I began investing in midstream energy infrastructure almost two decades ago. When SL Advisors was founded in 2009 it was one of our core strategies. Over the years it’s become our principal focus. Infrastructure possesses enduring qualities for the long-term investor, and energy is just one segment of what’s often referred to as real assets.

Although we focus on energy infrastructure, real assets are much broader than that. They can be structured as REITs. They can be involved in transportation, mining, aerospace and defense. They can be involved in water management and distribution, logistics and the petrochemical industry. Utilities operate infrastructure dedicated to power generation, storage and distribution.

Key attributes of infrastructure include long-lived assets that: provide inflation protection; possess barriers to entry either for regulatory reasons or because of synergies/economies of scale with other assets; generate attractive yields with visible long-term cash flow; and have a low correlation with the equity market.

Maintaining the purchasing power of savings is the goal of all long-term investors other than the foreign central banks and other institutions who hold trillions in US government bonds. Real assets that can raise prices either on commercial terms or because their regulatory framework ensures a minimum return on invested capital can be an effective way to achieve that goal. Oil and gas pipelines often operate under a system of tariffs managed by the Federal Energy Regulatory Commission. Utilities typically have their rates approved by a local regulator. Marine ports and airports often have a scarcity value, in that the alternatives available to shippers and airlines are less convenient or more expensive.

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The US fiscal path is well known to be dire and unsustainable. The higher inflation of recent years looks to have dissipated quickly, but the Fed’s sharp increase in short term rates nonetheless raised the cost of financing our debt. Between May 2022 and February 2023, the point at which the Congressional Budget Office forecasts Federal interest expense will exceed $1TN was brought forward by two years, from 2030 to 2028. Higher inflation may turn out to have been transitory this time around, even if Fed chair Jay Powell conceded it wasn’t during its early ascent. But tight monetary policy does hurt our fiscal outlook more than in the past.

This makes it more likely that monetary policy will eventually accommodate our spiraling Debt:GDP by allowing higher inflation and negative real interest rates, increasingly common until the last couple of years. For centuries, monetary debasement has been the refuge of fiscal profligacy.

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Infrastructure assets often have barriers to entry. Transco, the natural gas pipeline network owned by Williams Companies that runs through America’s eastern states from Texas to New York is an example. Since its origination in the 1950s, towns and highways have developed that make the construction of a competitor pipeline economically unfeasible. Railroads possess similar features. Where real assets are regulated, it means their stable profits are visible but not excessive, reducing the potential benefits for a competitor.

Established pipelines, railroads and other logistics assets create synergistic connections to other infrastructure, making their replication harder. And scale usually works to the advantage of the incumbent.

Predictable, recurring cashflows allow companies holding real assets to pay a substantial portion of their profits in dividends, which often results in attractive yields. This can be true for REITs, pipelines and many other assets. Just be cautious of utilities with their growing obligation to fund energy transition assets, since this is pressuring their cashflows (see To Lose On The Energy Transition Buy Utilities).

The S&P500 was dominated by the “Magnificent Seven*” last year. JPMorgan calculates that since early 2022 free cash flow growth of the S&P493 (ie excluding the seven) has been flat. Profit margins for the seven high flyers are 2X the other 493.

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Owning the Magnificent Seven in 2023 was a great call. But they have caused the market to be less correlated with real assets, and when the inevitable reversal happens that low correlation will be welcomed by those who have retained some portfolio diversification.

The dominance of the Seven has led to the market being more “tech-centric”. Because real assets provide good earnings visibility, their valuations tend to be more grounded. They’re less likely to soar on hyped up expectations or plunge on deep pessimism.

Inflation protection, barriers to entry, attractive yields and a low market correlation are all reasons for investors to consider an allocation to real assets.

*Alphabet (GOOG), Amazon (AMZN), Apple (AAPL) Meta Platforms (META), Microsoft (MSFT), Nvidia (NVDA) and Tesla (TSLA)

We have three have funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Real Assets Fund

Income-seeking investors often compare midstream energy infrastructure with utilities. Both own long-lived infrastructure assets dedicated to delivering energy to customers. Both tend to be regarded as yield-generating investments and are subject to considerable regulatory oversight on rate-setting.

But the energy transition is impacting each sector very differently.

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Midstream growth capex peaked during the shale revolution when new pipelines were being built to help exploit new sources of oil and gas released through fracking and horizontal drilling. The subsequent abundance was good for consumers but not investors. Financial discipline returned. The pandemic and the brief but sharp collapse in prices further cemented the energy sector’s focus on financing only those projects that would clearly be profitable.

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Now utilities are experiencing their own boost in growth capex. They are the sector most responsible for delivering on the promise of electrification using more renewables. This means investing in shorter-lived solar and wind farms along with the high voltage transmission lines to move power to population centers. It means adding more back-up power, either batteries or natural gas, to compensate for the grid unreliability that the increasing share of intermittent power imposes. And sometimes it means phasing out coal-burning power plants before they’ve reached the end of their useful lives.

Democrat politicians have promised voters that renewables are cheaper than conventional power sources. It’s not uncommon to read that per Kilowatt Hour solar now beats natural gas. This superficial analysis usually omits the cost of back-up power, which ironically is often natural gas.

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Caught between the higher cost of renewables and political promises of lower costs, grids across the US are gradually reducing their capacity buffer to deal with extreme weather events and substantial loss of power. The MISO system which runs from Minnesota to Louisiana is assessed by the North American Electricity Reliability Association as having the greatest risk of power outages.

Every grid region will experience steadily declining ability to support demand peaks. Power losses because of increased grid reliance on renewables will not sit well with consumers. At times when electricity falls short of the 100% availability that the public expects, the responsibility for explaining why will sit with utilities.

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In recent years the market has been reaching the conclusion that investing in the energy transition via utilities isn’t a great bet. They face an increased need to spend to meet unrealistic expectations fueled by Democrat politicians.

There is much that can go wrong with that unappealing risk/return profile. It’s why the S&P Utilities index has returned only 3.5% pa over the past three years versus the American Energy Independence Index at 24.6% pa.

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Whether it’s the S&P Global Clean Energy Index or the losses suffered by offshore wind manufacturers such as Denmark’s Orsted (see Windpower Faces A Tempest), holding equity in companies dedicated to the energy transition has left investors worse off.

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Adding insult to injury, the miserable performance of utility stocks hasn’t made them cheap. Wells Fargo notes the lower EV/EBITDA and leverage of midstream versus utilities along with the higher dividend yield and growth outlook.

Midstream companies have plenty of energy transition opportunities. These include increasing global demand for US LNG along with domestic natural gas back-up for growth in renewables. Then there are substantial tax incentives to develop carbon capture and hydrogen.

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But pipeline companies can make decisions to invest in such projects largely based on IRR. They don’t face any political pressure to do so.

By contrast, utilities do face political pressure to deliver the energy transition. Goldman Sachs expects their capex over the next five years to be 38% higher than the past five. Nobody is going to build a new coal-burning power plant (thank goodness) regardless of IRR. But they’ll be dependent on regulators to allow rates that justify prior investment in solar and wind. This is what’s led to the collapse of several offshore wind projects in recent months.

Several years ago, investors feared that oil and gas pipelines would be retired early as the world moved to widespread electrification and renewables. A more realistic outlook has prevailed in recent years that acknowledges the risks facing companies at the forefront of the energy transition.

Shifting the world’s economy to low or no emission energy will be costly. It may be worth it but until politicians are honest about the costs, utilities look to be in a Catch 22.

Last week the Wall Street Journal published an article (see You’ve Formed Your Opinion on EVs. Now Let Me Change It) which concluded with the incorrect statement from Bloomberg NEF that globally, “…EV adoption cut demand for oil by 1.8 million barrels in 2023… thereby avoiding 122 megatons of carbon-dioxide emissions”

This overlooks that China, the world’s biggest EV market, overwhelmingly relies on coal to produce electricity. This is sloppy analysis that’s all too common in the debate about climate change.

We have three have funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Real Assets Fund

All three TV networks recently carried stories of northern state Electric Vehicle (EV) owners stranded. Chicago’s very cold weather reminded EV owners that not only do their batteries hold less charge when temperatures drop, but they are slower to charge as well. Public charging stations saw vehicles lined up – some EVs ran out of power before they could even pull up to the charging station. Not all charging stations were working.

The cold weather caused some drivers to sit in their EVs with the heat on, further slowing recharging. One driver reported seeing ten flatbed trucks taking away dead EVs. Because you can’t just get a gallon of gasoline and bring it to your car. The flat EV must be taken to a source of electricity.

A 2019 study by AAA found that temperatures below 20 degrees can reduce EV range by up to 41%.

This was an extreme weather event. Every Tesla driver I know loves their car. But they all own another gas-powered car and would have used it at a time like that. The drivers on the network news didn’t look as if their EV was a second car. They looked as if it was their car, and as such it needed to do better than work most of the time in most conditions.

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Given the negative press around slowing EV sales, the industry didn’t need this.  Hertz is selling a third of its EV fleet because of low demand. They found repairs were more costly than expected. And who seriously wants to rent an EV in an unfamiliar region and worry about finding somewhere to charge it? Hertz’s embrace of EVs always looked like a dumb move. They expect to take a $245MM charge in 4Q23 for EV depreciation.

It increasingly looks as if hybrids would have been a more sensible intermediate step while EV technology improves beyond its current standard.

Over 60% of car trips are less than five miles. Over 90% are under 25 miles. Most of these can be supported by a hybrid’s battery, recharged when the owner is at home. The gasoline assures that a long journey or a cold one won’t end with a flatbed truck. The average hybrid gets over fifty miles per gallon.

Policymakers have chosen the perfect over the good. The White House has a goal that half of US auto sales be EVs by 2030. Hybrids are included in this, which is just as well because anyone who relies on a single EV to get around is taking more risk of getting stranded than the owner of a conventional car.

Progressive liberals, many of whom live in urban environments with adequate public transport, naturally believe we should transition straight to fully electric EVs. Americans (1) drive long distances, (2) like bigger cars, and (3) benefit from cheaper gasoline compared with other OECD (ie rich) countries. We are less likely than others to embrace EVs absent even more substantial tax breaks until the reliability improves.

Another example of progressive liberals increasing greenhouse gas emissions by pursuing perfection is the recent news that the White House is considering tougher rules before approving new Liquefied Natural Gas (LNG) export terminals. Environmental extremists calculate the emissions the additional LNG exports will generate when consumed by foreign buyers. They naively think that limiting LNG availability will support more solar and wind power in Asia.

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Meanwhile, power generation from coal hit a new global record last year. 82% of all coal-fired power generation was in Asia, up from 75% in 2019. Reductions in Japan and South Korea were almost completely offset by growth in Vietnam alone. Along with China, India and the Philippines they all saw strong import growth last year.

Coal is cheap and reliable. It also generates on average 2X the emissions of natural gas.

The most effective way for the US to help developing countries in Asia reduce their coal consumption is to send them more LNG. The correct analysis of LNG’s impact on emissions would consider what energy source it’s displacing. In the US, coal to gas switching is our biggest success on emissions. We should be helping other countries do the same.

The White House appears to be adopting the superficial analysis described above as a soundbite to the progressives rather than trying to solve the problem. If you want to invest in lower emissions, natural gas infrastructure is a more certain bet than renewable energy.

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Progressive liberals are often the biggest hurdle to sensible energy policies that recognize the reality of developing countries’ prioritization of growth over climate. Outgoing climate czar John Kerry will be remembered as a booster of what he perceived as China’s commitments to reduce emissions even while they have grown by burning half the world’s coal production. That’s the dominant source of the power than runs through China’s EVs.

Pragmatic climate policies will have better success than the idealism too prevalent on the left.

We have three have funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Real Assets Fund

The US is unique in that sub-surface mineral rights typically belong to the landowner. In every other country we’ve looked at, ultimately the government is the owner of what’s beneath you. This was a crippling feature of the failed effort by driller Cuadrilla to produce natural gas using US fracking technology in Yorkshire, north England (see British Shale Revolution Crushed: America’s Unique Ownership of Oil and Gas).

Because the local community didn’t have any ownership and therefore no royalties on output,  the disruption and noise that accompany fracking became a political issue. It was perceived as the government exploiting regular people, even though Britain could use more natural gas of its own.

Caudrilla gave up.

The Osage Nation recently won a famous court victory over Italian “green energy” company Enel when a judge found that 84 wind turbines had been illegally installed on Osage land and ordered their removal.

Litigation had been going on for a decade, but ultimately the case turned on whether Enel had been mining when they dug up and crushed rock to create the foundations for their wind turbines. The Osage Allotment Act of 1906 awarded subsurface mineral rights to the Osage Nation.

We know much more about Osage thanks to David Grann’s 2017 book Killers of the Flower Moon, now also a movie. The story of how their rights to crude oil were violated almost a century ago through numerous murders perhaps makes them a more energetic legal adversary.

Enel argued that digging up and crushing rock did not constitute interfering with the “minerals estate”. They argued that they had temporarily trespassed, and offered to pay damages of $69K.

This argument suffered a setback when the court was shown a video of dynamite being used to dislodge the rock.

Enel estimates that removing the turbines will cost $300 million. There will also be another trial to determine Enel’s liability for damages over the past decade.

A good summary of the story can be found here.

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The Osage Nation ultimately won their case because Enel violated their ownership of the mineral rights that came with the land. In another country they would be separated, but in America you own what’s beneath you “to the center of the earth” as Enel’s lawyer conceded in court.

This is the third time a Federal judge has ordered the removal of wind turbines.

In 2018 a judge ordered three turbines to be removed in Iowa. In 2022 Falmouth, Massachusetts was ordered to remove two turbines.

People who live close to these structures tend to complain about the noise. They’ve been compared to helicopters, and one Vietnam vet said it triggered traumatic memories of combat.

Homeowners on the New Jersey shore won a big victory when Danish wind turbine maker Orsted gave up on plans to build dozens of turbines (see Environmentalists Opposed To Windpower).

Other countries have seen similar legal battles. Two years ago an Australian court ordered 52 wind turbines to shut down at night in response to a lawsuit from neighbors complaining about noise. In 2016 a French court ordered seven turbines be removed because of the threat they posed to golden eagles.

Meanwhile that wretched little girl Greta has shown that a singular focus on climate change is complicated. She recently protested in Norway against wind turbines that were located on reindeer pastures, which she said “violated the human rights” of the indigenous Sami people who farm there.

Perversely, liberals are often accused of trampling over the environment in their pursuit of renewables, while conservatives are the ones fighting to preserve nature as it is. This was most clear in the opposition lined up against Orsted by residents of the Jersey shore, which is solidly the red part of a very blue state. Critics of the proposed windfarm cited danger to sealife. The construction of renewables infrastructure is often in underpopulated areas because solar and wind have a much bigger footprint than conventional power plants. This is turning the traditional environmentalism normally associated with Democrats on its head.

For years energy infrastructure projects have struggled with legal delays. Climate extremists have discovered how to weaponize the court system very effectively. These techniques are increasingly being used against renewables projects. The same principles apply, and pipeline companies are spending much less on new projects than they did five or more years ago.

In spite of these setbacks, onshore windpower has enjoyed many successes in the US (see Offshore Wind vs Onshore). Iowa relies on it for half its electricity. Texas is easily the leading generator of US windpower at around a quarter of the US total.

However, Offshore windpower faces problems with cost inflation as well as growing local opposition. China has also tightened up the permitting process for onshore. Wood Mackenzie cited these factors in recently downgrading its forecast for global windpower capacity in 2030. Windpower will continue growing, but the obstacles are growing too.

We have three have funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Real Assets Fund

Allocating to emerging markets is a Wall Street construct designed to confuse investors and justify periodic reallocations to higher fee products that obscure measures of relative performance. Some financial advisors will be outraged at this statement. So let me quickly move to the evidence.

Start with the Vanguard Emerging Markets Stock Index Fund, the biggest ETF in the sector. Over the past decade it has returned 3% pa versus the S&P500’s 12%. Emerging Markets (EM) hasn’t just had a poor couple of years. It’s had a lousy decade.

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This shouldn’t be surprising. Nobody ever emerges from an EM index. For my entire 44 year career in finance, the EM composition has barely changed. “Emerging” is a marketing gimmick that suggests upward progress. But in reality, these countries are all destined to have living standards below the OECD (ie developed countries) indefinitely.

Nobody ever emerges.

EM proponents will argue that their higher GDP growth means better equity returns. But GDP and corporate profits are different. An uncompleted apartment building generates GDP but is clearly not generating any profits to equity owners if its units can’t be rented. China’s many zombie cities are an example. Building out infrastructure creates immediate GDP, but only helps equity investors if it improves an economy’s productivity.

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Many countries exhibit a poor transmission mechanism from GDP growth to equity returns.

Then there’s disclosure standards and property rights. EM countries typically don’t meet western standards on these two issues. The EM investor adopting the tenuous argument that GDP growth = corporate profits next has to consider that the companies she’s invested in are less than transparent in their accounting. Or that local government officials may misappropriate parts of the businesses she owns through dubious legal maneuvers. Outside of western liberal democracies, it’s rare to find countries with a history of respect for individual rights, for the impartial application of contract law and with strong investor protections in place.

Returning to China – can you really trust the government to protect the interests of foreign investors?

The case for an EM allocation isn’t supported by historic returns. But the financial advisor who recommends EM exposure for a client benefits from the complexity this introduces into performance evaluation. Only the most financially sophisticated will have the tools to establish whether EM added any value. And because EM is rarely a buy and hold strategy, a second timing decision on when to exit also looms. EM is the refuge of the financial advisor obfuscating results with complexity.

All but a handful of the S&P500 does business in EM. Their presence can be used to justify an investment – if Coke is making money in Brazil, why aren’t you? But Coke is so much better equipped to navigate local laws, ownership rights and taxes while still complying with US GAAP standards. And Coke is better situated to calibrate their EM exposure among the countries where they perceive the best opportunities.

If you apply the same logic to another 475 or so members of the S&P500, an investment in the biggest US companies comes with an EM exposure through the filter of US standards and sized according to the collective capital allocation wisdom of hundreds of executive teams and boards of directors.

There’s no reason for the retail investor to make an EM allocation. If your financial advisor recommends it, share the dismal decade displayed above, reject the complexity that benefits him not you and tell him you’re happy with the EM exposure your S&P500 investment provides.

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On a different topic, China’s National Energy Administration recently reported, “Based on the overall promotion of oil and gas supply security and green development, oil and gas development enterprises have accelerated the pace of integration and development with new energy on the basis of effectively stabilizing oil and gas and improving the ability to independently guarantee oil and gas resources,” (translated from Chinese by Google).

Don’t be confused by China and renewables. Energy security explains the dual focus on clean energy and coal, because they help reduce China’s reliance on imported oil and gas.  Coal provides over 60% of China’s power and is 70% of its emissions. They’re adding new coal plants at more than one a month. Security, not climate change, drives their policies. Why else would a country boost electric vehicle sales powered with the worst of fossil fuels if not for energy security?

Chinese consumers are being connected to natural gas supply across the country. Many provinces have tripled or more the local population able to use natural gas. In 2022, 15 million new customers were added. This contrasts with New York state which is impeding the ability of new customers to access natural gas.

Do New Yorkers know that China is extending natural gas access while their government does the opposite? Have they bought in to the liberal proposition that we’ll reduce emissions while others grow them? Or are they simply unaware, accepting constrained access to reliable energy in the naive belief that all the world’s emitters are aligned in their efforts to achieve a common goal?

Next time you encounter a New York Democrat voter (and there are many), ask them.

We have three have funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Real Assets Fund

Chesapeake (CHK) and Southwestern (SWN) are the latest energy companies to be contemplating a merger. Chesapeake was founded by Aubrey McLendon, whose belief in higher natural gas prices combined with his ample risk appetite led the company into financial difficulties during a period of low prices. In 2016 he was indicted by a federal grand jury on charges of conspiring “to rig bids on oil and natural gas leases”. The following day McLendon died alone in a fiery car crash. Chesapeake ultimately filed for bankruptcy in 2020 and emerged with reduced debt the following year.

The US natural gas story is about growing LNG exports. By combining, CHK and SWN would be America’s biggest natgas producer.

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The opportunity can be seen in the futures curves for three regional benchmarks. Because natural gas is difficult and expensive to transport across the ocean, huge price discrepancies can persist for years until liquefaction and regassification infrastructure can be built in the appropriate places to allow for increased trade.

US natgas is very cheap, at under $3 per Million BTUs (MMBTUs). 13 Billion Cubic Feet per Day (BCF/D) is our export capacity, because that’s how much can be chilled and loaded onto specialized LNG tankers. But the discrepancy is so wide that it’s driving the construction of additional capacity.

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The US Energy Information Administration (EIA) expects North American LNG export capacity to double by 2027. Given the several years construction takes, this is more than simply an economic forecast. Many projects have already reached Final Investment Decision (FID), meaning financing is lined up and they will be built. By adding in probable projects to those that have already reached FID, Wells Fargo sees 17 BCF/D of new US capacity by 2027 and 24 BCF/D by 2030, for 38 BCF/D of total US export capacity.

Perhaps the most tangible and certainly the most spectacular ESG disaster is Germany’s now shredded belief that they could rely on Russian gas while they transitioned to windpower. The WSJ quoted Bill Ackman thus: “Well-intentioned movements like ESG can have catastrophic consequences for the world. Europe’s loss of energy independence was a contributing factor in Putin having the confidence to invade Ukraine.”

The bet that a CHK/SWN tie-up is making is that the price differential between US natgas and other regional benchmarks will narrow. Asia has represented around 70% of global LNG trade in recent years. But Europe is becoming a bigger player, thanks to a misguided reliance on Russian gas and overly optimistic assumptions on renewables. European and Asian prices are $10-15 per MMBTUs higher than US, It costs around $2 per MMBTU to ship LNG from the US to Asia. Add in a $3 fee charged for liquefaction, and that still leaves a substantial price difference to support increased global trade.

The long term price curves for natgas futures suggest that increasing US LNG exports won’t be that impactful. This seems wrong. If US exports reach 25% or more of domestic production by 2030, as seems likely, domestic prices will rise. The market is not pricing in any narrowing of the differentials between the Asian/European benchmarks which are where the buyers are, and the US which is bringing more availability online.

Some may doubt Europe’s long term appetite for natural gas. It is the region most committed to reducing CO2 emissions, although much of their recent success on this has come from ruinously high energy prices forcing industrial output lower. German companies are relocating manufacturing out of Europe, including to the US.

But European energy companies aren’t behaving as if global LNG gas demand will disappear. Shell recently signed a twenty year contract to buy Canadian-sourced LNG from a new export facility in British Columbia. The Ksi Lisims project isn’t expected to be operational until 2030. And while Asia is geographically the obvious destination for these exports, if the European premium sustains it won’t be hard for Shell to redirect their purchased LNG to other buyers.

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CHK and SWN are motivated by the likely upward pressure on US natgas prices growing LNG exports will cause. They’re probably also aware that as relatively high-cost producers, they are vulnerable to some more efficiently run competitors.

The bet on higher natgas prices looks like a sound one. If completed, the CHK/SWN merger will represent a pureplay bet on growing US LNG exports, something that’s also good for the midstream energy infrastructure companies that make it possible.

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We have three have funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Real Assets Fund

President Biden probably won’t brag about US energy production, but when the final figures for 2023 are in the US will have set numerous records.

Crude oil production reached a record 13.2 Million Barrels per Day (MMB/D) in October, surpassing the prior record set four years earlier before the pandemic. Few analysts were projecting this at the beginning of last year. Upstream capital discipline was expected to moderate output growth. But drillers squeezed efficiencies out of their operations, producing more with fewer rigs and drilling longer laterals.

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Biden complained bitterly two years ago that US oil production wasn’t increasing in response to higher prices. As he was reminded back then, it takes time to raise production and the Administration doesn’t exactly behave like a friend of reliable energy. But the market works, and most bullish price forecasts for crude oil last year were wrong because they didn’t expect increasing US supply.

Our crude exports averaged a record high of 3.99 MMB/D in 1H23.

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Natural Gas Liquids (NGLs, which include ethane, propane and butane) continue to set new records with volumes more than doubling over the past decade. Ethane is increasingly used in the petrochemical industry to manufacture various forms of plastics. Propane is used domestically for cooking where natural gas is unavailable, and by farmers for drying crops. But export growth is behind the steady increase in US propane production.

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Natural gas production continues to set new records. As with crude oil, this has been done more efficiently, with the gas rig count falling 24% during the first ten months of last year. Some of the increased gas production has come from oil wells as associated gas, largely in the Permian basin in west Texas and New Mexico. The three major oil plays in the Permian are now producing almost 14 Billion Cubic Feet per Day (BCF/D) of gas, over a tenth of US output.

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Natural gas production growth helped reduce our use of coal for power generation and is increasingly offering the same opportunity to our trade partners. LNG exports set another record last year, and the Energy Information Administration (EIA) expects export capacity to more than double by 2027.

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This is all a big success story for America.

This abundance has weighed on prices for crude oil and domestic natural gas. Exxon Mobil warned that 4Q operating results could drop to $8.9BN, down 30% on a year ago. They also expect to write down California-based assets by $2.5BN in response to the Golden state’s hostile policies towards reliable energy.

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Chevron expects to take $3.5-4.0BN impairment on its California assets due to “continuing regulatory challenges.”

Both stocks are down over the past year. Most of the energy sector had a poor year.

But the increasing volumes were good for midstream, with the American Energy Independence Index beating eight of the 11 S&P 500 sectors (see Higher Despite Retail Selling). The link between oil prices and pipeline stocks is weakening in response to lower leverage.

Record-setting US production of oil, NGLs and natural gas under a Democrat administration shows that the party in the White House has less influence than some think over the sector. Even though Biden famously promised to end fossil fuels four years ago when he was campaigning, that goal soon became aspirational and before long he was pleading for more oil.

VP Kamala Harris is from California, and assuming Biden keeps her on the ticket the presidential election will carry a real possibility that a second Biden term might be completed by a President Harris. There’s little about California’s energy policies that should endear investors to such a prospect.

But when you’re looking for energy policies to avoid, Germany usually offers a better example. The WSJ recently estimated that pursuing zero emissions will cost Germans €1.9TN by 2030. This is around half their GDP.

German voters have generally supported policies that are domestically ruinous and mostly serve to accommodate growth in emissions by emerging economies led by China and India. You’d think a willingness to spend so much would assure results – and emissions from Germany fell to 673 Million Metric Tonnes (MMTs), down by 73 MMTs and well below the government’s annual target of 722 MMTs. However, only 15% of this reduction was credited to improved efficiencies and renewables.

Half came from production cuts.

German policies have made energy so expensive, both because of the focus on renewables but also because of the reliance on Russian natural gas, that they are shrinking their way towards their climate goals.

Some of those German companies cutting back production are investing in new facilities in America.

Let’s hope the sharp contrast between American and German policies persists, unless German voters become more pragmatic – and more American.

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We have three have funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Real Assets Fund

It can fairly be said that the bond market boosted stocks in the last couple of months of the year. Equities have lost their cheapness in recent years, ever since the Fed belatedly became concerned about inflation. TINA became unfashionable as interest rates returned to unfamiliar, reasonable levels.

Compared with bonds, stocks are as expensive as they’ve been for at least two decades.  October was the worst point of the year for relative valuation. The Equity Risk Premium (ERP), defined here as the yield spread between S&P500 earnings and the ten year treasury, touched 1.0 as long term rates briefly reached 5%. The subsequent bond rally was helped in December by the FOMC’s Summary of Economic Projections (SEP) indicating rate cuts in 2024. The fall move in bond yields was so strong that the relative pricing of stocks still isn’t as poor as it was two months ago, even after an almost 16% rise in the S&P500.

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The problem with considering the market’s ERP is that performance has been dominated by the “Magnificent Seven”*. Five of them sport an earnings yield nowhere close to the market. Tesla in particular looks ruinously priced. This blog maintains a spirited dialogue with fervently happy Tesla owners (watch EVs are NOT cheap) whenever we fail to embrace the charms of waiting 20-30 minutes to recharge.

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Uber leases Teslas to some of their drivers, and I’ve only heard one complain about having to stop at a charging station in the middle of each workday. Elon Musk has built a devoted following, and a short trip to penury awaits those who short Tesla. The last short squeeze ended in 2020 when Tesla finally took pity on the shorts, providing more supply with a secondary offering following a tripling in price. It spent most of last year near the top of most shorted names. Bernstein is recommending a short sale.  but I think Tesla’s best avoided from both sides.

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The domination by the Magnificent Seven is evident in the contrasting results of the S&P500 with its equal weight cousin. From 2013-2022, the annual returns of the market cap weighted version beat equal weight by an average of 0.7%. Last year was 12.4%. It was less about stock picking than how much AI you had in your portfolio.

The “Dogs of the Dow”, popularly defined at the ten stocks in the DJIA with the highest dividend yield, all lagged the S&P500 last year. Historically, their purchase has rewarded investors over the following year.

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It does seem to be a moment of extreme valuations. Without the Magnificent Seven, the ERP would be closer to its long term average.

After examining the market from these various angles, 5.25% three month treasury bills seem pretty reasonable. The market is telling you the yield won’t last, but you never know. Jay Powell downplayed the inference from the December SEP that they’ll be cutting rates in the first half of this year. If you’re ambivalent on adding to equity exposure, even if rates fall this year and rolling over treasury bills averages, say, 4.5%, that hardly looks like a disaster.

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Energy infrastructure continues to offer compelling cash returns. Enbridge (ENB) yields 7.6% and has increased its payout for 29 straight years. It still looks a compelling pairs trade versus a short SPY (noted in Fiscal Policy Moves Center Stage in early October). And January should see seasonal buying pressure in MLPs (see The MLP Yuletide Spirit). AMLP is the simplest way to play that – although this deeply flawed ETF is regularly criticized on this blog, it does have its uses as a short-term trading vehicle.

On December 26, also known as Boxing Day to Brits (email me if you want to know more), the Vogtle nuclear power plant in Georgia finally began commercial operations. It’s the first new nuclear reactor in the US since the Tennessee Valley Authority’s Watts Bar 2 was commissioned in 2016. France relies heavily on nuclear for power, and China is leading the world in new construction, as for many things. Spain confirmed they’re phasing out nuclear power by 2035.

It’s not credible to be concerned about global warming but also be anti-nuclear, the world’s safest form of power generation. If your only solution is to run everything on weather-dependent solar and wind, you’re promoting an enormous leap backwards for humanity rather than trying to solve the problem.

*Amazon, Apple, Google, Meta, Microsoft, Nvidia and Tesla

We have three have funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Real Assets Fund

Heading into year’s end, a number of interesting stories caught my attention. Energy Transfer (ET) rarely avoids conflict and is embroiled in a dispute with three pipeline developers in Louisiana who sought crossings over Gulf Run Pipeline, owned by ET. Momentum Midstream, one of the developers with a $1.6BN project, accused ET of unfair trade practices. ET has also sought temporary restraining orders against Williams Companies and DT Midstream.

Pipelines routinely have to cross over or under each other as they crisscross the country. Momentum argues that without competition, ET could control up to 80% of the pipeline capacity supplying LNG exports in Louisiana. ET argued that the crossings sought were numerous, threatened pipeline safety and disregard ET’s exclusive ownership over certain stretches of land.

A court ruling is awaited. ET’s well-earned bare-knuckle approach to business hasn’t hurt the stock, +27% this year.

Morgan Stanley continues to report attention around the Alerian MLP Infrastructure Index (AMZI), which AMLP tracks (albeit not very well). The shrinking pool of MLPs is causing AMZI to be more concentrated and even to move beyond midstream infrastructure by incorporating USA Compression Partners, LP. At their recent rebalancing, AMZI publisher Vettafi retained the 12% position cap. Morgan Stanley continues to warn that AMZI might eventually relax its 12% cap or, more radically, AMLP might adopt a RIC-compliant index which would limit its MLP holdings to 25% (versus 100% now).

Such changes could create turmoil in MLP names. But Vettafi could also do nothing, reasoning that if investors didn’t like the fund’s current structure they wouldn’t own it.

Kinder Morgan’s (KMI) prescient sale of the TransMountain (TMX) pipeline project to Canada’s federal government in 2018 (see Canada’s Failing Energy Strategy) looks better every month. Facing unexpectedly hard rock, TMX recently asked the regulator for permission to drill a smaller-diameter pipe through a 1.4 mile section. The regulator turned them down, causing TMX to warn of a further two year delay if they are forced to proceed with the wider diameter. Canadian Natural, the country’s biggest oil producer, has urged the regulator to give its approval. Meanwhile the Trudeau administration approved another C$2BN in loan guarantees for a project quickly exceeding triple the cost anticipated when KMI made its well-timed exit.

A drought in Panama has impeded ship traffic through the canal in recent weeks. This is because the locks rely on supplies of inland fresh water to operate. As a result, Chile and some Asian buyers have reduced their imports of US gasoline from the gulf coast, depressing prices. The alternative route around the tip of South America is more costly and slower. Interestingly though, an LNG executive recently told us that Panama sets the canal tarrif close to the break-even point for ships considering the alternative. For US LNG exports to Asia, this suggests that the long route takes longer but doesn’t cost that much more.

In Oklahoma, fans of David Grann’s Killers of the Flower Moon will have been fascinated to see the Osage Nation win a victory against a wind farm built by Italian energy company Enel. A decade-long legal fight was settled when U.S. Court of International Trade Judge Jennifer Choe-Groves ruled eighty wind turbines had been illegally built. They have to be removed. You can find a more complete telling of this unusual tale here.

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We know oil production has become more efficient over the years, but this chart of rigs versus production back to 1980 is a compelling visual. Few forecasters saw US oil production reaching a new high this year. But it did.

Finally, the slowdown in US EV sales continues to draw unwelcome news coverage. They’re still growing, but at a declining rate. EVs are also taking dealers about three weeks longer to sell than conventional cars. Sales tend to be concentrated in blue counties and states. Across the US EVs have an 8% market share, but in California it’s 24%. In Michigan it’s 3%.

The Administration wants to require that EVs represent 2/3rds of all automobile sales by 2032. Canada is planning to require all auto sales be zero emission by 2035.

The EPA estimates that the typical passenger car emits about 4.6 Metric Tonnes (MT) of CO2 per year. The Inflation Reduction Act values CO2 pulled out of the ambient air and permanently buried via Direct Air Capture (DAC) at up to $180 per MT in tax credits. This is enough to have encouraged Occidental to build the world’s biggest DAC plant and CEO Vicki Hollub is bullish on the technology.

It looks as if public policy is to force EV adoption by making conventional cars scarce. But if you’d prefer to own just one car, not two like most EV owners I know (a regular one for long journeys), a carbon tax based on 2X the DAC credit would impose a $1,656 annual cost on the owner of a gas-powered car. Some would willingly pay that for the convenience of easy refuelling and assurance that inadequate charging infrastructure wouldn’t force them to have their EV transported back home on a truck.

I would be one of those people willing to pay the $1,656 annually. It’s why a carbon tax would be better than the current method of subsidies, tax credits and regulation. It gives people a choice.

We have three have funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Real Assets Fund

The only negative about the pipeline sector today is the direction of fund flows. It’s regularly covered in this blog and a topic that continues to mystify us. Although we’re still awaiting data for the last two months of 2023, it’s almost certain to be the fifth year of the last six during which retail investors exited MLP funds.

This category includes both the non-RIC compliant MLP-only funds like the Alerian MLP ETF (AMLP) as well as other RIC-compliant funds such as the ones we run. The $4.6BN that investors withdrew in 2020 can fairly be attributed to the pandemic. Leveraged funds were partly to blame (see MLP Closed End Funds – Masters Of Value Destruction).

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But the outflows continued the following year even as the sector maintained its recovery. 2022 was an exception, perhaps because nine of the eleven S&P sectors were down as the Fed aggressively tightened policy. Energy was +64% and Utilities scraped out a 1% return.

The monthly data tells the same story, with only 19 out of 70 months since 2018 being positive.

Even more incongruous is that performance has been good. Four of the past six years have been positive, even though there was net retail buying in only one of those.

For investors, the 2020 market collapse caused by the pandemic was sharp but mercifully brief. The S&P500 finished the year +18%. The recovery was well under way entering 2021, as the vaccine rollout progressed. You’d think those pipeline investors not panicked into selling by the Covid collapse and blow up of closed end funds would be unshakeable. Apparently, they weren’t.

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Over the past three years, the S&P Energy sector has easily beat the other ten S&P sectors, returning 36% pa. The “Magnificent Seven” with their AI theme have left the other 493 members of the S&P500 behind. But in spite of this, the S&P Technology sector has lagged energy considerably, delivering 15% pa.

Midstream energy infrastructure also beat the other ten sectors over three years, with 25% pa. There is this incongruity in which retail investors are selling but prices are nonetheless rising. Usually fund flows follow performance and even accentuate the prevailing trend.

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The retail sellers are clearly missing out on the pipeline sector’s strong performance. Some are probably motivated to avoid energy because of concerns about climate change, and that must also apply to the legions of investors who choose not to commit capital to the sector. This is in spite of strong operating performance and declining leverage, routinely noted on this blog. In rejecting midstream energy infrastructure, these investors exhibit the antithesis of irrational exuberance – call it irrational gloom.

Pipeline companies have taken the other side of the retail selling. Just one company, Cheniere, has offset the retail outflows from MLP funds with their buyback program in 2023. Adding back those from Kinder Morgan, Targa Resources, Enterprise Products and Energy Transfer results in buybacks of more than double the net outflows. The less informed have been selling to the better informed. It’s why the sector has performed so well in spite of investor selling.

Perhaps those who have been underweight traditional energy for up to the last three years will finally reconsider as we enter 2024.  If they’ve been allocated to clean energy they’ll have done even worse.

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The S&P Global Clean Energy Index (SPGTCED) has done worse than any of the S&P’s eleven sectors since 2021 and finished behind all of them in two of the past three years. Even a 1% bias within an investor’s energy allocation towards clean energy would have cost 0.5%pa in underperformance.

We’re open to investing in renewables if only we could identify profitable opportunities. Stable visible cashflows are nowhere to be found in solar and wind. Many of the investors who reject traditional energy on non-economic grounds use the same analysis to favor SPGTCED. But they’ve found that Federal subsidies and a conviction that they’re doing the right thing can’t overcome poor economics and the cost of intermittency. If the prospects for steady profits improve we’ll revisit, but don’t feel we’ve missed anything so far.

Pipeline companies will continue their buybacks next year, continuing to offset the net fund outflows. And if retail investors merely stop selling that should provide a further boost.

This blog can be accused of being a persistent cheerleader for the sector. But for the past three years, that advice has aligned with results. We’re optimistic that 2024 will be similar.

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We have three have funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Real Assets Fund