The BP Statistical Review of World Energy used to be a fact-based compilation of useful data. Skimming through the 2016 version, it recounts what happened and comments on likely trends. In recent years it has unfortunately degenerated into a political document. The historic data remains useful, but its implausible forecasts are there to defend itself against woke climate cops accusing it of burning up the planet.

BP can point to its Net Zero and Accelerated scenarios which show global CO2 emissions immediately declining from 40 Gigatonnes (GT) to reach 9 and 4 GTs respectively by 2050. This shows they’re on board with global energy consumption dropping by a third or a fifth, at odds with over a hundred years of history. The emerging world’s insatiable desire to raise living standards and energy use will somehow be ameliorated by a dramatic increase in efficiency improvements. Nobody who has studied the issue takes this seriously.

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If you accept that solar and wind are better for the environment, they are certainly not more efficient. They are much less energy dense which means they require more land. Long distance transmission lines move power from lightly populated areas where it’s produced to cities where it’s needed.  Batteries or natural gas power plants provide back up for weather-induced intermittency. More renewables means higher energy costs, possibly a price worth paying, and a choice made most clearly in western Europe.

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BP can wave this document at the climate extremists who reject everything but solar and wind, to show that they are directionally aligned if not yet in the same place. Net Zero and Accelerated are climate sound bites.

But the executive summary then adds, “These scenarios are not predictions of what is likely to happen or what BP would like to happen.”

BP neither wants nor expects Net Zero or Accelerated? So why include them? It’s how big energy companies deflect their left-wing critics while delivering the energy the world needs in the form it wants, at considerable profit last year. What BP puts in its energy outlook doesn’t reflect its assumptions when investing capital, allowing them to act differently than they speak.

New Momentum, the third and only realistic scenario BP offers, is based on current trends and plausible policies. It’s the only one worth considering.

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We think the world will reduce greenhouse gas emissions with cleaner energy (coal to gas switching), increased use of other forms of reliable energy (nuclear; hydrogen), carbon capture and new technologies such as additives for cattle feed (see How Seaweed Can Fight Global Warming).

Solar and wind will assuredly grow but don’t offer the reliable long term cash flows available in infrastructure. The reality of investment results caused BP to slow its planned reduction in fossil fuel production from 40% to 25% by 2030 amid disappointing returns on renewables. Shell plans to keep renewables at about 14% of capex, flat with last year.

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Duke Energy is taking a $1.3BN impairment loss on the sale of its renewables business. Dominion Energy recorded a $1.5BN impairment on its unregulated solar business. Exxon has slashed funding for Viridos Inc, a company in La Jolla, CA that makes environmentally friendly fuels from algae. This initiative was once among Exxon’s highest profile in its Low Carbon Solutions unit. They now see better opportunities in carbon capture and hydrogen.

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The outlook for practical climate change solutions is improving. Growth in natural gas trade will temper coal consumption and offers the world’s best chance to reduce emissions if emerging countries follow what the US has done. The Inflation Reduction Act increased the tax credits for carbon capture. This is causing much greater take-up than the Congressional Budget Office (CBO) forecast, so Credit Suisse believes the $3BN ten year cost the CBO originally forecast is likely to be over $50BN (see US Oil And Gas Production Growing).

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Enbridge has 10-15 hydrogen projects underway in Ontario and Quebec. They’re developing a hydrogen and ammonia production/export facility near Corpus Christi, TX. Converting renewable energy into clean-burning liquids that can be transported via pipeline or ship to power plants seems more viable than a grid that’s overly dependent on sunny and windy weather. It pushes the intermittency problem back to a production facility, doesn’t rely on batteries or require extensive new transmission lines.

Midstream is transitioning beyond fossil fuel infrastructure to play a critical role in reducing emissions. The fear of stranded assets is receding in favor of repurposed assets that gain a longer useful life and a higher net present value.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Enterprise Products Partners’ (EPD) earnings release last week revealed that leverage (Debt:EBITDA) fell to 2.9X at the end of last year. They are now targeting 3.0X, down from 3.5X previously. This is among the lowest in the industry, and reflects a continuing trend to strengthen balance sheets, de-risking the businesses. Years ago, Kinder Morgan argued to rating agencies and investors that their diverse asset footprint justified a 5.5X debt multiple. Poor capital allocation (see Will Kinder Morgan Cover Its Cost Of Capital?) led to distribution cuts and KMI has since fallen in line.

Also cheering for investors is that higher EBITDA has been the main driver of the lower risk profile. Growth is creating stronger balance sheets.

JPMorgan estimates that average leverage at big US pipeline corporations and MLPs this year will average 3.5X. Canadians Enbridge (ENB) and TC Energy (TRP) push this figure higher. ENB’s business includes gas distribution with regulated rates and is generally perceived as less risky.

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The International Energy Agency recently forecast continued demand growth for global supplies of LNG.

News from the energy patch has been uniformly good in recent weeks, led by strong earnings but supplemented by greater realism about energy security and its impact on the energy transition. Emerging economies, especially in Asia, are growing and how they provide increasing energy to their upwardly mobile populations will determine the path for CO2 emissions.

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The US shift from coal to cleaner-burning natural gas for power generation is a great success story in reducing global Green House Gases (GHGs). India is providing encouraging signs of emulating this, with its biggest LNG importer looking to add an additional 12 million Metric Tonnes per year under long term contracts.

Asia-ex Japan burns vast quantities of coal for power generation. The Asia Pacific region consumes an astonishing 80% of the world’s coal output. China is in a league of its own, burning more than the rest of the world combined. India is a distant second at 12% of global demand. PM Narendra Modri  recently said he wants natural gas to provide 15% of India’s power by 2030, up from 6% today.

Poorer countries following the US lead in relying more heavily on natural gas to produce electricity offer our best chance of curbing emissions. It won’t be done with only solar and wind.

South Korea is recognizing the shortcoming of intermittent, weather dependent energy. They’re now planning for nuclear to meet a third of their power needs by 2030, up from 24% in their prior forecast. Renewables have been downgraded from 30% to under 22%. In countries with growing energy needs, reliability is a priority.

Exxon and Chevron both reported record profits recently. BP just followed suit, and now plans to increase its spending on oil and gas production although they’re still targeting a production cut of 25% by 2030 (previously 40%). This follows earlier reports that investments in renewables are delivering disappointing returns, leading to less emphasis on ESG goals. BP’s capex decisions are now guided by a long-term price target for Brent crude of $70 per barrel, up from $60 previously.

Siemens Energy is an example of the low returns in windpower, having recently announced a 4Q22 loss of €598MM due to quality issues on installed wind turbines. Siemens is planning to raise €1.5BN in additional equity to shore up its balance sheet.

ESG-driven capital allocation doesn’t assure profits.

Asian urgency around securing long term commitments of LNG supplies contrasts with Europe. Buyers are fearful that signing 20-year deals typically required by suppliers to ensure an adequate return on infrastructure investments will conflict with government regulations on hydrocarbon use. The EU is the region most willing to impose higher costs and inconvenience on their population in pursuit of reduced emissions.

Carbon capture is also growing in Europe. Denmark just approved a project that will by 2030 inject up to 8 million metric tonnes a year of CO2 into depleted oil and gas formations under the North Sea. Returning carbon in the form of CO2 underground into the formations it left as hydrocarbons has a certain logic to it. We noted a similar virtuous loop in Enlink’s plan to transport CO2 in south Texas from a petrochemical plant for eventual storage in the Eagle Ford (see Putting Carbon Back In The Ground).

Energy companies are showing they’re critical to providing secure energy with reduced emissions. It seemed improbable just three years ago, but the sector is having a good energy transition.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Wednesday’s soothing words on inflation from Fed chair Jay Powell seemed a distant memory after Friday’s blockbuster employment report. The market liked hearing that , “…the disinflationary process has started.” More relevant now is his warning that, “The historical record cautions strongly against prematurely loosening policy.” Investors are Confronting Asymmetric Risks, as we noted on Wednesday.

Lost among the inflation questions was Powell’s reminder that the Federal Reserve is Treasury’s “fiscal agent.” This was in response to a question about the debt ceiling and whether the Fed had done its own “analysis of any legal constraints” that might impede or affect its actions during the fiscal brinkmanship that would accompany a stand-off over raising the debt ceiling.

A refusal by Congress to authorize more borrowing is a crisis of its own making, a rare but significant error in the US constitution. Whenever Congress approves spending it’s axiomatic that includes the intent and ability to pay for it, through taxes, borrowing or asset sales. The debt limit should be raised by whatever’s necessary to fund spending that’s been approved. The refusal by Congress to treat the two issues as one may one day lead us all off a fiscal cliff led by miscalculating innumerate Tea Party Republicans.

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The Fed is much more than Treasury’s fiscal agent. They are the biggest holder of US government debt ($5.4TN), a position they’re unlikely to exit in the foreseeable future. In total, central banks own $8.3TN is US debt, almost 40% of the total. When long term bond yields stubbornly fail to rise to levels that might induce purchases from a return-oriented investor, it’s because the biggest holders have non-commercial objectives. Foreign central bank holdings have been stable in absolute terms but falling as a percentage of debt outstanding because, well, there’s a lot more debt.

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Warnings of US fiscal catastrophe have been around for at least as long as my 43-year career. A perpetual trade deficit creates lots of dollars needing a home, and a fiscal deficit creates lots of debt seeking buyers. It is to the benefit of US taxpayers that this benign symmetry has resulted in persistent demand for treasuries. We should hope it continues.

Low or negative real yields are the savior of profligate governments. Elevated inflation has temporarily slashed the real cost of financing our debt. Fed policy has been to ensure such a benefit is fleeting. 2% inflation is not the optimal policy for our fiscal outlook, and positive real rates won’t help. The only time in living memory when there was political consensus to improve our fiscal balance was in the early 1990s when ten year notes yielded as high as 8%. Since then, the tangible costs of profligacy have receded, along with any political gain to be had from tackling it.

The Congressional Budget Office (CBO) publishes extensive information on our fiscal future complete with charts and figures that leave little room for optimism. A couple of years ago we noted the surprisingly low cost of financing in their projections (see Inflation – Back By Popular Demand).

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In subsequent revisions, the real cost of financing has moved up by almost 1% over the next decade. The CBO’s long term inflation outlook is unchanged, but by last July tighter monetary policy had raised the cost of new debt issuance above what the CBO was forecasting in 2021. It’s likely that the next long term budget outlook from the CBO will project even higher real rates.

The Federal Reserve has considerable influence on fiscal policy because of Quantitative Easing (QE), although Jay Powell would prefer not to concede this. Because QE keeps bond yields lower than they would otherwise be, it dampens the concern about fiscal profligacy that the market would otherwise communicate. The CBO and numerous private forecasts are out there for all to see, but QE constrains the urgency. It’s doubtful that we would have had a balanced budget in the 1990s (albeit for one year) if QE had been employed then.

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Monetary policy also directly impacts the cost of issuing new debt. The average interest rate paid by the US government has risen quite sharply in the past year. The longer tight policy is required, the worse our fiscal outlook will become. The Fed will continue to pursue their dual mandate, but a graceful exit from QE is probably necessary to generate serious concern about skyrocketing Debt:GDP. Legislating limits on QE would help but is unlikely.

Higher inflation is the only long-term solution to our slowly developing fiscal catastrophe. It’s hard to keep real rates negative when inflation is only 2%. This is why we’re invested in the energy sector.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

The Fed’s mid-week policy meeting will punctuate a busy earnings week. Sell-side analysts continue to ratchet down earnings forecasts. Factset reports bottom-up 2023 earnings expectations of $226, down over 10% compared with last spring when Fed tightening started to have an impact.

Energy continues to be a bright spot, providing positive surprises in 4Q earnings released so far. Companies continue to return capital to shareholders. Chevron tripled its planned buybacks to $75BN over the next five years, drawing more economically illiterate criticism from the White House for not plowing this money into increased production. Incoherent energy policies and fair-weather friendship aren’t inducing Chevron CEO Mike Wirth and other energy executives to alter their capital allocation.

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The broad equity market isn’t cheap, based on the Equity Risk Premium (ERP). Stocks are vulnerable to higher interest rates. Fed funds futures project a peak in Fed policy this summer with rates coming down later this year. By contrast, the FOMC Summary of Economic Projections (SEP) released on December 14 pushes that scenario back around a year.

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Fed funds futures six to twelve months out differ as much as 1% from the FOMC. Data since the last SEP has been on balance slightly weaker. So a surprising move in futures to more closely align the two would leave the stock market vulnerable, especially given the trend towards weaker earnings forecasts.

Morgan Stanley strategist Michael Wilson is cautious because of the Fed outlook, although Robert Kad, who heads up their MLP and Energy Infrastructure research, is gloriously bullish on his sector.

Midstream energy infrastructure should be resilient to higher rates. Yields of 5-6% are already attractive, but more important is the embedded inflation hedge that is in many pipeline tariffs. Inflation expectations remain low considering recent history. Risk here is also skewed to the upside. Wells Fargo has estimated that half the industry’s EBITDA is linked to inflation protected contracts.

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European demand for LNG imports jumped last year, but over the long-term emerging economies are likely to grow consumption. The Gas Exporting Countries Forum expects natural gas to increase market share from 23% to 26% by 2050 while global energy demand increases at 0.7% pa. Thanks to Stephen Stapczynski of Bloomberg for pointing this out.

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The University of Michigan consumer survey revealed the uncertainty consumers have about the inflation outlook. Although households expect it to return to 2% based upon the average of responses, the range of expectations is the highest it’s been since the 1980s. The difference between the 25^th and 75^th percentiles for 5-10 year inflation is 4%. Over the next year it’s 8%. There’s not high confidence that it’s returning to 2%.

Benign inflation forecasts, which are similar in the bond market, represent asymmetric risk. Inflation isn’t going to trend below 2%. Retirement planning should be based on 3% and scenarios should be run with higher rates to test how well an investment portfolio will meet one’s spending needs. There are several reasons why conventionally reported inflation figures aren’t a good basis on which to plan growth in living expenses (see Why You Can’t Trust Reported Inflation Numbers). The most obvious is the hedonic quality adjustments that are routinely applied to the CPI to reflect improvements in quality. CPI tries to measure a basket of goods and services of constant utility. Quality improvement at the same price is treated as a price cut.

Hedonic quality adjustments are made to a wide range of products such as clothing, electronic goods and housing. The problem this creates for a consumer is that if a jacket, iPhone or rental property provides better quality at the same price, you don’t have any money left over even though your utility has risen. If you plan on replacing your iPhone regularly in retirement, it’s going to cost you more even though the Bureau of Labor Statistics calculates iPhones are cheaper (because they’re better).

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Returning to the ERP – based on the past two decades, the S&P500 is somewhat expensive compared with bonds. Low inflation expectations and optimistic futures create asymmetric upside risk to interest rates, and downside risk to earnings, forecasts for which are trending lower. Both leave stocks vulnerable.

For now, Factset bottom-up earnings for 2023 is for 3% growth over 2022. Flat earnings and ten-year yields back to 4% where they were in November would require a 15% drop in the S&P500 before the ERP was back to its two-decade average. We’re not selling stocks for long-term investors, but the risk asymmetry suggests little need to rush purchases.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Last week Energy Transfer (ET) raised their quarterly distribution to $0.305, restoring it to a level last paid in July 2020. This cheered a great many people. Among the financial advisors we talk to it is the most widely held individual name. It is perennially cheap. JPMorgan, Morgan Stanley and (according to Refinitiv) 94% of sell side analysts list ET as Overweight.

Following the distribution hike, up 75% year-on-year, ET yields 9.1%. It remains the cheapest big MLP with a 2023 Distributable Cash Flow (DCF) yield of 18%. Under the old MLP standard that prevailed prior to the shale investment bust, 90% of DCF was commonly paid in distributions. Following the hike, their payout ratio is a parsimonious 50%. Like a great performer, ET leaves its audience hoping for more.

Co-CEOs Marshall McCrea and Tom Long retain the deft touch of former CEO (now Executive chairman) Kelcy Warren. ET executes well but always prioritizes management’s interests. Search results on our blog reveal they’re mentioned in 141 separate posts. Enbridge is 54.

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In 2016 Energy Transfer Equity (ETE), the entity that ultimately became ET, issued a lucrative class of convertible preferred securities to insiders on the management team (see Is Energy Transfer Quietly Fleecing its Investors?). These securities allowed reinvestment of preferred dividends at $6.56 even if the prevailing unit prices was higher which it always was. This attractive feature was denied to other investors which led to a class action lawsuit. We wondered aloud, Will Energy Transfer Act with Integrity? ET answered by arguing that their maneuver had allowed them to preserve their distribution, winning the case.

ETE was once the General Partner (GP) of MLPs Sunoco Logistics, Energy Transfer Partners and Regency Partners. Through a series of mergers culminating with being absorbed by ETE in 2018, all these LP unitholders endured substantial distribution cuts while ETE’s was preserved (see Energy Transfer: Cutting Your Payout, Not Mine). Management’s investment in Energy Transfer was overwhelmingly in the GP, ETE. We made our investment there to assure the best possible alignment of interests. Notwithstanding the legal case argued in Delaware Chancery by ETE in defense of its indefensible preferreds, many investors in the Energy Transfer family have endured payout cuts.

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ET, the surviving entity having absorbed all its MLPs, cut its distribution in late 2020. Investor skepticism about the payout had driven the yield to 18%. Covid-led demand destruction, albeit brief, didn’t help. With no reward in the stock price for such largesse and facing rating agency pressure because of its 5X Debt:EBITDA leverage, the company decided it had better uses for available cash than paying ungrateful unitholders (see Why Energy Transfer Cut Their Distribution). This 50% cut meant long-time investors in Sunoco Logistics, Energy Transfer Partners and Regency Partners had endured cuts of 66%, 72% and 76% respectively since being combined with the parent.

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Following last week’s distribution hike ET still trades at a meaningful discount to other large MLPs Enterprise Products Partners (EPD) and Magellan Midstream (MMP). We retain a full position for this reason, but always with a self-protective wariness. ET’s history does not induce the comfort of straight dealing that, say, Jim Teague of EPD provides to their investors.

In 2019 Blackstone acquired the 56% of Tallgrass Energy it didn’t already own via a transaction that paid a substantial premium for management’s units versus the lower one paid to everyone else (see Blackstone and Tallgrass Further Discredit the MLP Model). Perhaps ET’s $41BN market cap makes it too big for such a coup. But you know that if they could do it, they would.

ET’s diverse and well positioned midstream assets, which are largely supported with fee-based contracts offer attractive upside. Their Lake Charles LNG project will add exposure to growing global demand for US natural gas.

LNG import terminals allow for diverse sources. As Germany has learned, if your energy comes via a pipeline you’re locked into a long-term relationship with the supplier. European LNG demand is growing but Asia remains the biggest market. The Philippines expects to increase imports as their Malampaya gas field in the South China Sea winds down. The government just approved construction of a seventh import facility.

The slide in US natural gas prices is due to our mild winter. The Freeport LNG export unit is coming back on line, which will create some additional demand. Cheap US gas will stimulate additional demand for US exports, which will eventually support domestic prices. Curbing US households’ use of gas stoves never looked like a serious proposition, but in any event will not alter the growth in long-term demand.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Most of the commodity questions we get relate to crude oil, since its price reflects energy investor sentiment and can move midstream prices. When oil and pipelines are down, people want to know why the volume dependency of midstream cashflows isn’t visible in stock price performance. The correlation between the two is unstable (see Energy’s Asynchronous Marriage).

Pipelines are even less correlated with natural gas. This is partly because there are enormous global price disparities. US LNG exports are growing but still constrained by insufficient liquefaction capacity to satisfy global demand. Hence US natural gas prices are far lower than European and Asian benchmarks.

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Gas prices have been sliding in recent weeks, confounding some who think Europe’s pivot away from Russian pipeline exports should create immediate incremental demand. The main reason is weather. Just before Christmas the US experienced a cold snap which boosted domestic demand, but since then it’s been a relatively mild winter. The same has been true in Europe, where fears that rationing might be required before winter’s end are receding.

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Most of the US has seen milder weather as defined by Heating Degree Days (the average of the day’s high and low subtracted from 65, or 0 if negative). Only the Rocky Mountains and west coast have been different. California’s relentless rain is being blamed by some on global warming, but it reaches the mountains as snow which I can personally attest is creating great skiing conditions.

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The milder winter is curbing demand for natural gas, most clearly seen in the 17% drop in the residential and commercial category compared with a year ago. Exports are also less than forecast. The Freeport LNG plant is the 2^nd biggest such facility in the US behind Cheniere’s Sabine Pass. Restarting operations there following the fire last June has also taken longer than expected, curbing demand for natural gas supplies to be converted into LNG. The company is sticking with its latest forecast that it’ll be back up by the end of January.

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Looking ahead, LNG demand will assuredly grow and the weather will fluctuate. The Energy Information Administration’s Short Term Energy Outlook sees US LNG exports averaging 12.1 Billion Cubic Feet per Day (BCF/D) this year and 12.6 BCF/D in 2024. They did trim this year’s forecast modestly because of the delay in Freeport’s restart.

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US LNG export capacity won’t grow significantly for another couple of years, but by 2030 will have almost doubled in a decade. This will help close the price gap between US natural gas and other global benchmarks, although even then LNG exports will represent less than 20% of domestic demand.

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Australia vies with the US and Qatar for top LNG exporter. But LNG exports have become a political issue down under, because such a big portion of production is flowing overseas that it’s boosting domestic prices. In recent years Australia’s federal government has contemplated export curbs. These are vehemently opposed by the gas industry which argues they may be forced to violate contractual obligations. Partly as a result of political pressure, Australian LNG exports are expected to dip this year.

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The Netherlands is also planning to curb exports, but for different reasons. Their Groningen gasfield, the largest in western Europe, has been widely linked with earthquakes. There have been up to 100 annually since 1980, ranging as high as magnitude 3.6. Several years ago tremors in Oklahoma were attributed to fracking, although blame was eventually pinned on improper wastewater disposal not the fracking itself.

But fracking is not used in Groningen, and it appears that the removal of natural gas itself destabilizes the ground. 160,000 damage claims have been submitted by residents of the area. The Dutch government has been promising to halt gas production there since 2018 and now sounds as if they will finally follow through.

The timing is awkward because Groningen borders Germany and supplies the northwest of the country. The EU pressed the Dutch to increase production following Russia’s invasion of Ukraine. Depending on Europe’s supplies Groningen may continue production until October 2024 but not beyond that.

Political pressure in Australia and the Netherlands will enhance the prospects for US LNG exports both to Europe and Asia.

Following Sunday’s blog critical of Kinder Morgan, some readers asked why we have any position in the company at all. We’ve been critical of their returns on invested capital for several years (see Kinder Morgan’s Slick Numeracy) and they’ve long been an underweight for us.

Today the company’s poor investment history is well known by analysts if not acknowledged by the board since they just elevated a long-time member of the management team and former CFO Kim Dang to CEO. We’ll look for signs of improvement. Their Enhanced Oil Recovery business (EOR) was an unwelcome source of EBITDA volatility, but with the Inflation Reduction Act increasing tax credits for CO2 capture including from EOR, there’s some chance for this segment to become more interesting.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Kinder Morgan (KMI) reported earnings last week and announced that President Kim Dang will be taking over from Steve Kean as CEO. This prompted us to look back over KMI’s history, which reflects some of the best and worst of the MLP sector for the past ten years.

A decade ago the shale revolution drove increased capex for upstream E&P companies as well as the midstream ones that service them. Prior to 2014 KMI operated as the General Partner (GP) to MLPs Kinder Morgan Partners (KMP) and El Paso Partners (EP). The GP-MLP structure always looked to us like the hedge fund manager-hedge fund relationship.

The GP (HF manager) calls the shots and the MLP (HF) does what it’s told with limited rights for the limited partners. The GP could and often did sell assets to its MLP (a “dropdown”), directing the MLP to issue equity and debt to pay for them. Or the GP could direct the MLP to build new infrastructure. The GP had Incentive Distribution Rights (IDRs) which operated like the carried interest taken by HF or private equity managers. It gave them a share of the profits with minimum capital at risk.

Back then we always invested in the GP rather than the MLP because, as with hedge fund managers, that’s where the big money gets made. Rich Kinder exploited his MLPs masterfully and became a billionaire in the process. However, by 2014 the increasing need of MLPs to raise ever more capital to finance infrastructure for the shale revolution was driving up yields, making raising equity capital more expensive.

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Kinder was frustrated at KMP’s high cost of capital, so in August 2014 Kinder Morgan announced it was simplifying its structure and rolling its MLPs into KMI to create one single entity. We were moved to write enthusiastically about it (see Valuing Kinder Morgan in its New Structure).

Rich Kinder said at the time, “”We have vastly simplified the structure” and promised “modest cost synergies,” He also promised a $2 annual dividend growing at 10% for the next five years. Less than two years later it was slashed by 75% and still hasn’t recovered.

KMI began a trend to roll MLPs up into their GP parent, which was often a corporation. MLPs had attracted income-seeking, K-1 tolerant investors but the model broke when midstream companies followed their upstream clients into over-investing. Increased leverage led to distribution cuts, alienating the traditional income-seeking investor. The MLP structure has never recovered, and they now represent around a third of the sector. The Alerian MLP ETF remains as an anachronistic vehicle for those who only want MLP exposure and are content with a tax-inefficient structure (see AMLP Trips Up On Tax Complexity).

August 2014 was the peak in the energy sector for that cycle. Since then, KMI has generated a minus 2.9% annual return with dividends, lagging the sector, defined as the American Energy Independence Index (AEITR), which has generated 3.3% pa. KMI’s dividend is $1.11, still a long way from the $2 promised nine years ago.

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KMI has a track record of investing in low return projects. Wells Fargo calculates that over the past five years KMI has earned a Cash Return On Investment (CROI) of only 4.4%, the lowest of any big company. Since 1999 they’ve earned 5.6% versus an industry median of 10.7%. KMI’s stock has lagged because they keep investing in projects that earn less than their cost of capital.

Rich Kinder ran the company during most of this period, and he’s misallocated his own capital as well as his investors’ because he’s still the biggest individual owner of KMI shares with around 11% of the company. His personal fortune is from understanding how to exploit the GP/MLP structure that used to exist, but he must think it’s from making good investments.

Which brings us to the new CEO Kim Dang. She became CFO in 2011 and has been part of the management team ever since. The low CROI projects substantially occurred on her watch. Did she internally oppose misdirected capital, or did she misestimate returns as much as Kinder? Neither explanation is good, and KMI’s pliant board of directors doesn’t seem too concerned about the company’s investment track record.

On KMI’s 4Q22 earnings call, Dang commented that, “A large part of my job is going to be about continuity.” Long-time investors may feel a twinge of nervousness at this prospect. An improvement on past performance is needed.

Encouragingly, KMI added $1BN to their buyback program. Given the stock’s poor performance for many years, this might be one of their best uses for excess capital.

We continue to own KMI but at a reduced size relative to its percentage of the sector’s market cap.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

On the weekend the WSJ highlighted contrasting views of the 60/40 portfolio between Goldman Sachs and Blackrock. The classic asset allocation had its worst year in nominal terms since the 2008-9 Great Financial Crisis (GFC) and adjusted for inflation the worst since the Great Depression.

It shouldn’t be a surprise. Bond yields have been too low to justify the discerning investor’s capital for many years – a point I made in my 2013 book Bonds Are Not Forever: The Crisis Facing Fixed Income Investors.

The Federal Reserve owns $7.3BN in treasury bonds and Mortgage-Backed Securities (MBS). These holdings are a result of Quantitative Easing (QE), which Ben Bernanke first unleashed in response to the GFC. At the time this was a controversial move that many (including me) thought would be inflationary. Bernanke understood better than anyone how the monetary system would respond. It was a unique moment and QE should have been a one-off.

But in 2020 Jay Powell took it to a new level before the prior QE holdings had run off. Now one must conclude that any economic downturn will be met with Fed balance sheet expansion. The current lethargic pace of balance sheet reduction will likely be reversed with the next recession. This partial debt monetization is becoming permanent. It’s a consequence of too much debt.

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Japan is the biggest foreign holder of US treasuries with $1.1TN. China is second at $0.9TN. Along with the Fed, for these investors a return ON capital is unimportant – they want a return OF capital. The old fear that China might dump their holdings is irrelevant with QE. Selling a $1TN of bonds would be destabilizing, but who now doubts the Fed would step in and take the other side?

Inflexible investment mandates that require fixed income allocations regardless of return prospects are another source of excess demand for bonds.

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The result is that return-oriented bond investors are competing with substantial capital disinterested in a return. Bonds had some good years following the publication of my book warning investors to take their capital elsewhere. The adjustment away from fixed income is slow. But last year was a wake-up call. Paltry yields left diversification as the only justification for owning bonds. But their correlation with stocks has been rising sharply. The ascendancy of TINA (There Is No Alternative) caused this. The tyranny of pygmy interest rates and consequent shift to equity risk increased the stock market’s vulnerability to rising rates.

Over the past decade the Barclays Agg returned just 1.3% pa, versus 12.2% for the S&P500.

Today’s higher yields suggest a better decade ahead. But much depends on inflation. At 3.5% the ten year treasury note offers just 1.5% above the Fed’s long term inflation target of 2%. This is below the real return of the past hundred years. And it relies on inflation quickly returning to 2% and remaining there.

Inflation expectations are encouraging. Like many banks, JPMorgan expects falling inflation this year and is forecasting CPI of 2.8% in 4Q23. Ten-year TIPs yield 1.3%, implying a 2.2% embedded inflation rate in the bond market. The University of Michigan consumer survey regularly confirms this benign outlook.

The broad consensus on price stability isn’t easily ignored. It’s possible that return-insensitive buyers noted above are distorting the message unconstrained bond yields might offer. But Wall Street analyst and household views are harder to explain away. Nonetheless, having endured two years’ of high inflation a cautious investor should assume something above 2% in the future if only to compensate for the risk that these forecasts are wrong. A saver assuming her annual living expenses will increase at 3% into retirement will quickly find equities offer the only hope of keeping up.

60/40 was finished years ago. I haven’t owned a bond in probably two decades. There’s no point. Neither do any of our SMA clients. Instead they hold cash as a diversifier. 90-day treasury bills averaged 0.8% over the past decade, 0.5% less than the return on the Barclays AGG over that time but with no risk. Cash is a risk enabler. It supports increased exposure to equities which is the only chance savers have to maintain purchasing power. Bonds offer risk with an inadequate return.

Yields are still too low. The Congressional Budget Office forecasts sharply rising Debt:GDP over the next thirty years. US taxpayers are benefiting from investor inertia, since long term yields aren’t commensurate with the debt outlook.

In BlackRock vs. Goldman in the Fight Over 60/40, the WSJ finds Blackrock believes it outmoded while Goldman defends the indefensible. However, Goldman’s asset management business asked Is the 60/40 Dead? in October 2021 and warned “investors should at the very least recalibrate expectations.” Even within Goldman Sachs, reasonable people can disagree.

For more on how a combination of stocks and cash can replace fixed income, see The Continued Sorry Math Of Bonds, which we published around the same time. Adding midstream energy infrastructure to the equity portion of the stocks/cash barbell will, in our opinion, further boost its performance.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

The US Energy Information Administration (EIA) published their Short Term Energy Outlook last week. The EIA produces an enormous amount of data and is apolitical. For energy investors it’s really all good news.

US crude production is expected to grow, but slowly. Natural gas production will increase at a faster pace with export growth more than offsetting a modest drop in domestic consumption. US CO2 emissions will continue to fall, accommodating growth in China and other emerging economies where higher living standards are their priority.

The charts tell their own story. You’ll note that Residential and Commercial consumption of natural gas is expected to rise in spite of the musings of the Consumer Product Safety Commission about eliminating gas stoves. And the last four years have shown slightly cooler weather in the US, although not enough to form a trend.

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Climate Action Tracker, a website that assesses countries’ commitments to reduce emissions, rates China “Highly Insufficient”. No country is compatible with the UN’s “Zero By 50” goal which requires eliminating CO2 emissions by that date in order to limit global warming to 1.5°C above 1850. Britain and Norway are among those rated “Almost Sufficient”. The US is “Insufficient” while China, India and most of Asia ex-Japan are rated “Highly Insufficient”.

China’s emissions are expected to grow through 2030, at which time the government says they’ll start falling and reach zero by 2060. Western negotiators at the UN who are dominated by liberal politicians too readily accept China’s word. They haven’t been forthcoming about Covid or much else, so it’s unclear why climate change would be different. Rich world countries, where climate concern is greatest, will push ahead with emissions-reducing policies that are more than offset by developing Asia. This gets too little media coverage.

Last week in a significant development, Climeworks announced that they had pulled CO2 from the air and stored it underground at a meaningful scale, verified by an independent third party. Direct Air Capture (DAC) is not easy – there’s around 412 parts per million of CO2 in ambient air, although it has been trending up. Much higher concentrations can be found in the emissions of power plants or petrochemical facilities. Although cheaper to capture at the source, the CO2 then needs to be moved by pipeline to permanent storage underground. Climeworks equipment can be built on or near the porous rock formations appropriate for permanent storage.

This development is another step towards proof of concept. Microsoft, e-commerce company Shopify Inc. and payments firm Stripe Inc have each agreed to pay hundreds of dollars per Metric Tonne (MT) for credits which they can use to offset their own emissions. Because the CO2 is permanently stored and independently verified, this is a more robust and honest way for companies to demonstrate reduced emissions.

The Inflation Reduction Act provides for 45Q tax credits as high as $180 per MT for DAC, a level that is generating interest among several US energy companies. We’ve been following carbon capture developments for some time (see Clean Energy Isn’t Just About Renewables). Occidental is developing the world’s biggest DAC facility driven in part by the 45Q credits (see How Occidental Invests In Lower Taxes).

Concrete maker Lehigh Hanson, plans to capture CO2 from its operations. Start-up CarbonCapture expects to remove 5 million MTs per annum by 2030, and UK-based DRAX 12 million MTs. The 45Q tax credits aren’t capped. The Congressional Budget Office estimated they’ll cost $3BN over the next decade. Credit Suisse thinks $52BN. Forecasts are that around 200 million MTs, representing 4% of US energy-related CO2 emissions, will be captured by 2030.

It’s also possible for carbon atoms to make a virtuous roundtrip. They first leave a natural gas formation as methane (CH4) to be used by a petrochemical facility before being emitted and returned as CO2 for sequestration back in a geological formation similar to the one they left (see Putting Carbon Back In The Ground).

It’s appealing to think that DAC could ultimately solve the problem of climate change. If the technology works, the world only needs to identify enough sites to deploy the Climeworks equipment for permanent CO2 sequestration. It’s much more appealing than relying on vast, intermittent solar and wind farms with requisite battery backup.

But Climeworks understands their market, and their website sensibly positions the company as complimenting other efforts to reduce emissions: “To mitigate climate change, we need all solutions to be working together. One measure alone is not enough.”

When the EIA’s outlook is combined with the positive fundamentals outlined in Wednesday’s blog post (see Bearishness Is Holding Back Energy), there are plenty of reasons for pipeline investors to remain optimistic.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Michael Wilson, Morgan Stanley’s chief equity strategist, thinks stocks could fall 22% this year. Wall Street is bearish, and the mood has spread to consumers. Earnings forecasts are falling and households report expectations close to the depths of the 2008 great financial crisis. A lot of smart people are negative. We don’t spend any effort positioning for the economic cycle – when recessions have struck they’ve usually been unexpected. If the US slips into one later this year it’ll be the most anticipated in living memory.

Fortunately, Morgan Stanley like most firms encourages disparate opinions and does not enforce a “house” view in its public pronouncements. Hence Robert Kad, who heads up MLP and Energy Infrastructure research is publicly, even giddily bullish on the sector. Of the companies they cover, which is most of them, he expects a median one year price return of 21.9%. With dividends he expects 29.1%. Kad is so bullish that he even expects those companies that are ranked Underweight to deliver a total return of 17.1%.

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Some readers may think your blogger is the most relentlessly optimistic on pipelines. When investors ask me to offer an estimate for one year returns, I meekly offer 6% dividends plus 3% growth plus 1% in buybacks, or 10%. I have to confess that Kad’s bold optimism casts a pall of inadequacy over my forecast compared with his fearless proclamation of the opportunity that is presented.

JPMorgan’s Jeremy Tonet expects a median one year total return on his coverage group of 23.5%. Wells Fargo’s Michael Blum is more constrained, expecting a 13% price return on their Overweight group

We agree with Kad’s reasoning – the sector’s free cash flow yield is 2X the S&P500 and well above those of all major sectors. The boost to carbon capture from increased tax credits in the Inflation Reduction Act should cause a rethinking of terminal asset values as pipelines remain key to the energy transition. Sluggish growth in US crude production looks likely as areas mature and capital discipline persists among E&P companies. China is emerging from its three year lockdown, Russian exports are falling with the price cap imposed in December, and the Administration has completed its sale from the Strategic Petroleum Reserve (SPR). Oil looks like a risky short. The US rejected offers of crude to replenish the SPR as too high or the wrong grade. The White House attempt to trade oil is likely to leave it unable to cover earlier sales profitably.

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The energy sector’s P/E ratio is 0.6 of the S&P500, the lowest in over twenty five years according to Yardeni Research. Energy analysts are bullish, but the market is not. The three headwinds of shale overbuild, fears of stranded assets and covid demand destruction inflicted such financial trauma on investors culminating in 2020 that the cathartic rebound continues amid skepticism. Retail investors are not yet contributing net inflows into sector funds, although the year-end bounce we postulated (see Will The January MLP Effect Beat Negative Sentiment?) is working. Sector analysts are more bullish than investors.

Last month Tallgrass bought the Ruby natural gas pipeline which runs from the Rocky mountains west to California, out of bankruptcy. Combined with the Rocky Mountains Express (REX) pipeline Tallgrass owns, this creates the potential for natural gas in the Marcellus to move across the country to California markets where prices are high even as Californian politicians seek to reduce its use. Tallgrass likely assesses the Golden state will be using gas for a long time yet.

In other news, AQR’s Cliff Asness wrote an eloquent criticism of private equity valuations. Increasingly, the absence of a regular mark to market is being regarded as a welcome absence of volatility instead of simply an absence of information. Blackstone (see Is BREIT Marked To Market?) recently raised $4BN from University of California (UC). Far from endorsing Blackstone’s valuations, the terms which include close to a guaranteed 11.25% return to UC, suggest that’s what it took to raise new money.

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Lastly, a photo from Vail where my younger daughter and I are on our annual ski trip with good friend, client and instructor Bill Edwards. Bill’s a retired orthopedic surgeon from San Antonio that I’ve known for twenty years. We’ve spent many enjoyable ski vacations in his unfailingly good company. Every year he generously sees improvement and I really think he’s right. Any skiing competence I exhibit is down to him; the falls are my own work (or as he says, a failure to listen).

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

Energy Mutual Fund

Energy ETF

Real Assets Fund