The global energy crisis is turning out to be the catalyst driving the sector higher. Years of under-investment in new oil and gas output are finally colliding with relentless demand growth. Energy investors are enjoying growing free cash flow because of reduced capex. The credit for this shareholder-friendly behavior should be shared with climate extremists – although Wall Street has lost interest in non-accretive production growth, executives have also been forced to acknowledge the reality of the energy transition by a relentless barrage of protests, court challenges, noisy activists and media.

The consequent improvement in financial performance has investors cheering while management teams proclaim that they were always planning to adapt. The irony is that the resurgence of the energy sector on the back of high prices is one of the most tangible results of Greta et al. The inability of oil and gas producers to respond to rising energy demand by increasing output was supposed to be made irrelevant by greater penetration of solar and wind power. That traditional fuels have seen their prices rising while solar panels and windmills are not reported to be in short supply highlights both the effectiveness of climate extremists as protesters and the ineffectiveness of their policy prescriptions.

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Williams Companies (WMB) reported another strong quarter after Monday’s close. Natural gas volumes in their gathering business (14 Billion Cubic Feet per Day, BCF/D) and pipeline transportation segment (23.8 BCF/D) underpinned results. Asian buyers have paid as much as $56 per Million BTUs for shipments of Liquified Natural Gas (LNG), an enormous premium to US prices of around $6. China has returned as a significant buyer of US LNG exports, and is likely to replace Japan this year as the world’s biggest importer.

The price gulf reflects constraints on US liquefaction infrastructure. Adding capacity takes years. Cheniere, America’s biggest LNG exporter, is one of the biggest beneficiaries. They are now reducing growth capex with commensurate improvement in free cash flow after many years of developing its export facilities.

US LNG exports averaged 9.3 BCF/D during September – down from August but the most ever for that month. Poor weather in Louisiana delayed some shipments and Cove Point was down for annual maintenance.

Given the price differential, foreign buyers are desperate for higher volumes from the US. The Energy Information Administration expects LNG exports to average 10.7 BCF/D during the winter months, buoyed by continued global demand.

Regular readers know we have long favored natural gas over crude oil pipeline exposure. Natural gas has a more visible growth path. The shift to electrification of energy consumption provides strong support, as does weaning power stations off coal. Growth in renewables also increases the need for “dispatchable” power — i.e. electricity that can be transmitted when needed and not just when the weather co-operates. Most serious long term forecasts of global natural gas demand show growth of 1-2% p.a. for the next three decades (generally the forecast horizon).

I spent the last couple of days visiting with clients in SW Florida. Bigger firms are seeing close to normal return to the office. Commutes in the Tampa Bay area are typically less than 30 minutes – a far cry from the 75-90 minute twice-daily trip I endured commuting between NJ and NYC for 25 years – so the case for remote work is less compelling.

In conversations with Investors, it’s clear that the income offered by pipeline stocks is regaining its former appeal. Dividend coverage continues to grow. For example, WMB expects its adjusted funds from operations to exceed dividend payments and growth capex. Their dividend is +2.5% on a year ago and they announced a $1.5BN stock buyback program.

The COP26 climate change conference in Glasgow is exposing the fault lines between OECD countries, that generally want lower CO2 emissions now, and emerging economies like China and India that prioritize raising huge swathes of their populations out of poverty. This requires increased energy use, most starkly shown by China and India’s refusal to curb domestic coal consumption.

Just as attendees at the Davos Global Economic Forum appear tone-deaf by arriving in private jets to preach reduced emissions to the proletariat, so are political leaders in Glasgow. Photos of dozens of limousines with their engines idling and President Biden’s 85-car motorcade on a recent tour of Rome suggest that lifestyle changes are still expected to apply to others.

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One might think that rich world efforts to reduce emissions would lose momentum if the world’s #1 and #3 CO2 generators plan to keep increasing theirs. What seems more likely is that developed countries will maintain their efforts to decarbonize. Therefore, energy demand is likely to keep rising as living standards improve in poorer countries while publicly held oil and gas companies maintain their relatively parsimonious control over capex budgets. Higher prices over the medium term seem inevitable. Bank of America expects crude oil to reach $120 per barrel by next summer. BP said global demand is back to 100 million barrels per day and is likely to be higher next year. US production remains 1.7 MMB/D below where it was when world demand was last at this level, as drillers remain cautious about capex.

Methane leaks from natural gas production face new more stringent regulation in the US from the EPA, which is another constraint on new infrastructure investments to support higher production.

Firm oil and gas markets combined with still attractive valuations and continued financial discipline are why midstream energy infrastructure remains a compelling investment.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

A significant interest rate move has taken place in recent days that has received scant coverage from mainstream financial media. The market has priced in a more aggressive pace of Fed tightening over the next couple of years, while simultaneously moderating the outlook beyond that. This flattening of the yield curve has been reflected in the spread between two and five year treasury securities, which reversed a steepening trend. The change in yields appears unremarkable. Eurodollar futures incorporate the same rate expectations but with greater precision, because they reflect market expectations of Fed monetary policy in three month increments.

Over just a few weeks, projected tightening of rates has been brought forward by at least a year. Ten year treasury yields have risen just a few basis point on the month, whereas eurodollar futures two years out have jumped 0.50%.

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As a result, the trajectory of Fed policy has shifted even farther from guidance set out by the FOMC and many analysts.

For over a decade the Fed has sought to be more transparent about their decision making. This has included publishing minutes, holding regular press conferences and releasing projection materials on their economic outlook. The Fed’s projections have not always been accurate. The “dot plot” which sets out what FOMC members individually expect for short term rates has in the past been revised to match those reflected in the yield curve.

The Fed’s “neutral” rate is the level of Fed Funds at which they’re not seeking to provide stimulus or restraint. For many years it was 1-2% above long term bond yields, even though they should theoretically be similar (see Bond Investors Agree With the Fed…For Now). The two finally converged in 2018, mostly via the Fed consistently revising their figure down. The discrepancy returned after Covid and still exists today to a lesser degree.

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The central bank’s past failure to correctly forecast its own actions is a source of amusement for those who pore over such minutia. Fed chair Jay Powell has said in the past that forecasters have much to be humble about, an observation most applicable to the FOMC.

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So it’s not the first time the market and FOMC have disagreed. Based on history you’d have to favor the collective wisdom of millions of investors over the Fed, even though the latter makes the decisions. Nonetheless, futures prices now anticipate short term rates 0.65% higher by the end of next year. As recently as late September, nine of 18 FOMC members thought monetary policy would still be unchanged at that time.

The Fed continues to buy $120BN of bonds per month. Next week they’re expected to announce tapering, and past comments have suggested a measured reduction of $15BN per month which would take until June 2022 to complete. They won’t tighten while they’re still buying bonds, which would mean no sooner than 2H22. Market forecasts of earlier tightening rely on faster tapering or a series of rapid moves as soon as July.

Either scenario is at odds with an FOMC whose public comments maintain inflation is transitory and that the employment situation still needs improvement. Interest rate futures are priced for Jay Powell to express less confidence in the “transitory” narrative around inflation.

Wednesday’s press conference following the FOMC’s two-day meeting should resolve the discrepancy for now. If Jay Powell confirms market forecasts, that will represent a concession that earlier confidence on moderating inflation was misplaced. If he sticks with his theme, at least some of the recent curve flattening will reverse.

Recent data has been mixed. US 3Q GDP rose just 2%, held back by the delta virus in some states and continued supply difficulties. Apple’s earnings on Thursday were a case in point. But the Employment Cost Index rose 1.3% over the prior quarter, up 3.7% over the past year. Healthy wage growth suggests strong employment

Total employment of 147 million remains five million below pre-covid levels, a metric Powell has often cited as evidence that the employment component of their mandate remains unfulfilled. Nonetheless, record high job openings noted in last Sunday’s blog post (see Life Without The Bond Vigilantes) suggests demand for workers is being frustrated by a skills or location mismatch.

Rising energy prices are a predictable part of the energy transition (see Is The Energy Transition Inflationary?), even if progressives whose policies have constrained oil and gas supply won’t claim credit. Tighter monetary policy isn’t much help for consumers paying more to fill up their cars and heat their homes. The COP26 climate change meeting is well timed to grapple with the challenges unrealistic climate extremist energy policies have created.

The real issue is that consumption is running well ahead of trend, because the fiscal and monetary response to Covid was disproportionate. That could justify tighter policy, but isn’t a reason that’s received much attention.

A few central banks have already begun to withdraw stimulus. Canada abruptly stopped their bond buying last week. The UK’s Bank of England has said they may consider raising rates. Short term rates in Brazil have reached 7%.

Last week the European Central Bank (ECB) maintained their large bond buying program, and ECB President Lagarde said markets were incorrectly pricing in a tightening next year. Traders were non-plussed, and yields rose further. The Fed and the ECB are the two heavyweights not yet willing to abandon the transitory narrative.

Some commentators suggest that stubbornly elevated inflation may force central bankers to concede to the market’s forecast of higher rates, sooner. But the bond market has lost its ability to cower policymakers into submission. Persistently low bond yields and record high stock prices suggest that the Fed has plenty of time to continue their single-minded pursuit of maximum employment.

Next week’s Fed press conference and the conclusion of COP26 will provide important guidance for investors in bonds and energy.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

We spent last weekend in Boston with our daughter, who’s at school there and just turned 21. We visited the Mapparium, a glass spherical room that has the visitor standing inside the globe, with the world’s countries as in the 1930s (i.e. much of Africa was controlled by European powers and India had not yet gained independence from Britain).

It’s a cool experience. The Mapparium highlights features often not apparent on a 2D map – Greenland and Madagascar are approximately the same size; Britain is further north than Nova Scotia but enjoys a milder climate thanks to the Gulfstream; Russia sits at roughly the same latitudes as Canada; and Naples, FL is approximately on the same latitude as Riyadh, Saudi Arabia, even though the latter is often at least 20 degrees F hotter. Visiting the Mapparium, in the Mary Baker Eddy Museum, can be done in an hour or less and is worth the visit.

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Visiting New England reminded me of the region’s dysfunctional energy policies. Unwilling to allow natural gas to be transported by pipeline from the Marcellus shale in Pennsylvania, Boston has in the past relied on imported Liquified Natural Gas (LNG) from Russia. The US has been mostly spared the impact of the energy crisis engulfing Europe and Asia.

This winter that will change as high natural gas prices increase the cost of heating homes and businesses. New Englanders will feel it more acutely than most based on futures prices.

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Favoring imports from our geopolitical rival rather than Pennsylvania means they’ll soon be following LNG prices in Europe and Asia, since that’s who they’ll be competing with to stay warm.

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Once again, energy policies designed with little more thought than a Greta soundbite will see the region paying 2-3X what they could for natural gas if they favored domestic supply over foreign. Residents are getting used to it (see An Expensive, Greenish Energy Strategy).

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On Monday, the New England Independent System Operator (ISO) reported 74% of its power was being generated using natural gas and 8% renewables. It’s remarkable they can still access that much natural gas given opposition in the region from environmental extremists, but they need to keep the lights on even at the risk of their ESG credentials.

Of the 8% that was from renewable sources, the biggest share was from refuse. Solar and wind were providing around a quarter of renewables so 2% of the ISO’s power — about the same as wood, the burning of which can be more harmful than coal.

New England has the same misguided strategy as Britain (see The Cool North Sea Breeze Lifting US Coal) of believing renewables would compensate for self-imposed reduced access to natural gas. Theirs is another example that should inspire no emulation. But as natural gas pipeline investors, we find ourselves in broad alignment with their results (higher natural gas demand) if not their goals.

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Switching gears, the chart showing Personal Consumption Expenditures (PCE) on durable and non-durable goods provides further evidence that enormous fiscal and monetary stimulus have put the US economy on a faster, more inflationary growth path than pre-Covid.

The trendline over two decades provides a reasonable estimate of the drop in PCE (all goods) caused by Covid. The area beneath the trendline represents $860BN of purchases. Since then, Federal stimulus has driven an excess of consumption over this trendline of $7.6TN, almost 9X the shortfall. And that’s so far – future consumption is unlikely to immediately revert back to trend.

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It’s another example of how the initial US fiscal and monetary response to Covid, which was appropriate, morphed into an enormous handout which continues to distort much of today’s economy. Labor and housing are the two biggest examples. The unprecedented number of openings as detailed in Sunday’s blog shows that the labor market is struggling with a skills/location mismatch not a shortage of jobs (see Life Without The Bond Vigilantes). Everyone except the FOMC seems to understand that the housing market has been goosed higher by continued buying of mortgage backed securities.

The Federal Reserve is losing any credibility it may have had on inflation. Their singular focus on restoring the shortfall of five million jobs lost since pre-covid is creating all the upside risk on inflation that is confronting investors.

In recent months the energy transition and the exposure of the Federal Reserve’s inflation-seeking agenda have come together as twin threats to the stability of purchasing power. The term “irrational exuberance” was famously coined by Alan Greenspan in the late 1990s to describe the dot.com bubble, and it’s become part of the investment manager’s lexicon. For example, we often describe the pipeline sector as being completely devoid of any exuberance whatsoever, which is why it’s likely to keep rising. Similarly, one of Jay Powell’s less damaging contributions to financial history will be the re-defining of “transitory”, to mean something that is likely to persist longer than expected.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

“The Fed’s an inflation creator, not an inflation fighter.” So said Paul Tudor Jones last week in an interview on CNBC. It’s doubtful that charge has been leveled at the Fed in at least half a century. William McChesney Martin ran the Fed for almost 19 years (1951-70) during a period that set the stage for the inflation of the 1970s, so it’s possible contemporaries were similarly critical. But it’s not a criticism that could have been made of Paul Volcker, Alan Greenspan or Ben Bernanke. Janet Yellen also avoided such a label although as Treasury Secretary she’s a high profile cheerleader of current policy.

Larry Summers also weighed in, expressing concern at the Fed’s apparent embrace of climate change and income inequality as policy issues that should concern them. Summers argued the Fed should stick to their core mission of monetary policy – a task he believes they’re not mastering at present.

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Faster tapering is the obvious change required of Fed policy. The Federal Reserve balance sheet sits at a record $8.5TN. Current expectations are for the Fed’s $120BN of monthly bond buying to be reduced by $15BN per month before the end of the year, which means they’ll add almost another half a trillion dollars to the world’s biggest balance sheet in the meantime.

It’s increasingly clear that the supporters of current monetary policy are an exclusive group living within the DC beltway and attending Democrat cocktail parties. Inflation doesn’t benefit any specific income group, but higher interest rates are never sought by the party in power and the Fed’s management of monetary policy no longer appears independent.

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Job openings hit a new record in July — like the Fed’s balance sheet, this metric has doubled since the lows of Covid. The symmetry is compelling and one more confirmation that hiring is vibrant. Measuring the unemployed is straightforward since they file for unemployment – counting open jobs understates demand for workers, because many jobs aren’t advertised. Therefore, the unemployed usually exceed open jobs – which makes today’s situation so unusual.

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With nearly 11 million positions open, the highest on record, and 8 million unemployed, it strongly suggests a mismatch between skills or location. Neither of these can be resolved by the blunt instrument of monetary policy.

In the past, a combination of rising inflation, tight labor market and easy monetary policy would have sent bonds into a tailspin. I well remember how in the summer of 1987 incoming Fed chair Alan Greenspan was regarded by some as a lightweight, unwilling to impose the tough interest rate medicine of his predecessor Paul Volcker. Establishing one’s “inflation fighting credentials” required responding to the bond vigilantes.

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That’s no longer the case. Bonds long ago ceased to offer any value for return-oriented investors. Today’s buyers are central banks and others with inflexible investment mandates. Inflation doesn’t seem to curb their demand. Therefore, today’s FOMC is under no market-oriented pressure to respond to rising inflation fears, because bond yields remain low. Markets are nonetheless pricing in a faster tightening of monetary policy, as if the Fed’s transitory narrative on inflation will be abandoned. Low real rates, helped in part by the Fed’s own buying of bonds, are muting the messenger which affords them a more leisurely normalization of policy than might otherwise be the case.

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Tightening sooner means less later. The yield curve has been flattening sharply, pricing in monetary policy more than 0.5% tighter than the FOMC’s projections within two years, yet lower than FOMC projections by 2025. It reflects the possibility of a policy error – the yield curve can be interpreted as warning of overly aggressive monetary tightening causing a slowdown in growth.

Fed officials have had little to say recently on this adjustment — future comments will need to either move away from the transitionary narrative or confirm they’re still comfortable.

In fact, it may be harder than many think for the Fed to slow the economy with higher rates. Ten year treasury yields at 1.6% already incorporate the anticipated loss of Fed buying of bonds next year, and short term rates at 1.5% within a couple of years. Long term rates would probably have to increase a couple of percent from here to have any significant economic impact. That would presumably require short term rates also a couple of percent higher than currently priced in.

Moreover, negative real yields on bonds mean that persistent inflation poses less of a financing problem for the Treasury — if inflation settled in at, say, 4%, today’s TIPs yields of –1% suggest the cost of US debt would gravitate towards 3%, which doesn’t seem that onerous.

It’s not hard to find support for modestly higher inflation (see America Needs Higher, Longer-Lasting Inflation for example), and if the government remains able to finance its enormous debt at rates below inflation, that could be an attractive outcome. The losers would be holders of low-yielding debt, which is foreign central banks, sovereign wealth funds and pension funds – not a group likely to attract much sympathy.

The bottom line is rates seem likely to rise slowly. Bond market concern about inflation is limited by return-agnostic buyers, and the FOMC has made clear their willingness to risk inflation for numerous objectives not limited to employment. Don’t look to this Fed to protect the dollar’s purchasing power.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Bond yields have drifted up 0.25% over the past month. Real yields on TIPs have barely budged from around –1%, so the move in bonds has translated into rising inflation expectations — now solidly above 2.5% for the next decade.

The persistence of negative real yields is surprising – with the Fed likely to finally rein in their bond buying, one might have expected this loss of support to be reflected in TIPs, but so far it hasn’t. Inflation-adjusted returns have been falling for many years. Negative TIPs yields undercut the concern of fiscal hawks about our ballooning debt, since there’s apparently no negative consequence.

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The increase in ten year treasury yields has not been evenly distributed across the eurodollar futures curve. Over the past month, the market has factored in a more hawkish FOMC  – one additional tightening of monetary policy by the end of next year (total of two) has been priced in. By the summer of 2023 almost two additional tightenings  have been priced in (a 1% increase in total). The rise in inflation expectations is creating the anticipation of a reaction from the FOMC.

$120BN a month of quantitative easing has continued for too long. The $40BN a month of mortgage-backed security purchases is especially egregious, and the slothful exit from this strategy is turning out to be too slow. Following last month’s payroll report some even questioned whether tapering might be delayed, although the shortfall in employment was due at least in part to a shortage of workers. The FOMC remains focused on restoring the five million jobs still missing from pre-covid, and is willing to risk some inflation in the process.

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The move in rates has pulled the market further away from the FOMC’s outlook. This Fed is the most dovish in living memory. It’s easy to see how chair Jay Powell could justify temperance before raising short term rates. In addition to the employment picture, widely acknowledged logistics problems won’t be fixed with higher rates.

Although Democrat politicians won’t accept credit, they’ve engineered rising oil and gas prices through curtailed investment so as to shift consumption to renewables – even if solar and wind aren’t yet up to the challenge (see Why The Energy Crisis Will Force More Realism). Reducing CO2 emissions requires more expensive energy (see Is The Energy Transition Inflationary?). Tightening monetary policy because of a green agenda seems unlikely.

Few policymakers want higher rates, but the “transitory” narrative is looking less compelling. The next public comments from FOMC officials will be worth watching to see if they confirm the more hawkish rate path currently in the market or remain true to their previous guidance. Powell has said they wouldn’t contemplate raising rates until they’d stopped buying bonds. This suggests 2H22 as the earliest they would raise rates, although they could also speed up tapering if necessary.

The net result is that the market is increasingly challenging the Fed’s benign inflation outlook and slow policy normalization. The FOMC’s dovish instincts are being challenged.

On a different topic, liberal commentators have been lambasting Senator Joe Manchin (D-WVa) as the one person thwarting efforts to combat climate change (see As Manchin Blocks Climate Plan, His State Can’t Hold Back Floods). This overlooks the 50 Republican senators also opposed to the Administration’s agenda, so Manchin’s concerns place him in the majority, even if that is inconvenient to progressives. It is democracy in action.

Manchin believes that the voters of West Virginia have more to lose from a system of rewards and penalties for utilities dependent on their adoption of renewables than they do from climate change. This seems rational – the drop in coal demand they fear would hit quickly. The adverse effects of global warming are loosely related – China’s choices on emissions are the most important and are unlikely to be swayed by West Virginia.

Once again we’re seeing the failure of climate extremists to move beyond broad yet shallow support, due to pretending the energy transition is costless. Voters in West Virginia don’t see it that way, which is why a more honest discussion about costs and benefits will be necessary before we make any real progress on the issue. Hopefully that is coming.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

The two front covers from The Economist, thirteen months apart, represent an overdue liberal education. Much of the mainstream press has heralded the energy transition to renewables as a source of jobs, innovation and everything else good including lower CO2 emissions. In September 2020 The Economist ran a leader titled Is it the end of the oil age? They excitedly continued, “As covid-19 struck the global economy earlier this year, demand for oil dropped by more than a fifth and prices collapsed. Since then there has been a jittery recovery, but a return to the old world is unlikely. Fossil-fuel producers are being forced to confront their vulnerabilities.”

Today, the US Energy Information Administration (EIA) expects total liquids demand to be 36% higher by 2050. OPEC expects crude oil demand in 2045 to be 108 million barrels per day, versus around 100 currently. In covering the energy crisis engulfing most of the world, The Economist now warns, “the first big energy scare of the green era is unfolding.”

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It shouldn’t have been hard to see coming. Climate extremists have disingenuously promoted solar and wind as the only acceptable sources of electricity. They have glossed over intermittency and the reliance of weather-dependent energy on back-up (usually natural gas or coal) to make it work. They’ve ignored that electricity provides only 17% of the world’s energy, assuming that the other 83% could be electrified and all supplied by renewables.

Oil and gas production has been demonized to such an extent that public companies have pulled back from making new investments, causing today’s rising prices. Over 80% of the world’s energy comes from fossil fuels. Vaclav Smil, a prolific multi-disciplinary writer, has explained in detail why energy transitions take decades to play out, and why this one will be no different.

Finally, political leaders have been keen to demonstrate their green credentials by using every opportunity to curb new production of oil and gas, but hypocritically reluctant to welcome the higher oil and gas prices that result. Energy systems will shift mostly based on economic signals. With Europe and Asia paying 3-5X more for imports of liquified natural gas than a year ago from Qatar, Australia and the US, liberal politicians could claim that their policies are working. Instead, European leaders are pleading with Russia to dispatch more natural gas. President Biden wants OPEC to increase oil production even while he promotes policies to curtail domestic production.

With inconvenient timing, the COP26 climate change conference will be held next month in the UK, where coal plants have been restarted to compensate for a windless North Sea and prior policy decisions that slashed the UK’s natural gas storage capacity. Although energy prices are rising, nobody is bidding up solar panels or windmills.

We’ve been writing about the unrealistically narrow focus of climate policies for several years. Emerging economies want higher living standards, which mean increased energy consumption, more than they want to reduce CO2 levels. Climate extremists oppose everything that works even including nuclear. Advocates claim that solar and wind are the cheapest form of power, implying that utilities are stubbornly retaining legacy energy systems and foregoing higher profits in the process.

The juxtaposition of the two Economist front covers represents the start of a more realistic debate over the energy transition. Now their editors recognize that “the mix must shift from coal and oil to gas which has less than half the emissions of coal.” A year ago, The Economist argued that solar and wind could reach 50% of global power generation by 2050. Last week, the EIA’s International Energy Outlook 2021 predicted a more sober 40% share. Even that figure relies on robust 8.7% and 4.7% annual growth for solar and wind respectively over the next three decades. Today’s chastened Economist editors now concede that, “More nuclear plants, the capture and storage of carbon dioxide, or both, are vital to supply a baseload of clean, reliable power.” A year ago they mentioned neither.

Most people who give the issue much thought favor reduced CO2 emissions. But political discourse has been simplistic, which has led to bad policy. Germany and California are leaders in renewable power. Their residents pay the world’s highest electricity prices and in the Golden state suffer third world reliability. Sales of diesel-powered generators have risen 22% in California in the past year, as residents seek protection from their unreliable grid. Nobody should want to emulate their model. Meanwhile China goes on burning half the world’s coal and producing 28% of emissions, content to sell OECD countries the solar panels and windmills they crave.

Transitioning to an energy system that generates less CO2 will be very expensive – if it’s worth doing, it’s worth the cost. Policymakers should be honest with voters and explain why concern about climate change means accepting higher energy prices. We should be using more nuclear; switching from coal to gas; using carbon capture; introducing hydrogen; and including solar and wind only to the point where relying on their opportunistic supply model doesn’t destabilize power markets.

An example of new technology is Air Products, which is building a “blue hydrogen” plant that will produce 750 million cubic feet per day. For reference, the US produces around 90 billion cubic feet per day of natural gas. The new facility will use natural gas as feedstock, and sequester the resulting CO2 underground.

Hydrogen is expensive to produce, so initiatives like this need higher energy prices in order to compete. Democrat policies are helping do just that, even if their political leaders won’t take the credit. For energy investors, the unfolding energy crisis is great news. As public policy becomes more realistic, the outlook for natural gas and US midstream infrastructure keeps improving.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Yesterday the IMF warned central banks around the world to be “very, very vigilant” about inflation. The Fed and its peers employ legions of economists and it’s doubtful the IMF will have triggered a sudden reassessment in marble halls in Washington, Frankfurt or Tokyo. But their outlook will add to the growing concern investors have about inflation and the likelihood of it remaining elevated.

Inflation expectations as derived from the treasury market have edged up in recent days – the ten year forecast average inflation rate as derived from the bond market (ten year  treasury yield minus ten year TIPs) is now 2.50%, close to the high it reached in May of 2.54%. The NY Fed’s Survey of Consumer Expectations also reflects rising inflation fears among consumers. Three years out the median is now above 4%. Although the IMF, like most forecasters, expects inflation to come back down, they revised up their forecasts sharply. Compared with April, they now expect developed country inflation to be 2.8% this year (versus 1.6% in their April forecast) and 2.3% next year (versus 1.7%). Like the Fed, the IMF was way off for 2021 inflation.

Real rates (i.e. the return investors need after inflation) are solidly negative, having reached –1.0% in August before improving recently. The persistent fall in real yields is an important reason why interest rates are so low. Explanations include increasing income inequality (rich people save more) and a growing pool of return-insensitive investors such as central banks who own treasuries for safety and liquidity. Whatever the reasons, the drop in real yields has continued even while the fiscal outlook for the US and others has dimmed. The warnings of deficit hawks look old fashioned.

In Bonds Are Not Forever: The Crisis Facing Fixed Income Investors (2013) I argued that an increasingly indebted society would favor low real returns and tolerate higher inflation, since these are the least painful way to repay less than was borrowed, in real terms. These themes have continued today, accelerated by the Covid-inspired uber-stimulus.

A recent op-ed in Bloomberg made the case that higher inflation (say, 4%) would benefit the US. The writer argues that it would make debt more manageable, and would provide the Fed more room to lower rates in a recession. It’s easy to see how this view could gain support. Record Debt:GDP challenges the orthodox view of fiscal hawks by not presenting any real economic problems. Modestly higher inflation could be the same.

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Maintaining income growth at reported inflation is likely to leave one feeling poorer (see Why It’s No Longer Enough To Beat Inflation). House prices are the biggest omission from inflation indices, but quality adjustments also create a result that doesn’t capture changing living standards. When a new iphone is released at the same price as the older version, its new features mean it goes into inflation statistics as having dropped in price. But you can’t buy 95% of an iphone, so there’s no actual saving.

Hedonic quality adjustments are intended to strip out the improvements that constitute rising standards of living, since inflation statistics aim to measure “constant utility.” This is hard to do in practice, especially with services. A recent article noted that the CPI omits “quality adjustments on 237 out of 273 components that go into the index, including the vast majority of services.”

To give one example, on a recent road trip from Charlotte, NC to Naples, FL we noticed that hotels don’t automatically provide daily room make-up service for guests. It needs to be requested, and since some guests don’t bother, the hotel is saving some money. Having to specify the type of service (one hotel offered “full or partial”) each morning is a small drop in quality almost certainly overlooked by the price indices. Quality improvements for services are more subjective – the same article noted longer wait times for service at high-end retail outlets – another reflection of the shortage of workers. Inflation statistics are relevant in that they determine Fed policy and cost of living adjustments for retirees, but they’re so deeply flawed that their use is limited beond that.

The IMF is forecasting US GDP growth of 5.2% next year – substantially more than the Fed’s forecast last month of 3.8% (revised up from 3.3% in June). Although Friday’s non-farm payroll report was a disappointing 194,000, the unemployment rate fell 0.4% to 4.8%. Hourly earnings continued their series of increases, rising 0.6% although the Bureau of Labor Statistics cautioned that large fluctuations in employment across industries since Covid struck complicate the analysis of whether or not wage inflation is setting in.

Fed policymakers normally eschew anecdotal evidence, but the evidence of a booming economy is overwhelming. Help wanted signs are abundant. Worker shortages are being reported across many industries. The housing market remains buoyant, and the FOMC’s ponderous roll-back of bond market support will likely turn out to have been recklessly delayed.

Finally, New York Times columnist Thomas Friedman sounded so intelligent on this recent video that he’s jeopardizing his liberal credentials. He blamed the global energy crisis on insufficient investment in natural gas and too hasty an exit from nuclear power (Germany and California) without first establishing reliable alternatives. His policy prescriptions echoed those often found in this blog – the hope for more pragmatic solutions to CO2 emissions may not be in vain.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Covid introduced us to first-time meetings over Zoom. Last week I had the pleasure of meeting Jack Jeffords and Adam Bloomberg, from Mount Pleasant, SC, in person after having first met them both via a video call several months ago. Recognizing a familiar face along with the person’s voice reinforced how helpful it is to chat on a screen when traveling to a meeting isn’t practical. Like it or not, zoom is now an adjective (although we prefer Microsoft Teams).

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Over a convivial lunch reflecting southern hospitality, we chatted about the long term outlook for natural gas, the main focus of our energy investing nowadays. Conveniently, the US Energy Information Administration’s (EIA) International Energy Outlook 2021 (IEO2021) was released the following day. Long term projections such as these are why we’re confident that US pipelines will be in use for decades to come.

As an aside, we learned that port congestion is also an issue at Savannah, with some two dozen ships waiting offshore. Truckers and port warehouse workers are reported to be in short supply.

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The energy transition brings together two opposing forces – the desire of developed countries (i.e. OECD) to lower emissions, and the intention of emerging countries to raise living standards, which requires increasing their energy use.

The trajectory of global population and GDP growth means the latter of these conflicting forces will dominate. Even if the US and the rest of the OECD countries cut CO2 emissions in half over the next three decades, the world would still be emitting more CO2 than it does today. The inevitable reality of population growth dictates that emerging economies will drive energy demand for the foreseeable future.

The upcoming COP26 global climate change conference is well timed as it coincides with a developing global energy crisis (ex-USA). This is largely the result of years of policy aimed at dissuading investment in new production of oil and gas, which has directly led to today’s high prices. Europe’s demonstrated vulnerability to supply shortages should inject some overdue humility and realism into the COP26 deliberations (see Europe Follows California Into Renewables Oblivion). They don’t need any more of Greta’s grandstanding.

China has ordered its coal mines to increase output — not good optics for a country that already burns half the world’s coal heading into COP26. India is experiencing blackouts as some of its power stations run out of coal. Energy security supersedes climate change for these countries.

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The result is that, for all the relentlessly positive media coverage about increases in solar and wind, renewables will fail to satisfy the growth in world energy demand. Therefore, we’ll be using more of everything – sadly including coal.

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Even in the power sector, which most easily lends itself to increased solar and wind, these two intermittent energy sources will fail to cause a contraction in fossil fuels – in part because increased use of weather-dependent power will necessitate more dispatchable (i.e. there when you need it) sources to compensate for cloudy, windless days.

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Perhaps most surprising is the strong outlook for “petroleum and other liquids.” It’s set to grow at 1% p.a. over the next three decades, with growth in every region even including Europe which is farthest ahead on decarbonization. In spite of increasing uptake in electric vehicles, far more conventional automobiles will be bought as living standards rise in emerging economies.

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The last chart illustrates the challenge facing policymakers. India’s electricity output is expected to increase five-fold over the next three decades. Enormous increases in solar and wind will still fall short of meeting this growth. This, along with the continued need for conventional power sources to compensate for renewables’ intermittency, explain why India’s coal consumption isn’t likely to fall. Canada’s electricity transmission is on track for zero emissions, but India’s power output is likely to be 10X Canada’s by 2050.

The EIA outlook is based on current policies and technology, which they call their “Reference Case.” The contrast it presents with where most of the world says it wants to go is so jarring that one has to expect some policy changes to come out of the COP26. Nonetheless, it highlights the enormous difficulty the world will have in achieving the IPCC emission goal, which is to reach zero by 2050. The IEO2021 forecasts CO2 emissions going from 34 to 42 Gigatons over that period. We may do better, but zero seems implausible. Given our dependence on energy supplies that work, technologies such as carbon capture will likely become a more important solution, which augurs well for today’s investments in natural gas.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

In June of last year my wife and I fled the draconian lockdown imposed on New Jersey for the south (see Having a Better Pandemic in Charleston, SC). Whereas back then our autocratic governor had even forbidden a solitary walk in the park, Charleston SC felt like a world apart. We were left awestruck at the sight of diners enjoying an evening out. The welcome freedom was somewhat marred by BLM protests, that being the big news story of the moment. Boarded up storefronts did not present Charleston at its best, and we vowed to return at a more auspicious time.

That moment arrived 16 months later, and we enjoyed a wonderful dinner with long-time friend of the firm Jim Agostini and his delightful wife Lindsay. We found Charleston fully open. In keeping with southern manners, masks were politely requested if non-vaccinated, as opposed to demanded. Few were evident, even among the employees of restaurants and stores sporting such a sign. We all agreed we’re fed up with being required to wear a mask “for your protection” when it’s really to protect the unvaccinated who demonstrate little fear of covid. Most are moving on.

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Client meetings are coming back, as financial services’ finds a new balance between the convenience of remote working and the benefits of in-person interaction. Our business went fully and permanently remote a year ago. Face to face client meetings are becoming more frequent, but not yet back to where a full day of meetings on a road trip is possible

I was interested to learn that Lindsay Agostini is a member of Conservatives for Clean Energy (CCE). In fact, Lindsay was recently named a Conservative Clean Energy Champion. CCE promotes innovation along with continued use of nuclear energy and greater adoption of electric vehicles – more pragmatic than the liberal climate extremists who have helped cause Europe’s current energy crisis.

We’ll hear more from Lindsay in the near future.

Meanwhile, the energy sector continues to strengthen, in almost willful defiance of most observers. Many have wrongly concluded that the energy transition makes the sector uninvestable, whereas the policies advocated by climate extremists are behind Europe’s energy crunch. Pushing for reduced capex is achieving the free cash flow growth investors have long yearned for but were unable to engineer themselves.

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European natural gas prices continue to reach levels unfathomable in the US. Britain is the new poster child for a mis-managed energy transition, joining Germany and California as examples to avoid. British natural gas prices hit £3 per therm on Monday, the equivalent of $41 per MCF (versus around $6 in the US). The WSJ wrote How Not To Do An Energy Transition to offer some belated advice. Aramco noted that the natural gas crisis had driven oil demand up by 500K barrels per day, more than OPEC’s recently announced production increase.

Recent developments are highlighting the poor planning behind many countries’ headlong rush to renewables. It shows the problems of building policy on soundbites, instead of designing good policies that generate their own slogan. Lessons will be learned, including that the energy transition is far from costless. This should lead to a more thoughtful approach that acknowledges the vital role natural gas will continue to play in providing reliable power for decades to come. The wake-up call for policymakers is good news for energy investors. Electricity can’t be intermittent, and the UK government is paying a steep price for over-reliance on windpower without adequate back-up.

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Natural gas is far from the only commodity in a bull market. The Bloomberg Commodity Index tracks 23 energy, metals and crop futures contracts. Even cotton, hardly a target of climate extremists, has rallied sharply in recent weeks.

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The inflationary implications of the energy transition were harder for the Fed to forecast than the impact of fiscal uber-stimulus and debt monetization. Rising energy prices offer a graceful exit from the Fed’s transitionary narrative around current inflation, should they choose it. The eurodollar futures curve is priced for a 0.70% increase in short term rates between December 2023 and 2025, a pace of slightly over one tightening per year. Although it’s widened from 0.55% over the past couple of weeks, it still represents an asymmetric bet, since even today’s dovish FOMC is more hawkish than the market. If inflation fails to return to its 2% FOMC target, the risk is for much more tightening in a couple of years than is reflected in current pricing.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

The global energy crisis is becoming the biggest investment story of 2021. US consumers are uniquely unaffected so far by spiraling prices for natural gas and coal. Crude oil continues to cause some discomfort at the White House, which regularly pleads with OPEC to offset their own policies by increasing supply. Limited export capacity for Liquified Natural Gas (LNG) is keeping a lid on domestic prices for now, but as more becomes available the huge US discount will narrow, to the benefit of domestic natural producers and the detriment of customers.

It would be wrong to blame this on Britain’s inconvenient recent loss of windpower (see The Cool North Sea Breeze Lifting US Coal). Higher prices are exposing the poorly conceived energy policies of many western governments. By pandering to climate extremists to demonize fossil fuels, the world is now coming up short of energy. High prices for natural gas are stimulating demand for coal. Even in the US, the Energy Information Administration expects the black stuff to regain market share from natural gas in power generation. A decade of reduced emissions due mostly to cheap natural gas is being reversed because of a shift in relative pricing. The Biden administration is likely to find itself explaining why US CO2 emissions are approaching pre-Covid levels by next year’s midterms (see Emissions To Rise Under Democrats).

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In February last year, there was a period of a couple of weeks when Covid became the major news story in Asia and Italy but hadn’t yet reached America. It felt like waiting for a distant tsunami to reach our shores. The global energy crisis feels eerily similar. Other than a mild rise in prices at the pump, it hasn’t drawn much media attention.

By contrast, with European natural gas prices up roughly six-fold, politicians are scrambling to deal with the fallout. France plans to cap utility bills, providing what French PM called a “tariffs shield.” Governments across Europe will spend tens of €BNs over the next several months.

China’s Vice Premier Han Zheng reportedly told state-owned energy companies to secure supplies so as to ensure continued power supply “at all costs.” Such a directive will concentrate minds among those receiving the directive – the consequence of failure is likely to be more than just a smaller year-end bonus.

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China’s highly motivated coal buyers are competing with many other countries. Over half of India’s power plants are down to fuel stocks (mostly coal) of under three days, well short of the two-week government minimum. A German power plant recently shut down because it ran out of coal.

The scramble is all about acquiring fossil fuels, because they’re reliable. There’s no evidence of a scramble to obtain more solar or windpower. The managers of China’s power supply mandated to ensure reliability are not rushing to buy windmills.

The public policy error committed in many countries including the US has been to pander to climate extremists while disingenuously pretending that transitioning to low carbon energy can be done without disruption or enormous expense. The EU has a form of carbon tax via a cap and trade system, but it’s clearly not onerous enough to affect demand. Instead of fossil fuels generating increased taxes that European governments could redeploy into renewables, they’re going to be heavily subsidizing coal and natural gas use by capping homeowners’ utility bills.

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Since no politician has hailed high energy prices as a successful consequence of policies to advance the energy transition, government leaders have concluded that public concern about global warming doesn’t imply a willingness to spend much.

There hasn’t been much serious thought given to the transition. It’s being handled disastrously. Tiresome Greta Thunberg (listen to Greta’s Grandstanding), who admonished the world for jeopardizing her future (“How dare you”) is what passes for climate strategy.

The result is that higher energy prices are headed to the US too.

This will be good for energy investors, but will also challenge the Fed’s belief that elevated inflation will be coming down. Energy prices will feed through to the general price level. German inflation reached a 29-year high of 4.1% in September, and across the eurozone it reached a 13-year high of 3.4%. German workers at a motorhome manufacturer are striking for more pay. The country’s biggest union, IG Metall, is demanding 4.5% pay hikes because “Inflation in Germany keeps going up”.

The Fed believes short term logistical challenges are impeding the supply of goods, and as these are resolved price pressures will recede. They ought to consider whether the 25% of GDP that the IMF calculates the US government has provided because of Covid might be the real issue, along with the Fed’s monetization of much of the debt that was issued as a result.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund