Right up until the last minute, environmental extremists continued to use the court system to stymie completion of the Mountain Valley Pipeline (MVP), which will move natural gas from West Virginia to Virginia. Permits have been issued by too many Federal and state agencies to list here. Extremists led by the Sierra Club with their agenda of limiting energy access continued their relentless abuse of the courts seeking the overturn of previously issued permits.

On Friday, the US Court of Appeals for the District of Columbia agreed that the Federal Energy Regulatory Commission (FERC) had “inadequately explained its decision not to prepare a supplemental environmental impact statement.”

This is how infrastructure projects get held up. The US judicial system is ponderous and unpredictable, which can shred IRR estimates. It’s why nuclear power plants don’t get built. And the same technique is already impacting the build out of renewables. Nobody wants transmission cables built near them.

Equitrans, the main owner of MVP, has struggled for years to overcome legal obstacles and complete the remaining few miles of the pipeline so it can be put into service. A 98% completed pipeline doesn’t generate cashflow. Senator Joe Manchin (D-WVa) thought he had an agreement to pass permitting reform that would have ended the legal challenges to MVP when he threw his support behind the Inflation Reduction Act (IRA). But the expected new legislation never came, as support from both parties melted away.

West Virginia is coal country, and Manchin’s support of the IRA, which includes features intended to drive coal consumption down, has made him one of America’s least popular senators. He’s running for re-election next year and has said he’d vote to repeal the IRA if given the opportunity. Manchin’s Republican opponent Governor Jim Justice has a higher approval rating than Manchin in the state even among Democrats.

Improbably, the debt ceiling legislation is being used to help Joe Manchin’s re-election prospects because a policy rider attached to it supercedes existing legal challenges. The draft legislation includes the following language:

Congress (1) ratifies and approves all permits for construction and initial operation at full capacity of MVP through Secretary of the Army, FERC, Secretary of Agriculture and Secretary of Interior (together, the “Federal Agencies”), (2) gives 21 days from enactment for the Secretary of the Army to give permits for MVP to cross waters and operate, (3) provides judicial review whereby no court has jurisdiction to review any action by the Federal Agencies, including any pending lawsuits (importantly removing the overhang from 4th Circuit, which vacated the WV water permit), and (4) directs any claim against the validity of this law to the DC District US Court of Appeals.

In other words, Congress makes completion of MVP a matter of law, greatly reducing although not eliminating the power of the courts to continue blocking it. That a virtually completed pipeline still requires specific congressional legislation to cross the finish line shows how broken is our country’s permitting of new infrastructure. Climate extremists won’t be happy with MVP, but deployment of renewables infrastructure is at least as vulnerable to similar abusive tactics of the court system.

Equitrans (ETRN) stock jumped yesterday on the news. We had felt its prior valuation assumed MVP would never go into service, so it offered a free call option on its completion. NextEra, a partner in the project, wrote their interest down to zero last year (see High-Energy Earnings Boost Pipelines).

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Oneok’s (OKE) proposed acquisition of Magellan Midstream (MMP) is quietly losing support. As we’ve noted (see Oneok Does A Deal Nobody Needs) many MMP investors will face a bill for the recapture of deferred taxes. Advisors who own MMP in separately managed accounts will need to explain this to every client, and since deferral of taxes is often the point of owning MLPs, this isn’t a conversation they’ll approach enthusiastically.

OKE’s stock has sunk 10% since the deal was announced, so their investors are less enamored of the promised $1.5BN tax shield (obtained at the expense of MMP unitholders) than they are dismayed at the jump in leverage to 4.0X to finance the deal.

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There are plenty of stakeholders who could find it in their interests to vote no. We calculate the odds of it going through have slipped noticeably, although still more likely than not. Both management teams face an uphill battle persuading investors to approve the deal. As we’ve mentioned before, as owners of equity in both OKE and MMP we’re going to use both opportunities to vote no. We would have preferred to see MMP combine with another MLP, which could have avoided the deferred tax recapture.

MLPs were also noticeably weaker than c-corps yesterday, unwinding some of the boost the smaller ones had received in anticipation of Alerian having to rebalance its index (see Alerian Still Clinging On). This confirms the market’s revised assessment of the probability of the deal closing.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

An unintended side-effect of Oneok’s (OKE) proposed acquisition of Magellan Midstream (MMP) has been to give a bid to smaller MLPs. This has come about because of the shrinking pool of names available to populate the Alerian MLP Infrastructure Index (AMZIX) and the Alerian MLP ETF (AMLP) which tracks it.

AMZIX recently increased its maximum weights, from 10% to 12%, because there aren’t enough MLPs. Even before the OKE/MMP transaction NuStar Energy (NS) and Crestwood (CEQP) were both weighted at 3.5X their respective share of MLPs and more than 5X their weight in the American Energy Independence index (AEITR).

MMP is currently the biggest holding in the AMZIX, at 12.5%. NS and CEQP have both performed strongly since the announcement as traders anticipate a reallocation towards them and other small names once the deal closes.

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It’s been good for most MLP investors, other than MMP because of the unwelcome recapture of deferred taxes. The worst place to be in the sector has been a market cap-weight investor in OKE and MMP. That combination has underperformed AMZIX by 6%.

Had you been able to trade on the inside information that MMP was being acquired, you would have done better to buy CEQP than the target company itself. It’s a pity for the deal’s proponents that the uninvolved MLPs can’t vote, because it’s been better to be an observer than a participant.

This is the distortion that AMLP’s anachronistic structure is causing.

It may sound churlish to knock AMLP when the MLPs which are 100% of its portfolio have just outperformed. But over the past decade AMZIX’s 0.6% annual return lags the AEITR by 11%. Concentrated MLPs haven’t been nearly as good as diversified midstream energy infrastructure.

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The deal still has to be voted on by the owners of both companies. We own both and will be voting against it twice. The market assesses the transaction as likely to close, although the odds have dipped in recent days. The discount to the deal price divided by the deal premium can be thought of as a rough expression of the odds of a successful completion. We estimate current market prices suggest a high likelihood of 82%, although this is down from 90% early last week.

JPMorgan reported on the weekend that “investor feedback appears mixed to negative on the deal.”

Based on comments our blog has received and other feedback, people are generally against but not all are. One thoughtful reader noted that as a long-time MMP holder living in a high tax state he was already paying 50% on his distributions. He added that MMP management, “… have done an absolutely incredible job – just look at MLP returns over the last 20 years without MMP as evidence. I trusted them all the way and I tend to still trust them in this case to have done their best for their shareholders.”

Another reader, retired tax attorney Elliot Miller, warned that, “In addition to the capital gains taxation due to adjusted basis in MMP units having been reduced by tax deferred distributions, MMP unitholders will have significant ordinary income taxed resulting from depreciation recapture even after the release of suspended passive activity losses.”

I had noted that many MLP investors plan to donate their units, thus eliminating the recapture of deferred taxes. But another reader quoted an IRS publication on the topic:

Donated, publicly traded partnerships – in particular master limited partnerships (MLPs) – are an important exception to the typical fair market value deduction for long-term gain securities, as the charitable deduction must be reduced by the amount of ordinary income that would have been realized if the property had been sold at fair market value on the date contributed.

These comments reflect the complexity of MLPs when it comes to taxes. Many MMP unitholders likely won’t know their precise tax outcome when voting on the transaction.

C-corps and MLPs aren’t easily combined. Whenever it’s happened in the past, such as with Kinder Morgan and its MLP Kinder Morgan Partners in 2014, the MLP unitholders have been mistreated. If there was a case for MMP to sell itself, it would have been preferable to combine with another MLP. This would have avoided the tax issues MMP unitholders will now face.

But most importantly, the deal highlights the challenges facing AMLP with ever fewer names to hold. It’s too big to convert to a more diversified fund – although its holders should hope it never does because it would create a fire sale of MLPs. It remains the biggest ETF in the sector – hoping nothing else changes and that its investors don’t think too hard about what it owns. Nobody would create AMLP today. It’s clinging on.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Wall Street analysts are predisposed to be supportive of management’s M&A activities.  The sycophantic posturing that precedes an earnings call question with, “Nice quarter, guys” lives in the hope of investment banking business. Hence the response of sell-side analysts to Oneok’s (OKE) proposed acquisition of Magellan Midstream (MMP) is one of mild surprise at this unlikely combination that stops short of overt criticism.

The numbers offer a less enthusiastic reception. OKE is –8% since the deal was announced, in spite of the $1.5BN tax shield and $200-400MM of annual synergies. MMP is up 13%, but this is well short of the 22% premium that heralded the deal because of OKE’s underperformance. In addition, MMP investors are facing the recapture of deferred taxes on prior distributions. This will be more for long term holders, which runs counter to the point of MLPs which is to allow long term management of tax deferrals by investors.

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It’s hard to see anyone other than a recent MMP investor being untroubled by the recapture. The cohort of long term MMP holders may be too small for their votes to disrupt the deal. MMP has presumably analyzed this closely. But financial advisors who hold MMP in client accounts will not relish explaining any unexpected tax bill to clients.

An investor who owned OKE and MMP in proportion to their relative market caps is down 2.2%. By contrast, the Alerian MLP Index (AMZX) has gained 4.8% since the deal, partly due to MMP’s jump but also because traders have anticipated a rebalancing from MMP once it disappears into the shrinking group of remaining MLPs. In other words, the investors who have done best out of this deal are the ones not involved in it.

If the transaction ultimately closes, enthusiasm will be muted. The proposed OKE acquisition of MMP is a solution to a problem nobody has.

Turning to the regional bank crisis — a few weeks ago I shared my experience as treasurer of our Naples co-op in trying to earn a fair interest rate on our cash (see Some Banks Are Having To Pay More). We recently switched banks and left the 3% deposit rate that we had only achieved through persistent complaints. Banks operate on the assumption that you don’t know where treasury bills or Fed Funds are.

Our new bank relationship began at 0.25%. The initial response when I requested a competitive rate was that I should point out a competitor’s rate and they would then consider the matter. I responded that 0.25% was so off-market that it was unworthy of such effort and that they were insulting my intelligence. Days passed with no response, and finally they improved to 2%. This is from a bank whose market cap has shed two thirds in the past eighteen months.

So we’re going to open a brokerage account and buy treasury bills which yield 5%. It creates some additional administrative work, but such offensive behavior demands it. This is how one regional bank will lose a $500K deposit. Banks behave as if we’re stupid, or lazy. Their prior experience may justify such a stance, but it hardly seems like a stable business model to hold your customers in such low regard.

The question regional bank investors must answer is whether large numbers of depositors will react like us. Banking services need to be paid for. Banks rely on paying a discounted rate on deposits. The last time Fed funds traded above 2.5% was in 2008 before the Great Financial Crisis (GFC). Since then, deposit rates near zero haven’t represented much of an opportunity cost for customers.

Now they do, and in the intervening fifteen years moving money and gaining access to information have only become easier. Banks don’t seem willing to create linked brokerage accounts that can own treasury bills, and information about deposit rates for business clients is kept intentionally opaque. They don’t make it easy.

Nonetheless, foregoing a couple of per cent on $250K might strike many depositors as a steep price to pay for banking services.

If competitive pressure forces deposit rates higher, net interest margins will be squeezed. The argument against marking to market bank holdings of securities rests on the notion that deposits are sticky and when rates are rising the value of that stickiness (ie the discount to treasury bill yields) increases. But this is based on past behavior. How depositors reacted to rising rates prior to the GFC may not be a useful guide today. Deposits can leave, at times quickly. Regional bank investors will find out in the months ahead how responsive savers are to more competitive rates from the US Treasury.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Oneok Inc (OKE) surprised sell-side analysts with their Mother’s Day acquisition announcement of Magellan Midstream, LP (MMP) at a 22% premium. Anticipated synergies of $200MM aren’t that big for the $18.8BN transaction value. Management expects that to reach $400MM+ but nobody can ever tell after the fact whether it happened or not. And given the merged entity’s $60BN enterprise value, it’s insignificant.

By resetting the cost basis of MMP’s infrastructure assets, OKE expects to realize tax deferrals with an NPV of $1.5BN. Critics assert that taxes are the chief motivation with few visible benefits from synergies. Moreover, the tax benefits are coming from long-time MMP unitholders, for whom the transaction is defined as a sale of their MMP holdings.

MLP investors enjoy tax-deferred distributions, because the K-1s allow them to include their proportional share of the business’s depreciation in their tax returns. Eventually this tax has to be paid, usually when the investor decides to sell. Making a charitable donation of MLP units is one way to avoid the recapture of deferred taxes. Another is to never sell, instead leaving the investment to one’s heirs who acquire the units with a current cost basis.

The least attractive way to deal with the deferred taxes is to be forced to pay them when the company decides to sell. This is what MMP has done. Tax impacts vary by length of ownership. The longer your ownership the bigger your tax recapture. Recent MMP buyers aren’t much impacted by this.  Your blogger, a long-time MMP investor, is at the less pleasant end of this range.

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MMP is treating its investors in a similar way to Kinder Morgan when they rolled up Kinder Morgan Partners (KMP) into the parent c-corp in 2014. As well as a tax bill at a time of management’s choosing, KMP investors were also stuck with a reduced dividend. Nine years later former KMP holders remain bitter.

MMP can calculate the recapture liability for all their unitholders. On Monday’s call to discuss the deal, management noted that the $25 per MMP unit cash component was based on the aggregate tax liability of MMP unitholders. Assuming they use the cash portion of the deal to pay taxes generated by the transaction, Wells Fargo calculates that the average MMP investor will suffer a 38% distribution cut. Long-time investors will do even worse, because they’ll have a bigger than average tax liability. MLP investors are highly attuned to taxes, which is why they tolerate the K-1s. A significant percentage of MMP holders will face a tax liability in excess of the cash component. They won’t be happy.

Many investors own both companies. OKE likes the diversification provided by MMP refined products pipelines, but investors already had that as separate entities. By Tuesday’s close, the 22% premium had shrunk to 13% because OKE dropped 11% since the announcement. This increases the proportion of MMP unitholders who are net worse off from the transaction after calculating the tax recapture. An investor who holds both names in proportion to their market cap has lost more on OKE’s slump than she’s gained from MMP’s rise. And that’s before adding in the cost of the recapture of taxes deferred on prior MMP distributions. The market regards this as a value-destroying transaction. It’s not even clearly good for MMP investors alone because of the recapture.

A simple way to think of the transaction is to imagine that you owned 100% of both companies. Would you borrow $5.1BN, like OKE, to pay deferred MMP taxes in exchange for a tax shield from the stepped-up cost basis? Few of us would take on debt to pay taxes sooner rather than later. Moreover, MMP investors are there for the tax deferral and have lost it. By contrast, OKE investors care more about the increased leverage than the tax shield offered by acquiring MMP assets, as shown by the weakness in OKE since the deal was announced.

Small MLPs initially performed strongly on the news, because MLP-dedicated funds like the Alerian MLP ETF (AMLP) will have to rebalance away from MMP by investing in the ever-diminishing pool of MLPs. For example, Crestwood LP (CEQP) rose 8.5% on Monday as traders anticipated this inflow of index-constrained buying. Energy Transfer LP (ET) didn’t react the same way because it’s already at its position limit in AMLP’s index.

There’s nothing about the OKE/MMP transaction that is intrinsically bullish for CEQP or other MLPs. Traders are positioning ahead of a rebalancing. The MLP structure is out of favor compared with the more conventional c-corp because of its limited investor base. Most institutional equity investors are tax exempt and face onerous taxes if they invest in partnerships. Retail investors dislike the tax complexity of K-1s.

This leaves US taxable, K-1 tolerant buyers – wealthy individuals and taxable institutions. This includes the poorly structured AMLP, which will have to accrue for taxes once more when market appreciation turns its unrealized losses into gains. So it’s hard to interpret one more MLP going away as a reason to own a concentrated portfolio of MLPs, even though MLP-dedicated funds did receive a performance bump on Monday.

The combination looks unattractive all round. SMA managers will be explaining to clients for whom they own MMP why a strategy designed to defer taxes has instead presented an unwelcome tax bill. It tarnishes the entire MLP structure, because being a long-term investor brings increased exposure to another MMP deal with sudden tax recapture. It’s unclear why investors in either company should vote to approve. We own both OKE and MMP. That will give us two chances to vote no.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Last week the WSJ warned that We May Be Getting Used To High Inflation. Only 9% of respondents in a recent survey think inflation is our most important problem. Government leadership (presumably the absence thereof) and “the economy in general” were both bigger concerns.

Americans are learning to live with higher inflation. The University of Michigan shows that one year inflation expectations among consumers have been rising all year. The Employment Cost Index is increasing at 5%, a figure generally felt to be inconsistent with 2% inflation. The Fed’s preferred Personal Consumption Expenditures (PCE) deflator has been above 3% for two years. These are all signs that households and businesses are adapting to a world of 3-4% inflation, not 2%.

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The bond market tells a different story. The spread between ten year treasury notes and TIPs implies investors expect CPI to average around 2.3% over the next decade. By this measure, markets have never been that worried about persistent inflation. It’s remained below 2.5% for most of the past year.

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TIPs ought to be a reliable indicator, because return-seeking bond buyers are presumably putting considerable thought into their purchases. But to this observer it looks likely that years of Quantitative Easing (QE) along with $TNs held by foreign central banks (China; Japan) and others who want returnless liquidity have distorted the message bonds would otherwise communicate. Bonds are a broken indicator.

WSJ writer Greg Ip thinks Americans getting used to higher inflation “very bad news”. He’s right if the Federal Reserve regards embedded inflation expectations as in need of further monetary attention. But it’s not clear that 3% or 4% inflation is worse for real GDP growth than 2%.

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Since 1990, five year trailing CPI inflation has ranged from 2-4% and had been slowly declining until the pandemic-induced jump. There is no statistical relationship with real GDP growth. That doesn’t mean that inflation doesn’t matter, but the data shows that if it’s relatively stable 2% isn’t any better than 4%. Central bankers have made 2% a religious tenet. It’s really a shibboleth.

Raising the debt ceiling will soon become the biggest concern of market participants, since negotiations look likely to reach or even pass the deadline. A rare flaw in the US constitution separates spending decisions from financing ones – Congress ought to raise the debt ceiling whenever they approve a budget. The debt ceiling standoff is what passes for serious consideration of America’s fiscal outlook in Washington, so every couple of years we wonder whether this game of chicken will go wrong. US credit default swap spreads are wider than Greece.

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Our projected indebtedness is familiar with no solution in sight. The deficit barely registers as an issue. Politicians who suggest raising taxes or cutting spending soon get dumped by voters and move on to the more lucrative business of lobbying.

The Fed deserves their share of blame. Fifteen years of QE has held bond yields down, muting whatever warning of fiscal profligacy higher yields might otherwise transmit.

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More recently, higher interest rates have brought various terrible milestones closer by two to three years (see How Tightening Impacts Our Fiscal Outlook). The February 2023 edition of The Budget and Economic Outlook, published by the Congressional Budget Office, was updated for the Fed’s tighter monetary policy compared with the previous publication in May 2022. Debt:GDP will now cross 100% in 2024 rather than 2027. Annual interest expense will reach $1TN in 2028 not 2030.

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Inflation is the friend of the inveterate borrower. It reduces the real value of obligations. Our fiscal outlook will benefit if debt growth lags nominal GDP. Low interest rates, especially negative real rates, help. 4% inflation leaves more room for real yields to be negative. 2% doesn’t, and as we’re seeing the effort to get inflation back to 2% is making our fiscal outlook worse.

Throughout history governments have eased their debt burden through currency debasement. I explained why this will be America’s solution a decade ago in Bonds Are Not Forever. Developments since then confirm this outlook. There’s little reason to expect spending cuts or tax hikes because there are no votes in it and no apparent cost to current policies. Today’s biggest economic disruption is coming from the Fed’s efforts to restore inflation to 2%. Regional banks and the Federal government need lower rates. There’s a fiscal cost to tight monetary policy.

We can lower inflation or our debt burden. We can’t do both. They are mutually incompatible objectives. We are already learning to live with 4% inflation. It’s not that bad. It’s the path of least resistance.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

The relationship between crude oil and pipelines exhibits the qualities of a copula distribution. This was suggested to us last week by a highly numerate financial advisor, commenting on the tendency of the midstream energy infrastructure sector to have its biggest falls when oil is also collapsing.

It is an unfortunate historical truth that a sharp drop in economic activity, such as at the onset of the pandemic, can depress both the price of oil and expectations for volumes of hydrocarbons passing through America’s pipelines. At such times investors recall being told it’s a toll model largely indifferent to commodity prices. This is true, but when commodities fall far enough it can signal a drop in volumes.

This is why the weakening relationship between the two is so welcome. Since mid-April Brent crude has shed $10 per barrel, while the American Energy Independence Index (AEITR) is close to unchanged. America’s regional banking crisis is one of the causes. Signs of the credit crunch are few, but a bank whose regulator is checking on their liquidity is likely to be trimming its risk appetite.

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Construction loans would seem especially vulnerable. 350 California Street in San Francisco is expected to sell at an upcoming auction for 80% less than its $300 million 2019 appraised value. This will provide a useful benchmark for commercial real estate. Hybrid work has hit the Bay area office market especially hard. But the city also shows how much wreckage unchecked liberal policies can inflict. City leaders are considering a slave reparations bill that would award $5million to every eligible black adult, to be funded by the other 94% of the city’s population. A commensurate population shift will likely follow. California is contemplating something similar, at a cost of up to $800BN.

The decoupling of pipelines from crude oil relies in part on stronger balance sheets. The median Debt:EBITDA for investment grade companies is 3.5X. Ten years ago 4-4.5X was common. Most businesses are on a trajectory towards further reduced leverage next year, driven by increasing EBITDA.

Since the beginning of last year, daily returns of oil and the AEITR have a correlation of 0.45. They move together more often than not, but it’s a weak relationship. Following Russia’s invasion of Ukraine crude oil gyrated wildly while pipelines trended up. Crude was up over 50% by midyear, while the AEITR was +13%. During the second half of last year crude fell over 30% while the AEITR was +7%. So far this year they are down 5% and flat respectively.

The AEITR has also been helped by 1Q23 earnings, which followed a familiar pattern whereby companies generally beat expectations by a few percent. Cheniere is usually the exception, once again reporting a huge beat with 1Q23 EBITDA of $3.6BN (versus $2.5BN expected). They also raised full year guidance from $8-8.5BN to $8.2-8.7BN.

The energy sector is sitting on a growing pile of cash. This also acts to shield companies from movements in oil and gas prices. Exxon Mobil finished the quarter with almost $33BN cash on hand. Six big global oil companies have almost $160BN in cash.

Midstream companies tend not to accumulate cash to the same degree but are returning it to stockholders with dividend hikes and buybacks. Capex is creeping up in a few cases, but for the most part financial discipline remains.

The other day an investor asked me why riskless treasury bills yielding 5% weren’t better than energy infrastructure yielding 6% but with equity volatility. The answer is that treasury bills won’t always yield 5%, and interest rate futures imply they’ll be at 3% by the end of next year. Ample dividend coverage with the continued prospect of increases will lead more investors to this sector once the Fed starts cutting rates. Two publications from the Fed on Monday showed that they’re starting to appreciate the risk of regional banks adopting a more cautious attitude towards new exposure.

Bill Gross told Bloomberg TV that he has 30% of his personal portfolio in MLPs. He referred to Energy Transfer as an ETF (he was appearing on ETF IQ) and likes the tax deferred yields. His comments are at the 15 minute mark.

A fixed income investor likes the yield on pipeline stocks. Ten year treasuries at 3.5% are an improvement on the past few years but still inadequate to prevailing inflation.

It’s also interesting to see that NextEra, the most valuable power company in America and a leader in renewables, is planning to invest $20BN in hydrogen. The tax credits in the Inflation Reduction Act (IRA) are an important driver. But solar and wind projects are facing increasing challenges. Danish company Orsted, Spain’s Iberdrola and a JV including Shell are all developing offshore wind projects in New England and have requested a regulatory review of contracts because of sharply higher costs.

Weather-dependent power that requires enormous space and long-distance transmission lines is a miserable future. Hydrogen is expensive, although less so under the IRA. But like natural gas it’s energy dense and dispatchable, meaning it’s there when needed not just when it’s sunny or windy. And it can move by pipeline. Midstream energy infrastructure companies will be ready.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

I looked through First Horizon Bank’s (FHN) 10K last week. They were in the news because Toronto Dominion (TD) canceled their merger agreement due to uncertainty about when they might receive regulatory approval. FHN’s stock slumped to below $10. The merger price, agreed in February of last year, was $25.

FHN CEO Bryan Jordan told CNBC that he had never been able to ascertain from TD the precise nature of the regulatory impediment that TD was facing. Nonetheless TD had second thoughts and regarded the $200 million break-up fee as better business than paying $13.45BN for a bank whose market cap is now less than half that.

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FHN reported $1,159 million in pre-tax income last year, down modestly from 2021’s figure of $1,284 million. This excludes unrealized losses on their securities portfolio and hedges of $1,080 million, reported under Other Comprehensive Income. Including them would have wiped out the whole year’s profit. Perhaps this convinced TD to walk away.

When interest rates depress the value of bonds, banks don’t have to record unrealized losses as long as they have the intention and ability to hold them until maturity. Defenders of this approach argue that higher rates benefit the liability side of a bank’s balance sheet because deposit rates typically rise less than Fed Funds. Revaluing the assets and not the liabilities would present an inaccurate picture. However, it assumes the deposits won’t leave. Banks rely on history to assess the stickiness of their deposit base. Sometimes, as with Silicon Valley and First Republic, they’re wrong.

Deposits are sticky because savers are lazy or unsure how to access better rates using treasury bills. Banks are relying on this historic behavior repeating to fund their underwater bonds with uncompetitive deposit rates.

It costs money to provide banking services, and fees are highly unpopular. So in effect the fees are bundled into the service. Banks don’t pay much interest. That’s the fee.

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Most of us weren’t watching while banks steadily loaded up on interest rate risk following the 2008 Great Financial Crisis (GFC). Quantitative Easing (QE) was intended to stimulate demand for capital by suppressing rates. But what’s good for borrowers can be bad for lenders. Many banks responded to low rates by increasing fixed rate commercial loans and mortgages. QE was supposed to encourage borrowing, but it also encouraged more long-term lending from banks.

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FHN is a portfolio of underwater bonds and loans whose funding relies on uninformed depositors willing to leave money with them at low rates. Banks have always paid uncompetitive rates on savings. It’s part of the business model. It’s why banks traditionally do well when rates go up. FHN’s 10K shows that their Net Interest Margin (NIM) improves with higher rates. In 1Q23 earnings released on Thursday NIM deteriorated in spite of continued Fed tightening. And last year higher rates cost FHN over $1BN.

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Like most banks, FHN assumes their deposits are unlikely to leave for higher rates elsewhere. But is that about to change? Silicon Valley caused people to ask two questions: (1) Is my money safe? (2) What interest is it earning?

The Fed has played a significant role in this. Because of QE investors and banks have faced unattractively low rates for years. The Fed was slow to recognize the risk of inflation. As a result, they raised rates faster than many expected. And they didn’t consider the impact on the banking system, which they regulate, of higher rates.

The Fed added to the pressure on regional banks by raising rates last week, further highlighting the uncompetitive rates paid on deposits. An increase in the FDIC cap above $250K would slow the outflow, but what banks really need is lower short term rates. Heavy reliance on large uninsured deposits isn’t every bank’s problem. But holdings of low fixed rate securities and loans are widespread.

America has over 4,000 banks. The figure has been declining for decades. We had twice that number in 1999. This abundance is a uniquely American construct, a legacy of state banking regulations which used to impede expansion. Often the small bank strategy was to be acquired by a bigger one. Today that’s only happening as a distressed sale. We’re learning that there aren’t 4,000 competent chief risk officers employed in the banking system.

Today, why would you deposit cash at First Horizon or indeed any bank beyond the amount you need to keep in a checking account? Fees are disguised as paltry rates on deposits. Banks have insulted our intelligence in this way for years. Rapid Fed tightening is illuminating it.

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The market is priced for the Fed to provide banking relief in the form of lower rates, this year. The FOMC is in denial – slow as usual to comprehend what’s happening. The regional banking crisis won’t end until the Fed gets it. In the meantime, loan growth at all but the biggest institutions will be constrained by the risk of a rapid loss of deposits and recourse to wholesale funding in the Fed Funds market. Few banks can profitably fund their assets at 5%.

This is why you should bet on 4% inflation instead of 2%. It’s the path of least resistance.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

The Inflation Reduction Act (IRA) may be the least appropriately named legislation in recent memory. That doesn’t detract from its impactfulness. Ever since its passage last summer, energy companies have been exploring ways to benefit from the uncapped tax credits and other subsidies available.

The IRA provided an improved tax credit of $180 per tonne under Section 45Q of the Internal Revenue Code for Direct Air Capture (DAC) of CO2. Occidental is building the world’s biggest DAC facility in Texas to extract CO2 from the ambient air and store it underground. They also increased the tax credit for CO2 that’s captured as emissions from facilities such as petrochemical plants to $130 per tonne.

Even CO2 used in Enhanced Oil Recovery (EOR) generates up to $85 per tonne in tax credits if it’s permanently stored underground. Tax credits for CO2 used in EOR does seem at odds with far left wing views of the energy transition but reflects a more pragmatic approach than some expected.

The Congressional Budget Office (CBO) estimated the expense of all these provisions at $3.2BN over a decade. Last year, when Credit Suisse was still expecting to thrive as an independent company, they estimated the cost of all these revised tax credits at $52BN.  Bloomberg New Energy Finance has estimated the cost could be over $100BN. Assuming a multiplier effect on government spending, Credit Suisse thinks the economic boost over a decade could be $1.7TN.

The tax credits are uncapped, so there’s no legislated limit on how high they can go. They’re credits not payments, which ordinarily would restrict their recipients to companies with a tax obligation. But the IRA allows the tax credits to be sold. Even though this would likely require a discount to face value to induce a transaction, the transferability greatly increases the pool of potential users and therefore the ultimate cost.

More recently, Goldman Sachs has estimated that the IRA will cost $1.2TN. Last year, Senate Democrats put the cost at $369BN. There’s a growing realization that the IRA represents substantial stimulus and will move the US towards lower greenhouse gas emissions. The IRA relies on incentives to reduce emissions, contrasting with the European approach which relies on penalizing emissions. Economists favor the latter. The US political system responds better to the carrot than the stick.

There are probably hundreds of companies that will benefit from the largesse of the IRA. Next Carbon Solutions is a division of NextDecade. They expect to be able to provide “end-to-end carbon capture and storage (CCS) solutions for industrial facilities.” They are planning to “partner with industrial facilities to invest in the deployment of CCS.” Management has even suggested to us that the carbon solutions business could be more important than the LNG facility they’re planning.

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Another company that’s well positioned is Enlink. They recently signed a CO2 transportation agreement with a company in Louisiana. The Bayou state is the second largest industrial emitter of CO2, more than half of which comes from petrochemical and manufacturing businesses along the Mississippi River Corridor. Enlink already has an existing natural gas network that reaches this area and believes it can repurpose certain pipelines to carry CO2. They plan to gather gaseous CO2 and move it to central compression facilities where it’ll be converted to a supercritical state before being injected into appropriate geological formations. Many receptive rock formations exist in the area.

The improved 45Q tax credits in the IRA have made this a bigger opportunity.

In what seems like a regular occurrence, Cheniere raised full year guidance when releasing their 1Q23 earnings yesterday morning. Investors are becoming harder to impress; EBITDA of almost $3.6BN was $1.1BN ahead of consensus, yet the stock slumped 3%.

Enterprise Products Partners came in slightly ahead of expectations. Earnings for other energy infrastructure companies have provided few surprises, as is usually the case.

Meanwhile, Fed chair Jay Powell will hold a much-anticipated press conference following what most expect to be a 0.25% increase. JPMorgan advises parsing the FOMC’s statement to see if reference to “some additional policy firming” is changed to “any additional policy firming”. Such a revision would signify a pause in tightening. There still exists a wide divergence between the 2.9% yield on December 2024 Fed Funds futures and the 4% “blue dot” for that time from the last FOMC projection materials issued in March.

Inflation has been 1% or more above the Fed’s 2% target for two years, as we noted on Sunday (see Not Yet Cool Enough). Excessive Covid stimulus was part of the cause. The IRA shows that parsimony still has no place in setting US budget priorities. We think infrastructure offers some protection against persistent inflation.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

The regional banking crisis rolled on with two key developments on Friday. One was the release of several reports detailing the errors that led up to Silicon Valley Bank’s sudden collapse. Poor regulatory oversight combined with an absence of risk management were to blame. The other was the slow collapse of First Republic, which is turning out to be small enough to fail. Founder and executive chair Jim Herbert doesn’t sound as reckless as the team that ran SVB, but their equity looks to be similarly worthless.

Against this backdrop of regulatory failure and a banking system that has been caught out by higher rates, the Fed is about to deliver more of the same next week, taking short-term rates to 5%. December 2024 Fed Funds futures at 3% are priced for a 2% reduction by the end of next year. Reduced appetite for risk among regional banks worries the Fed less than the market.

Inflation’s return to 2% isn’t assured. Nominal GDP rose at 5% in 1Q23. Since real GDP was +1.1%, the price level is rising at a healthy clip. The 1Q23 Employment Cost Index (ECI) rose 1.2% versus 4Q22, and the prior quarter was revised up from 1.0 to 1.1%. We had thought year-end raises would be more reflective of recent inflation, overwhelming the seasonal adjustment, and this looks to have been true.  Compensation is up 4.8% year-on-year.

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The Fed’s preferred measure of inflation, Personal Consumption Expenditures ex-food and energy (“core PCE”) rose 0.3% month-on-month and is up 4.6% year-on-year. We’ve now experienced two years of inflation above 3% (ie 1% above the Fed’s target). As the ECI figure showed, people are starting to adapt to inflation above 2%.

In the University of Michigan survey one year inflation expectations jumped to 4.6% in April, up from 3.6% in March. It’s been rising all year and is the highest since November. It’s hard to justify assuming 2% cost inflation for any big project or for retirement. Long term inflation expectations remain well behaved, but as consumers and businesses manage their affairs for near term inflation of 3% or 4%, it will keep upward pressure on prices.

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As 3% becomes the new 2%, the Fed will continue to push back. It’s harder than usual to forecast confidently. The Fed may single mindedly pursue 2% and cause a recession, or the political blowback may force an eventual acceptance of a higher level.

We think midstream energy infrastructure is a good place to be in either scenario.

On April 21 the Federal Energy Regulatory Commission (FERC) reaffirmed prior approval of NextDecade’s proposed LNG export facility at Rio Grande, alongside a deepwater channel within the port of Brownsville, Texas. A Final Investment Decision (FID) should come within a couple of months. Last week their Chairman and CEO Matt Schatzman said, ““We have publicly disclosed that we expect to make it by the end of Q2.”

Building three “trains,” as LNG export facilities are called, is an $11-12BN project. The returns to equity investors will rely on successful execution and also on the mix of debt and equity the company adopts for financing. We still like the stock.

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The Energy Information Administration (EIA) expects natural gas consumption to moderate in the years ahead as renewables gain market share in power generation. The need for permitting reform is illustrated by the Mountain Valley Pipeline’s continued failure to complete, held up by legal challenges to permits issued long ago.

Increased output from solar and wind also depends on a predictable approval process for infrastructure to move electricity. Solar and wind need wide open spaces and are generally not close to population centers. The EIA assumes new transmission lines will match increased output. Nobody wants their view sullied with electric pylons, especially if the electricity is merely passing by on its way elsewhere. Environmentalists are not a cohesive bunch, and every project will face objections.

However, even accepting the EIA’s rosy assumptions on vast grid improvements, increasing exports will drive improving economics for the owners of natural gas infrastructure. Russia’s invasion of Ukraine has created long term European demand for natural gas, competing with Asia and other emerging economies.

This outlook doesn’t depend on a defter execution of monetary policy than in the past few years. It does align with the desire of developing nations to consume more energy. If in time 3-4% inflation becomes the new normal, tariff escalators on pipeline tariffs linked to PPI and CPI will enable energy infrastructure to grow cashflows commensurately, if not better.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

This Friday’s inflation update will include the monthly Personal Consumption Expenditures (PCE) deflator and the Q1 Employment Cost Index (ECI). The Fed prefers the PCE because its weights are dynamic. When apples rise in price relative to oranges, CPI assumes no change in behavior, whereas some substitution towards oranges is to be expected. PCE picks this up.

Long term inflation expectations are remarkably low. The difference between treasury yields and TIPs is one measure of what investors expect consumer prices to do. By this measure, 2.3% inflation over the next decade is the market forecast. Since the next twelve months will be higher, expected inflation for the subsequent nine years is close to 2%. This is based on the CPI, since that’s the underlying index for TIPs. Since PCE inflation typically runs 0.2-0.3% below CPI, the Fed could declare victory anytime by noting benign expectations.

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A few months ago (see Can Pay Raises Keep Up With Inflation?) we pondered the seasonal adjustment factors to the ECI. Most workers get annual pay raises around year-end. The seasonal adjustment factors will already pick this up. However, elevated inflation means higher annual raises than normal, so the seasonal adjustment factors may be inadequate.

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JPMorgan is forecasting 1.1% for the Q1 ECI, up slightly from Q4 which was 1.0% after three successive declines. Interest rate futures continue to forecast that the Fed will be cutting rates by the end of the summer. The FOMC projection materials envisage a Fed Funds rate 1% higher than the market by the end of next year. Current market pricing is inadequate for a disappointment on inflation.

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The Equity Risk Premium (ERP), defined here as the 2023 earnings yield minus ten year treasuries, sits below its 20+ year average. This measure shows stocks to be expensive. They’d need to drop at least 10% to put the ERP at neutral. This leaves the market vulnerable to higher yields.

Alternatively, the ERP could move higher to its long run average by yields falling. The ten year treasury would need to drop to 2.9%. Yields have been implausibly low for many years, so they could fall further. It’s not a bet we’d make.

The regional banking crisis and Silicon Valley Bank’s abrupt collapse caused a sharp revision in the rate outlook. Having worked in banking for much of my career, I can well imagine the anticipation of regulatory scrutiny that will cause all but the biggest (ie systemically important) banks to review their interest rate risk and reliance on large, non-FDIC guaranteed deposits. Simply the knowledge that interest rate risk will draw more questions than in the past will make many banks more cautious about extending fixed rate loans.

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The sharp drop in Tier 1 capital as a percent of risk-weighted assets is another consideration that is likely to cause tighter terms on new exposure.

There are also signs that depositors are not being quite so tolerant of banks underpaying on deposits.

First Republic is the latest bank having to issue reassurances that they have ample liquidity – once you have to respond to such fears it’s usually too late.

The market expects banks’ reduced risk appetites and competition for deposits to hurt the economy. The Fed believes the broader economic risks are minor. Such differences are usually resolved at the costs of the FOMC’s forecasting reputation, but that already looks fully priced in to the futures market.

Bonds had begun to offer at least a modest return, but the recent drop in long term yields is moving the asset class closer to the returnless risk state that has prevailed for years.

Stocks aren’t cheap vs bonds, and while that implies fixed income is attractive, the Fed still owns $8TN of government debt from Quantitative Easing, so is distorting yields.

Behavioral finance teaches that investors often make mistakes due to overconfidence. It’s a human trait, and one more common in men than women I regret to say, that opinions about how many jellybeans are in a jar, sports outcomes and the year-end level of the stock market are held with greater conviction than they should be. Humility around one’s market forecast would seem especially important during current circumstances.

Earnings season is upon us, and we expect that it will reaffirm the solid position of midstream energy infrastructure companies. With dividend yields of 5%+, two times covered by free cash flow, improving leverage of 3.5X Debt:EBITDA and still low growth capex for most names, the prospects for this sector look more assured than for many others.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund