Although we generally write about investing in midstream energy infrastructure, we find macro subjects interest our readers too. In April, not long after the market low, The Stock Market’s Heartless Optimism was popular, as any guide to the market’s direction was eagerly sought. We regularly use the Equity Risk Premium (ERP) to illustrate the relative value of stocks versus bonds. Earnings forecasts never fell as far as the market, which is what propelled its rebound for the remainder of the year.

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Full year S&P500 EPS is currently forecast by Factset to come in at around $140 once 4Q20 reports are out. For 2021, analysts are forecasting S&P500 EPS of $170. The 21% increase looks impressive, but a year ago the 2021 EPS forecast was $197. Despite this 14% drop in forecast earnings, the market returned 18%. It’s been cheaper. Lower bond yields helped, but relative value has clearly deteriorated. At 3.6, the 2021 ERP shows stocks are attractive compared with the past 50 years, but mid-range for the past decade.

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A 1% jump in bond yields would likely expose the market’s lofty valuation. This has been true for years without result. Investors need to consider the possibility of such, improbable though it seems. Recent M2 money supply growth of 26% has eclipsed the inflationary ‘70s and ‘80s. Taming the deficit is a quaint hobby with few votes, and the Fed wants to see inflation above its 2% target for a period of time before acting. This doesn’t mean inflation is about to jump, but the mismatch between investor positioning and the odds of such a surprise appears significant.

We wrote on this topic recently (see A Cheap Bet On Inflation), drawing a good number of emailed comments. One friend and client generously described it as “post of the year”.

Inevitably, we wrote on Covid, as reasonably numerate non-medical people trying to figure it out. Opinions are strong on both sides, and the most reasoned responses came from those who believed we were underestimating the threat. Our morning meetings often include a discussion, and there isn’t complete agreement even within SL Advisors on certain elements. What is unarguable is that life won’t return to normal until people feel safe, regardless of whether they’re over-estimating their risk or not.

For my part, in New Jersey in March and April of last year we endured a loss of personal liberty I never thought possible in America. Even a solitary walk in the woods was banned. As soon as we could, my wife and I escaped for a trip south, where infections were lower and society more open. This was briefly chronicled in Having a Better Pandemic in Charleston, SC, which many enjoyed.

Climate change will continue to be a dominant driver of energy sector returns. Anything linked to the energy transition draws fund flows (see Hydrogen Lifts an LNG Company).

Valuations defy fossil fuels’ 80% share of global energy, and the relentless growth in developing countries’ consumption to support rising living standards. We have long thought natural gas a better bet than crude oil. 2020 highlighted the former’s resilience as the collapse in transportation demand was mostly felt in oil markets (see With Energy Uncertainty, Natural Gas Offers Stability and Natural Gas Demand Still Stable).

The election result means energy companies will continue cutting growth spending, a welcome development. Next week’s Georgia runoffs for the Senate will determine whether Goldilocks Gridlock or a razor-thin Democrat majority prevail. The former is better, but pipeline free cash flow is growing in either scenario. Why Exxon Mobil Investors Might Like Biden explained how we thought politics would affect the sector.

Our podcasts have developed a growing listener base too. Among the most popular were Joe Biden and Energy, Climate Change Was Never Our Biggest Threat, Exxon’s Bet Against Renewables and Democrats Mean Higher Energy Prices.

As always, we invite your feedback whether positive or negative. We aim to produce what you want to read or listen to.

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

Writers care what their audience thinks, and we monitor pageviews and comments to learn what resonates. For pipeline investors, a few months into the year it was looking like the mother of all bear markets. The sector had been persistently lagging the S&P500 since peaking in 2014, and pre-Covid the fundamentals were improving strongly. Fortunately, the recovery since then has repaired much of the damage to portfolio values, if not the emotional scars from extreme volatility. The American Energy Independence Index is –13% for the year, compared with –51% at the end of 1Q.  

In reviewing the year’s most popular blogs, they can be divided into (a) commentary on the energy market, and (b) politics, especially around climate change. Part one of this two-part, year-end review will focus on the market blogs. 

Most of all, investors want to understand why stocks are moving as they are. Pipeline stocks bottomed in March, and crude oil in April when it briefly traded at negative prices. Can An ETF Go Negative? looked at the United States Oil Fund, LP (USO), an ETF that provides exposure to crude oil. It’s a result of our Balkanized regulatory structure which separates stocks from futures. That the SEC and CFTC persist as separate entities is because their overseers are separate Senate Committees (Banking and Agriculture, respectively). Merging them would eliminate campaign contributions to one Senate committee’s members, a battle successive Administrations have avoided.  

Different oversight means different rules, so firms tend to offer either stocks or futures, but not both. Buying crude oil futures would be a more efficient way for oil bulls to express a view but preferring to keep assets at one firm they buy USO instead. USO then buys oil futures, increasing the friction for the ultimate investor. 

A regular theme is the diminishing importance of the MLP structure. The shrinking pool of MLP buyers, caused by serial distribution cuts, has reduced MLPs to only a third of North America’s midstream energy infrastructure sector (see The Disappearing MLP Buyer). It’s also created problem for MLP-dedicated funds, which are becoming increasingly concentrated in the few remaining names (see Today’s Pipelines Leave MLPs Behind and Are You In The Wrong MLP Fund?). 

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MLP closed end funds offer a target-rich environment for criticism (see MLP Closed End Funds – Masters Of Value Destruction). As Warren Buffett said, if you’re not going to kick a man when he’s down, when are you going to? They are a dumb idea, and if they didn’t already exist no responsible fund manager would fill the void. Most recently, the Fiduciary/Claymore Energy Infrastructure Fund (sporting the delightfully inappropriate FMO ticker — Fear of Missing Out) announced an “income tax accrual adjustment” following “a further review and change in understanding” of the tax rules under which they operate. Markets and the tax code are too much for this hapless fund, -86% YTD.  

In a year of superlatives, pipelines have surprised by maintaining strong growth in Free Cash Flow (FCF) despite the pandemic. During the collapse in transportation demand that culminated with April’s briefly negative crude prices, any FCF growth appeared implausible. Nonetheless, even by May the outlook was improving (see Pipeline Cash Flows Will Still Double This Year), and one of our most read pieces was from two days before the low (see The Upside Case For Pipelines). We were bullish then, but as regular readers know we usually are, so won’t claim any credit for foresight.  

The outlook remains very positive, with FCF expected to increase by a further 50% next year supported by lower spending on new projects. Incoming President Biden is likely to be an impediment to growth capex, a welcome development.  

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

It is the time for nostalgia. I fondly remember Christmases from my childhood in England with a close friend and our two families. Here in New Jersey, my wife maintains many of our English culinary traditions, since they’re from her childhood too. Christmas pudding (also called Plum pudding) was acquired weeks ago. None of our children will touch it, a disdain I’ve wasted little time trying to reverse since it means there’s enough left for Boxing Day too.

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Covid has canceled bits of Christmas, including our annual Christmas Eve fish dinner with friends. And a virtual church service remains a poor substitute for live Christmas carols. I admire our rector for gamely pressing on in solitude in front of a camera, but this year organized religion has offered less when some needed more, leaving it with a diminished role.

I’m currently reading These Truths: A History of the United States, by Jill Lepore. It was on Bill Gates’ summer reading list. An engaging read, it covers much but rarely in depth, since it’s a single volume. I have reached the 1940s. Winston Churchill knew that Britain could only prevail against Germany if the U.S. could be persuaded to enter the war. Following World War II, Churchill referred to his bonding with President Roosevelt thus, “No lover ever studied the whims of his mistress as I did those of President Roosevelt.”

My old country could use Churchill’s leadership today. Most of the population is under virtual Covid house arrest, and they’ve agreed a Brexit deal with the EU very different than voters were led to expect during the 2016 referendum. I have never regretted growing up there, nor leaving for the U.S.

How ironic that British PM Boris Johnson’s wonderful biography The Churchill Factor: How One Man Made History represents a bigger tribute than his current leadership of the country.

Few individuals produce enough lifetime material for a book of humorous quotes, but my library includes The Wit and Wisdom of Winston Churchill, boasting over 1,000 entries. Browsing reveals gems such as, “Although always prepared for martyrdom, I prefer that it shall be postponed.” Another favorite is, “There’s nothing more exhilarating than to be shot at without result.” When a close friend of mine with Covid risk factors survived an extremely mild case, I read this quote to him.

Churchill’s mother was American, and he felt strong affection for our country. During a speech to Congress in 1941, he noted that, “… if my father had been American and my mother British, instead of the other way around, I might have got here on my own.” This overlooked the constitutional requirement that a U.S. president be born here, but still drew appreciative laughter.

Some of Churchill’s descriptions of America remain true today.

“The Americans took but little when they emigrated except what they stood up in and what they had in their souls. They came through, they tamed the wilderness, they became a refuge for the oppressed from every land and clime.”

“There are no people in the world who are so slow to develop hostile feelings against a foreign country as the Americans and there are no people who once estranged, are more difficult to win back.”

In the House of Commons when a veteran member offered disjointed criticism of Churchill’s war leadership, the PM warned that his critic, “…will run a very grave risk of falling into senility before he is overtaken by age.”

Churchill’s ready wit was often deployed in social settings to parry criticism. Nancy Astor was a Virginian who became Britain’s first female member of the House of Commons. Astor was part of a clique that admired Hitler, prompting Churchill to describe appeasers as those who, “…feed the crocodile hoping that it will eat him last.” At a dinner party Astor told Churchill, “Winston, if I were your wife, I’d put poison in your coffee.” To which he replied, “If I were your husband, I’d drink it.”

Perhaps his most famous exchange was with an unknown woman who complained that he was drunk. “My dear you are ugly, but tomorrow I shall be sober and you will still be ugly.” he replied.

It’s been a testing year in so many ways, with little of recent humor to offset it. I hope you and your family are healthy, and that you’ve enjoyed Christmas and the holiday period under whatever Covid restrictions allowed. We all have much to look forward to next year.

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

“If I seem unduly clear to you, you must have misunderstood what I said” was Fed chair Alan Greenspan’s response during testimony to the Senate in 1987. Transparent communication has come a long way since then. Greenspan continued the policy of obfuscating responses, reflecting a belief that it improved the Fed’s operating flexibility by disguising mistakes. This inspired Secrets of the Temple: How the Federal Reserve Runs the Country, William Greider’s 1989 scripture describing faith-based monetary policy.

Today, the Fed’s projections are public. Their meeting minutes are published. The mystery has gone, although they still are the most important market participant. Transparency allows for comparison between market forecasts of interest rates and the Fed’s. Of course, the latter has the advantage of being able to make their forecasts correct through their actions, should they be so moved. Fortunately, the Federal Open Market Committee (FOMC) is not burdened with excess vanity, so serially inaccurate interest rate projections do not bother them.

In recent years it’s been mildly amusing, in a nerdy sort of way, to show how the FOMC’s long term forecasts for inflation and the Fed Funds rate have followed bond yields lower, conceding the market’s prescience. Fixed income investors have been ahead of this for years, exhibiting greater accuracy about Fed policy than the FOMC itself (see Bond Market Looks Past Fed). Covid made such games irrelevant, but as markets look beyond the pandemic, revisiting FOMC Projection Materials is becoming worthwhile again.

In August, Fed chair Powell gave a speech where he addressed persistently low inflation and how this had caused FOMC members to continually lower their rate forecasts. He explained how 2% inflation remained their definition of price stability, but since recessions typically cause it to undershoot, the FOMC would henceforth be more tolerant of greater than 2% during a strong economy. The inference, reflected in subsequent FOMC projection materials, is that short term rates will remain low for a long time, at least long enough for inflation to exceed 2%.

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The chart compares the futures market with the FOMC’s forecasts. There is some judgment involved – the FOMC provides annual estimates through 2023 followed by a long-term assumption. The chart assumes that the long run is five years away. The market, as has been the case for years, is assuming lower rates than the FOMC.

Rates probably will stay low. Betting on higher inflation has been a fool’s game for longer than the average investor’s career. But these are unusual times. M2 money supply growth is 24%, higher even than when we were trying to whip inflation in the 70s and 80s. The fiscal outlook is as bad as ever, with debt projected to exceed the wartime highs of 1945, and stay there.

Modern Monetary Theory (MMT) as explained by Stephanie Kelton in The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy, holds that deficits don’t matter until they cause inflation. MMT has been widely panned by mainstream economists and isn’t regarded as a serious framework for fiscal policy. But the reality is that deficit hawks win few votes nowadays. We are, in truth, already pursuing the unlimited government spending that MMT advocates. Higher inflation is the only remaining obstacle, as we noted on Sunday in Deficit Spending May Yet Cause Inflation.

Low inflation remains likely, so betting against this is unbelievably cheap. The eurodollar futures curve offers precise forecasts of short-term interest rates, which in 2022 are expected to rise only 0.06%; that is, the spread between the December ‘21 and December ‘22 futures contracts is 0.06%.

Suppose that the economy emerges from Covid by the spring, as the vaccines allow a return to our previous lives. Consider whether a desire to live for the present promotes a vigorous economic rebound, as people catch up on experiences, trips and visits long delayed. The Roaring 20s followed the 1918 Great Influenza, although the still fresh horrors of World War I also played a significant role in the zeitgeist.

If inflation does pop above 2% next year, markets will start looking more carefully at near-zero Fed Funds and its longevity. No rate hike until 2023 will look to some like an awfully long time. The 0.06% spread between the December ‘21 and December ‘22 futures contracts could easily move to 0.25%, still representing only a single rate hike over that year.

The question is whether the odds offered by the market are sufficiently different from the odds of such happening, the minimum criteria to justify a trade. The money market curve is unlikely to invert, so the loss if nothing happens is a few basis points. The risk/return on this trade is a long way from 50/50, but the odds of an inflation jump are low too. Call it the MMT trade.

Some investors are already contemplating higher inflation. Bitcoin buyers are among them. There are cheaper ways, with well-defined downside, to express such a view. The eurodollar futures curve is one of the best. Your blogger has already initiated this trade.

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

The biggest question for long term investors is why bond yields remain so low. The Equity Risk Premium (see Stocks Are Still A Better Bet Than Bonds) has favored equities for most of the time since the 2008 financial crisis. Inflation expectations remain well-anchored and are noticeably lower than a year ago. Investors don’t expect it will even rise to the Fed’s 2% target within the next three decades, despite the Fed’s professed objective to overshoot this.

Should inflation, and therefore interest rates, move surprisingly higher, a key support for the bull market would be knocked away.

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Betting on higher inflation, or even worrying about it, has been a wasted effort for as long as any of us can remember. My own career began in 1980, around the time inflation peaked. Bond yields have been falling ever since. Jim Grant’s Interest Rate Observer has been warning of resurgent inflation for this entire period. That he retains so many subscribers shows how erudite prose beats accurate forecasts.

The most likely outcome remains low inflation. However, it’s safe to say that few investors are prepared for a surprise. Should it happen, the resulting market response is likely to be traumatic.

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There are reasons to worry. M2 is rising faster than at any time in the past 50 years, exceeding even the inflationary late 70’s and early 80’s. The link between money supply and inflation appears to have broken, and any analysis of current conditions must consider that Covid has affected everything. Nonetheless, 24% year-on-year growth means something.

The Federal deficit, invariably nowadays the subject of hand–wringing but inaction, is forecast to be $3.3TN this year, at 16% of GDP the highest since 1945. The Congressional Budget Office expects total debt outstanding to reach 109% of GDP by 2030, exceeding the 1945 peak at the end of World War II. Unlike then, it is expected to remain at elevated levels.

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Fiscal discipline has gone because there are few votes to be had in it. Past and present fiscal profligacy has caused little visible damage, as measured by the bond market. The burden of proof increasingly lies with the advocates of prudence.

Believers in Modern Monetary Theory (MMT) should be pleased. MMT holds that countries with a fiat currency, the prevailing global standard nowadays, can never go bankrupt. This is because the government can always issue itself money to pay any bill. Therefore, deficits don’t matter, as explained by Stephanie Kelton in The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy (you can read our review here). Or at least, deficits don’t matter until excessive government spending leads the economy to exceed its productive capacity, which is inflationary.

MMT remains at the fringes of political discourse, embraced by the same progressive Democrats who love the Green New Deal (see The Bovine Green Dream). It’s not conventional economic policy.

And yet, the deficit trend suggests that we are embarking on a great MMT experiment. $1TN is now a round lot for stimulus spending, rebuilding our creaking infrastructure, forgiving student debt or combating climate change. Proposing less betrays a lack of urgency. Derisively low bond yields deny fiscal conservatives their most potent weapon. MMT advocates must retain a disciplined silence, in case the rest of us comprehend that we are unwittingly doing their bidding.

Years of costless Federal profligacy have caused voters to become so disinterested in budget discipline that inflation is the only remaining constraint. We will continue testing the limits until we get a different result. MMT has become our fiscal policy. Higher inflation is assured, eventually. We don’t know when, but until then fiscal hawks will remain defenseless, disarmed of empirical arguments.

Therefore, every investor needs to consider how their portfolio will cope with higher inflation.  Though the timing of such is unclear, it is inevitable. Gold and Bitcoin suggest that some see warning signs ahead.

The point of investing is to preserve purchasing power. For years, simply earning positive returns was almost sufficient. Companies with pricing power offer some protection. If inflation is 5%, Coca-Cola will pass that through to customers, like so many companies with a strong brand and barriers to entry.

Real assets are another good choice. The rising cost of pipeline inputs (steel, concrete, labor) will increase the value of what’s already built. The next few years will in any case see few new pipelines. President Biden and relentless legal challenges from environmental extremists will add value to existing assets that have become hard to replicate.

This is why planned spending on new pipelines is continuing its downtrend. Investors are welcoming the resulting boost to free cash flow, which has spurred a series of buyback announcements (see Pipeline Buybacks To Shift Fund Flows).

Oil is a global commodity whose recent price rise is partly to compensate for a weakening US dollar. Natural gas is similar, although relatively high transportation costs allow greater regional price disparities. And much of the North American pipeline network operates with tariffs that include inflation adjustments.

Inflation remains dormant, but America is probing for the conditions which will change that. MMT proponents are getting their wish. Pipelines offer protection for every portfolio.

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

Technological advances in solar, wind and batteries receive widespread media coverage. Costs are falling and battery back-up is improving, vital to cope with renewables’ intermittency. As Enbridge CEO Al Monaco noted last week (listen to our podcast, Oh Canada’s Pipelines!), the world is going to use more energy, and consumption of every form of energy will increase. While the media focus is on renewables, fossil fuels represent 80% of global energy consumption. Improving what already works, by dealing with emissions, is also a recipient of considerable R&D.

Hydrogen is receiving increasing attention. It has a reputation for being perennially five years away from cost effectiveness – but investors are certainly taking note of anything that’s hydrogen-related. A couple of months ago we noted how New Fortress Energy (NFE) had seen their stock triple this year on little more than vague plans to ship hydrogen (see Hydrogen Lifts an LNG Company).

The emission benefits of using hydrogen depend on how it’s produced. The most common method is methane pyrolysis, which uses heat to separate hydrogen from carbon (methane is CH4). Another process applies electrolysis to water, which separates the hydrogen atoms from oxygen, Both require energy as an input.

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Most hydrogen in use today is “gray”, meaning fossil fuels are used in its production. “Blue” hydrogen is derived from methane, with the CO2 that’s produced as a by-product being captured. That’s already a pretty good result. “Green” hydrogen relies on energy from renewables to power the extraction process.

Hydrogen is an appealing solution if costs can be brought down, because burning it produces water, not CO2. Compared with methane it is less dense, and causes the steel used in pipelines to become brittle, which means it can’t currently be moved in a pure form through existing infrastructure.

But hydrogen is already being added in small quantities to existing supplies of natural gas (methane). For example, Los Angeles is currently adding 4% hydrogen to their natural gas supply and is hoping to get to 10%.

Pipeline companies are watching this area closely, awaiting solid evidence that it can be made commercially viable. If hydrogen use does gain traction, today’s midstream infrastructure businesses are well positioned to benefit, since hydrogen transportation will be via pipelines. The industry will surely find a technical solution to the problems caused by direct interaction of hydrogen with steel – perhaps by applying a protective coating to the inside.

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Recently, United Airlines announced an investment in 1PointFive, a joint venture between Occidental (OXY) and Rusheen Capital Management that aims to extract CO2 from the atmosphere. Airlines know that renewable energy won’t help them curb emissions – batteries are far too heavy to be built into an airplane. And jet fuel has the added benefit of being burnt as it’s used, decreasing weight.

Aviation is estimated to produce over 2% of global CO2 emissions. Post-Covid, flying is likely to resume its upward path in developing Asia at a minimum, even if a full return to normalcy is five years away as some airline executives fear. Nonetheless, it highlights that solar and wind offer a limited set of solutions, which means ongoing need for liquid fuels.

Extreme weather events have caused a jump in solar panel insurance. Last year a hailstorm in Texas caused $70MM in damage to a solar farm. California wild fires damaged three sites earlier this year. Solar panels are easily damaged, and insurance rates are 20-30% higher than a year ago.

“We have seen projects that were achieving their expected returns no longer able to do that, as a result of the change in the cost of insurance,” said Michael Kolodner, US power and renewables practice leader at Marsh, an insurance broker.

Those who blame these and other extreme weather events on climate change will not appreciate the irony.

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Another non-renewable, clean energy solution is NetPower’s emission-free natural gas turbine (see Clean Fossil Fuels May Be Coming). The company explains that their patented “Allam-Fetvedt Cycle burns natural gas with pure oxygen. The resulting CO2 is recycled through the combustor, turbine, heat exchanger, and compressor.”

NetPower says they have, “Multiple projects are in development worldwide for rapid global deployment of commercial units.”

Cleaner ways of burning natural gas; extracting harmful CO2 out of the atmosphere; commercially viable hydrogen. These are all potential solutions to the problem of lowering emissions that don’t rely on solar panels, windmills and batteries. These are the types of breakthrough that could quickly put today’s pipeline companies at the forefront of combating climate change. What’s clear is that innovation is happening in many more areas than simply the use of sun and wind.

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

The pipeline sector’s increasing Free Cash Flow (FCF) has quietly allowed several companies to initiate buyback programs. We calculate that over $8.5BN in buyback programs have been announced this year, including $3.5BN following 3Q earnings.

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One of the biggest headwinds to improved equity returns this year has been selling by funds. There was the forced selling in March (see MLP Closed End Funds – Masters Of Value Destruction), which was likely in the $1-4BN range, and $6.4BN in steady redemptions from open-ended funds all year.

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Recent buyback announcements have improved the buy/sell balance in the sector, such that companies could be absorbing investor sales with their own excess cash. Of course, buyback programs don’t have to be executed if, for example, prices rally to less attractive levels. This flexibility adds to their appeal. And while it’s impossible to predict what fund investors will do, their total AUM sank as low as $24BN in November before rising prices increased values.

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It’s likely that positive investment returns will turn outflows to inflows before too long.

Increased buybacks, if combined with a shift in investor appetite for the sector, would represent a substantial change in flow of funds into pipeline stocks. Valuations have been attractive for months (see May’s post, Pipeline Cash Flows Will Still Double This Year). Fund flows are starting to reflect this.

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Next year the continued growth in FCF will leave excess cash after dividends. Over the next two years, we estimate that the sector will generate $25BN in excess FCF after dividends. This should leave room for further buyback announcements over the next few quarters.

The market has been slow to recognize this, but pipelines are becoming cash-generative businesses. Enbridge (ENB) reflected this shift on a slide at their investor day last week. Large capital projects are being replaced with a focus on boosting returns from existing assets. Funding is now internally generated cash rather than the capital markets. And they are making investments in  renewables as part of the energy transition, as long as returns justify it.

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Related to the energy transition, on Thursday United Airlines announced an investment (amount unspecified) in 1PointFive, itself joint venture between Occidental (OXY) and Rusheen Capital Management. They are developing technology to extract CO2 from the air and convert it into pellets that can be stored.

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It’s possible to by cynical about such efforts – United Airlines, like every public company, has an ambitious ESG agenda. The requirements to score well on ESG criteria are extremely flexible. For example, Lockheed Martin has been in the Dow Jones Sustainability Index for seven years (see Pipeline Buybacks and ESG Flexibility). Think green bombs. In many cases there’s more style than substance to ESG-initiatives. Nonetheless, this illustrates that the R&D to combat climate change isn’t limited to improving battery storage to compensate for renewables’ intermittency. Commercially viable carbon capture would recast the debate about climate change. It’s worth watching.

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

The pipeline sector continued on its tear last week. The catalyst was Pfizer’s vaccine announcement a month ago, but cheap valuations have drawn increasing attention as prices have risen. The buybacks announced by several companies added further support.

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For many months, we’ve argued that the biggest problem with the sector was negative sentiment. Since peaking in 2014, midstream energy infrastructure has lagged the S&P500 significantly. The industry began to acknowledge investor criticism of over-investment back in 2018. That’s when growth capex peaked. Since then, the path to growing free cash flow has been clear – but sentiment is often the last piece to fall in place.

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Rising stock prices are starting to do that. This is persuading investors that what appears cheap perhaps really is. We are seeing it in our own business, where inflows have returned and investors are increasingly prepared to commit capital. The energy sector ETF XLE is on track for a record year of AUM growth.

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Energy is part of the broader shift from technology to value, including small cap. The widely-watched QQQ/IWM ratio solidly crossed its 200-day moving average to the downside last month, and has continued its new trend.

Since the beginning of October, the American Energy Independence Index has rallied 32%. At –8% YTD, it’s not inconceivable that it could claw back its remaining losses for the year. At the end of March, it had lost more than half its value over the prior three months.

So it’s worth pausing to examine valuation.

The components of the AEITR still yield 7.5% — still sufficiently high to suggest healthy skepticism regarding sustainability. Yet all companies except for Energy Transfer paid quarterly dividends at least as high as before. We calculate that payouts are now covered almost 2X by Distributable Cash Flow (DCF).

Free Cash Flow (FCF) should come in at $23BN for the year, up from $8BN in 2019. We entered 2020 expecting FCF to double, and by May reaffirmed that forecast (see Pipeline Cash Flows Will Still Double This Year).

The increase is fully driven by reduced growth capex. We see it rising to $44BN next year, an 11% FCF yield which is more than 2X that of the S&P500.

One of the reasons we like our prospects with incoming President Biden is that pipeline spending plans are likely to remain constrained. New projects are almost impossible nowadays. Environmental extremists have figured out how to use the court system to introduce unpredictable legal delays into any project. We are not unhappy with this (see Pipeline Opponents Help Free Cash Flow).

Long term capital commitments to fossil fuels face significant uncertainty with respect to public policy. While this will disappoint executives who love to build, investors like us will find much to like. Less building means less execution risk as well as more cash for buybacks, dividend hikes and debt reduction. How ironic that a Democrat president is likely to create an improved environment for investors – such was the exuberance unleashed by Trump’s pro-energy, deregulatory push.

Meanwhile, the U.S. Energy Information Administration reported that natural gas fired power generation increased in most of the U.S. over the past five years. Natural gas is going to see demand growth for years to come, especially from developing countries intent on raising living standards. Don’t be distracted by all the media attention to renewables. What counts is what’s actually going on.

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

November was a month of records for stocks, including for the energy sector. The American Energy Independence Index (AEITR) was +20.8%. This year has seen the top two months, and it’s still –16.1% YTD. 

Crude oil grabs most of the attention, but propane is an under-appreciated area of rising production that’s driving higher exports. It’s generally used for heating by businesses, industry and homes, but is also used for cooking in rural areas that are not reached by natural gas (methane).  

Propane exports have been rising steadily for the past decade, growing at a 26% compound annual rate since 2010. We crossed the 1 million barrels per day threshold in 2017. The Covid pandemic is barely a blip. 

One reason for this is increased demand in India. Propane is often produced as a by-product of oil refining, but in the U.S. it’s found naturally in gas wells where it’s separated out from the methane.  

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Tens of millions of households in India rely on bottled propane for cooking and heating. The drop in gasoline demand earlier this year lowered local refinery runs, depressing propane production. So India turned to the U.S. for imports (see Energy Does More Than Move People). 

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Enterprise Products Partners (EPD), the biggest MLP, is one of the winners from this business. They include propane in their Natural Gas Liquids (NGL) segment, and they’ve participated in this growth as much as any company.  

NGL exports volumes are now similar to crude oil, though few outside those following EPD would know that. Propane dominates the segment. 

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This has driven EPD’s margin from NGL pipelines and services to a 9% compound annual growth rate over the past five years. Based on the first 9 months, 2020 looks set to be another record year for NGLs.  

This all highlights the resilience of their business model.  

Nonetheless, EPD’s stock price has lost a third of its value this year, even after a 17% gain in November. This reflects continued loss of appetite among investors for the sector. EPD’s $1.78 dividend currently yields almost 9% and looks secure since the company has bought back $225MM in stock this year out of an announced $2BN program.  

Investors often ask whether EPD will convert to a c-corp. There can be little doubt that, if accessible to a far broader set of buyers, their stock would rally. However, insiders own 32% of the company, and they have concluded that subjecting their profits to corporate taxes doesn’t justify the potentially higher valuation. Although EPD never had to cut its distribution, unlike most of its MLP peers, it suffers guilt by association with many poorly run brethren. CEO Jim Teague usually runs a colorful quarterly earnings call – regular listeners look out for the Vietnam references (i.e. he’s been in tougher spots than 2020).  

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