In mid-January in Why You Shouldn’t Expect A Return To 2% Inflation we explained some of the persistent upward pressures on inflation. Since then ten year inflation expectations derived from the treasury bond market have increased by 0.5%. Russia’s invasion of Ukraine is a big factor, but nonetheless a half point increase over the next decade is a substantial move. Preserving purchasing power is the point of saving, and inflation entrenched at a higher level investors presents new challenges to investors.

Five year inflation expectations have moved up to 3.5%

Interest rates have moved sharply higher, with the market pricing in at least one 0.50% hike over the next few months and a neutral rate around 2.5%, up from 2% a month ago. Inflation permanently above the Fed’s 2% objective is being priced in.

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The list of reasons to expect inflation closer to 4% than 2% over the next several years includes:

1. Excess fiscal stimulus from Covid. The $1.9TN American Rescue Plan that the Democrats passed shortly after Biden’s inauguration last year is now widely accepted to be the root cause of sharply rising prices. The Federal government boosted consumption even while the Covid vaccine was allowing the economy to re-open.

2. Profligate fiscal policy in #1 was exacerbated by the Federal Reserve’s August 2020 reinterpretation of its mandate to tolerate inflation risk in pursuit of maximum employment. This led them to maintain highly accommodative monetary policy and expansion of their balance sheet for an additional year compared with what more orthodox policy would have required. Note also that this inflation risk tolerance persists. So while everyone can agree today’s 7.9% inflation is too high, once it falls expect the rising unemployment rate to cause much angst at the FOMC.

3. Oil and gas prices were already rising before Russia’s invasion gave them a further boost. Joe Biden ran on a platform of eventually putting traditional energy companies out of business. ESG proponents like Blackrock’s Larry Fink have helped demonize producers of reliable energy. Climate extremists have used the court system to block pipeline projects largely completed. An example is the Mountain Valley Pipeline project owned by EQM Midstream Partners, LP, NextEra Capital Holdings, Inc., Con Edison Transmission, Inc., WGL Midstream; and RGC Midstream, LLC. Biden canceled the Keystone XL pipeline shortly after becoming president, resulting in TC Energy filing a $15BN lawsuit against the US. The Administration is getting the results its energy policies deserve, and the industry’s capex discipline is a result of prior poor returns as well as the long term hostility of Democrats to reliable energy. See I Can’t Go For That (No Can Do) – Why U.S. E&Ps Have Been Slow To Ramp Up Crude Oil Production for further detail.

4. Russia’s invasion of Ukraine and the consequent sanctions have disrupted many commodity markets. Corn, wheat, fertilizer and steel are all sharply higher. No matter how the war plays out, Russia’s standing as a reliable supplier has been set back decades. Soviet troops violently suppressed protests in Budapest (1956) and Prague (1968), events that colored the west’s perspective of the Soviet Union until its fall in the early 1990s. Today’s war on Ukraine is much bigger and bloodier. Germany has led western Europe in belatedly correcting a posture of supplicant that relied on Russia for oil and gas and America for security. Many countries will regard Russia’s exports of commodities as permanently at risk to unpredictable military moves by the Kremlin, with prices higher as a result.

5. Globalization has been an important source of disinflation for over three decades, allowing OECD economies to benefit from cheap Asian labor. Covid had already exposed supply chains to lockdowns overseas. Sanctions imposed on Russia will cause a further reassessment of suppliers and investments in other countries at risk of invading their neighbors. China and Taiwan is an obvious case. To put it in terms a CFO might consider, even 95% confidence that China won’t invade Taiwan in the next year translates into a 40% probability they will over a decade, resulting in a possible write off of any Chinese assets. This type of risk reassessment runs counter to globalization. Blackrock’s Larry Fink and Oaktree’s Howard Marks have both warned of a fundamental reordering of supply chains. “Cheapest” may lose to “most secure”, which will be closer to home or even domestic. This is inflationary.

6. The energy transition is fundamentally inflationary, since it means paying more for the same amount of energy. This receives scant attention in the media which breathlessly reports on falling prices for solar panels and windmills. Obviously renewables cost more – otherwise they would dominate. Germany and California, both farther ahead in renewables use than most, have high electricity prices. Accepting more expensive energy is a legitimate public policy to lower emissions. In spite of the shrill climate extremists, coal-to-natgas switching, carbon capture and increased nuclear power are gaining support as more pragmatic solutions than weather-dependent ones. But reducing emissions is raising prices.

7. Federal debt is on track to exceed the levels of World War II as a percentage of GDP. Treasury secretary Yellen has said that current levels of debt are sustainable but not the trajectory. Negative real yields on US treasuries are a persistent gift from return-insensitive buyers such as central banks, sovereign wealth funds and pension funds. They are facilitating our fiscal profligacy. But the US economy’s ability to tolerate rising rates has been decreasing with each cycle. Monetary policy is constrained because it effects the cost of financing our debt.

When wages rise faster than productivity, that provides an easy justification for the Fed to tighten policy. But the other factors listed above are less clearly in need of a hawkish response. Sanctions on Russia, de-globalization and policy choices to pay more for lower-emission power are all inflationary but do they really justify the Fed to counter them by slowing economic growth? This is the debate that will be occupying the FOMC during the current rate cycle.

If the Fed does overshoot, expect more $TNs of inflationary fiscal stimulus and Fed debt monetization via balance sheet expansion, because that’s how we combat recessions nowadays. We dislike recessions more than inflation, so the latter is more likely. Getting inflation back to 4% will calm their critics, such as Larry Summers who’s been as right as the FOMC has been wrong. But the Fed’s reinterpreted dual mandate along with fundamental shifts in world energy markets and trade flows make it likely we’ll adapt to permanently higher inflation than in the past 30 years.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Most US energy investors are familiar with Cheniere, America’s leading exporter of Liquified Natural Gas (LNG). Founded in 1996, the company was originally dedicated to increasing domestic supply, first as an oil & gas exploration business and then as an LNG importing company, which looked unlikely to keep up with growing demand. The Shale Revolution turned America into an exporter of cheap natural gas. Cheniere pivoted from importing to exporting, and currently ships just under half the LNG that leaves US facilities.

Natural gas is much trickier to move than oil or coal. Unless it’s traveling through a pipeline it has to be cooled and compressed. LNG export facilities cool methane and reduce it to 1/600^th of its volume, while regasification plants at the receiving end warm it up for use by customers.

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Not surprisingly, LNG facilities take years to construct. This makes it possible to project US export capacity out several years, based on existing projects either under construction or approaching Final Investment Decision (FID).

NextDecade was founded in 2010 by Kathleen Eisbrenner who took the company public in 2017 before retiring a year later. Their journey to building an LNG export facility has been long. In 2020 French utility Engie ended negotiations to become an anchor buyer due to concerns about flaring and methane leaks associated with US natural gas production.

This prompted NEXT to reposition themselves as a supplier of responsibly sourced gas that is chilled and compressed via a zero-emissions process. They even created a new division, Next Carbon Solutions, to lead this effort and explore selling their carbon capture expertise to other companies.

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Data from the International Energy Agency (IEA) suggests that US exports of LNG have done more to reduce global CO2 emissions than any other project, including Germany’s drive into renewables (“Energiewende”). Last year the US Energy Information Administration (EIA) noted switching from coal to natural gas was the biggest driver of reduced CO2 emissions, a fact ignored by climate extremists.

Global coal consumption continues to increase, largely in emerging economies. Switching to natural gas for power generation remains the world’s most realistic hope for emissions reductions.

The outlook for US natural gas, already positive, received a further boost when Russia invaded Ukraine (see Russia Boosts US Energy Sector). Within days Germany had acknowledged its strategic error in relying so heavily on Russia for natural gas. Two new LNG import facilities are now planned on Germany’s north coast, and construction is expected to be fast-tracked. They are negotiating a long-term purchase agreement with Qatar.

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Markets were quick to anticipate what Europe’s abrupt shift in energy policy means for US natural gas. Since February 1, Cheniere is 20% ahead of the S&P500 and 10% ahead of the American Energy Independence Index (AEITR). NextDecade and Tellurian, another company planning to export LNG, have both rallied over 60%. The odds of these two obtaining the necessary financing have improved sharply.

We had an opportunity to talk with Michael Mott, Senior VP, Next Carbon Solutions. Michael described a process that will capture up to 90% of the CO2 involved in LNG – both the pre-combustion when CO2 and other impurities are separated from the methane, and the CO2 emissions generated from energy use in chilling the methane for loading and transportation as LNG. He believes this will be the world’s first LNG facility that uses Carbon Capture and Sequestration (CCS), resulting in the “greenest LNG in the world.” NCS is planning to market its technology for capturing CO2 from the combustion of natural gas to others.

NextDecade’s Rio Grande site where they plan to build trains 1 and 2 of their LNG facility has all the necessary permits in place and is “shovel-ready”. They expect to secure financing to allow FID in 2H22. The war in Ukraine has added urgency to potential LNG buyers to secure supplies. Mott described the current market as the “strongest I’ve ever seen” and noted that analysts were still only belatedly catching up with how tight supply conditions will be in the years ahead.

NextDecade is taking a traditional approach to pricing, in that contracts are typically linked to the Henry Hub or a Brent crude-related benchmark and where NextDecade earns a set margin. This is similar to Cheniere’s approach, and by reducing NextDecade’s direct commodity price risk it makes securing financing easier.

FERC recently included resulting emissions as an additional factor they consider in approving pipeline projects. This is controversial to many in the industry – Kinder Morgan and Enbridge have both publicly criticized FERC’s changed posture. Mott believes this is an increasing trend, and that NextDecade is positioning itself to offer solutions.

The failed Build Back Better legislation included increased 45Q tax credits for CCS, and many expect this element to ultimately be passed. Mott said the industry believes a carbon price of at least $100 is necessary to incentivize investment and thinks that will eventually become a reality with direct payments being preferred over tax credits. CCS could eventually become a big source of growth for the pipeline sector.

NextDecade is a company worth watching. For the full version of our conversation with Michael Mott, check out our next podcast.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

It must have been a lively FOMC meeting last week. The Fed has obviously committed their biggest mistake in living memory, and they finally started to normalize short term rates. They’re a year late, to the evident frustration of James Bullard who dissented on the 0.25% increase because he preferred 0.50%.

The FOMC revised up their forecasts of short term rates (the “dot plot”) by 1% over the next couple of years. They’re also now projecting they’ll need to raise rates above neutral before reducing them. In this respect they are belatedly confirming the forecast of the eurodollar futures market, although yields overall rose in response to the hawkish tone of the meeting.

Interest rates are interesting once more, after endless years of tedium. In 2008 the CME introduced half-tick increments to create the illusion of greater movement, and even quarter tick on near contracts. But for this blogger who traded interest rates in the 80s and 90s, the last 20+ years have been mostly glacial. Now once more there’s plenty to consider.

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Although today’s high inflation is partly due to the Fed misinterpreting deep-seated as transitory, it’s also a consequence of their increased tolerance for elevated inflation in order to maximize employment. Any setback in employment will create a dilemma. Fed chair Jay Powell has argued that stable inflation is necessary to promote maximum employment over the long run. This central bank orthodoxy may sit less comfortably with some FOMC members given their bias towards making sure everyone has a job. Powell is presumably roughly in the middle of his FOMC’s range of views. The Administration is unlikely to add any hawks, especially with a presidential election in 2024.

When the first sign of economic weakness appears, the FOMC will need to assess whether it’s evidence that tighter policy is already doing its job. In recent tightening cycles the economy has succumbed at successively lower peaks. Somewhere on the way from 1% to 2% some self-doubt may intrude.

The matter is further complicated by Russia’s invasion of Ukraine. It is disingenuous for Biden to refer to “Putin’s gas hikes” since the global supply of oil and gas were already impeded by greatly reduced capex. The independent voter likely understands that promises to phase out fossil fuels, along with canceling the Keystone XL pipeline, were hardly intended to encourage more output.

Rising prices for wheat, corn and numerous other commodities exported by Russia and Ukraine can be more properly traced to Putin, but those haven’t yet captured consumers’ attention. It’s a boon for US farmers, although don’t expect to hear any suggestion of a windfall profits tax on agriculture.

The Fed’s next challenge will be to interpret which elements of inflation they should care about. Traditionally they’ve worried most about wage inflation. Higher commodity prices represent a wealth transfer and, to the extent that wealth flows outside of the US, a drag on GDP. Pre-Ukraine, higher oil was caused by Covid recovery, the $1.9TN American Recovery Act of early 2021 and energy sector financial discipline. The first two warranted a monetary response. The more recent and broad based jump in commodity prices is down to Russia and the west’s reaction. This is contractionary, in some respects achieving the same goal as higher short term rates.

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The path of sequential tightening described by Powell and reflected in the yield curve is vulnerable to being shaken by signs of weakness. Some FOMC members, smarting from the previous error, will be inclined to press on. Strong advocates of favoring maximum employment over inflation will want to pause. The yield curve will shift.

The range of FOMC rate forecasts widened at last week’s meeting compared with December. This is especially evident over the next couple of years. The range of forecasts for the end of this year has widened to 2% from 1%, and for 2023 to 1.5% from 1%. Just as forecasting next month’s return on stocks is harder than next decade’s, so it is with interest rates. The most dovish 2023 forecast is 2.25%, equal to where the three hawks were in December.

This suggests a wide range of views, and therefore uncertainty on what the correct rate path should be.

For investors, it makes interest rate volatility more likely as FOMC members navigate an especially difficult environment. It means the inversion in the yield curve 2023-24 could vanish if economic weakness leads to even a slightly slower pace of tightening. And it means inflation is unlikely to return to 2% for years.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Investors have endured several body blows this year. Inflation was already rising due to the strong rebound from Covid exacerbated by last year’s $1.9TN Covid relief spending. The long heralded and late removal of excessive monetary accommodation is about to start.

More recently, Russia’s invasion of Ukraine has abruptly upended decades of western engagement, ushering in sanctions, European rearmament and urgent diversification of energy supplies. As if this isn’t enough, China placed the 17.5 million residents of Shenzhen into lockdown after new virus cases doubled nationwide to almost 3,400. The rest of the world has resigned itself to living with Covid – China’s lone insistence on complete suppression seems futile but not yet abandoned.

There’s no shortage of articles, some quite thoughtful, on Russia’s invasion and its consequences. The Weakness of the Despot is an interview with historian Stephen Kotkin who has written two volumes on Stalin (he’s working on a third). Kotkin argues that Russia’s history repeatedly shows “its capabilities have never matched its aspirations” as a great power. In Possible Outcomes of the Russo-Ukrainian War and China’s Choice a Chinese academic argues that once it becomes clear Russia has blundered, Chinese interests will draw them back towards economically successful western nations, cooling relations with Russia.

Tempting as it is to become an expert on wars and geopolitics, the more useful insight we can offer is that Russia’s estrangement from most of the world is going to last years if not decades. We can be more confident on this forecast than the conflict itself or China’s next moves, because the fact and manner of Russia’s invasion can’t be undone.

For example, Christopher Smart, chief global strategist and head of the Barings Investment Institute, said “Until you have a new leader in Russia, one who apologizes for invading Ukraine and who writes a check for reparations, these sanctions are going to remain in place. And I don’t see any of the three things I just described happening.”

Some predict that Russia’s economy will be set back thirty years. The global oil giants were only the first in a long line of western companies to announce the exit or abandonment of their Russian operations. So far more than 300 of the world’s best known brands have announced plans to leave. The port of Hamburg reports that container traffic with Russia is “approaching zero,” compared with “hundreds of thousands annually” before the invasion.

CNBC noted that, “none of the experts who spoke to CNBC for this story believe that any of the current sanctions against Russia or Belarus are going to be eased or lifted for at least the next three years.”

As upwards of 300 companies deal with messy exits and the inevitable write downs, corporate memories will be scarred.

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The change in trade flows as much of the world turns away from imports of Russian oil, gas and wheat represents as significant a change as we can recall to the world economy. The recent drop in crude oil was caused by the Chinese reminder that Covid remains with us, even if they’re alone in still trying to wipe it out. The rest of the world has moved on. “Remask between bites and sips,” the offensive demand on US commercial airlines to constantly adjust facegear while eating and drinking, is redundant and virtually the only restriction left while the CDC takes yet another month to review its policy for public transport. Bites and sips. Ugh.

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After the kind of run the energy sector has had, it’s reasonable to ask if it’s still cheap. On an Enterprise Value/EBITDA (EV/EBITDA) basis midstream is still well below its long term average. If the current 10X EV/EBITDA re-rated to 12X, assuming 50/50 debt/equity that would mean a 40% price increase from here. For several years the fear that the energy transition would lead to the early retirement of pipelines weighed on the sector, lowering terminal values. As it becomes increasingly clear that this transition, like those before it (wood to coal, coal to oil/gas) will take decades, equity investors should adopt the more realistic assessment that bond investors in the sector have always retained (see Pipeline Bond Investors Are More Bullish Than Equity Buyers).

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The US Energy Information Administration (EIA) forecasts continued growth in production of natural gas, crude oil and renewable power through 2050. Few have noticed that since 2017 the EIA has revised up its forecast long term output of natural gas nearly as much as renewable power. Crude oil has been revised up even further. The renewables increase matches the reduction in coal output. The numbers tell a different story than much of the liberal media.

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Wells Fargo estimates that adding ten years to the expected economic life of midstream infrastructure provides a 1.0X uplift in EV/EBITDA, which we estimate is worth 20% on equity prices.

Moreover, the energy sector’s weighting in the S&P500 has almost doubled from its low of 2.1% reached in 2020. As it recovers, the cost of an underweight becomes more significant, something abundantly clear to investors so far this year. There are anecdotal reports of generalist investors adding to energy exposure.

The sector still has a long recovery ahead of it.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Next week the Fed Funds rate is expected to be raised, for the first time in over three years. Pundits love to say the Federal Reserve is “in a corner”, implying a Hobson’s Choice between possible courses of action. This hackneyed term is being deployed again, mischaracterizing their choices.

It’s true inflation expectations have edged up – five years implied CPI is 3.4%, and ten years 2.9%. But these figures aren’t that bad – if inflation runs at 7% this year, falls to 4% next year and then returns to the Fed’s 2% long term target, that would be consistent with the 3.4% average implied by the treasury market. Moreover, the Personal Consumption Expenditures (PCE) deflator which is the Fed’s chosen metric typically runs 0.25% or so below CPI. Although inflation is 7.9%, the FOMC can interpret long-run expectations as well contained.

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Higher crude oil is both a constraint on consumer spending and a boost to inflation. These factors prescribe opposite pressures on monetary policy – higher oil works like a tax hike without the corresponding improvement in our fiscal balance. Leaning hard against current inflation makes less sense when energy prices are already tempering disposable incomes.

The justification for monetary accommodation receded long ago, and the FOMC will want to get back to neutral probably at the pace implied by eurodollar futures – reaching 2% in a year or so.

The interesting question is in which direction is this forecast vulnerable? Goldman Sachs puts the odds of a recession by next year at 20-35%, which they calculate is the odds implied by the yield curve. The market’s priced for the Fed to modestly over-tighten by the end of next year, causing them to reverse course.

The bond market is being tugged between these two opposing forces – increased odds of recession and rising inflation.

Although crude oil fell last week, the supply shock to a broad range of commodities caused by Russia’s invasion looks set to persist. It’s hard to envisage a scenario in Ukraine that will restore Russia’s trading links with much of the world. Regardless of the military outcome, diversity of supply is now a pillar of European energy security and probably food security too.

As commodity prices continue to reflect tight markets, recession odds and inflation will both increase.

For an FOMC attuned to “transitory” explanations for elevated inflation, there is a long list of candidates, even if chair Jay Powell has officially retired the adjective. Supply constraints as consumption of goods rebounded faster than services was the original one. Putin’s gas price hike is another that White House press secretary Jenn Psaki has coined. Tighter monetary policy isn’t much help there.

The energy transition is inflationary – properly executed it means energy will cost more without doing more. Administration policy has been to discourage new supply of traditional energy, which was already pushing prices higher before Putin provided another shove. If Russia’s isolation from global trade continues for many months, which seems likely, this will dominate the narrative around energy inflation.

Then there’s Owners’ Equivalent Rent (OER), the deeply flawed estimate of the cost of shelter based on survey responses measuring what homeowners think they could rent their house for (see Why You Shouldn’t Expect A Return To 2% Inflation). This metric lagged the strong housing market that followed Covid, providing the BLS economists who publish it and the FOMC to ignore what American home buyers experienced.

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OER does tend to track the Case Shiller index over the long run, and has recently been trending higher (+4.3% year-on-year). Surveyed homeowners are belatedly reflecting the strong housing market by demanding more theoretical rent from their hypothetical tenants. Having ignored the housing market, as OER pushed up measured inflation the FOMC could dismiss it as a non-cash expense. It would be bizarre for monetary policy to be influenced by OER – it never has been. Housing bubbles have never induced higher short term rates, and there’s no reason to expect OER to either.

OER is another item on the list of inflation that can be tolerated. Having dropped “transitory” look out for “ephemeral” or “impermanent” as replacement adjectives.

The yield curve can be interpreted as the market’s way of grading the Fed. Too steep suggests they’re allowing too much inflation. Inversion suggests policy is too tight. They want to get back to neutral, which is 2.5% although 2% would be close enough. Given this FOMC’s full employment bias and inflation risk tolerance, we’re only ever one weak payroll report away from the market repricing to a slower pace of policy normalization.

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Eurodollar futures suggest a cycle peak late next year. The impact of Russia’s invasion has been to shift the neutral rate higher and increase the odds of an overshoot. If the FOMC ever finds themselves contemplating a rate hike when the market is priced for it to be their last, many members will be find reasons to demur. This is why ten year inflation expectations should continue moving up. Portfolios should be structured accordingly.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Last week the US Energy Information Administration (EIA) published their 2022 Annual Energy Outlook. Solar and wind output are expected to grow at 4% pa, reaching 12% of our total energy production by 2050, triple their share today. This is an impressive growth rate, although less than the media coverage of renewables would suggest. It’s higher than in the EIA’s 2017 annual outlook, which looked for solar and wind to have a 9% market share by 2050.

In other revisions, the EIA has also boosted its forecast of natural gas production, which is now expected to grow by 8 Quadrillion BTUs (QBTUs). This puts 2050 production at the equivalent of 121 Billion Cubic Feet per day (BCF/D) versus a forecast of 89 BCF/D for 2022.

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Many will be surprised to learn that the energy equivalent increase in natural gas production through 2050 is close to the increase from solar and wind (9 QBTUs). This reflects cheap natural gas, the slow pace of energy transitions and continued growth in domestic energy consumption, which is expected to increase by 7 QBTUs, from 99 to 106. In effect solar and wind will do a little more than cover increased demand.

Another surprise will be the revisions to crude oil production. Over the past five years, the EIA has boosted its 2050 forecast of US oil production by the equivalent of almost 3 million barrels per day. This is more than revisions to solar/wind, or natural gas. Coal is the one area where they’ve lowered expected production.

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There are other surprising trends. The non-fossil fuel share of electricity production is expected to increase relatively slowly through 2050, from 42% to 58%. This adds back hydropower and nuclear, both sectors unlikely to grow much. The best locations for hydropower were identified and used long ago, while nuclear plants face debilitating opposition. There are signs climate extremists in Europe are becoming more amenable to nuclear, a welcome sign of pragmatism versus the purist view that requires running everything with solar and windmills.

The natural gas share of power generation is not expected to change much – from 30% to 29%. Coal will absorb most of the losses, representing the most realistic path to reducing emissions. By contrast, Germany recently brought forward the deadline by which they plan to reach 100% renewable power, from 2040 to 2035. The US is on track to reach 56% by then after which little change is forecast.

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Russia’s invasion of Ukraine has suddenly made Europeans more aware of energy security. Renewable power is almost always domestic, so increasing this makes sense on top of buying more LNG from other countries including the US. But so far Germany’s headlong rush towards windpower hasn’t been something to emulate. We’re fortunate that the US isn’t moving at the same speed. It would only serve to accommodate China’s persistently increasing emissions. Russia isn’t helping much either.

The EIA’s outlook on emissions shows generally steady state for the next three decades – a slight dip through 2035 followed by a modest increase. High oil prices and slower growth might cause a bigger reduction  – a combination we are likely to experience based on recent events. But until voters accept higher-priced energy as necessary to reduce emissions, we’re unlikely to see much change.

Neither political party has offered appealing solutions – Progressives implausibly want the whole world to run on solar and windmills. Conservatives see little appetite among voters to pay more to reduce emissions. US states play a big role, which has led to more modest steps reflecting popular ambivalence on the issue.

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That contrasts with the Administration’s stated goal of cutting CO2 emissions in half by 2030, although they haven’t yet provided any details on how they plan to do that. The infrastructure bill that recently passed included $8BN in funding to establish four hydrogen hubs, which would enable greater use of the clean-burning fuel by the power and industrial sectors. Hydrogen is 2-3X the price of US natural gas, but the right economic incentives would boost its role. The EIA projects almost no hydrogen use even by 2050. Europe is farther ahead because natural gas prices before the Ukraine war made it competitive.

The EIA annual outlook reminds that US natural gas output has a bright future, likely to grow for decades. It’s why we invest in the sector – the economics are more attractive than renewables, helped by the widely-held erroneous belief that fossil fuels are going away. Over the past five years the EIA has revised fossil fuel production up by more than renewables. Europe’s sudden realization that they need to import more LNG isn’t factored into the EIA’s report, prepared as it was before Russia’s invasion.

Investors are starting to recalibrate their expectations, like the EIA.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Had Jay Powell and the FOMC prudently begun reducing the economy’s degree of monetary support a year ago when the Covid vaccine was already being administered, they’d have more flexibility to manage the economy’s current challenges. From a 2% neutral rate and with the balance sheet shrinking, they’d be able to pivot towards easing or further tightening depending on circumstances. Because of that policy error they’re now having to get back to neutral during high economic uncertainty.

Hence eurodollar futures are anticipating a follow-up error to last year’s which is excessive tightening by the end of next year which then has to reverse in 2024, an election year. Some FOMC members must regret having followed such a reactive strategy.

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The good news for the Fed in Friday’s payroll report was a small increase in the participation rate and flat earnings growth – although changes in the composition of the workforce make month-to-month comparisons difficult.

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Higher energy prices will constrain growth in the months ahead, while also boosting inflation. Food prices are also likely to rise. Russia is almost 20% of gobal wheat exports, and Ukraine 10%. Fertilizer prices will probably also rise.

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Inflation ex-food and energy won’t look as bad, although some of this will pass through via higher transportation costs. The Fed will want to control the inflation that’s caused by excess demand while looking beyond the transitory effects of supply constraints now exacerbated by Russia’s invasion.

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The futures market reflects some risk that the FOMC will fail to judge correctly. Ten year inflation expectations derived from the treasury market edged up 0.25% over the past month. Since higher energy and commodity prices will constrain growth while boosting prices, the Fed will likely have to tolerate higher inflation for longer than they would like. With the FOMC biased towards maximizing employment at the possible risk of higher inflation, signs of economic weakness ought to moderate their path to normalization of policy.

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Financial markets are pricing for slower growth with higher inflation, what became known in the 1970s as “stagflation”. Fortunately, persistently negative real yields are softening the blow by allowing nominal rates to stay lower than they would otherwise be. Next time you run into the trustee of a public pension fund, thank them for unthinkingly financing America’s growing indebtedness for no real return.

On crude oil, the Administration’s anti-fossil fuel posture is translating into higher prices. White House press secretary Jen Psaki responded to a reporter that oil companies should increase production. Meanwhile, members of the Federal Energy Regulatory Commission (FERC) were justifying their recent decision to consider climate change when approving new natural gas pipelines. Senator Joe Manchin (D-W.Va) accused FERC of, “setting in motion a process that will serve to further shut down the infrastructure we desperately need as a country and further politicize energy development in our country.”

Chevron’s CEO Mike Wirth has called for “long-term commitments to support investment in America’s domestic oil industry.” Administration policy has been to dissuade domestic oil and gas production, a strategy that has been a disaster for US consumers. Energy executives understandably see little point in major capital commitments given the Federal government’s stance. It represents a collision between proponents of an overly rapid energy transition and energy security.

Russia is already having trouble finding buyers for its oil, with Shell reporting a transaction on Friday at a $28.50 discount to the Brent benchmark. JPMorgan estimates that 70% of Russian crude exports are struggling to find buyers. Political support is growing for banning US imports of Russian oil, a move the White House probably regards as a trap since it would quickly be followed by calls to support increased US production.

The Administration is unlikely to shift their energy policy before the mid-terms, which means US consumers shouldn’t expect much relief from high prices.

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The outlook for US midstream energy infrastructure is unambiguously good. Large new pipeline projects are almost impossible to complete, so free cash flow continues to grow because spending on new projects remains a third of its 2018 level. And no matter how the conflict in Ukraine plays out Europe will be less reliant on Russia for its energy supplies.

Liquified Natural Gas (LNG) export facilities take years to build. Williams Companies anticipates strong export-led demand for natural gas through their pipeline network.

Amidst considerable uncertainty, prolonged inflation well above the Fed’s target and robust demand for US natural gas both seem likely.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Who can’t be moved by the pictures of women being trained to fire automatic weapons, and crates of Molotov cocktails being prepared in backyards. The Ukrainian people are drawing the world’s admiration and financial markets’ attention. There are numerous possible paths for the war to follow, and each one brings its own set of investment outcomes with risks. It’s hard to have high conviction on any assessment, because few of us have the background. But run through all the scenarios you can imagine, and every one of them includes Europe finding alternatives to Russian natural gas.

Sunday’s extraordinary meeting of Germany’s Bundestag was a watershed. For decades European nations have underspent on their defense needs – something Trump brought up regularly including in this meeting. Past presidents rarely did.

Now Europe will rearm, starting with Germany’s decision to spend an additional €100BN on defense. And they will build two import terminals for Liquified Natural Gas (LNG). Germany is especially exposed, since Russia provides over half their natural gas which itself constitutes over 30% of total energy consumption. Switzerland, Denmark and Italy all rely on Russia for over a third of their natural gas. Of the four, only Italy has LNG import capability. Landlocked Switzerland doesn’t have that option.

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For an in-depth look at Europe’s natural gas options to prepare for next winter, read Preparing for the first winter without Russian gas.

Even if Putin was implausibly replaced with a non-despot, the shift in European energy security will roll on, because planning takes years and the prior policy has been discredited. Amid all the uncertainties of a war in Europe, their need for alternative LNG and the US’s ability to help provide that is a reliable outcome. Tellurian and NextDecade, two nascent LNG companies with contracts but not yet secure financing, have both rallied strongly on improved expectations that their projects will be completed.

What’s less clear is whether US energy policy will change. Europe’s energy security is suddenly a big concern. Chevron CEO Mike Wirth called for US policy to support investment in our domestic energy industry. It’s too early to tell whether it will become US policy to provide that security through increased oil and gas production. Probably not with a Democrat administration, although Senator Joe Manchin has called for the US to end imports of Russian oil, which is a start.

The west is edging towards placing sanctions on Russian oil and gas exports. It’s a good time to avoid any overly-confident forecasts unless they’re like US midstream where any outcome confirms its increased importance.

Today’s investors in pipelines own a call option on US energy policy shifting in response to Europe’s suddenly changed need. The sector isn’t yet priced for it, so US midstream energy infrastructure can only benefit and has no discernible downside from a policy reassessment.

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What’s also changed is the inflation outlook, which must be higher in almost every scenario. Europe’s pivot on energy policy is bullish for prices. This will feed through to inflation. 2023 eurodollar futures yields have fallen by 0.40% two days, sharply reducing the expected path of short term interest rates. Higher energy prices will constrain growth while boosting inflation.

Given the Fed’s bias towards maximizing employment and greater tolerance for inflation risk, the market’s repricing makes sense. Elevated crude oil because of the energy transition or geopolitics seems the type of upward pressure to which the Fed would find little benefit in responding.

Here again, pipelines with their PPI-linked tariffs represent a good way for investors to construct portfolios with inflation protection. Ten year inflation as measured by TIPs and treasury notes has edged up 0.15% in the past week despite the drop in nominal yields.

The energy transition as pushed by climate extremists offers the antithesis of energy security, since it seeks reduced supply. Proponents of renewables like to argue that they create independence too – the utopian ideal of a countryside packed full of solar panels and windmills would seem to be free of imported fossil fuels from unreliable suppliers. But so far renewables remain insignificant, and the immediate problems are not going to be solved with solar and wind.

The physical security of renewables doesn’t receive much attention, but fragile solar panels are easily damaged by hard objects. If progressive policies had made it to Ukraine so that the country ran on solar, the Russians could have disabled their power supply with airdrops of ball bearings. The energy transition is colliding with energy security. As US consumers pay more to fill up at the pump, they’ll demand more oil not more windmills.

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The American Energy Independence Index (AEITR) has been outperforming the S&P500 ever since its March 2020 Covid low. The reassessment of energy policy triggered by Russia’s invasion has given AEITR a further boost, so it’s now recouped all its relative underperformance since pre-Covid. Last week’s events make an investment in the sector even more compelling.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Maslow’s Hierarchy of Needs is a stylized pyramid with food and shelter at the base and self-actualization at the top. Maslow wasn’t around to contemplate where ESG (Environmental, Social and Governance) aspirations sit on his pyramid, but he would likely have placed them near the summit. The people and institutions most sensitive to ESG have already satisfied the other needs on the pyramid.

This is how the EU has come to rely on Russia for 40% of its natural gas while ambitiously pursuing the energy transition and, in Germany’s case, phasing out nuclear power. They perceived the world as post-geopolitical, making climate change a high priority since they identified few other big problems. The green movement’s hostility to reliable energy has stifled investment in new supply without much impacting demand. The consequent high prices have helped fund Russia’s invasion of Ukraine, and the EU’s impotence is most visible in the exclusion of energy from the west’s list of sanctions.

Europe’s energy policy has been a catastrophe.

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The reason emerging countries continue to increase emissions is because their populations are lower on Maslow’s pyramid than rich world populations. If like John Kerry you’ve spent the last few decades flying on private jets, you’re afforded the luxury of preaching on climate change because you’ve ascended past all the other needs. The EU and Russia are at different levels on the pyramid, as the tanks rolling through Ukraine have shown. Russians don’t do virtue-signaling.

Geopolitical risk tends to be a right-tailed event for energy investors – a low probability positive outcome. Few sectors have that risk profile – left-tailed events (9-11 attack, 2008 Financial Crisis, Covid) cause all the trouble, and higher energy prices may yet be another financial shock. But it’s positive for the US energy sector.

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US shipments of Liquified Natural Gas (LNG) have been heading mostly for Europe in recent weeks as Russian pipeline deliveries were mysteriously lower than expected. Two months ago, this inconveniently coincided with less blustery weather that slashed output from windmills. Many of the buyers of US LNG are trading companies able to direct cargoes to the highest price. China is the world’s biggest buyer of LNG, with Asia representing 75% of global LNG trade. Europeans have had to compete on price to acquire needed supplies, at times driving European LNG prices to 10X the US. Cheniere, the leading LNG exporter in the US, raised 2022 EBITDA guidance by 20% and Distributable Cash Flow guidance by 35% when they reported 4Q earnings last week.

Williams Companies, which operates the Transco natural gas pipeline network, sees an additional 12 Billion Cubic Feet per Day (BCF/D) of LNG demand through 2030. That would almost double our existing exports – that they won’t grow even faster reflects the length of time LNG facilities take to build.

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The Russian invasion of Ukraine is a near term positive. Europe’s response may make it a permanent one, if EU countries reassess their energy security. The US, including our pipeline companies, are well positioned to benefit from this. For example, in late 2020 French power company Engie halted LNG negotiations with NextDecade because of concerns over emissions. Today they might react differently.

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Higher oil and gas prices will also feed through to inflation. Last year Wells Fargo estimated that around 60% of the pipeline sector’s EBITDA was linked to inflation escalators via tariffs that reprice based on PPI. Six months ago with PPI running at 5.5% they estimated a 3% boost to sector EBITDA for 2022. PPI is currently running at over 13%.

Persistently high inflation doesn’t necessarily mean the Fed will have to boost rates higher – this is a dovish FOMC and there are numerous avenues for them to identify temporary price surges soon to abate, as they did last year. But it does mean that inflation persistently above the Fed’s long term 2% target is even more assured (see Why You Shouldn’t Expect A Return To 2% Inflation). The market has begun looking ahead to another mistake, an overshoot of monetary tightening (see Policy Errors On Interest Rates And Energy). Investors should be concerned that reducing inflation below 3%+ is ultimately deemed too economically disruptive.

The PPI-linked tariffs on pipeline stocks have been a fixture for many years, and in the seductively unexciting days before the Shale Revolution were regarded as positive by income seeking investors. Over-leverage and MLP distribution cuts diverted attention from the PPI linkage, but it never went away and will attract increased attention later this year as earnings reports reflect price increases.

Midstream energy infrastructure is well situated to benefit from Europe’s mistakes on energy policy and elevated inflation. Maslow would not be surprised.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Last week JPMorgan forecast that the Fed will raise rates at their next nine meetings, resulting in a 2.25% hike in short term rates by March 2023. They warned that inflation is entering a “feedback loop”, whereby higher wages demanded by workers to compensate for eroding purchasing power feed back into higher prices.

Over the past month, the eurodollar futures yield curve has inverted from September ‘23 out. Although monetary policy remains highly accommodative, and the Fed is still buying bonds, forward-looking markets are anticipating another policy error. Having kept rates too low for too long, excessive tightening is looming as the next risk.

For the rate cycle peak to occur below the FOMC’s 2.5% assumed neutral rate suggests that the neutral rate is lower. The economy’s resilience to rising rates seems to have weakened with each recession. Since 1980, the two year treasury note yield has peaked at successively lower levels. CPI inflation has generally followed, with the current jump clearly breaking that pattern.

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Financial markets are priced for the assumption that the history of declining rate cycle peaks will persist through this one. In November 2018 two year treasury yields reached 2.98% before declining. They’re currently half that, at just under 1.5%.

The contrast with past cycles speaks for itself.

Whatever the outcome over the next couple of years, the Fed’s forecasting ability has already taken a knock. If the current yield curve turns out to be prescient, inflation will have moderated with the Fed barely tapping the brakes. Betting on higher rates still seems like an asymmetric bet.

Former NY Fed chair William Dudley noted an unusual side to the political challenges likely facing the Fed as they raise rates. Federal Reserve profits historically come mostly from seignorage, the income from printing and distributing currency. But as the Fed’s balance sheet has neared $9TN, they’ve earned increasing amounts on the spread between the yield on what they own and their cost of funding (close to 0%). Dudley explains more in an op-ed delightfully titled U.S. Treasury’s Golden Fed Goose Is About to Get Cooked. Shrinking their balance sheet will reduce the Fed’s interest income, and monetary tightening will increase their own cost of funding, by raising the rate they pay on bank reserves.

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Dudley estimates that the Fed may start posting losses by next year, which would require funding from Congress. The Fed always remits profits to the US Treasury, so the political optics of the reverse happening are untested. At a minimum expect Congressional hand-wringing over the Federal budget subsidizing monetary policy which by then may even be harming employment. Whether this will hamper the Fed’s desire to push rates higher remains to be seen, but traders expecting a rate cycle peak below 2.5% probably anticipate such an issue.

Russia’s bellicose posture towards Ukraine complicates things – it’s bearish for most equity sectors except energy, since it’s boosting oil and gas prices. Conflict is rarely good for bonds because wars are expensive and the US may yet start incur costs in providing weaponry to Ukraine. At the same time, the imposition by the US and EU of ruinous sanctions on Russia is dampening growth prospects. Further complicating the issues facing policymakers, elevated energy prices will not help reduce inflation in the near term.

The energy crisis roiling Europe has reaffirmed the need for reliable natural gas through sharply higher prices. European buyers have scrambled to access additional sources, mostly from the US via shipments of Liquified Natural Gas (LNG). This is to compensate for the poor planning that has left the EU reliant on Russia for up to 40% of its natural gas. Recently up to two thirds of US LNG shipments have gone to Europe, highlighting the flexibility and market responsiveness of this resource. Windmill prices have not been similarly boosted. European fears about energy security are most obviously bullish for the US energy sector.

The US Federal Energy Regulatory Commission (FERC) is moving in the opposite direction. FERC revised the standards under which they evaluate new pipeline proposals to consider the impact on emissions from the oil or gas to be transported.

Building new pipelines is almost impossible in the US anyhow, because environmental extremists have figured out how to create endless judicial roadblocks. Demand for reliable energy continues to grow, representing the complete failure of climate extremists to convince consumers of the need pay higher prices in support of the energy transition.

Meanwhile five European energy companies are suing EU governments for €4BN in damages over traditional energy resources that may not be fully utilized under current EU climate policies intended to phase out fossil fuels. This is happening under the hitherto obscure Energy Charter Treaty (ECT) originally crafted during the Cold War. It is likely to further complicate European efforts to reduce emissions.

While additional US impediments to new energy infrastructure are disappointing to pipeline executives, for investors they represent a further optimization of free cash flow since constrained spending opportunities leave more cash available for dividend hikes and buybacks. As long as progressive policies don’t impede our access to reliable, dispatchable energy they can be regarded as pro-investor. National security is once again becoming a factor in energy policy.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.