Last week recession questions were more common than in the past during our many conversations with clients. The likely performance of the energy sector during a slowdown is what they’re asking.

Recession risks are growing in the minds of many. In one recent survey, a third of economists are forecasting a recession within two years. Some may joke that a third of economists are always forecasting a recession – but Goldman Sachs puts the odds at about 35% and JPMorgan has increased provision for loan losses because their internal modeling showed heightened risk.

Recessions aren’t good for stocks, and no sector is immune. If you’re worried about a recession, you should reduce your equity holdings. But the market invariably bounces back – most spectacularly following Covid. The bigger risk for investors is inflation, and it may not always come with robust economic growth as we have now.

Data on Friday showed 1Q22 Eurozone growth of only 0.2%, down from 0.3% the prior quarter. France was flat and Italy contracted. Year-on-year inflation is running at 7.5%. Stagflation, which is being increasingly heard from European analysts, is especially hard for central banks to manage because the correct monetary stance is unclear.

The US is in better shape. Last week’s GDP report was negative partly due to a bigger trade deficit, evidence of robust demand. On Friday personal consumption expenditures were solid and the quarterly Employment Cost Index increased by 1.4%, up from 1.1% in December. In America, everyone who wants a job has one. Gasoline prices are high, but Democrats can promote that as a reason to accelerate the energy transition while Republicans can feel good about the boost this provides to domestic production and energy independence. Maybe I’m overly glass half full, but spending $100 to fill up feels pretty good right now.

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The Fed is forecasting a utopian combination of falling inflation, moderate rate hikes and continued strong employment that is so hopeful it’s certain to be wrong.

We looked back at the performance of Exxon Mobil (XOM) versus CPI going back to 1970 to see what type of inflation protection the energy sector might offer. It turns out that one year returns on XOM and year-on-year CPI aren’t correlated during times of low inflation, but the relationship is stronger when prices are rising faster. The chart plots both sets of one year returns from 1970 to 1982, the last time we had inflation as high as it is today.

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High returns on XOM anticipate higher CPI, although the time lag does seem to vary. When inflation is running above 6%, one year XOM returns have a 0.25 positive correlation with one year lagged CPI. In other words, when investors anticipate rising inflation, they invest in the energy sector ahead of time. The strong recent returns on energy stocks have similarly correlated well with higher inflation.

Which element of the FOMC’s utopian forecast is most likely to be wrong? It doesn’t even have the Fed Funds rate reaching inflation until the end of next year. A real policy rate that’s negative is not how monetary policy has in the past curbed inflation. It’s also unclear why wage inflation, currently 4.7% and rising year-on-year, will moderate if the unemployment rate remains at 3.5% as they expect.

The path to a recession runs through stubbornly high inflation. The last two downturns, 2020 Covid and 2008 Great Financial Crisis, were unusual. Most recessions occur because the Fed waits too long to raise rates and then goes too far. If those recession fears turn out to be prescient, it will most likely be because the Fed’s rate forecast was too benign. That would mean their inflation forecast was also too optimistic. This would in turn suggest that energy stocks would continue to play an important role in protecting against inflation.

In brief – if you fear a recession, you could do worse than buy energy stocks because it’ll be higher than expected inflation and interest rates that causes one.

On a separate note, Tellurian (TELL) CEO Charif Souki has many talents but deferred reward for good execution is not one of them. We’ve long preferred NextDecade (NEXT) over TELL – both are planning new export terminals for Liquefied Natural Gas (LNG), but Souki’s risk tolerance and inflated view of his own compensation have never sat well with us. When energy stocks cratered two years ago, Souki was forced to sell TELL stock he owned on margin. No matter – the board soon granted him more.

In a proxy quietly filed on Thursday (see here pg 69 paragraph c), TELL granted Souki over $17 million in stock awards. His payday ought to wait until TELL is actually loading LNG onto tankers from its not yet built terminal. TELL’s prospects look very good, but if the additional equity capital they assuredly need comes on terms that are ruinously dilutive for today’s common equity holders, their CEO will nonetheless have done very well. Souki is a risk factor for investors in TELL to consider.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

The US was increasing its net exports of natural gas before Russia’s invasion of Ukraine added an element of urgency. Liquefied Natural Gas (LNG) gets most of the attention, but this year we’ll export nine Billion Cubic Feet per Day (BCF/D) by pipeline, to Mexico and eastern Canada.

LNG exports are still rising, with most global trade directed to Asia. Cheniere, whose Sabine Pass and Corpus Christi terminals export over half the total, often signs flexible contracts that give the buyer (typically a large trading firm like Trafigura) destination flexibility.

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As Europeans buyers have scrambled to replenish storage, they have outbid Asian buyers. Competition between the two is likely to intensify later in the year. Germany hopes to begin using the four floating LNG terminals they’ve leased as soon as this winter, assuming the land-based infrastructure can be ready in time. Global LNG prices are likely to remain firm.

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The difference between US natural gas prices and the two main overseas benchmarks remains huge – far more than necessary to induce higher exports which are limited by our LNG export capacity. As we send more LNG overseas, it will create some upward pressure on domestic prices. The good news is that domestic production is increasing to keep up with exports.

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The US Energy Information Administration (EIA) in their current Short Term Energy Outlook US expects coal consumption to decline next year after rising in 2022. Power plants switching from coal to natural gas will be the driver, as it was for over a decade prior to Covid. The EIA expects US natural gas prices to ease from today’s relatively high prices because of increased production. This will keep our energy-related CO2 emissions flat next year.

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Kinder Morgan (KMI) reported better than expected 1Q22 results last week, buoyed by their Natural Gas Pipelines segment. Growing natural gas takeaway capacity out of the Permian basin in west Texas is behind KMI’s decision to invest in more compression on their Permian Highway and Gulf Coast Express pipelines that run from west Texas to the Gulf of Mexico. Increasing capacity on existing pipelines is preferable to greenfield projects across most of the country. It heads off environmental extremists and requires less capex, so is preferable where existing infrastructure allows it.

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Energy Transfer (ET) is the individual name most often held by financial advisors we talk to. It has been consistently cheap, inexplicably so to many, for years even relative to a sector that has long been out of favor. This year it has been one of the leaders in the American Energy Independence Index (AEITR). Yesterday ET announced a 30% distribution hike, another step on the road to redemption for a company with a checkered history of fiduciary forgetfulness (see Energy Transfer: Cutting Your Payout, Not Mine).

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Clients who are underinvested in the pipeline sector often look at recent returns and ask whether they’ve missed the rally. Those possessed of sufficient fortitude or recklessness to have bought on March 18, 2020 are up 4X. Returns from the Covid low are spectacular, but highly aberrant. The YTD return at that point was –64%, caused in no small part by the managers of MLP closed end funds who combined poor judgment with misplaced self-confidence (see MLP Closed End Funds – Masters Of Value Destruction). It is to their clients’ misfortune but everyone else’s gain that sufficient capital was destroyed in the rush to delever that they’re now too small to repeat.

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A longer timeframe is more meaningful. Over four years, the AEITR has delivered almost the same return as the S&P500 (12.5% pa vs 14.0% pa). Another couple of days of relative performance like yesterday (S&P500 lagged AEITR by 2.5%) will make their four year returns match.

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An investor contemplating an equity allocation would scarcely be dissuaded by the stock market’s four year return. However, the prospects for inflation above the Fed’s 2% target for years might give her pause. Pipeline stocks should do well in such an environment.

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Or she may consider the growing importance of energy security to Europe and the resulting demand for US LNG; the continuing financial discipline exhibited by energy companies, and the global opportunity for reduced CO2 emissions from coal to gas switching.

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The point is that the traumatic V-shaped low of midstream energy infrastructure in 2020 creates high recent returns, but over longer periods pipeline sector returns look rather equity-like. Since December 2010, the inception of the AEITR, the S&P500 is ahead 13.3% vs 11.6%. The AEITR is 18% away from where its 12 year return would equal that of the S&P500, less than its YTD performance. We think it will close that gap too.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Earlier this month there was a fascinating exchange on Bloomberg TV between former NY Fed president Bill Dudley and journalist Jonathan Ferro. Dudley has been vocal in criticizing the slow rate at which his former FOMC colleagues have been normalizing monetary policy. He’s pointed to the robust stock market and warned that the Fed’s going to tighten financial conditions enough to push up the unemployment rate. Ferro, refreshed by the frank analysis and used to more guarded responses from Fed officials, asked Dudley “why Fed officials don’t talk like you?”

Dudley responded that it’s unpleasant to talk about how you have to push up the unemployment rate and put people out of work, even though that is the Fed’s goal.

The Fed wants tighter financial conditions. This needs to manifest itself via higher long term yields, since sectors like housing and capital spending are more sensitive to the ten year yield than the Fed Funds rate. And the Fed needs a weaker stock market, because households that feel poorer will spend less, cooling things down. It is truly an unpleasant prospect. Covid has receded other than a few remaining constraints – Broadway shows still require masks and travel outside the country may still leave you stranded if the required Covid test before re-entry is positive.

But with 3.6% unemployment the vast majority must be better off, and happier, than they will be once the Fed engineers tighter financial conditions and the consequent economic slowdown. On Thursday, Fed chair Jay Powell said, “It’s absolutely essential to restore price stability. Economies don’t work without price stability.”

Ten year yields are approaching 3%. Compared with 8.5% annual inflation Bill Dudley notes that policy remains very loose. But yields are edging up, helped by Fed officials warning of successive 0.50% rate hikes, as Powell did last week.

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The stock market isn’t helping much, even after last week’s sell-off. For the first time in a decade, the Equity Risk Premium (ERP) doesn’t make stocks look cheap. The 5.4% earnings yield, based on Factset bottom-up figures, versus a 2.9% ten year yield puts the ERP at 2.5, right on the average since 2000 when the dot.com bubble burst.

Earnings forecasts are being revised higher, reflecting little evidence of any influence from the Fed. Analysts still expect growth next year of 10%. But a 3.4% ten year yield in 2023 would be enough to keep the ERP at 2.5. By this measure, stocks are as expensive as they’ve been in the past decade. Tighter financial conditions include a weaker stock market according to Bill Dudley. If the stock market repriced to its average ERP of 3.3 over the past ten years, that would imply the S&P500 around 15%, lower.

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When a liberal-leaning magazine such as The Economist blames today’s inflation on the Democrats pushing through last year’s $1.9TN stimulus, you know it’s conventional wisdom. Larry Summers must be a thorn in the side of the White House, since he warned of such as the package was being debated and hasn’t let up since. This week’s Economist analyzes the Fed’s “historic mistake on inflation” and includes a special report on central banks. They blame the Fed’s modified interpretation of its mandate to allow higher inflation, along with institutional groupthink that assumed stable prices were hard-wired into the economy.

The Economist also notes that central banks have taken on a broader remit in recent years. In the US progressive Democrats wanted that to include policies to counter climate change. Fed candidate Sarah Bloom Raskin withdrew her nomination when Senate Republicans objected to her past comments pushing the Fed to withhold pandemic support from fossil fuel firms.

However, the Fed does now seek maximum employment that is “broad-based and inclusive”. Powell explained the shift thus: “This change reflects our appreciation for the benefits of a strong labor market, particularly for many low- and moderate-income communities,”

There is evidence that minority unemployment, which is always higher than for the general population, rises faster during a slowdown. This will be a consideration in the background when the FOMC is facing rising joblessness but has not yet conquered inflation. Debt:GDP is the most important reason America will learn to live with higher inflation, since it allows lower or negative real rates which makes it cheaper to finance. But the mix of unemployment will also play a role in FOMC thinking.

On Saturday I had the good fortune to play golf with Bill Dudley. He denied that he was captain of the Federal Reserve golf team, in spite of what I saw as evidence in support. We spent much time exchanging views on Fed policy and the outlook for rates. Dudley thinks the happy combination of declining inflation and a rate cycle peak of around 3%, as laid out in the most recent FOMC projection materials, will be hard to achieve. I think if Dudley was on the FOMC today they would have acted against inflation in a more timely fashion.

The Fed has committed the biggest inflation mistake in its history. The FOMC won’t concede such, but their hawkish shift shows it was obvious before The Economist made it official. They’re still a long way from creating tight financial conditions. Leave the bond market to those who tolerate returnless risk.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Wells Fargo describes Liquefied Natural Gas (LNG) as THE theme for midstream energy infrastructure. In a recent series of meetings they found investors were “highly constructive on long-term fundamentals for global LNG…and looking for ways to play the theme.”

One reason is that Europe’s pivot on energy security seems unlikely to change regardless of the outcome in Ukraine. The fact and form of Russia’s invasion are immutable. In a brief moment, Russia has shredded the hopes of those who embraced engagement via trade (see Russia Boosts US Energy Sector).

We were bullish on natural gas before the invasion, because its growth prospects already looked good based on growing Asian demand. The possibility that coal consumers around the world might follow the US lead and start switching to natural gas power plants so as to reduce CO2 emissions remains an upside option.

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Recent events have drawn more attention to LNG. Spot prices in Europe remain 4X the US and have been double that in recent weeks. The constraint on US exports to Europe isn’t the availability of natural gas, but the export facilities to liquefy it and load it onto LNG tankers. The Financial Times recently warned that building new export infrastructure will take years, meaning price relief won’t come quickly to Europeans.

The long lead time on construction provides decent visibility into future export capacity. Because there’s no Plan B for an LNG terminal, twenty year contracts are common to assure an adequate return on investment. Cheniere is the only pure-play publicly-traded US LNG corporation operating, so investors that are bullish on LNG have limited choices. Cheniere is one of the best Free Cash Flow (FCF) story in the midstream sector. Their capex needs have been falling since 2016 while Cash Flow From Operations (CFFO) has been increasing. Their reduced financing needs have allowed them to pay down over $1BN in debt in each of the past two years. This reduced FCF but is a use of cash likely to make most equity investors happy.

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Cheniere’s Executive Vice President Anatol Feygin recently described the natural gas market as undergoing a “demand shock” after years of underinvestment. Not surprisingly, he is very bullish on the company’s prospects.

Although Europe’s need for LNG has spurred the sector higher, Asia is the biggest market. Emerging economies are increasing their consumption of all kinds of energy, from coal to renewables, as they strive to raise living standards. When Asian power plants burn natural gas, they are probably substituting for coal. In fact, the single most constructive thing climate extremists can do is encourage coal to gas switching in the developing world, most especially Asia. China plans to invest $130BN in gas projects. Vietnam, Indonesia and India in aggregate are a further $100BN. Asia’s total capex is estimated to be 3X Europe’s, even with their hurried move away from Russian supplies.

Some are concerned that this locks in fossil fuel use beyond the time when the UN would like to it phased out – but solar panels and windmills aren’t a practical substitute for the size of energy needs these countries envisage.

Export contracts to cover long distances is how most people think of LNG. So RBN Energy published a fascinating description of the surprisingly widespread use of small scale LNG plants (see Piece By Piece – Small-Scale LNG Plants In U.S. Find Niche Markets At Home And Abroad). Needs vary from providing extra natural gas to meet peak demand to industrial use where natural gas pipeline capacity isn’t available. New England’s well known opposition to new gas pipelines has made them especially reliant on regasified LNG. There are even trucks which use LNG – they’re more expensive to operate than Compressed Natural Gas (CNG), so tend to be used for longer distances with limited opportunities to refill.

Although purists would like us to give up all fossil fuels, pragmatism is leading to a growing acknowledgment that energy transitions, including this one, take decades to play out. Energy security, historically not a European concern, has catapulted up their priorities.

NextDecade, on which we have written several times recently (see NextDecade Sees A Bright Future), and Tellurian, are among the few LNG stocks available for investors who find Cheniere expensive. Wells Fargo believes what they call the, “highly constructive long-term fundamentals” along with limited choices will keep these names well supported.

Concern about high oil and gas prices has even induced the White House to reverse one of their first steps and permit drilling on Federal land. They’ve managed to offend progressives. But by increasing the royalties by half, to 18.75%, they’re still encouraging caution among energy executives. They know the hand of friendship to traditional energy will be withdrawn as soon as prices drop. But even here, pragmatism is supporting the case for natural gas.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

The energy sector, already responding to inflation in recent months, has been a clear winner from Russia’s invasion of Ukraine. Few countries in history have striven for energy independence as much as America. Having achieved it, the US is now in a position to help Europeans achieve energy security. They have no hope of energy independence, but can at least achieve more diversity of supply.

Within the energy sector, natural gas has been a winner and companies involved in exporting Liquefied Natural Gas (LNG) have soared. Tellurian (TELL) and NextDecade (NEXT) both plan to export LNG from facilities that are not yet built. Their odds of acquiring the customers and capital to fulfill their goals meaningfully improved once the EU acknowledged the catastrophe that was its prior energy policy.

It’s rare to see political leaders abruptly forced to pivot. UK PM Chamberlain’s late 1930s appeasement of Hitler was one. It would have been more appropriate if former German chancellor Merkel was still in power so she could publicly abandon the now discredited policy of “Wandel durch Handel” – change through trade.

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NEXT’s Carbon Solutions division was created as a result of French utility Engie ending LNG discussions in 2019 because of concerns about US flaring. European customers were expected to be the target market for a new offering which captures the CO2 from natural gas processing and liquefaction – especially so now they’re scrambling to find alternatives to Russian supply.

But Asian buyers are moving more quickly. NEXT has recently signed two such deals each worth 1.5 million tons per annum. Meanwhile TELL has begun construction of their Driftwood LNG facility without yet having firm financing lined up – no doubt to demonstrate their confidence that the capital will be available. Of the two, we prefer NEXT. Its business model avoids exposure to natural gas prices, contrasting with TELL which retains some of that risk because they’re bullish on prices. TELL CEO Charif Souki has a healthy risk appetite – two years ago the sector’s collapse led to him being forced to liquidate personal holdings of TELL because of a margin call. The company issued him more shares anyway.

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Revamped European energy policy has provided support for the energy sector at a time when inflation expectations have remained surprisingly well constrained. Ten year inflation as derived from the treasury market moved from 2.5% to just below 3% by early March but has remained there ever since. Real yields have been moving higher – meaning they are less negative – as the market has begun to price in Quantitative Tightening (QT).

It seems inevitable that the opposite of Quantitative Easing (QE) will be needed when the Fed is trying to achieve the opposite result. The spread between two and ten year treasury yields had briefly gone negative, causing some commentators to warn of an impending recession. Discussion in the Fed’s minutes about the need to shrink the balance sheet helped reverse this.

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QE reflected the Fed’s recognition that long term rates matter more than the Fed Funds rate. Bill Dudley, former NY Fed president, has noted that the continued relatively low ten year yield means the Fed hasn’t yet achieved much in terms of imposing more restrictive financial conditions. St. Louis Fed president James Bullard worries that they are behind the curve (which hardly needs saying) and suggested a 3.5% Funds rate might be needed.

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It really depends on what it takes to get ten year yields higher. This is the first meaningful tightening cycle since Ben Bernanke conceived QE in 2008. Expect more discussion in minutes and elsewhere about what the Fed can do to push up long term rates. It’s a task made more difficult by negative real yields – a persistent gift from return-insensitive investors to America, that nonetheless mutes the transmission mechanism from the Fed Funds rate to bond yields.

If the Fed opts to shrink their balance sheet more aggressively, by for example auctioning off some of their holdings of mortgage backed securities, the resulting increase in bond yields would mitigate some of the need to drive up short term rates.

Hence the eurodollar futures curve lost some of its inversion recently. It’s still priced for the Fed to finish tightening by the end of next year and then begin lowering rates in 2024. Given this Fed’s reinterpreted dual mandate, it’s likely they’ll be acutely sensitive to the possibility of a recession. Since QT has never been done, it promises to be a learning experience for everyone.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

In the US, energy independence has been a sought after goal for generations. Ever since the 1973 Arab oil embargo in response to the Yom Kippur War, US presidents have spoken out in favor of reducing our dependence on foreign oil – notably OPEC. There are several definitions of energy independence — The definition of independence. Traditionally it’s applied to crude oil because of the iconic photos of American drivers sitting in gas lines in the 1970s. A broader and more accurate definition combines all primary energy into British Thermal Units (BTUs) and calculates that trade balance. By this measure the perennial quest for US energy independence was finally achieved, in 2019. Thanks to the Shale Revolution and fracking, we now produce more energy than we consume.

Few other countries have been as focused on energy independence. Some, such as Germany, in hindsight embraced energy dependence in a catastrophic effort to draw Russia closer through trade ties.

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Russia’s invasion of Ukraine has elevated energy independence as a pillar of national security. Germany might be the most connected to Russia, and therefore the most vulnerable. They hurriedly abandoned their previous strategy and announced their intent to drop Russian oil and gas imports just as soon as they can be replaced. Since Russia knows its gas trade to Germany is on borrowed time, it’s a good bet the flows will stop when Russia chooses and not when Germany is ready. It’ll provide a further lesson to everyone on the importance of diversified sources of energy.

Hydraulic fracturing (“fracking”) is almost exclusively a US practice. We listed the reasons in a blog six years ago (see Why the Shale Revolution Could Only Happen in America). The right type of rock, plentiful water and availability of capital are among the most important reasons. Less appreciated is America’s unusual form of property ownership in which mineral rights often belong to the owner of the land beneath which those minerals lie. We haven’t come across another country with anything similar. This makes it easy for private companies to partner with landowners to extract oil/gas and share the profits.

In the UK, like most countries, the government owns mineral rights. So when Cuadrilla set out to frack beneath the land of Lancashire in northern England, their activities quickly became a political issue since the government was approving exploitation of a resource they owned.

Cuadrilla’s efforts quickly ran into bitter local opposition, and in 2019 the British government finally bowed to public pressure (see British Shale Revolution Crushed: America’s Unique Ownership of Oil and Gas).

Cuadrilla’s two wells are due to be capped for good soon. But UK PM Boris Johnson responded to the Russian invasion by promising a revised “energy supply strategy” that would be more reliant on domestic energy resources. Britain was importing Russian Liquified Natural Gas (LNG), so can at least source elsewhere with America an obvious beneficiary. Meanwhile, Cuadrilla is now making a last-ditch attempt to revive their efforts.

Rethinking energy security isn’t limited to those countries that buy directly from Russia. Argentina’s Vaca Merta (“dead cow”) shale rock formation is the world’s second biggest shale formation for natural gas (behind the Marcellus shale in the northeast US). Argentina has struggled to develop this resource, but just announced a new concession to Chevron as part of a 282 sq km area area they hold rights to.

Greece has announced plans to speed up gas exploration in order to reduce their reliance on Russia, and hopes to do their first test drill in two decades by the end of next year.

Israel has reached gas independence thanks to resources in the eastern Mediterannean, and now provides natural gas to neighboring Egypt and Jordan. They see opportunities to export to the EU as it drops Russian supply.

India is planning to increase domestic coal production – both to meet growing internal demand but also to lessen its reliance on foreign supply. Indonesia, Australia and South Africa are the country’s largest suppliers, and together account for over 90% of coal imports.

The consequences of the war in Ukraine are being felt all around the world. The virtual cessation of global trade with Russia has caused many governments to reassess their vulnerability. Israel has fought wars against its neighbors and is in a hostile neighborhood. India probably worries about more strenuous efforts to reduce CO2 emissions impeding the trading of coal, on which their power sector relies heavily.

All of a sudden, energy independence is not just for America even though it’s been a goal almost since Saudi Arabia discovered oil. Every country is or will assess their vulnerability to disruption of imports. Diversity of supply is now vital. New pipelines will only link countries that have very high confidence of stable relations (ie US/Canada).

The US is an attractive trade partner in a world that is looking for more LNG. American energy independence is set to help other countries achieve the same for themselves.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

What’s the best shape for the yield curve? Today’s flat verging on inverted shape isn’t optimal. It suggests the market is worried that the Fed will tighten too much, causing a recession. It also makes it hard for banks to make much money extending credit, because they typically lend for longer maturities while funding themselves at the short end. With no curve there’s no positive carry.

But a curve can be too steep as well. If the market was worried that the Fed was going to be inattentive to inflation, long term yields would rise relative to the short end. In some respects the yield curve is a measure of confidence in the Fed’s execution of its mandate. A curve that’s positive without reflecting runaway inflation – a Goldilocks curve – reflects confidence in the future. A ten year treasury yield 2-4% above the Fed Funds rate might be that ‘not too hot not too cold” happy medium. It’s occurred to me that the Fed could do worse than adopt a strategy of maintaining a Goldilocks curve – adjusting the Fed Funds rate in response to changes in long term yields. If they maintained the spread between the ten year note and Fed Funds at 2-4%, they’d be setting monetary policy based on what financial markets are recommending.

A strategy of targeting a constant slope to the yield curve is made more complicated by the presence of so many return-agnostic buyers in the US treasury market. Negative real yields distort the expectations message the bond market would otherwise transmit. As long as there are foreign central banks, sovereign wealth funds and pension funds insistent on holding assets even if they destroy value in real terms, long term treasury yields present a distorted view of the market’s outlook for inflation.

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The Fed has added to this by inflating their balance sheet – former Fed chair Ben Bernanke showed the world how Quantitative Easing (QE) could be non-inflationary if practiced correctly, as it was during the 2008-09 Great Financial Crisis (GFC). Current chair Jay Powell made it part of the Fed’s toolbox when Covid caused a recession. QE was really a one-off tool to help unfreeze financial markets, but we can now assume that it will be used whenever the Fed is facing a recession.

The economy is more responsive to long term yields than the Fed Funds rate. Most residential mortgages are fixed rate. Corporate capital spending is partly financed with bond issuance. The Fed is trying to make financial conditions less accommodative, but even though their own forecast is for the Fed Funds rate to reach nearly 3% by late next year, ten year treasury yields remain stubbornly low at around 2.7%, a level that hardly translates into tight monetary conditions.

The Fed is part of the problem, because Covid QE saw their balance sheet grow to $9TN. Recognizing the importance of long term yields on economic activity, they bought bonds to push yields down. The Fed only just stopped adding to their balance sheet last month.

Having decided to operate directly in the bond market to lower yields during a recession, it’s logical for the Fed to take steps to increase bond yields when trying to slow growth – such as now.

The release of minutes last week showing the Fed intends to reduce their balance sheet by $95BN per month drew much attention. But it’s not that impactful. The Fed has $1.1TN of securities with maturities of under one year, so their planned monthly reduction simply amounts to letting these securities roll off and not reinvesting the proceeds. But even if the Fed decided to auction this $1TN in short maturity securities it would have little impact, because the Fed targets a rate for Fed Funds and buys/sells short term securities to achieve their desired rate.

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A meaningful reduction in the balance sheet would involve selling long term securities, especially the $2.6TN in Mortgage Backed Securities (MBS) with maturities of ten years and longer. The minutes make clear that the FOMC is uncomfortable with the current balance sheet size and wants to reduce it faster than following the GFC without being disruptive. They also need long term rates higher to as to tighten financial conditions.

Former Federal Reserve Bank of New York President Bill Dudley says the Fed “hasn’t really accomplished much yet” with its efforts to control inflation, and will need to tighten financial conditions to push bond yields higher and stock prices lower. “If financial conditions don’t cooperate with the Fed, the Fed’s going to have to do more until financial markets do cooperate,”

The opposite of QE means selling long term bonds. It’s hard to see how the Fed could auction their holdings of US treasuries without complicating the US Treasury’s always ample schedule of new issuance. But MBS auctions would be less problematic and look inevitable; a necessary step to cool a hot housing market that the Fed’s earlier buying of MBS helped create.

Nobody wants a flat yield curve. The Fed will likely conclude a steeper curve is a necessary element of their effort to curb inflation. Mortgage rates have probably bottomed for good.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

There were few places to hide last quarter. The S&P500 was –4.6% with nine of its eleven sectors losing. Energy sparkled at +39% and Utilities were +4.8%. Bonds were even worse, with the Bloomberg Aggregate –6.2%. Close to our hearts, pipelines (as defined by the American Energy Independence Index) were +24.5%.

Low yields have underpinned stocks for many years, so a deteriorating Equity Risk Premium (ERP) is weakening the case for “TINA” (There Is No Alternative). Although bonds remain a long way from offering a fair return, yields have risen far enough that stocks no longer look compelling. Factset bottom-up estimates for S&P500 EPS growth are 9%, putting the ERP close to its 20 year average. As a successful and now retired bond trader used to say, 3% on the ten year note is only a nine iron away. This would make stocks look decidedly neutral.

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Correctly calling interest rates is of greater import to one’s equity portfolio. JPMorgan produced an interesting chart that shows bond yields and equity returns are more highly correlated when rates are low. There’s no doubt low rates have driven investors to assume greater risk. Inconveniently, most of this relationship is since the Great Financial Crisis (GFC), so it’s unclear if the correlation has risen because rates are low, or because something changed structurally following the GFC. If ten year yields move above 3.6%, JPMorgan’s chart suggests the correlation will turn negative, meaning rising rates would be good for stocks. It’s hard to imagine, but inflation is changing many things.

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Larry Summers and Bill Dudley are competing via erudite blog posts for the title of most articulate Fed critic. Dudley recently said that The Fed has made a U.S. recession inevitable thanks to its slothful removal of monetary support. Jamie Dimon said in his annual letter that “the medicine (fiscal spending and QE) was probably too much and lasted too long.”

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Summers warned investors, The stock market liked the Fed’s plan to raise interest rates. It’s wrong. He took issue with the recently released FOMC forecast, which presents an impossibly optimistic outlook. He notes that the Fed is expecting inflation to moderate while pushing Fed Funds barely above their neutral target, all while maintaining close to full employment. Should Jay Powell and his FOMC colleagues pull this off, they will have threaded the proverbial needle and challenged economic orthodoxy. It’s more correctly an objective, or an upside case, rather than a forecast. No business could submit a budget with such hopeful outcomes.

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This makes the future path of interest rates quite wide. If inflation doesn’t moderate, will the Fed push rates high enough to cause higher unemployment? How willing will they be to risk a recession?  In August 2020 chair Powell revealed a subtle but significant change in how they regard their dual mandate of maximum employment consistent with stable prices.

Decades of declining real rates and an unemployment rate that continued to fall without causing wage pressures persuaded the Fed to allow inflation more upside than in the past. Since that symposium two years ago in Jackson their policy, “emphasizes that maximum employment is a broad-based and inclusive goal.” Data shows that minorities suffer employment more quickly than the general population, so the Fed is presumably now more sensitive to minority rates of unemployment. This isn’t necessarily a bad policy, but it is a modification and comes with increased tolerance for inflation.

The Fed now assesses “shortfalls” not “deviations” from maximum employment, since “employment can run at or above real-time estimates of its maximum level without causing concern.” And most notably, “following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”

Both Dudley and Summers impose a traditional Fed policy function on today’s situation. That would regard our current inflation spike as a manifest policy error demanding a prompt response. By contrast, Powell has admitted that inflation is too high but has yet to concede a policy error. Their revised consensus statement allows for some inflation risk in pursuit of getting everyone a job, so 7.9% inflation is less of a mistake than if, say, Paul Volcker was in charge.

If the FOMC projections turn out to be correct, stocks will do very well. The risk for equities is that inflation doesn’t moderate as expected – will an FOMC stung by their error tighten too much in response? Or will they place greater importance on near term maximum employment, always waiting for another month of hopefully better data? It’s unclear, but if Larry Summers is right that the FOMC forecasts are short on “intellectual rigor and honest realism” the Fed’s fealty to their reinterpreted mandate will be tested.

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Perhaps because we cover interest rates and energy markets, connections often leap out. It’s politically correct (even “woke”) to assume wildly unrealistic assumptions about renewables, because it suggests endorsement of the policies required. So JPMorgan includes a chart showing global primary energy from renewables reaching a 60% share by 2050 from under 5% today. Fossil fuel use collapses so that oil, gas and coal in aggregate are less than 20% of primary energy use in 2050 versus 78% today.

Because JPMorgan is not quite as idealistic as the chart suggests, an extensive footnote warns that it’s based on the Net Zero outlook from this year’s BP Energy Outlook. The Net Zero scenario, which isn’t BP’s central case, roughly aligns with the UN’s goals. In other words, it’s what many climate scientists believe should be happening, not necessarily what they expect.  JPMorgan adds that forecasts are “not a reliable indicator of future performance.” In other words, it’s not their forecast.

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Ten years ago JPMorgan published a series of charts based on work by highly regarded polymath Vaclav Smil on the slow pace of energy transitions. It took coal 60 years after reaching 5% to provide half the world’s energy. Oil and natural gas still haven’t reached that level and probably never will. The forecast that renewables will provide half the world’s energy within two decades is aspirational, and even less likely to be accurate than the Fed’s. Any serious effort to reduce emissions will use more natural gas instead of coal, increase nuclear power substantially and incorporate carbon capture. Improbable forecasts that are presented as Base Case are never good. Larry Summers would agree.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

The Administration’s planned release of 1 million barrels of oil a day from the Strategic Petroleum Reserve (SPR) is borne of their frustration with high prices. Average crude prices have been higher under Biden than Trump, even after adjusting for the collapse during Covid (not Trump’s fault) and the jump following Russia’s invasion (not Biden’s fault).

For energy investors like us, Biden has been a huge improvement. Trump knew he wanted lots of production to keep prices low and promote American Energy Independence. Executives were emboldened by a government they perceived as supportive. The results were good for consumers but ruinous for investors.

Although the correlation between the price of crude and pipeline stocks isn’t as strong as many think, rising prices that reflect strong underlying demand have boosted returns. For the quarter just ended, the pipeline sector returned +24.6% versus –4.5% for the S&P500.

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New Jersey still mandates attendants at gas stations to fill your car. It’s a trivial yet tiresome rule – people should have a choice to pump their own gas, since it’s quicker. But recently, watching the attendant as the register ticked up past $80, I nearly jumped out and gave him a high five. Clients of SL Advisors are benefiting from White House energy policies.

We hold a minority view. Presidents have less control over oil prices than voters think, although Biden could claim some credit for the energy sector’s resurgence if he wanted to.

The White House thinks US energy companies are being abstruse in failing to respond to higher prices by increasing production. They must have advisers that understand why the sector is apparently denying itself even greater profitability, but their public comments and policies don’t reflect this.

Crude oil is in backwardation, meaning that the futures strip is downward sloping. Spot oil prices get the attention because they drive what voters pay at the pump. Production decisions are based on what produced oil and gas can be sold for over the next few years. As with almost any business, capital has to be invested up front with the expectation of a future return. If the curve was upwards sloping (contango), that would allow drillers to sell forward production at prices higher than today’s, creating the additional supply the Administration wants. It’s been in backwardation for the past year, and Russia’s invasion exacerbated this – meaning the effect on prices was more pronounced on the front month futures that impact gasoline prices than it was on the rest of the strip which drives investment decisions.

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Moreover, oil companies can’t suddenly turn on a spigot. The list of reasons why current output hasn’t responded to prices as much as it might have five years ago includes (1) financial discipline, (2) White House long term anti-fossil fuel policies, (3) ESG opposition, (4) an increasingly capricious regulatory and judicial process for proposed and completed infrastructure projects, and (5) service provider inflation.

If you assume an oil well could be brought online in a year and produce equal volumes over the next four years, forward production could be hedged at $80, versus the June futures price of $101. Although futures prices are poor predictors, an E&P company that produces without hedging is just speculating on future oil prices. Investors can do that themselves with crude futures, so there’s little value added for the E&P company to do so themselves.

The SPR release of 1 Million Barrels per Day (MMB/D) over six months is an understandable political reaction, but isn’t likely to alter prices much, because it’s temporary. At about 1% of global demand, it will reduce our SPR to 345 million barrels, 48% of capacity and the lowest since 1983. Reducing crude in storage will increase our vulnerability to supply shocks from a hurricane for example. And depending on the compatibility between the grades of crude released and domestic refining infrastructure, these extra barrels may wind up being exported.

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Goldman Sachs thinks use of the SPR in this way exposes the market to greater turmoil in the event of a further supply disruption from Russia.

For energy investors, it’s probably net positive. The economics of investing in new production are modestly worse than before the announced SPR release. But it doesn’t represent new supply, and the brief drop in prices delays the demand destruction that many analysts believe is the only way to balance the market. CEOs understand that the White House’s desire to increase supply is ephemeral and related to the mid-terms. The Administration will regain its former hostility to traditional energy just as soon as they can get gasoline prices off the news headlines.

Concrete steps to streamline the regulatory process and eliminate much of the uncertainty around infrastructure projects could induce some companies to invest more in future production. This is the area to watch for signs that pragmatism is informing the government’s energy policies.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Europe’s realization that it needs a strategy to ensure energy security has provided a further boost to US natural gas stocks. Last week was especially good – NextDecade (NEXT) added another customer for their proposed Rio Grande Liquefied Natural Gas (LNG) export facility.

By coincidence we had just interviewed Matthew Mott, SVP of their Next Carbon Solutions division. President Biden also committed to increase US LNG shipments to Europe by 15 Billion Cubic Meters (BCM), equivalent to 1.45 Billion Cubic Feet per Day (BCF/D). US natural gas was already cheap, abundant and the biggest source of global CO2 emissions declines to date (see NextDecade Sees A Bright Future). Following Russia’s war on Ukraine, it is now part of Europe’s energy security too.

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Biden’s commitment grabbed headlines but his advisers will know that on current trend 2022 US LNG exports to Europe will already exceed last year’s by more than 15 BCM. LNG facilities take years to build, which provides visibility into how fast our export capacity will grow. Germany has no regasification facilities at which to receive LNG, and the most optimistic forecasts are for one to be in service by the end of next year. The market for Floating Storage and Regasification Units (FSRUs) is suddenly hot because only a handful are available and they offer Germany a faster route to importing LNG. But not all will operate in the frigid waters off Germany’s north coast. Energy security went from irrelevant to critical in Europe. Getting there won’t be elegant.

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Nonetheless, the German government hopes to be no longer reliant on Russian gas imports by the summer of 2024. So far it’s been in both Germany and Russia’s interests to maintain the flow of oil and gas. Germany has no near-term alternative, and Russia is enjoying the higher prices that their invasion has precipitated.

Russia is on notice that it will need to find alternative markets for the gas Germany will no longer want. That will require Russia to build new pipeline infrastructure, likely to their east coast for export as LNG. Western sanctions may impede the timely construction. Since the break in trade between the two countries is so well anticipated, Russia’s history suggests the timing will ultimately be at their choosing and not necessarily when Germany is ready to cut imports entirely.

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It’s not a leap to suggest that energy security for any country requires minimizing pipeline imports, since they create dependence on a single supplier that seaborne imports avoid. LNG trade is going to keep growing. And while increased investment in renewables is a natural move to improve security, their input prices are rising too.

US LNG trade is all run by commercial entities. Although Biden’s commitment drew attention, the Federal government isn’t about to get into the natural gas business. More meaningful would be an improved regulatory process that isn’t beholden to the liberal progressive wing of the Democrat party. Hewing to their anti-fossil fuel rhetoric has jeopardized Democrat control of the House in November – gasoline prices were already rising before Russia’s invasion. There are signs the Administration is tilting (pivoting would be too strong) towards a more balanced view of the energy transition.

For example, FERC recently shelved an earlier proposal to include the emissions ultimately generated by the oil/gas passing through any proposed pipeline they were considering for approval. This could even have applied to projects already under construction. Conveniently, last week this led to certificates being approved for two natural gas pipelines (the Evangeline Pass Expansion and Columbia Gulf Transmission’s East Lateral Xpress) that link up to Venture Global’s Plaquemines LNG export facility, among others (see Baby, I Got It – Could The U.S. Alone Meet Biden’s Call For 15 Bcm More LNG To The EU?).

The stalled Mountain Valley Pipeline (MVP) project run by Equitrans is another example where the Administration could signal a more enlightened policy. While courts can rescind previously issued permits from Federal agencies that were the basis for $BNs of invested capital, energy companies will correctly assess a hostile environment for new projects. Fixing this might require legislation, but like the Keystone XL pipeline that Biden canceled immediately upon taking office, capricious policy has its costs.

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The path to increased LNG exports is visible but long. Because it typically takes up to five years from Final Investment Decision (FID) to start-up, it’s possible to project out export capacity well into the future. Of 18.9 BCF/D in projects deemed “High/Medium probability” by Cowen and Company, 11.9 BCF/D are in North America. Russia’s Novatek project may struggle to complete because of western sanctions.

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Of the 20 BCF/D in US projects awaiting FID, only 6 BCF/D are on the High/Medium Probability list, whereas we think most if not all of these will eventually be done.

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Europe’s energy security and US LNG profitability are now more closely linked. What remains to be seen is whether Administration policy will pragmatically move from a tilt to a pivot away from its extremist liberal wing. So far US LNG has done more to reduce global emissions than anything else.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.