Pipeline Earnings Should Be Good

Earnings season for the pipeline sector kicks off Wednesday 20th with Kinder Morgan. Crude oil prices have slid over the past several weeks, reflecting increased fears of recession and China’s ongoing efforts to eliminate Covid through regional lockdowns. Sharp moves in oil affect energy sentiment and the consequent drop in midstream energy infrastructure reflects these global macro concerns.  Fundamentals continue to look very good to us.

Europe’s sharp pivot away from Russian energy is a permanent shift, with long term benefits for the US natural gas business. The drop in crude will provide some relief at the gas pump for households. Middle income households (average income around $66K) are spending 12.3% of their income on gasoline and home energy bills, up from 9.5% in 2020. The recent drop in prices will support demand, which is good for pipeline operators.

Political developments have also been positive. The EU recently classified natural gas and nuclear power as “green”, which will enable increased use and introduce some sensible pragmatism to European energy policy. In the US, Democratic Senator Joe Manchin did us all a favor by declining to support the Democrat party’s liberal agenda on climate change at least until we see some moderation on inflation. Policies that aggressively favor solar and wind result in more expensive energy. Empirical evidence is widespread – California and Germany being two examples.

It’s increasingly clear that the science around climate change has been far more accurate in forecasting increased levels of CO2 than in predicting the resulting impact on climate. Both Vaclav Smil in his latest book How the World Really Works and Alex Epstein in Fossil Future point out numerous predictions of climate catastrophe that have been dead wrong. Smil notes four decades of shoreline change in all 101 islands in the Pacific atoll nation of Tuvalu show that the land area has increased by 3%. The Maldives, in the Indian Ocean and most of which is four feet or less above sea level, apparently faces an existential threat from climate change and nonetheless added a new airport to accommodate more tourists.

Europe is enduring a heatwave. Parts of southern England are expected to reach 100 degrees this week. The UK Met Office, which issues weather forecasts, has never before issued one so high. Having grown up in the UK I can attest that a warm summer’s day peaking around 80 degrees is thoroughly agreeable. When combined with an evening beer or three in a pub garden basking in the warm glow of a 930pm sunset, life is positively sublime. However, with residential air conditioning unknown, the country isn’t prepared for Texan weather.

Climate change will be blamed. We’ll be warned to expect more such extreme weather events. But the reality is that, as miserable as the heatwave will be, if such events occur more frequently the British will simply start installing AC. Following the policy prescriptions of climate extremists would be economically ruinous on a scale completely disproportionate to the costs of adaptation. The public has largely concluded as much, which is why global demand for fossil fuels has stayed robust. The same is true of asset markets, where no discernible “climate change discount” exists, a point memorably offered by HSBC’s former head of responsible investing, Stuart Kirk, in a wonderfully irresponsible presentation that became his swan song.

In midstream energy infrastructure, positive fundamentals are leading sell-side firms to upgrade their earnings forecasts. JPMorgan expects Kinder Morgan to revise full year guidance higher based on what they anticipate will be solid 2Q22 results. Targa Resources should have strong gathering and processing results. Williams recently provided optimistic feedback so their forecast 2Q22 EBITDA was revised modestly higher. JPMorgan has raised their 2Q22 EBITDA forecast for Enterprise Products Partners by 266MM (13%) across various segments. Energy Transfer is expected to deliver strong results from their midstream segment, with crude oil a headwind due to bad weather in the Bakken.  There should be updates on eventually getting back to a $1.22 distribution, easily covered in our opinion with distributable cash flow next year providing comfortable 1.8X coverage.

If these stocks rally it may be a case of “selling the news”. Long-time readers know better than to rely on us for short term market timing. The point is, for these companies and others, business is good.

If pipeline stocks were marketed by Walmart, their promotional ads would remind that you can “Buy midstream at pre-Ukraine war prices.” It sounds Cramer-esque.

With earnings season upon us, that might be the most accurate sales pitch.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

Hoping Russia Will Send More Gas

On Monday Nord Stream 1 was shut down for annual maintenance, cutting off the remaining Russian natural gas exports to Germany. Europe’s biggest economy continues to provide lessons to the rest of us on what a flawed energy strategy looks like. German industry anxiously waits to see whether some contrived additional repairs will extend the pipeline’s maintenance beyond its scheduled ten days. Germany is dependent for energy on a country whose soldiers are being fired at by Ukrainians using German weapons. It’s not a good place from which to negotiate.

Austrian energy company OMV said it’s receiving less than a third of the natural gas from Russia that it’s ordered.

German day ahead power is trading at €370 per Megawatt Hour. French month ahead power is over €430. Europe’s problems are being compounded by a heatwave which is forcing reduced nuclear output in France. When the river water used to cool nuclear plants rises above a certain temperature, returning water back to the river risks damaging the environment.

Right on cue, west European wind power is falling too. Hot weather tends to occur with little breeze. That’s why it’s hot. Texas is experiencing a similar drop in wind output during their current heatwave, with output running at only 8% of capacity. It is possible to want reduced CO2 emissions while valuing reliable energy over opportunistic solar and wind. Policymakers are increasingly embracing natural gas as the solution.

Global trade in Liquefied Natural Gas (LNG) rose 4.5% last year, a trend that’s likely to continue for some years now that Europe has pivoted away from Russian supplies. A recent profile of Tellurian CEO Charif Souki in the New York Times offered an unexpectedly balanced view of the benefits of natural gas. The article presented what is fast becoming orthodox thinking as policymakers confront the energy crisis:

The world may be facing energy and climate crises, he said, “but one is going to happen this month, and the other one is going to happen in 40 years.” He added: “If you tell somebody, ‘You are going to run out of electricity this month,’ and then you talk to the same person about what’s going to happen in 40 years, they will tell you, ‘What do I care about 40 years from now?’”

EU lawmakers recently approved natural gas and nuclear as “green” investments, which will make it easier for companies to obtain financing. It’s another recognition that running the world on solar panels and windmills won’t work. Nonetheless substantial incongruity remains between what rich countries want for themselves versus their policy prescriptions for non-OECD countries. For example, Nigeria exports LNG to Europe who in turn wants to see Africa by-pass fossil fuels and use more renewables. It’s leading to accusations of “green colonialism”. Egypt is hosting COP27, the UN’s annual climate change conference, and increasing poorer nations’ access to natural gas is expected to be high on the agenda, as it should be.

Further boosting domestic demand for natural gas is growing interest in Electric Vehicles (EVs), US sales of which recently crossed 5% of total auto sales. Tesla owners love their cars, but most own a conventional car too.  Inadequate charging infrastructure for EVs remains a deterrent, as does the time it takes to top up a battery. As EVs gain market share they will increase demand for electricity, the two biggest sources of which are natural gas (38%) and coal (regrettably 22%).

Recession fears continue to weigh on energy prices which is depressing the sector. The American Energy Independence Index has pulled back 19% from its recent high in early June but is still +12% YTD. The fundamentals have hardly changed. Natural gas demand remains strong over the near term and its long-term prospects seem to improve every month. Even if crude oil demand grows more slowly, it will have a minimal impact on North American pipelines.

Williams Companies has experienced an 18% pullback and yet their prospects have barely dimmed if at all. The stock yields over 5%, has a Free Cash Flow (FCF) yield of 7% and we calculate an adjusted funds from operations yield of 10%. A similarly bullish case could be made for Energy Transfer, which yields 8% and has a Distributable Cash Flow (DCF) yield of over 20%. Both companies spend no more than 10% of DCF on maintenance capex. Cheniere has a FCF yield of 17%.

Many prospective investors looked at this sector during the spring and hesitated because of the strong YTD performance. They asked whether they had already missed the move. Those same investors can invest at the prices that prevailed in February, before Russia invaded Ukraine. Back when European leaders sat atop Maslow’s pyramid with all their problems solved other than curbing CO2 emissions. A time when energy dependence on Russia passed for thoughtful engagement. A time when energy security was anachronistic. Better to watch the education from here than to live through it there.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

These Are The Good Old Days

It’s an odd recession when the economy adds 372K jobs and the unemployment rate stays at 3.6%. We seem to be talking ourselves into one. Consumer expectations are the lowest in almost a decade. High prices for energy and food are the culprit. Few are seeing their incomes keep pace with 8% inflation, so real incomes have taken a significant hit this year.

So it’s curious that the measure of how households report their present situation is well above the average since 2006. The gap between today and how people feel about the future is historically wide. A sense of foreboding is creating the type of negative outlook only seen in recessions. Collectively, we saw a brighter future at all times during the pandemic than we do today. Maybe that reflected a recognition that something so bad had to end.

A few weeks ago on Josh Brown’s show The Compound and Friends I drew skepticism when I suggested that we might look back on today as the good old days. Inflation is a problem, but jobs are plentiful. The Conference Board survey data suggests that many respondents feel the same way.

Wall Street is warning that recession odds are increasing. Citigroup puts the odds at 30% within 18 months. Former NY Fed president Bill Dudley thinks the Fed will inevitably cause one in their inflation crusade. He’s betting they’ll follow up one mistake with another. Fed chair Jay Powell says avoiding a downturn largely depends on factors outside the Fed’s control, which is a way of preparing for that second mistake.

With stocks down 20% and bonds down 10%, the classic 60/40 portfolio is down 16% YTD. Regular readers know we have shunned bonds for the entire existence of SL Advisors (see my 2013 book Bonds Are Not Forever; The Crisis Facing Fixed Income Investors). Shoddy thinking is the only explanation for why return-seeking investors still own any bonds. We have often illustrated that a barbell of stocks and cash offers a better risk/return across most scenarios (see The Continued Sorry Math Of Bonds).

The pervasive negativity among consumers, reflected in the weak stock market, is a resounding lack of confidence that the Fed will operate with a deft hand. From this blogger’s perspective over 40+ years, today’s FOMC moves as a group without strong leadership. Powell strikes me as a chair who identifies the consensus rather than creating it the way Greenspan or Volcker did. This means they’ll  be slow to shift views, because the group will need to get there together. We saw this with the FOMC’s belated recognition of surging inflation. It’s certainly premature to expect an ease of the tightening cycle, but widespread pessimism reflects a concern that a slothful FOMC shift in consensus will lead to an excessive rate cycle peak.

Inflation expectations as measured by the treasury market have fallen sharply in recent weeks. Ten year CPI inflation is priced at 2.3%. Since it’ll be well above that level for at least the next year, the market is priced for the remaining nine years to average at a level very comfortable for the FOMC.

It’s true government bond yields have been distorted for years by non-economic buying by central banks and others with inflexible mandates such as pension funds. This has kept yields lower than they would be otherwise, but presumably such buying pressure works on TIPs as well. If anything, Quantitative Easing had a bigger impact on TIPs than nominal treasuries which, by further depressing real yields would cause implied inflation to be higher. That the Fed is still tightening is a rejection of market-based measures of future inflation. Perhaps they’ve concluded that their activity and that of others have rendered the bond market an ineffective measure of investor expectations.

In recent weeks the market has recalibrated the expected path of monetary policy higher. Meanwhile, signs of a slowing economy are increasing. Most dramatically, crude oil has slumped with December Brent futures falling $20 from their level in early June. GDP projections are being revised down. Bottom-up Factset earnings forecasts are being trimmed, for this year and next.

Goldman Sachs believes the oil market has overshot, with the price drop implying a 1.1% drop in global GDP 2H22-2023. They point out that the current oil deficit remains unresolved. Energy markets have dropped on expectations of lower future demand while current demand is unchanged. Aviation demand continues to recover strongly, spurred by a rebound in international travel. They estimate June demand for crude oil was up 2% year-on-year excluding Asia.

For now it seems investors are more afraid of the future than would seem justified by the present.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.


Germany Pays Dearly For Failed Energy Policy

US drivers may complain about the cost of filling up, but the epicenter of the energy crisis is Germany. The world’s third biggest exporter (behind China and the US) reported a monthly trade deficit for the first time in over thirty years. Higher energy prices hit in two ways – Germany is spending much more to import its energy, the result of its strategic blunder in relying on Russia. And its manufactured products are costing more to produce, raising the prices of their exports which is losing some sales.

It’s becoming increasingly clear that Russia intends to exploit its strong hand on energy in ways likely to maximize Germany’s economic pain. An energy strategy that saw fit to rely on Nord Stream 2 was already naïve. Following western sanctions on Russia, Germany still seemed to believe that the natural gas would keep flowing conveniently up until alternative supplies were in place. Decades of German political leadership have turned out to be misguided.

Coincident with Germany’s unfamiliar trade deficit and the cause of it is rising natural gas prices. The Dutch TTF futures contract is at almost $50 per million BTUs, more than five times the US benchmark. Germany’s mittelstand exporters, as efficient as they are, will struggle under such circumstances.

The economic pain is most apparent in power prices – 4Q22 electricity is approaching €400 per Megawatt Hour (MWh). US prices vary widely by region and time of year but are usually a fraction of Germany’s and rarely equal. Germany is preparing to bail out power companies that are having to make up for undelivered Russian gas on the ioen market while unable to pass those higher costs along to customers.

JPMorgan recently revised down their forecast for Germany’s 2H22 GDP to 1.5%.

It’s not only Germany’s reliance on Russia that has caused problems. The “Energiewende”, or energy transformation, represents a huge public commitment to reduce Germany’s CO2 emissions with very little to show for it. Over the past two decades vast investments in solar and wind have lowered the fossil fuel contribution of Germany’s primary energy use modestly, from 84% to 78%, as recorded in Vaclav Smil’s How The World Really Works.

Japan’s 2011 Fukushima nuclear disaster prompted the Merkel government to phase out nuclear power, which further exacerbated their vulnerability to Russian supply.

Germany is on track to show the world how much economic damage a disastrous energy policy can inflict on its citizens. Their embrace of policies to combat climate change is based on assumptions such as the EU’s, which anticipates global per capita emissions declining by half by 2050, even though over the past thirty years it’s risen by 20%. As Vaclav Smil notes, “…most of the power to enact meaningful change will lie more and more in the modernizing economies of Asia.”

One result is that Germany has turned back to reliable energy (ie not renewable) such that one day recently 72% of its power generation was from coal.

Floating Storage and Regasification Units (FSRUs) are an important near term solution to Europe’s energy crisis. They allow relatively fast import of Liquefied Natural Gas (LNG), since the onshore connectivity can be built in just a few months. A full-blown regasification facility takes at least three years. Germany is building two of them but has also leased two FSRUs for more immediate relief.

Building LNG infrastructure for export and import is expensive and time consuming, with little alternative useful purpose. Long-term contracts provide visibility for buyer and seller, which also makes the sector appealing for investors like us. Some of Europe’s LNG demand will be met by America in the coming years.

However, European negotiators remain constrained by an ambivalent attitude towards natural gas, in that they want it now, but they want to be able to reduce their consumption in the future when they believe solar and wind power can plug the gap. This has led to protracted and so far, inconclusive negotiations with Qatar, with the Europeans balking at Qatari demands that they sign twenty-year contracts. The EU still retains faith that cheap, long term battery storage will eventually be developed in enough size to power a city for a few days when it’s cloudy and calm.

Europe’s energy crisis has prompted more decisive action from Asian buyers, who aren’t as confused about their long-term energy needs and regard the EU as potential competition. As a result, they have been acting more quickly. China Gas just announced a twenty year agreement to buy LNG from NextDecade’s proposed Rio Grande facility, which is increasingly likely to move ahead.

Germany’s energy policy offers little worth emulating, but its exposure is creating opportunities for US LNG exporters.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.



Celebrating America

May 17 represented a memorable anniversary for me as it marked 40 years since I first moved to the US. Another Brit leaving the old world for the new. I arrived on an evening flight from Toronto where I’d spent a week with family. It was my first time in NY and such was the city’s reputation I was expecting to be robbed the moment I stepped off the plane. Over those four subsequent decades my wife and I raised three children who have (so far) produced seven grandchildren (ten months to six years old). An original family of two now has two dining tables joined end-to-end to accommodate family dinner.

This is the world’s greatest country and it’s worth celebrating. July 4th is such a positive holiday. I have spent all but one of them in America since 1982. In July 1985 I was back in London for our wedding, and very appropriately my best man obtained July 4th tickets to see Bruce Springsteen at the old Wembley Stadium. Born in the USA echoed around that cavernous arena even though most (like me) were not.

I love America but I am proud to be English. England was my home until I was 19. My outlook and values were formed there. It is also a great country. On the day after Thanksgiving when England play USA at the World Cup in Qatar, I shall be waving England’s flag, the Cross of St George. You have to be true to yourself.

My children long since tired of my well-worn speech about how fortunate they are to have grown up here. I warn that the best and brightest from around the world strive to move to America, which is good for our economy but means great success requires enormous commitment. In a few years I shall offer the same homily to our grandchildren.

I’m told I have a sunny outlook. And why not? This year the pipeline sector is up 12%, 32% ahead of the S&P500. Some may credit my demeanor to outperformance – and while not schadenfreude, I will admit to some satisfaction in holding that rare set of investments that is beating inflation. But I felt almost as upbeat two years ago when fears of stranded assets and demand destruction ravaged energy stocks. It’s how I’m wired.

I find pessimism is more prevalent than usual. Market performance is certainly a factor, but Covid put us through the wringer. Whether you were scared of dying or frustrated at endless restrictions, we all experienced the scrambling of normal daily life. It’s left its mark. We’ve moved on, only to confront inflation and, if the Fed makes another mistake, a recession. Didn’t we just have one?

Ronald Reagan was my first president. His perpetual optimism was a beautiful sight. Today we are polarized and politics is dark. Opponents don’t just have different views, they have inferior values — if any. I have good friends who voted for Biden and good friends who voted for Trump. I generally know and don’t much care. Neither party has all the answers and both hold positions on some issues that are wrong.

One regrettable change is that today people, cities, states and even regions are characterized based on their politics. And yet for me it’s always morning again in America. Reagan’s 1984 re-election ad may look syrupy today but it still pulls my heartstrings.

If I judge America by my friends, it remains the wonderfully warm, hospitable, energetic, generous place that pulled me here in 1982. This hasn’t changed in four decades and doubtless much longer than that. Most of us meet new neighbors, business associates or golf club members regularly. Usually, my optimism about the future is confirmed.

The Fed may cause another recession, but nobody wants one. A second downturn within five years will damage America’s confidence in our government’s ability to manage the economy. We just found out how unprepared we were for a pandemic. We’re due some competent leadership. Inflation is bad but will soon seem preferable to the costs of extinguishing it. A recession isn’t yet assured.

On climate change, the economic recovery from Covid and Russia’s invasion of Ukraine have quickly exposed how out of reach the zero by 50 goal is. It’s good this happened before extreme climate policy had an opportunity to decimate economic growth. Vaclav Smil’s latest book, How the World Really Works explains the physics and economics behind the energy we use (see Hydrocarbons Support The Four Pillars Of Civilization) and goes on to assert that the dramatic change envisioned by UN scientists and others is impossible.

Smil’s cold analysis reaches conclusions that climate extremists will find devastating. Accurate predictions of increased atmospheric CO2 have been around for over a century. Spectacularly wrong warnings of climate apocalypse have a similarly long history.

But Smil is no pessimist. His closing chapter predicts that, “…the most likely prospect is a mixture of progress and setback, of seemingly insurmountable difficulties and near-miraculous advances.” In other words, we’ll muddle through with reduced emissions and mitigation.

Our difficulties aren’t limited to a looming recession and global warming. But if you look around at your friends and imagine millions more like them across America, you’ll see it’s still a great country capable of meeting any challenge. I knew that when I arrived here forty years ago. I’ve been right ever since.

Happy 4th of July.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

Liberal Energy Policies Remain Good For Investors

The energy transition’s long overdue reassessment was already under way by the time Russian missiles began falling on Ukraine. Fear of stranded assets has been replaced by the sudden need for energy security.

At a recent JPMorgan energy conference, CEO Jamie Dimon repeated his call for a new “Marshall Plan” to ensure energy security for the US and our allies. Appropriately this took place during a “fireside chat” with Cheniere CEO Jack Fusco, who noted that his company provided 1/3rd of Europe’s natural gas imports during 1Q22. Many have noted that there can be no energy transition without energy security. Few companies are more important to Europe in avoiding natural gas rationing this winter.

In JPMorgan’s annual report, Dimon reminded that, “… using gas to diminish coal consumption is an actionable way to reduce CO2 emissions expeditiously.” Dimon is no climate change denier but is pragmatically identifying profitable business for the bank. Purists fret that building new infrastructure to support imports of Liquefied Natural Gas (LNG) means locking Europe in to burning fossil fuels for several decades, inconsistent with the UN zero by 50 mission. Meanwhile, German wholesale electricity prices one year out have breached €200 per MWh, up 4X over the past year.

Capital investment in future oil and gas production has been falling for years. The poor returns following the shale bust are the immediate cause, but the message from policymakers has been clear. Oil and gas look like a risky long term investment when governments are promising to stop using fossil fuels just as soon as they can. Now western leaders are acknowledging the public’s ephemeral concerns about climate change, which last until the costs are visible. Higher oil doesn’t seem to have caused a spike in windmill prices. St Augustine* might have said “Lord, give me renewables, but not yet.”

The problems of underinvestment aren’t limited to oil and gas. Goldman’s Jeff Currie expects oil prices to reach $140 per barrel during the summer. In a recent CNBC interview he said, “At the core of our bullish view of energy is the underinvestment thesis.” Currie noted that this month’s pullback in energy sector equity prices would exacerbate the problem by reflecting a withdrawal of capital from a sector that needs it in order to increase production.

The International Energy Agency (IEA) expects global crude oil demand to increase by 2% next year, taking it above pre-Covid levels to a new all-time high. US airline fares are up 38%. In spite of this, more people are flying around the world, with the aviation sector representing 5% of crude oil demand. International travel is growing the fastest.

Although global capex is up this year among the world’s biggest oil and gas companies, it’s still down by around a fifth from 2019. This downtrend dates back to pre-Covid, when policymakers were freely vilifying the energy industry. The collapse in prices in 2020 was a further incentive to impose financial discipline.

There’s an illuminating clip from the recent G7 meeting during which French President Macron tells President Biden that the United Arab Emirates is producing at maximum capacity while the Saudis have perhaps a small amount of extra capacity, for the next six months. One might think that Biden wouldn’t need a foreign leader to point this out to him, but this Administration’s energy policy does remind of the Keystone Kops.

Fortunately, in its final communique the G7 said investment in liquefied natural gas was a “necessary response to the current crisis”. It added: “In these exceptional circumstances, publicly-supported investment in the gas sector can be appropriate as a temporary response.”

With gasoline prices rising and little prospect of relief, it’s not hard to see the Republicans running as the party of cheaper energy. They have little useful to say on curbing emissions, so the appeal of such a message will reflect Americans’ concern about climate change. White House actions suggest that they believe only the liberal wing is willing to rapidly phase out fossil fuels. They’ve assessed that swing voters care more about what they pay at the pump.

Therefore, a Republican-controlled Congress following the mid-terms could pass legislation supportive of increased investment in domestic oil and gas production – by making it harder for endless court challenges to block infrastructure projects for example. Signing or vetoing such a bill would offer an uncomfortable choice for a lame duck president.

For now it seems meeting demand growth for traditional energy will drive prices higher. There’s little sign of demand destruction at current levels, and China is still enduring partial lockdowns.

*St Augustine is credited with saying, “Oh Lord, give me chastity, but do not give it yet.”

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

The Fed Can’t Afford Two Mistakes

Amid the more hawkish Fed and consequent sharp drop in the market, the jump in real yields has not drawn much attention. The rise in ten year yields came with inflation expectations remaining well anchored at around 2.75%. TIPs yields rose with nominal ones.

Factset earnings expectations don’t yet reflect the pessimism of public company CEOs, the majority of whom expect a recession within 12-18 months. That view relies on the expectation that the Fed will tighten excessively in their zeal to control inflation.

It’s a fascinating problem trying to predict the FOMC’s actions. Warren Buffett often responds that he never considers the economic outlook when analyzing investments, but some of these CEOs presumably do when making capital allocation decisions.

Meanwhile, the eurodollar futures curve has steepened somewhat but also has an increasing gap between yields five years out and longer compared with the FOMC’s equilibrium rate. The Fed’s latest projection materials show the median member’s forecast at 2.5% for the neutral policy rate. Futures markets have it closer to 3.25%.

It reminds of the Fed’s past poor record at forecasting (see from 2019 Bond Market Looks Past Fed). For many years after the great financial crisis of 2008-09, the bond market implied lower rates than the Fed. The bond market was right. Today circumstances have reversed, and interest rate markets are forecasting a higher neutral rate than the FOMC.

This is likely to be correct because the Fed’s reinterpreted mandate favors maximizing employment over stable prices. Therefore, inflation is likely to remain above their 2% target because they’ll be wary of the recessionary risk of extended tighter policy. Raising rates with inflation at 8% is not controversial. When unemployment is in the mid 4%s and rising while inflation is at 4% and falling is when the Fed will more clearly need to consider the employment/inflation trade-off. Even with the Fed moving at 0.75% increments, the 4% rate cycle peak represents little if any premium over then current inflation.

Today’s market prices support this view. So there’s some asymmetry every time important economic data is released, such as the employment report on the first Friday of the month. Signs of weakness will likely drive two year treasury yields lower and the market to anticipate the Fed moving to neutral or slower pace of rate hikes.

Coupled with this, the Equity Risk Premium (ERP) is starting to favor stocks again. Just two months ago we noted that the market wasn’t that attractive compared with bond yields (see Criticism Of The Fed Goes Mainstream). Since then, stocks have slumped 15%, and even though interest rates have risen stocks are more attractively priced. Bottom-up 2023 S&P500 earnings assume 9% earnings growth, which puts the ERP at 3.5, comfortably wider than its 2.5 two decade average. Even though ten year yields have been rising, bond prices seem to be permanently supported by return-insensitive holders (central banks) and rigid investment mandates (pension funds). The ERP is only likely to favor fixed income over stocks when the market is truly frothy – not its present state.

If soft economic data causes investors to price in a more moderate Fed, the equity market is poised for a strong rally.

A couple of weeks ago when I was on The Compound and Friends, Josh Brown’s weekly interview that’s published on Youtube, I suggested that we might look back at this period as the good old days. Josh and his co-presenter Mike Batnick were shocked. “There’s nothing more scary than a pessimist with a British accent” became that episode’s trailer. I explained my point, which is that although criticism of the Fed flows freely, they have achieved full employment – if anything they’ve over-achieved it.

Apart from those heavily invested in the energy sector, inflation is making many feel poorer since real incomes are falling. But at least everyone is coping with higher prices with a job. A few million people will need to lose theirs in order to reduce inflation for everyone. When that happens criticism of the Fed will take on a different form. If one policy error (a slow response to inflation) is followed by another (a recession caused by over-responding to the first), Powell’s congressional appearances will become uncomfortable.

That analysis is why it’s worth betting on the Fed claiming a premature victory over inflation. They can’t afford consecutive policy errors, so inflation is unlikely to return to their 2% target. Pipeline stocks have endured a sharp fall this month, but the strong fundamentals remain intact, and dividend yields have moved a little higher with the sell-off. In our opinion midstream energy infrastructure is attractively priced.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.






Texans Don’t Complain About Gas Prices

People may disagree on whether this Fed is hawkish or not, but reactionary is not a controversial adjective. They first demonstrated this in waiting eighteen months after the Covid vaccine and fifteen months after the last $1.9TN slug of fiscal uber-stimulus to roll back their monetary accommodation. Quantitative Easing (QE) is more aptly followed by Qualitative Tightening (QT*), since they regard the inverse of bond buying as letting holdings mature as opposed to auctioning their MBS holdings.

Mortgage yields have reached 6.5% and stocks have entered a bear market. The Fed’s projection materials show PCE inflation falling sharply next year to 2.6% and 2.2% by 2024. They have revised up their forecasts for interest rates and the unemployment rate. The FOMC is now more clearly warning that jobs will be lost in the effort to vanquish inflation. Perhaps smarting from earlier criticism that their forecasts were implausibly optimistic, the latest set is an improvement.

The next test will come when unemployment begins to rise. A Fed chair that regularly cites high minority unemployment as a concern is unlikely to draw much pleasure from job losses. When inflation and the unemployment rate head down/up respectively, the FOMC will be looking for an opportunity to declare victory.

Their projections already forecast victory, waiting for the time when monetary policy no longer simply reacts to current data rather than anticipating the lagged effect of its actions. Signs of economic weakness will cause traders to reassess the path of monetary policy.

Pipeline stocks fell substantially more than the market, with the American Energy Independence Index (AEITR) down 15.9% so far in June versus –11.1% for the S&P500. Weakness in crude oil and higher interest rates are the proximate cause. Natural gas and natural gas liquids are a more important driver of midstream infrastructure profits, and their demand outlook remains strong.

An overlooked feature of pipeline contracts is that they often include tariffs that are linked to PPI. This will begin to show up in quarterly earnings for several companies in later quarters. YTD the AEITR is +10.2% versus the S&P500   –22.3%. The AEITR made its high as recently as June 2 and has fallen 15% since then. Painful, but unlike the broader averages not a bear market. Russia steadily reducing natural gas supplied to western Europe serves as a reminder that the path to EU energy security runs through the US.

Exxon Mobil offered a mature response last week to the President’s seething incoherence, which is what passes for White House energy policy nowadays. Exxon offered some practical suggestions, such as relaxing Jones Act constraints that prevent foreign-owned vessels from transporting cargo between US ports. Consistent policy support for the development of domestic oil and gas assets, along with “streamlined regulatory approval and support for infrastructure such as pipelines” are sensible moves the oil supermajor reiterated.

We spent last week traveling Texas (Houston, Austin and San Antonio). The president’s criticism of the oil industry finds few fans there, where signs of a booming economy are everywhere. In NJ my high five to the gas pump attendant when the register hits $100 has not been widely copied. However, I suspect in Houston I’d find many adherents, although you pump your own gas and it’s still available at $4.60 per gallon.

In Houston it seems that everyone moved there from someplace else and southern accents are less common than you’d think. We had dinner with long-time client Geoff Lanceley whose career on the finance side of energy took him from Derbyshire, UK to Iran and Scandinavia before he settled in Houston in the 1970s.

Who knew that the first experiments with fracking saw a frustrated driller toss explosive down a dry well in a final attempt to find oil before sealing it with concrete. It didn’t stop there. In Russell Gold’s The Boom, the author recounts that from 1969-73 the US government set off several nuclear bombs underground in unsuccessful attempts to recover natural gas.

Geoff Lanceley also reminded us that the Houston Ship Channel traces its origins to Houston merchants dissatisfied with the terms demanded by the port of Galveston in the 1850s, who therefore developed alternative access to the Gulf of Mexico. The energy business is seemingly part of every Texan’s life.

Austin is enjoying a boom. It’s fueled more by Californian tax-exiles than energy prices.  It’s impossible to stroll through this normally walkable city without encountering construction and closed sidewalks on virtually every block. Delay your visit until it’s done.

Texas was enduring a heatwave which intensified as we made it to San Antonio. The Riverwalk, a delightful stretch of restaurants and stores, is a different city from the one at street level. We had a most enjoyable dinner with friends and clients Bill and Lisa Edwards. Bill is a retired orthopedic surgeon who still consults and teaches.

We first met over 20 years ago in Vail where Bill was our assigned ski instructor. Countless annual visits have followed. He’s taught our son and younger daughter. This was our first time together away from the thin air of Vail Valley (altitude 8,100 feet and higher). Any skiing competence I demonstrate is to Bill’s credit, and somehow every year I leave him believing I have improved.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.


Hydrocarbons Support The Four Pillars Of Civilization

Vaclav Smil is a polymath whose prolific writing on energy has produced his latest book, How the World Really Works. You read Smil slowly, taking time to digest the facts and conclusions that are his trade. He combines expertise across several disciplines to explain the technology and inputs supporting modern western lifestyles.

In Fossil Future, Alex Epstein notes the substantial improvements that traditional energy have brought to humanity and argues that we should be celebrating not vilifying the hydrocarbons that make this possible. Smil demonstrates that the world will remain dependent on fossil fuels for the foreseeable future with data-based arguments.

The first three chapters of How the World Really Works, explain how indispensable agriculture, steel, cement and plastics are to civilization. Smil reminds us that, “Modern history can be seen as an unusually rapid sequence of transitions to new energy sources, and the modern world is the cumulative result of their conversions.” He estimates that coal provided half of England’s heat by 1620, but even by 1850 only 7% of fuel energy in Europe and North America.

Shifting the transportation sector to electric vehicles and decarbonizing power generation generate media interest, but start with agriculture to understand how the world feeds its 8 billion people. In 1800 98% of the US labor force was engaged in farming. Producing a kilogram of wheat required ten minutes of labor. Today it’s two seconds – 98% lower, along with the proportion of our workers engaged in agriculture.

The entire production process has benefited from fossil fuels – tractors pull plows manufactured with steel. Combine harvesters collect and process the crop. Propane is used to dry it. Trucks transport it farther down the production line. Refrigeration reduces spoilage. Around 1920 one quarter of US farmland was dedicated to growing feed for the 25 million working horses and mules.

Nitrogen-based fertilizers have dramatically increased yields. Manure, which used to be laboriously spread on fields, contains less than 1% nitrogen whereas urea, the world’s dominant solid nitrogenous fertilizer, is 46% nitrogen. Over the last century corn yields in America have increased from two tons per hectare to 11. Natural gas is converted into ammonia, a key input into urea production. Around the world, farming efficiencies have enabled population growth.

It’s unclear how even small portions of modern food production could be migrated away from traditional energy. There is no known substitute for fertilizers derived from natural gas. Battery-powered farm vehicles are implausible. Returning agriculture to its form of a century ago would leave the world unable to support its current population. It’s not going to happen. Moreover, on current trends we’ll add a further two billion people, mostly in developing countries, by 2050. Smil concludes that, “…without the synthesis of ammonia, we could not ensure the very survival of large shares of today’s and tomorrow’s population.”

Smil refers to cement, steel, plastics and ammonia as “the four pillars of civilization”. Global production of these four “indispensable materials” requires 17% of the world’s primary energy and generates a quarter of fossil fuel CO2 emissions. Cement and steel require substantial heat, generated with coal (or coal dust) and coke. Plastic is a product of hydrocarbons such as methane (natural gas), ethane, propane or oil.

Recycled steel is almost 30% of global steel output and is 70% in the US. It can be melted in an electric arc furnace, which sounds promisingly as if it could be powered with renewables. But the energy required to reach a temperature of 1,800 degrees Celsius is enormous. Even the most efficient furnace requires the electricity of an American city of 150,000 people. Iron ore, from which steel is derived, is almost limitless. World resources are estimated at 800 billion tons, compared with annual production of 2.5 billion tons.

Smil estimates that for Electric Vehicles (EVs) to reach 25% of the global fleet by 2050, output of lithium and cobalt would need to increase by at least 15X; nickel by 28X. He estimates 40 tons of ores per EV. With global auto sales running at 100 million annually, 25 million EVs would mean mining a further 1 billion tons of ore every year.

Concrete and steel are the basis for today’s office towers, apartment complexes, bridges, dams and airports. US cement production peaked in 2005 at 128 million tons. Between 2018 and 2019 China produced 4.4 billion tons, almost as much as America during the entire 20th century.

There are no plausible, scalable methods to produce these four materials without the use of traditional energy. Fears that the energy transition would result in stranded assets of crude oil, gas and related infrastructure glossed over these vital inputs of modern civilization. Much of the growth in energy demand from emerging countries is aimed at building modern cities that emulate OECD countries.

This was always true even when ESG fervor was at its peak, inducing institutional disinvestment spurred on by that tiresome teenager Greta (“How dare you”). Energy reality is returning, rewarding those who relied more on analysis by Vaclav Smil than Climate Czar John Kerry. How appropriate that your blogger composed this on a flight to Houston.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

Energy Realism Is Spreading

There were three stories last week that can best be characterized as providing energy realism. The fire at Freeport’s LNG facility sent US natural gas prices skidding, with the loss of 2 Billion Cubic Feet per Day (BCF/D) of export capacity. Freeport warned it’ll be at least three weeks before operations can resume – meaning 2BCF/D of additional natural gas in the US domestic market. Dutch TTF gas futures similarly rallied on fears of reduced supply. But both markets later reversed their initial move.

Nonetheless, the spread between the two is far wider than the cost of transporting LNG across the Atlantic. The US is currently able to export around 12 BCF/D. LNG export facilities take several years to build, so there’s no near term prospect that cheap US natural gas will solve Europe’s energy security problem.

Over the next couple of years capacity will increase slightly, but within five years we should have the ability to deliver a further 10 BCF/D based on projects that have reached Final Investment Decision (FID).

Negotiations with potential buyers over the next couple of years will determine how far we go beyond that 22-24 BCF/D. If all the potential projects get funded, by the end of the decade exports could be almost 5X what they are now. Much depends on the willingness of buyers to make long term commitments. Cheniere has contracts of 20 years or more with highly rated buyers.

There’s no alternative use for a liquefaction facility, so customers have to be lined up before construction begins. US natural gas prices have been largely insulated from higher global prices because of export limitations. This will gradually change in the years to come, narrowing the gap to the benefit of US natural gas producers.

A second story worth reading concerns OPEC’s limited spare capacity. Crude oil continues to drift relentlessly higher. US motorists may complain about high prices at the pump, but they are low compared to most other countries. The current $5 per gallon would need to be $8.50 to compare with much of western Europe.

At some point demand destruction will become more apparent – but so far US states have been temporarily suspending gasoline taxes (ie New York) while the White House has resorted to ineffectually releasing oil from the Strategic Petroleum Reserve and seeking help from Saudi Arabia. Meanwhile demand continues to set new records, with global consumption expected to exceed 100 million barrels per day next year.

This is another example of the shallow support for efforts to combat climate change. Decarbonizing our energy means higher prices – obviously, or we’d already have done it. But Democrats fear a public backlash over higher prices even when they can plausibly shift at least some of the blame to Russia.

Deliberately engineering higher prices, via a carbon tax for example, is how we’d accelerate the energy transition. But there’s no support for that, so policy relies on vilifying the producers of reliable energy while claiming that solar and wind are ready to electrify everything with cheap energy and lots of union jobs.

This is why Democrats have improbably been so great for energy investors. They’re dissuading investments in new production and infrastructure, causing higher prices.

The huge weakness with solar and wind is their low, intermittent output. Solar panels and onshore windmills typically generate power around 20-25% of the time. Offshore wind is 30-40%. Combined cycle natural gas plants run at 90-95%. The result is that increased use of intermittent energy requires greater overall capacity.

Large scale battery storage adds substantial cost. A dozen large battery projects have been postponed or canceled recently, due to rising costs and difficulty in obtaining raw materials. Competition from electric vehicle manufacturers isn’t helping.

The purist view that solar and wind will solve every problem risks energy shortages in places like California. Coal to gas switching and increased use of nuclear power are the two best paths to lower CO2 emissions. US natural gas stands poised to help other countries emulate the reduced emissions we have achieved over the past decade.

In other news, I had the great pleasure of joining Josh Brown and Michael Batnick on Episode 50 of their show The Compound And Friends. We had a wide-ranging and fun discussion of markets. The episode is appropriately titled The Energy Bull Market Just Started. Josh and Mike are great hosts whose genuine interest in this guest’s opinions made being on their show utterly self-indulgent.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.