U.S. bond investors would do well to remind themselves that the Fed’s objective of stable prices is linked to maximizing employment. They have a twin mandate. In theory these goals are aligned, but not all the time. From 1980-82 the U.S. endured two sharp recessions as interest rates were hiked to vanquish inflation. Today, maximizing employment is the more important of the Fed’s linked goals. They’re willing to take a little risk with inflation, as Fed chair Jay Powell noted last week (see Bond Investors Are Right To Worry).

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Boosting employment is why the Fed launched Quantitative Easing (QE) during the 2008 financial crisis, to good effect. It turned out that monetizing debt, via the Treasury selling directly to the Fed, wasn’t inflationary. It’s become a permanent fixture. Sluggish improvements in employment meant that the Fed’s balance sheet continued growing until 2014 when it reached $4.5TN. It only began to shrink in 2018. Then Covid hit, and it quickly jumped to $7TN. It’s been growing at $28BN a week for the past three months.

Inflation expectations have been rising at the fastest pace since 2009 as the economy emerged from the last recession. Forward estimates of the five-year inflation rate five years from now (i.e. 2026-31) are around 2%, not yet especially worrying since that’s the Fed’s target.

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Such estimates are derived from the yields on treasury securities. The Fed’s increasingly large holdings of debt instruments distorts their message. For example, their position in inflation-linked bonds has risen sharply over the past year, such that they now hold 20% of the outstandings.

To the extent that these purchases depress real yields, the nominal minus real yield spread would widen, indicating markets expect higher inflation. However, their purchases of regular bonds have also been increasing, creating the opposite effect.

The bottom line is that the Fed’s large holdings make the bond market’s precise forecast of future inflation less reliable. Nonetheless, rising bond yields suggest investors are recalibrating their own expectations.

Increasing labor force participation by drawing discouraged workers back into the jobs market has gained more attention in recent years, both at the Fed and within Congress. This is no bad thing – it shows the twin mandate with Congressional oversight working.

But in a subtle way, the Fed has been shifting its focus. Inflation isn’t a problem; unemployment is. The returns to bond investors have been a low priority for years, as central banks around the world drove long term rates lower. Now there’s a risk that rising inflation will further erode returns.

Bond yields have been rising globally, reflecting the recovery from the pandemic but also, in the U.S., plans for fiscal profligacy. Central banks don’t like the market message they’re receiving. Australian ten year bond yields have doubled this year, from under 1% in December to almost 2% last week. The Reserve Bank of Australia has acted to counter this trend, recently announcing they’d buy A$3BN of longer-dated debt.

U.S. fixed income markets are communicating an important signal, that a robust recovery is coming. The Fed’s bond buying serves to moderate that message. Yields would clearly be higher, perhaps even affecting the political debate around whether we need $1.9TN in additional covid relief spending. America’s fiscal response to Covid will reach 25% of GDP as a result, regarded by many as more than sufficient. The Fed is muting the bond market’s response.

QE was originally conceived to extend easy monetary policy out along the yield curve. Yields were falling, but not as far as the Fed desired.

Today’s global yields reveal no shortage of return-insensitive buyers of bonds. In his annual letter published on Saturday, Warren Buffett warned that, “Fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future.” QE is evolving to counter the prevailing trend in bond yields – the Fed is rejecting the collective analysis of bond buyers who are demanding higher returns for what they perceive as increased risk. The Fed’s QE isn’t helping these investors. Withdrawing the support will be hard. Watch out if they do.

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Protecting portfolios against rising interest rates is hard for most investors. The ETFs that are designed to profit from falling bond prices are very inefficient and costly. Some shelter in bank debt, where their focus on short maturities linked to Libor insulates against rising bond yields. But the underlying issuers are non-investment grade, so this means swapping interest rate risk for credit risk. Interest rate futures are the best choice, but many are put off by the leverage. America’s bifurcated regulatory structure means financial advisors shorting eurodollar futures for clients would then come under CFTC oversight as well as FINRA.

Since the market bottomed almost a year ago, the recovery trade has transitioned into the reflation trade, spurred on by the first vaccine announcement in early November.

Pipeline stocks have tracked the ten year treasury yield higher over the past year, a connection that makes sense since renewed economic activity is driving both higher. Midstream energy infrastructure offers a source of return as rates move higher. It also comes with an attractive yield, something long absent from the bond market.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

“At this point, the Federal Open Market Committee is seeking inflation running moderately above 2% for some time.” Fed chair Jay Powell, Senate testimony February 23.

The Fed is walking a fine line, and it’s easy to take this comment out of context. Inflation can be too low, and in order to ensure they adhere to their dual mandate of maximum employment consistent with stable prices, the Fed is willing to take a little risk with price stability. Nonetheless, if the marble hallways of the Federal Reserve building in Washington DC display carved quotes from Powell’s predecessors, this one is unlikely to be added.

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The Democrats have embraced Modern Monetary Theory (MMT) in all but name (see Democrats Will Test The Limits On Spending). The only theoretical limit on government spending is when it’s inflationary, and until it is one must conclude spending plans weren’t bold enough. Today’s low bond yields are a piggybank to be raided for Covid relief, infrastructure spending and the energy transition.

Fixed income investors have been abused by paltry yields for years. The biggest question in finance today is why long-term rates have remained so persistently low for so long. Real yields have been falling for at least a generation. Inflexible investment mandates for institutional investors such as pension funds, which mandate a fixed income allocation regardless of return prospects, are part of the reason.

Bond investors’ passive acceptance of diminished returns has made Democrat spending plans possible. $2.8TN in the Fed’s expansion of its balance sheet, $3.4TN in deficit-financed spending, plus the latest $1.9TN Covid relief plan add up to over $8TN in stimulus.  As Barry Knapp of Ironsides Macroeconomics notes, this is to offset the estimated $1.1TN nominal GDP output gap caused by the recession. In other words, we’re plugging the economy’s hole by a factor of over 7X. There’s little risk that the government’s financial response to Covid could be criticized as inadequate.

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Against such a backdrop, even though Powell was simply repeating past comments on desiring higher inflation, it did betray a lack of sensitivity to bond investors still contemplating the 7X noted above. Under these circumstances, when the Fed wants inflation above 2% “for some time,” why would a return-oriented investor hold ten year U.S. treasuries yielding only 1.5%?

Inflation expectations have been drifting higher, recently breaching 2% for the first time in two years. Powell noted that, “… forecasters need to be humble and have a great deal to be humble about frankly.” Such humility must be abundant at the Fed, whose forecasts of short-term interest rates published in their projection materials were too high for most of the past decade (see Bond Market Looks Past Fed).

The bond market’s forecast of the “neutral”, or longer run Fed funds rate was consistently lower than in FOMC projections for years. The Fed steadily followed the market’s forecast lower. Predicting interest rates is hard. The Fed’s not very good at it. But their persistent failure to correctly forecast a rate that they set is amusing, for those who follow such things.

Now the situation is reversed; fixed income markets are beginning to price in higher short term rates by late next year, whereas the FOMC expects to keep rates low at least through 2023.

It’s unwise to bet against the Fed. But with $8TN of stimulus going up against the FOMC’s forecasting record, it’s likely that the Fed’s reputation will remain intact.

Inflation may not rise at all, in which case the bond market’s hissy fit will have been just that. However, Powell expects it to rise later this year before falling, which will be far more interesting.  The period of time during which inflation is above target may seem interminably long for investors positioned for it to be temporary. Bond yields will reflect how closely investors share the Fed chair’s breezy confidence.

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The eurodollar futures market reflected this change in expectations over the past week. Risks are more correctly priced in than before. However, there is no limit to the amount of stimulus that Washington will provide. If a Covid mutation creates a setback, the response will be predictable (see The Biden Put). Ten year treasury yields at 1.5% still don’t reflect that reality.

Rising rates aren’t necessarily bad for stocks, unless they move sharply.

For example, pipelines have performed well so far this year. The sector is more insulated than many to bond market risk – if rates do move substantially higher, it will be because demand for most things including energy is booming. Investors are beginning to recognize this, since the sector (as defined by the American Energy Independence Index, AEITR) has become a reflation trade, tracking bond yields higher.

Pipeline company dividend yields remain very attractive. Consider natural gas pipeline behemoth Williams Companies (WMB), whose equity yields almost 7%, a level still suggesting still some risk to the security of the payout.

Last week they announced they’ll be increasing it by 2.5% this year. Pipeline stocks still offer attractive upside.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

Inflation fears are percolating. The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) had its biggest ever stretch of outflows over the past six weeks. There are plenty of warnings signs. Commodity prices are booming. This is happily driving up midstream energy infrastructure, with the American Energy Independence Index up 15% YTD, well ahead of the S&P500 at up 4%. Cyclical and value sectors are drawing renewed interest. Energy has been outperforming technology since November’s vaccine announcement.

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M2 money supply is growing at 26% year-on-year, the fastest since records began. The link between inflation and money supply broke years ago. Money velocity is down sharply, which is why inflation isn’t surging. The Fed isn’t worried. They would be happy with inflation running above their 2% target for a while. For those of us whose careers include the 1980s, when inflation and interest rates peaked, this is quite an an adjustment.

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Covid figures are collapsing, which will likely unleash pent-up spending that interminable lockdowns have stifled for a year. The CDC counts 474K deaths involving Covid, less than the 500K figure seen elsewhere because the CDC waits for official death records to be uploaded by the states. This is without doubt a tragedy.

Over the same period, 3.3 million Americans died without Covid. They spent their last months or year alive constrained by all the restrictions we know so well. To pick one cohort, 99K people aged 65-74 died with Covid, but 631K of the same group died without it. 21K aged 45-54 died with Covid, reflecting their low risk profile, but 183K in this group died from other causes, while enduring pandemic restrictions like the rest of us. Even for those 85 and older, who are almost a third of all Covid fatalities, 87% of deaths in this group were non-Covid.

A friend of mine I’ve known since elementary school died on Saturday from a heart attack, which probably caused me to consider the figures in this way. The lost final year of life for the non-Covid fatalities denied the normalcy of dinners out, companionship with friends, travel and so on is another tragic element of the pandemic, but doesn’t get much attention. Do you know anyone who isn’t ready to get out there and live once more?

Money market funds hold around $5TN, a figure that’s slowly declining but still nonetheless $1TN higher than a year ago. This has low velocity while it’s sitting there but could easily be deployed in a recovery of consumer spending. Examples of rising prices include crude oil, copper and resins used to manufacture plastics. Pipelines, which move with commodity prices and reflect ownership in physical assets, offer more protection than most sectors in this environment.

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Meanwhile, the Administration wants to spend $1.9TN on Covid relief – even if that figure is negotiated down, the vaccine rollout and falling hospitalizations suggest that the worst is behind us. A weekend article in the WSJ even suggested that the U.S. was nearing herd immunity. It’s predicated on an estimate that 0.23% of people who get infected die. Assuming that’s a reliable statistic and the 500K Covid fatalities is also accurate, it suggests 217 million Americans have been infected (500K divided by 0.23%). That’s approximately two thirds of the country. Add the growing vaccinations and you can see the country could be at 70-80%.

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It’s a controversial assessment, and friends/readers who know more than us on the topic will be moved to respond. Fauci isn’t so optimistic. Virus mutations may cause a setback. But it’s not possible to definitively reject the optimistic conclusion, only to say it’s unclear.

Once the Covid relief plan is approved and money being sent out, Biden will turn to infrastructure – another $1TN. Climate change will justify at least that in addition. There are no longer any fiscal hawks (see Modern Monetary Theory Goes Mainstream).

Although there are plenty of warning signs that inflation will rise, we’ve had almost three decades where it hasn’t. Many worried about the inflationary effects of Quantitative Easing when it was first deployed following the 2008 financial crisis. To Ben Bernanke’s credit, he knew it wouldn’t and he was right. The economists at the Fed are similarly confident today. They’re expected to keep short term rates low for at least the next couple of years.

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Betting against the Fed is usually wrong. But today, betting with them doesn’t offer much upside. The eurodollar futures curve remains extremely flat, so an investor in two year securities will do scarcely better than holding overnight deposits for the same period of time. Fed chair Powell reiterated his cautiously optimistic outlook yesterday with no need to raise rates anytime soon.

The Federal government is pouring fiscal and monetary stimulus into the economy simultaneously. And if a virulent Covid mutation sets back the current path to re-opening, more $TNs will be forthcoming.

People used to refer to the Bernanke “put”, recognizing that the Fed would respond to sharp economic weakness by easing, giving equity investors effectively a put option on their holdings. Nowadays we have both the Powell Put and the Biden Put. Bond yields are too low to properly reflect the new reality.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

Bill Gates readily concedes that the world isn’t short of “rich men with big ideas” in How To Avoid A Climate Disaster. He brings an intellectual honesty to the climate change debate that is absent from Democrat policy prescriptions, and often ignored by Republicans. Gates has done his homework, producing a book spilling over with facts and insights. The climate impact of each human activity (use of power, making things, moving around) is presented, along with its contribution to the 51 billion tons of Greenhouse Gases (GHGs) emitted annually. He presents the issues in an easily understood framework that many readers should find engaging and accessible.

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Although Bill Gates is surely a Democrat, it’s unlikely progressives will welcome his contribution. He dismisses Democrat orthodoxy by showing that the energy transition will be very expensive. He feels we should be motivated by the moral obligation to counter planetary warming because it will harm poorer countries the most. Rich countries can afford to manage rising sea levels (see Netherlands).

Since the Gates Foundation is focused on disease and malnutrition in the developing world, his altruistic view isn’t surprising. And the moral argument is a respectable one. But it exposes the enormous political challenge in gaining popular support for higher domestic energy prices to stop, say, Bangladesh flooding. Last week Joe Biden rejected a French proposal to redirect 5% of our Covid vaccines to poorer countries until all Americans have been vaccinated. It was a minor acknowledgment of political reality. Few have the means or inclination to dedicate themselves to solving poor countries’ problems before their own.

How To Avert A Climate Disaster reaches positive conclusions because it argues that current technology and innovation make solutions within reach. It provides policy prescriptions but deliberately avoids the politics. In many cases Gates calculates a “green premium”, reflecting the cost of converting transport, power generation, cement or steel production to be emission-free. Not surprisingly he favors a carbon tax to create price signals that fully reflect the externalities of burning fossil fuels.

Renewables figure far less prominently than in the Green New Deal (see The Bovine Green Dream), a document Gates would likely view as fantasy if he didn’t studiously avoid such engagement. He illustrates the fundamental problem of solar and wind intermittency by considering the battery back-up a Tokyo 100% reliant on windmills would require to maintain power during a not-uncommon three-day typhoon. Even with optimistic assumptions about improved technology, the cost would be prohibitive. Gates concedes to have, “…lost more money on start-up battery companies than I ever imagined.” He knows a bit about the subject.

Although efforts to curb emissions around the world generate enormous energy and press coverage, any actual improvements to date have come mostly from coal-to-gas switching for power generation (i.e. the U.S.) or last year’s drop in global economic activity due to Covid. U.S. energy costs haven’t risen noticeably, although California’s energy policies have managed to combine high costs with unreliability (see California Dreamin’ of Reliable Power).

Gates believes poor countries should be allowed to increase emissions, since energy consumption is inextricably linked to improved economic well-being. “We can’t expect poor people to stay poor because too many rich countries emitted too many greenhouse gases” he argues from the lonely moral high ground.

Reaching zero emissions by 2050 requires western democracies imposing substantial new regulation and costs on economic activity for decades. Meanwhile, the world’s building stock will grow mostly in poorer countries, requiring cement, steel and all the other emission-producing byproducts of human advancement. This construction will add the equivalent of another New York City every month for decades.

Gates asserts that climate change will inevitably cost – inaction will lower GDP, and action will take lots of money. It’s well he doesn’t consider how governments will sell this to voters if an honest discussion ever occurs, because by comparison the technical challenges are more easily solved.

Recognizing the political impracticality, Joe Biden instead disingenuously talks about “…tackling climate change and creating good union jobs here” (his emphasis).

The technology already exists to capture the carbon dioxide emitted by burning fossil fuels, whether to generate electricity (27% of global GHGs) or produce steel (manufactures also including cement and plastics in total are 31% of GHGs).

Gates estimates that emission-free power in the U.S., to include gas and coal with carbon capture, would raise prices by 15%. The green premium to make ethylene (plastic), steel and cement without CO2 emissions would raise prices by around 12%, 23% and 110% respectively. We could already start implementing such policies if the support was there. But political leaders avoid such talk, recognizing that voters’ concern about climate change doesn’t include much tolerance for higher prices.

An energy investor today has to assess plausible outcomes, ignoring the shrill rhetoric of climate extremists unburdened by the costs, facts and technological challenges Gates lays out.

Emerging economies will continue to grow, feeding all the increase in global energy demand as they seek OECD living standards. Their GHG emissions will rise. How tolerant will western democracies be of rising costs for virtually everything while we save the planet and allow poorer countries to catch up?

Bill Gates is an unfailing optimist – invariably the most pleasant posture for living. But your blogger found the comprehensive list of what needs to be done dauntingly improbable. Mitigants of the results of global warming are probably a better investment than betting on decades of extended selflessness by 1.3 billion OECD citizens, the rich world whose collective actions Gates believes will save all 7.6 billion of us.

There are already bold options available. We could phase out coal. We could require carbon capture on industrial use of fossil fuels. We could use more nuclear, whose safety record per unit of power generated is unmatched. Instead, more solar and wind is the climate extremists’ mantra in spite of intermittency and the NIMBY challenges of building transmission lines to move power from sparsely populated solar and wind farms to population centers (see Review Of Russell Gold’s Superpower for an example of how hard this is).

Burning less coal, carbon capture and compensating for renewables’ unreliability all support growth in natural gas demand. Gates argues against a shift to natural gas for power generation. He fears the 30-year life of a typical combined cycle power plant would embed its CO2 emissions for too long. It would show progress to 2030, while putting zero by 2050 out of reach. But if tangible results within the timeframe of election cycles are needed, it’s hard to see a better way.

If in a decade that’s how things have turned out, Gates the pragmatic optimist will hail it as success. We should too.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

Debate continues over the cause of the extended power cuts in Texas last week. Predictably, party affiliation colors views. Republican Governor Greg Abbott said, ““the Green New Deal would be a deadly deal for the United States of America.” Two former Energy Secretaries, Rick Perry and Dan Brouillette blamed frozen wind turbines, and over-investment in renewables at the expense of ensuring more robust infrastructure.

It’s true that the extreme cold curtailed output from coal and gas power plants and even one nuclear facility. It’s also true that windpower works in cold northern latitudes. The state’s energy infrastructure just wasn’t prepared for such low temperatures. And the Texan power market, overseen by ERCOT, is a free-wheeling bazaar with hundreds of power providers all vying for business. Households routinely switch from one provider to another. As a result, the average retail price of electricity in Texas is 82% of the national average. But the market structure clearly doesn’t value 100% reliability.

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Both of these problems – winterizing equipment and altering market incentives for power providers, can be fixed.

Texas generated 17% of its electricity from wind in 2019 (most recent figures available). They are easily the leading state. At 83 Gigawatt Hours (GWh), they are 28% of the U.S. total and well ahead of #2, Oklahoma at 29 GWh. Wind power in Texas has been widely regarded as a success.

Was over-reliance on windpower to blame, as Republican politicians claim? Or did the cold weather show no favorites, with natural gas, coal and nuclear plants all going offline as well?

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Perhaps the chart showing power generation by source can be interpreted to favor either side, but an objective view would surely conclude that natural gas generation soared when needed, uniquely among all power sources albeit not by enough to avoid power cuts. Wind power became negligible. It’s hard to argue that more wind power would have solved this problem.

Climate extremists will argue that more extreme weather is an early warning of the adverse effects of global warming. This alone adds urgency to the energy transition. But if Texas had already converted their power generation to be 100% emission-free, that would remove around 200 million metric tonnes of CO2 emissions, 0.5% of the total emitted worldwide annually. The weather in Texas wouldn’t change. Advocates would argue that such leadership might induce behavior elsewhere. It would need to be in China and other emerging countries to make a difference.

In How to Avoid a Climate Disaster, Bill Gates offers a pragmatic view loaded with useful facts. We’ll be writing a review soon, but he notes the low power density of wind, which produces 1-2 watts of power per square meter. Solar is 5-10, while fossil fuels are 500-10,000. Wind takes up a lot of room.

It may simply be coincidence, but following California’s heatwave-induced blackouts last year (see California Dreamin’ of Reliable Power), two big states with a heavy reliance on renewables have suffered power outages. Since it’s not always sunny and windy, solar and wind have their place but are unwise beyond a certain threshold.

Both states could have redirected capital outlays from renewables to making their existing power supply and grid more reliable. In this way, environmental extremists’ obsession with growing unreliable sources of energy contributed to the blackouts. Gates argues that intermittency limits their ability to provide a significant portion of our power.

Texas is 26% renewables and California 29%. Few states should want to emulate them.

The deception of climate extremists is that renewables are cheaper and will create jobs. If that was true, the oil and gas industry wouldn’t exist. Energy today is cheap, perhaps unsustainably so. Technologies already exist to capture CO2 emitted from the manufacture of steel and cement, as well as from electricity generation. Implementing them will cost money and raise prices, but that should be no surprise.

A serious effort to reduce emissions will impose regulations or additional costs on fossil fuel emissions, which will create the necessary incentives to install equipment that curbs emissions, just as coal plants are required to do for the sulfur they emit. Natural gas will fare well, since it’s cheap, not intermittent and relatively clean burning. That’s why long term forecasts of energy use show natural gas enjoying continued growth.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

Bill Gates, in an interview two years ago, asked how Tokyo would cope with a typhoon if it was fully powered by renewable energy. Compensating for the loss of solar and wind for two to three days would require enormous battery back-up that would sit mostly idle, other than once every few years. He noted the economics would be unworkable.

Texas is a leader in wind energy. It’s tempting to blame the recent blackouts prompted by exceptionally cold weather on the intermittency of wind power. A photo of a helicopter de-icing windmill blades  became an iconic reminder of the opportunistic nature of renewables. Widely circulated on social media, it turned out to be from Sweden several years ago.

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Texas uniquely has its own power grid, overseen by the Electric Reliability Council Of Texas (ERCOT). Power suppliers compete to provide electricity to the network, and while free markets have much in their favor, reliable power in that market is clearly under-valued. Wholesale electricity prices reached $9,000 per MWh, the limit set by ERCOT. Average U.S. residential prices are 13 cents per KWh, equal to $130 per MWh. Some Texan households will be getting a shockingly high utility bill.

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Wind power collapsed leading into the Presidents Day weekend. This wasn’t an unfortunate coincidence, but was a result of icy temperatures that caused power demand to spike. Rolling power cuts extended well beyond Texas, and some natural gas power plants also went offline because cold weather restricted their operations. Nonetheless, natural gas power generation soared when needed. It’s negatively correlated with wind power output, a valuable quality for portfolios of power generation as well as stocks.

The energy sector responded by continuing its strong rally. The American Energy Independence Index, which consists of North America’s biggest pipeline companies, is up 15% YTD, 10% ahead of the S&P500. This could simply be a response to rising oil and gas prices, but it may also reflect a growing awareness that the world will need all sources of energy for the foreseeable future. Solar and wind are prone to go offline during extreme weather events. California’s drive to expunge everything but solar and wind led to rolling blackouts last year during a heatwave (see California Dreamin’ of Reliable Power). Renewables are developing an unfortunate reputation for being there until demand surges, when they’re most needed. Providing back-up adds significant expense.

It’s too early to judge the public response to this failure. Texans are still trying to stay warm. But a cooling dose of realism poured on the single-minded focus on renewables is long overdue.

U.S. foreign policy is now configured to take account of our climate goals, which is a positive development. However, the charge of hypocrisy is easily leveled against both people and countries trying to persuade others to change their ways.

For example, the U.S. plans to halt funding for overseas fossil fuel projects, so as to highlight China’s continued bankrolling of coal projects among poorer countries. China is doing more to warm the planet than any other country – they burn half the world’s coal and are promoting its use among others. With poorer countries less able to cope with rising sea levels, we’re in the odd position of promoting behavior that we find more in their interests than they do. And while reduced coal use is a good objective, the U.S. is forecast to increase its coal consumption this year and next (see Emissions To Rise Under Democrats).

Past years switching from coal to natural gas are being reversed, because natural gas isn’t as cheap as it used to be. Democrat policies are designed to increase energy prices, with sometimes unintended consequences. American leadership would mean phasing out our own use of coal.

Moreover, Joe Biden’s emissary to convince the developing world to use less coal is John Kerry, whose lifetime of private jet travel must make his personal carbon footprint the envy of those he would persuade.  Climate change is a serious issue but is not yet receiving a coherent policy response.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

BP’s Statistical Review of World Energy offers many interesting and sometimes surprising insights about global energy. Start with our neighbors to the north. In a poll last year, two thirds of Canadians believed climate change is as serious an issue as Covid. Canada has a carbon tax, and lowering emissions has long been official government policy. However, adjusted for population Canada is an energy hog, consuming 380 Gigajoules (GJ) per person, compared with the U.S. at 288 GJ. Canada has the highest use of any OECD (i.e. rich) country, and two times the OCED average.

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Moreover, 10.1% of Canada’s primary energy comes from renewables (including hydro), while the equivalent U.S. figure is 12.2%.

Germany’s per capita energy consumption is 157 GJ, less than half Canada’s. While Germany’s commitment to renewables has caused many problems (see Renewables: More Capacity, Less Utilization), using less energy lowers emissions.

Canada is better than the U.S. in coal consumption though (5.3% of primary energy production vs 11.3%), which explains why their per capita emissions are just below ours. Most Canadians would probably assume their country is a global leader on climate change, but this isn’t supported by the numbers.

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Phasing out coal-burning power plants is a simple and direct way for most countries to reduce emissions. Replacing coal with natural gas has been a big source of America’s reduced emissions in recent years. U.S. coal consumption has been declining at over 5% p.a. for the past decade, faster than the OECD average of 3% (Canada has reduced coal consumption at a 6% CAGR). However, non-OECD countries have increased coal consumption at a 2% CAGR over this time, which is why global coal consumption unfortunately continues to increase.

Herein lies the conundrum for the simplistic world view of climate extremists. Developed countries are using less of the dirtiest fuel, while emerging countries are using more. The rich world wants to save the planet, while the emerging one wants rich world living standards. These conflicting goals are clearly visible in the numbers on global energy consumption.

Coal is cheap, easily handled and ubiquitous. Because coal is found in so many parts of the world, coal trade is a much smaller portion of global consumption than for other fuels such as crude oil. OECD countries could decide to stop exporting coal, but they won’t. Australia exports 86% of its production.  China’s domestic production (79.8 Exajoules) approximately equals its consumption (81.7 Exajoules).

Australia possesses 14% of the world’s coal reserves. China has 13%. Should Australia leave most of theirs in the ground, slashing exports and pushing up prices on the dirtiest fossil fuel, thereby promoting switching to cleaner alternatives such as natural gas? Should China, consumer of half the world’s coal, leave theirs in the ground? The U.S. possesses 23% of the world’s coal, and will burn more of it to generate power this year and next than in 2020, according to the Energy Information Administration (see Emissions To Rise Under Democrats). Coal’s continued prevalence around the world mocks all the media hype over solar panels and windmills.

The U.S. is the world’s biggest producer of natural gas, with around a 23% share. The big opportunity is for Joe Biden to send John Kerry, Climate Czar, around the world promoting this as a far better choice than coal.

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Less appreciated is our dominance in natural gas liquids (mostly ethane and propane) where we produce 40% of global output. Volumes grew at 9% p.a. over the past decade. Much of this is used by the petrochemical industry as feedstock for plastics. Propane exports are now above 1.2 million barrels per day, up over 10X in the past decade.

Climate change exposes many misalignments of interests. Developed countries are pursuing lower emissions, while developing countries like China and India favor economic growth to raise living standards, which is why their emissions are rising and offsetting reductions elsewhere. But reserves of crude oil lie predominantly in non-OECD countries too.

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We’re told that we have a moral obligation to take the lead in reducing emissions, because poorer countries are less able to afford flood control and other mitigants. But 85% of the world’s proved oil reserves are in non-OECD countries. How much of this will be left in the ground? OPEC has 70% of the world’s crude reserves. Providing this oil to the rest of the world will create wealth that can be invested to protect against the effects of global warming. That may even be in some countries’ best interests.

If the U.S. trims crude consumption (which isn’t on the horizon) and imports less from Nigeria, a willing seller, are we really helping them? More broadly, the world’s poorest continent, Africa, produces 8% of the world’s oil. Environmental extremists haven’t yet reconciled a desire to reduce global demand for their output with those countries’ efforts to raise living standards by selling oil.

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Misalignments of interest are everywhere. The rich world wants lower emissions, while emerging countries want rich world living standards, which require more energy. Rich countries seek to use less oil, which is predominantly owned and sold by poorer countries. OECD countries burn 20% of the world’s coal, leaving non-OECD, supposedly more vulnerable to climate change because they’re poorer, burning the other 80%. It should be no surprise the biggest contributors to reduced emissions have been economic: coal-to-gas switching because of cost, and the Covid recession.

Interestingly, Bloomberg’ NEF, which writes about the energy transition, expects electric vehicles to represent only 8% of the global auto fleet by 2030, with internal combustion engine sales still growing at 0.8% p.a. over the next decade. Rising incomes in developing countries will drive auto sales growth.

As long as environmental extremists reject nuclear power, you can be assured their concern for the world’s future isn’t genuine. Nuclear is clean, cheap, and the record shows proportionately safer than any other form of energy. If the extremists really believed the world has ten years left before irreversible catastrophe, they’d be embracing every solution including this one.

Japan’s consumption of nuclear power dropped to zero in 2014 following the 2011 Fukushima disaster. But they have pragmatically been restarting nuclear plants since then. Following power shortages this winter, Japan’s energy minister said nuclear was crucial to the country’s emission goals.

Solar panels, windmills and batteries will demand more of certain key minerals, of which U.S. reserves are negligible. We have no cobalt (over half is in Congo); 4% of the world’s lithium (Chile has over half) and 1% of the planet’s rare earth metal reserves (China has 35%). Having reached energy independence, policymakers will need to consider the geopolitical consequences of becoming dependent once more on other countries for key energy inputs.

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Recent cold weather in the U.S. has once again exposed the fickle nature of renewable power. Its intermittency means its often available but not always when you need it most. Texas expects to see record electricity demand over the President’s Day weekend. However, the chill has reduced windmills’ share of power generation from 42% to 8%, as ice has impeded their operations. Natural gas, always there to compensate for weather-related unreliability, tripled its contribution to Texans’ electricity needs.

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North Asian LNG prices exceeded $35 per Million BTUs (MMBTU) during a cold snap in  January (see Asia Leads Natural Gas Demand). On Friday, natural gas on the Oklahoma Gas Transmission line (OGT) touched $600 per MMBTU intra-day on Friday, settling at over $360. The Henry Hub benchmark closed at $2.91. Few fans of renewables will factor this cost in when promoting how “cheap” wind power is.

The world is using more of every kind of energy. China’s electricity consumption grew at 7% p.a. over the past decade. An energy transition that makes the most of natural gas is one that’s likely to succeed. A fund backed by Bill Gates recently backed start-up C-Zero, which aims to split natural gas (methane) into hydrogen, which it’ll burn, and solid carbon which it will bury. Since combusted hydrogen only produces heat and water, it’s zero-emission energy. There are many R&D efforts to use natural gas cleanly, often by capturing the emissions before they enter the atmosphere. The U.S. and our pipeline sector are well positioned for it.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

Modern Monetary Theory (MMT) argues that because a government can never go bankrupt in its own currency, the only constraint on spending is inflation. Applied to the U.S., this justifies pandemic stimulus checks, spending on infrastructure and clean energy initiatives, expanded Obamacare and doubtless other initiatives too. Price tabs begin at $1TN nowadays. Stephanie Kelton’s book, The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy is worth reading to better understand where this theory will take us. We reviewed it last November.

There are no votes left in fiscal discipline, and investors don’t seem too worried either. With 30 year yields at 2%, there’s little evidence that voters should be more concerned than the bond market.

Kelton was an advisor to Bernie Sanders, now head of the Senate Budget Committee. We are embarked on MMT – although even Kelton’s advocacy of fiscal profligacy recognizes the inflationary constraints of the government outspending the economy’s ability to deliver goods and services. She quaintly believes Congress should score spending plans based on their potential to cause higher inflation, as if election cycles had ceased to exist. No such concern burdens Biden’s $1.9TN proposed Covid relief plan.

Betting on higher inflation, and rising rates, has been a losing proposition for over thirty years. It would seem foolish to expect anything different now – except that making such a bet is extraordinarily cheap.

The eurodollar curve, which reflects market expectations for three month Libor, is very flat. It’s true Fed chair Powell has said the Fed plans to keep rates low for a long time, and is willing to see inflation move above 2%, compensating for periods when it’s been stubbornly below their desired average. The futures curve takes him at his word.

But the stage is set for the market to test this view. The kindling includes unprecedented fiscal stimulus, almost $5TN in money market funds, up $1TN in a year (some of which is entering the stock market via Robin Hood) and a probable burst of pent-up consumption once pandemic lockdowns are eased. This may all be easily absorbed by the economy – but many are watching carefully, and a couple of high CPI figures will confirm the worriers.

Commodity prices have been rising. Energy companies are more cautious with their investment plans, which is going to constrain supply in the future. Pipeline opponents have made new construction prohibitive. Investors in the sector like higher energy prices and lower growth capex, so are finding the Democrat agenda surprisingly appealing. These are encouraging circumstances for midstream energy infrastructure, up 11% so far this year.

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Bond yields are slowly rising to reflect inflation risks, but remain uninvestably low. Sovereign debt ceased offering real returns (i.e. above inflation) years ago. Those days may never come back – MMT advocates will eagerly grasp this vindication of their policies.

December 2022 eurodollar futures yield 0.30%, just 0.10% above today’s three month Libor with 22 months to go and reflecting equanimity about the possibility of higher rates over that time frame. A short position will lose roughly half a basis point per month — this is the cost of negative carry. If the market develops even the slightest fear that rates may rise, a 25 or 50 bps move in eurodollar futures is likely. The Fed probably will remain on hold – but there’s little to be made betting with them, and little cost in betting against.

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Stocks remain modestly attractive, but that is dependent on bond yields. Factset 2021 and 2022 earnings forecasts for the S&P500 are moving steadily higher, albeit still not back to pre-pandemic levels. But 2021 forecast S&P500 EPS of $173 per share is nonetheless $10 ahead of pre-pandemic 2019. Covid has changed millions of lifestyles for the better and created big winners and losers among businesses, but history will show a one year dip in public company profits.

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Energy companies dominate the list of 1Q21 upward revisions to earnings. The Equity Risk Premium (ERP), the difference between the S&P500 earnings yield and ten year treasuries, is supportive. However, if long term interest rates were to rise, say, 1% stocks would be less alluring.

The goal of MMT is to push the edge of the envelope. Both political parties have discovered that increased deficits carry no penalty. Now that we’ve informally adopted MMT, higher inflation one day is assured. We just don’t know when. But Federal government spending policies reflect an enthusiastic pursuit.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

Last week the U.S. Energy Information Administration (EIA) released their 2021 Annual Energy Outlook (AEO). It is produced by their Bipartisan Policy Center, and presidential elections aren’t supposed to affect their work. It isn’t a policy document but is intended to make forecasts based on current policies and known technology.

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Past AEOs are taken down from their website, which is a pity because it can be fun comparing current forecasts with prior ones. Fortunately, we save it every year, and the comparisons are interesting.

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Our initial thought in watching the webinar that launched their new release was that they see a very different energy future than the new Administration, one that still relies primarily on fossil fuels. Joe Biden ran on a platform of getting the U.S. to net zero greenhouse gas emissions by 2050. The AEO projects a modest drop over the next decade before growth resumes. Energy-related CO2 emissions are projected to remain below 5 gigatons by 2050, roughly unchanged over the next three decades but clearly not zero. Nonetheless, it’s a more optimistic than the 2016 AEO. Since then, switching from coal to natural gas for power generation and the Covid-recession have brought emissions down from above 5 gigatons back then. Changed policies and new technologies will be needed to alter that projection.

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The 2021 AEO projects faster growth in renewables than five years ago, but oil and gas consumption still dominate. In fact, growth in natural gas consumption is expected to track renewables closely, with both gaining market share. Coal has seen a big downward revision since 2016 but will continue to provide more energy than nuclear. If we can’t flip that around over three decades, it will represent a significant missed opportunity.

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One controversial element of the 2021 AEO concerns consumption of petroleum and other liquids. By contrast with AEO 2016, this is now expected to grow, in apparent defiance of everything the Administration and many others have to say. The explanation is greater industrial use of liquified petroleum gas (LPG) which is mostly propane and butane. The U.S. produces 40% of the world’s Natural Gas Liquids (NGLs), almost three times the next biggest (Saudi Arabia, at 14%). NGLs, which include propane and butane and are usually separated from “wet” gas, are one of the Shale Revolution’s big successes. In recent years, increasing domestic production has spurred investment in domestic petrochemical facilities and driven greater exports.

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But even gasoline consumption is expected to remain close to current levels over the next thirty years. That it won’t grow reflects increased electric vehicle penetration as well as continuing efficiencies in traditional internal combustion engines. GM recently announced plans to only sell zero-emission cars and trucks by 2035. The incongruity between AEO 2021 and GM’s investment plans lies in policy expectations. GM is preparing for a world of government-imposed constraints on gas-powered automobiles, whereas the AEO 2021 Reference Case assumes unchanged policies. In 30 years we can look back and see which one of these was way off

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The other big change is in natural gas exports. In 2016 the EIA expected the U.S. to be a net importer of natural gas, while five years later that has reversed. An interesting chart which is more relevant today shows high oil prices stimulating increased natural gas production, because of substitution. The continued decline in capex for new oil production across the industry makes supply-constrained higher oil prices more likely than in the past. Previous AEOs have long considered this link, but it now is a higher probability. Democrat policies are designed to promote higher energy prices, an unintended benefit for energy investors.

The 2021 Annual Energy Outlook offers support to energy investors convinced that today’s weak security prices reflect a far too pessimistic outlook. In fact, we can’t think of a serious forecast of natural gas demand that doesn’t project steady growth for decades. It may not be what progressive Democrats would like to see, but since global energy demand is going to keep growing, we’ll need more of every energy source.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

The impact of GameStop (GME) will resonate far beyond a few short-selling hedge funds. It’s a rare breed of manager that runs exclusively or mostly short positions. Behind the forensic financial analysis that’s required lies a deep skepticism of company executives. They see a dark side to human behavior lurking out of sight to most of us. Short sellers often believe they’ve uncovered a fraud – they’re not just looking for a quick 10-20% gain, they think the stock is a zero. One short seller was so disgusted at the failure of men’s clothier Joseph A Banks to collapse that he abandoned the industry for a few years to rear chickens (see A Hedge Fund Manager Finds More to Like in Farming).

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Unshakeable conviction and thick skin absorb the blows of massed opposing forces, from sell-side research, management and other investors to, now, social media sites.

Shorting stocks isn’t limited to specialist funds such a Kynikos, run by Jim Chanos. The original hedge fund created by A. W. Jones was a long/short fund. It sought to neutralize its exposure to market moves by balancing long and short positions. The objectives of hedge funds have evolved over the years. They were originally described as Absolute Return funds — reliably positive, inspiring AR Magazine, which has since folded into Institutional Investor. The 2008 financial crisis showed hedge funds could lose money like anyone else, so marketing shifted to Relative Returns, except those were relatively poor (see Hedge Funds: Still Fleecing Investors with Expensive Mediocrity). In recent years they’ve settled on delivering uncorrelated returns, which Melvin Capital provided so spectacularly last month (reportedly down 53%).

Whatever the description, hedge funds are supposed to offer something different. For a broad array of strategies, that includes carrying some short positions.

Shorting stocks is hard. Almost everyone else involved with the company is against you. Investors in the stock, research analysts and the company itself all regard the short’s failure as vindication of their work. In Germany, the securities regulator was so incensed at negative press coverage of Wirecard that it sued two Financial Times journalists. The lawsuit was only dropped after Wirecard itself confirmed the €1.9BN hole in its balance sheet.

The risk in shorting is asymmetric – as the price falls, your position size shrinks as well. If it rises, your losses are theoretically unlimited, and can reach unfathomable depths as we just saw.

Hedge fund managers regularly describe the difficulty in adding value from short positions. Betting against a company certainly requires more care and attention than other positions. I’ve always thought managers would often be better off simply focusing on long ideas and hedging out the market risk with S&P futures. By focusing their often-considerable analytical abilities on long positions, maybe they’d do better.

Of $3.4TN in hedge fund assets under management, 45% can be estimated as using short positions in some form. Scraping data from social media sites to identify the crowd’s next victim will quickly become another tool. But shorts just became more risky than previously imagined, and this will have consequences.

A year ago, GME was under $4. A short-seller might have considered a doubling, or perhaps even a quadrupling in price as a plausible worst outcome, and size the position accordingly. For GME, this would have been inadequate by an order of magnitude, since it rose over 100X. The standard definition of “how bad can it get?” just changed.

The social media crowd is reveling in its newfound power. They believe they have launched a form of high-tech populism taking on what they regard as the financial establishment, although hedge fund managers used to think that was their role. We continue to scour chatrooms hopefully for signs they’ll corner the pipeline sector. It must be ripe for their exploitation.

Hedge fund managers will adapt. They’ll have smaller positions, will use options to control risk and will follow DeepF***ingValue on r/WallStreetBets. But shorting stocks has changed forever. Finding a fraud won’t make as much money, because of tighter position limits. Out of the money option volatility will be high, as the value of tail-risk protection rises. Borrowing stock to short may become harder.

Hedge fund investors will add the Melvin question to their due diligence questionnaire. Prime brokers will tighten their financing requirements for most individual short positions. Nobody wants a surprise like this. Being associated with a subsequent GME-like debacle will abbreviate careers.  So everyone will avoid it. There will be less shorting of stocks.

This will cast a chill over the hedge fund business. Many of the smartest people in finance run hedge funds, and they’ll continue to prosper personally. But hedge fund returns, which any casual observer can see have mostly failed to justify their fees for almost two decades, now face an additional headwind.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.