogen offers several substantial advantages, particularly around decarbonizing a very challenging area, which is power generation. The Energy Information Administration estimates that 31% of U.S. carbon emissions in 2019 were from electricity generation. The reduction in emissions is crucial if the EU wants to meet the goal it set in September 2020 to reduce carbon emissions to 55% of 1990 levels by 2030.

We think the earliest opportunities probably lie with European utilities and industrials, given the lack of a consistent regulatory framework across U.S. states, but we do not expect hydrogen to displace material amounts of gas generation in the near to medium term. A U.S. framework could come from the Federal Energy Regulatory Commission, particularly as some utilities have ample availability of plastic pipelines, which will not crack like steel pipelines will, providing an early opportunity to test the usage of hydrogen. The U.S. has spent more than $4 billion on hydrogen research over the past two decades, and President Joe Biden has outlined in his clean energy plan that he wants to bring green hydrogen costs in line with conventional sources. Blending hydrogen with natural gas and exploring dedicated hydrogen pipelines would allow utility pipeline and distribution network owners to extend the useful life of existing assets for years, particularly if renewable energy standards increasingly put economic pressure on natural gas power generation.

Hydrogen: A Massive Opportunity?

The EU announced in the summer of 2020 that it plans to spend $500 billion or more on hydrogen investments, including up to 40 gigawatts of hydrogen power generation by 2030. Hydrogen is attractive as a zero-carbon fuel and a substitute for hydrocarbons to produce electricity via hydrogen-compatible turbines, but also hydrogen fuel cells, vehicles, and building heating. Nearly all hydrogen produced in the U.S. today is gray hydrogen, generated from natural gas. Department of Energy estimates (2018) and our own analysis peg current natural gas usage for hydrogen production at around 4.3 billion cubic feet per day, about 5% of U.S. gas production. Early investments by utilities and turbine manufacturers to date have focused on hydrogen and natural gas power generation.

Private/public capital investment in hydrogen-related efforts has been relatively low over the last decade. The original deal between General Motors (GM) and Nikola (NKLA), in which GM planned to invest $2 billion in Nikola, would have been the largest deal of the decade. As it stands, the 2020 spike in investment was driven by two deals: the $530 million acquisition of PBF Energy’s five hydrogen plants by Air Products and an earlier $525 million investment in Nikola by ValueAct and other investors.

If the European vision is realized, U.S. gas producers, gas pipeline operations that can be converted to partial hydrocarbon use, and Cheniere (as an exporter of the gas) would be in the best position to obtain any benefits from higher European gas demand.

What Are the Roadblocks to Achieving the Hydrogen Economy?

Consensus expectations for hydrogen imply that massive infrastructure issues are resolved easily, but we’re more skeptical. U.S. hydrocarbon transportation infrastructure is made predominantly of plastics (for last-mile distribution by utilities) and steel (for long-haul pipelines). Plastic pipelines have issues with hydrogen permeation, and steel is subject to hydrogen-induced embrittlement, which we think is the more serious issue, though both can be resolved with close monitoring and the use of special materials. Thus, while existing infrastructure can transport hydrogen (certain pipelines can handle up to a 10%-15% blend), the U.S. will primarily rely on dedicated hydrogen infrastructure. There are also storage considerations, as one of the more efficient hydrogen storage options is salt caverns, primarily located in Texas but not widely available nationally. Finally, trucks capable of delivering hydrogen are primarily used for industrial applications, but there are not enough for widespread adoption of hydrogen within power generation.

Water usage could actually decline because of reduced fracking, which can consume up to 6 million gallons of water per well. Still, the Environmental Protection Agency estimated that fracking typically only consumes less than 1% of a county’s water usage in 90% of the 400 counties it studied.

Hydrogen Costs
Hydrogen market expectations have focused on $2/kilogram for hydrogen as crucial, but that cost remains several times higher than natural gas. Today, the levelized cost of green hydrogen is substantially more expensive than any of the alternatives. We believe costs will need to decline well over 50% to become more cost-competitive with fossil-fuel-derived hydrogen and substantially more if it wants to compete with combined-cycle natural gas power generation costs. Proponents of the shift have suggested that hydrogen can be competitive at approximately $2/kg compared with current pricing around $15/kg, but $2 per kg equates to about $17 per thousand cubic feet compared with the current natural gas price of $2.63/mcf. Both the Biden administration and the EU have outlined goals of bringing green hydrogen costs in line with fossil-fuel-derived hydrogen by 2030, a substantial improvement over the International Renewable Energy Agency’s expectations of cost parity by 2050. Pipeline company Energy Transfer (ET) said on its third-quarter 2020 conference call that it found hydrogen investments “a head-scratcher,” given its estimates of green hydrogen and gray hydrogen being about 8 and 3 times the cost or value of methane, respectively.

In any case, reaching cost parity with gray hydrogen even by 2030 is not quite enough for hydrogen to make substantial inroads into the power generation market, in our view. The imposition of a per-ton carbon tax could close the cost gap faster, as it would increase natural gas costs. However, such a scenario does not appear likely in the U.S. in the near to medium term, even with a more green-friendly Biden administration. Thus, as many countries in the EU have already implemented carbon tax policies, the tipping point for green hydrogen adoption is likely to come earlier overseas than in the U.S.

Regulatory Concerns
Consensus expectations ignore the fact that a per-ton carbon tax will need to be materially higher than even expert recommendations for hydrogen to be competitive. Therefore, governments will need to set clear and transparent hydrogen mandates to encourage appropriate market development. These mandates, which don’t exist today, can take several forms, including a target for hydrogen production, use of hydrogen in specific sectors, or a goal for the amount of hydrogen blending with natural gas.

We also expect utilities to be one of the first adopters of hydrogen for use in power generation, with the development of small hydrogen hubs or parks potentially every 5-10 miles composed of last-mile distribution pipes and storage options serving individual utility needs initially, with long-haul pipelines developed as required. In the U.S., this will require the FERC to lay out a strategy and provide support via allowed returns on equity.

Finally, a carbon tax could go a long way toward closing the gap between fossil fuel and green hydrogen costs, which are targeted around $1.50-$2/kg in 2030. But to completely close the gap, the carbon tax would need to be at least $150 per metric ton, far higher than even the High-Level Commission on Carbon Prices and International Energy Agency recommendations of per-ton pricing by 2030 of $50-$100. For comparison, the Environmental Protection Agency under the Trump administration estimated the carbon cost (or tax) at $1-$8 per ton. This is equal to $11-$15/mmBtu when the current natural gas price is $2.63, which means hydrogen is nowhere close to competitive.

Identifying Quality Winners Across Multiple Sectors

Our analysis across multiple sectors concludes that European and U.S. industrials are among the biggest hydrogen beneficiaries, including Johnson Matthey and industrial gas suppliers such as Air Products. This is mainly because we see hydrogen as one of the top three areas for investment for these companies over the next decade. We expect the hydrogen opportunity to be material for these companies, which also includes Alstom, and it could make up 15%-25% of profits. We think there are select opportunities within a narrower group of U.S. and European utilities as well as nitrogen producers, which can sell clean ammonia at a premium price. We’ve identified four midstream entities that could have upside, mainly operating in natural gas and liquefied natural gas, which would already involve exposure to hydrogen molecules. Finally, for investors seeking to identify areas that will not benefit from increased use of hydrogen, we’ve flagged U.S. exploration and production companies such as the currently pricey Antero Resources (AR). U.S. E&Ps have limited options to avoid the negative impact from natural gas demand destruction if the U.S. and other economies seek to decarbonize natural gas power generation with green hydrogen.

For U.S. and European utilities, hydrogen offers an opportunity to help save stranded assets that would suffer from phasing out natural gas. For others, it’s a way to leverage existing wind and solar assets.

Stephen Ellis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.