Market Volatility Is Becoming Normal

Every investor is aware that the market’s been volatile recently. The VIX is high but converting it into typical daily moves isn’t intuitive. Several readers like the chart below, which shows what % of the last 100 trading days have seen the market move by more than 1% in either direction. It’s currently 55, so more than half of the past 100 trading days have seen such a move.

The prevalence of this “more likely than not to move 1%” metric is unusual; over the past quarter century such a regime has prevailed only 8.5% of the time. We’re approaching the volatility that Covid caused, but still short of the 2008-09 financial crisis. This metric is indifferent to direction, but it peaks during bear markets because volatility induces selling.  

2% daily moves are occurring 24% of the time. 100 day periods like that have occurred only 7% of the time since 1996. 

There have been few places to hide. The 17.3% fall in the S&P500 has been accompanied by a –10.9% YTD return on the Barclays Agg fixed income benchmark. The 60/40 portfolio is down 14.8%.  

The drop in markets this month has been especially hard on the energy sector, although the American Energy Independence Index is still +11% YTD. Increased odds of a recession have hurt cyclical stocks, and midstream energy infrastructure has been dragged down in the process. The Fed is entering a tricky stage – having made one policy mistake in being too slow to confront inflation, they’re trying to fix it without committing a second error. Their critics have momentum, because so far they’ve been right. Former NY Fed chief Bill Dudley warned that The US Economy Is Headed for a Hard Landing. 

In Senate testimony Fed chair Jay Powell conceded that a recession was possible and avoiding one depended on factors outside the Fed’s control. Cynics may regard this as preparing the next set of excuses. It’s easy to see events unfolding such that the Fed loses the few friends it has. Senator Elizabeth Warren offered a preview of what may become criticism not limited to the left: “You know what’s worse than high inflation and low unemployment? It’s high inflation and a recession with millions of people out of work,”   

The 60% of CEOs that expect a recession within eighteen months assume that the Fed will overdo tightening.  

Whether the consensus turns out to be right or not, the fundamentals for the energy sector keep improving. Unsurprisingly, Russian natural gas supplies to Germany through Nord Stream 1 are down sharply. It was never plausible that Russia would co-operatively keep the gas flowing right up until Germany no longer needed it. Rationing of natural gas supplies is looming as German citizens pay the price for decades of poorly advised energy policy.  

A string of US Liquefied Natural Gas (LNG) deals were announced last week. Cheniere decided to move ahead with an expansion of their Corpus Christi LNG export facility. Chevron signed purchase agreements with Cheniere and Venture Global to buy 2 million tonnes a year of LNG from each of them. 

Germany is considering expropriating part of the Nord Stream 2 natural gas pipeline that Russia’s Gazprom built but has never been used. That part of Nord Stream 2 that is on German territory might be cut off from the rest of it and repurposed to facillirate LNG imports.

Japan announced that they will stop offering low-interest loans to developing countries to build new coal-burning power plants. According to Bloomberg, Japan accounted for more than half of the $6.6 billion of coal support from G-7 countries in 2019. No meaningful progress on emissions reduction is likely without persuading emerging economies to reduce coal consumption. Cutting off cheap financing is at least consistent with that goal. It will make natural gas power plants more attractive. 

Berkshire Hathaway added to its stake in Occidental Petroleum, taking advantage of recent weakness. Berkshire now owns 16.3% of the company.  

Research from Wells Fargo estimates that approximately 55% of midstream EBITDA has built-in inflation escalators. Liquids pipelines are often regulated by FERC, which permits tariff increases based on the PPI (currently running at 11%). Among the companies best positioned to benefit from this are are MPLX, Oneok and Magellan Midstream. Wells Fargo expects this inflation protection will boost midstream sector EBITDA by around 5.3% this year, a permanent step-up in EBITDA since negative PPI is implausible.  

This is why pipelines offer useful protection against higher inflation. If the Fed beats the consensus and is successful in avoiding a recession, it’ll probably be because economic weakness induces a premature declaration that inflation is vanquished. Real assets will offer valuable upside in such a scenario.  

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

Why You Should Worry About Inflation

Watch this nine-minute video to learn:

Why You Should Worry About Inflation


Profiting From The Efforts Of Climate Extremists

Last week was hailed as a big victory for climate activists. In a 1-2-3 punch on Wednesday, a Dutch court ordered Royal Dutch Shell (RDS) to further reduce emissions from its products; Exxon Mobil (XOM) shareholders elected two new directors proposed by an activist hedge fund against management’s recommendation; Chevron (CVX) shareholders approved a proposal to reduce emissions caused by its customers. 

All three companies will become less invested in future oil and gas production than they were previously. For those who regard energy companies as the cause of global warming, rather than the billions of individuals who buy their products, Wednesday’s three events were a watershed. 

Vanguard, Blackrock and State Street are XOM’s three biggest shareholders and also members of the Net Zero Managers Initiative which is committed to “net zero greenhouse gas emissions by 2050 or sooner.” It’s often believed that you can do well by doing good, and a popular narrative is that ESG funds are delivering good returns because ESG-oriented companies deliver better operating performance.  

The biggest ESG fund (ESGU), run by Blackrock, is imperceptibly different from the S&P500 (see Pipelines Are ESG). XOM and CVX are both holdings in ESGU. Blackrock’s ESG definition is flexible, like most proponents. Lockheed Martin is a perennial member of the Dow Jones Sustainability Index, so pretty much every company claims ESG-ness. Big natural gas pipeline corporations really are ESG, since they are helping displace coal for power generation in the U.S.  

Engine No 1, the activist shareholder in XOM, argued that the company was risking its very existence by continuing to provide the world with oil and gas. This is a non-ESG view based on an assessment of the company’s business prospects, but conveniently aligned with the climate change goals of its three biggest shareholders. XOM will presumably now chart a course that directs more investment to renewables.  

CEO Darren Woods clearly wants to keep his job – he has welcomed the new board members, even though in the past he’s questioned XOM’s strategic advantage in pursuing renewables. The business of fossil fuel extraction, processing and distribution (geology, refining, petrochemicals, retail gasoline) would seem to offer few synergies with building solar farms and windmills. Woods has in the past noted that they have little more than money to offer to such efforts.  

Perversely, all three developments from last week make the rest of the energy business more attractive. Future supply will grow less than it would have, while demand will continue to be led higher by emerging economies in Asia and elsewhere. Oil and gas prices will likely drift higher. All the focus of climate extremists is on supply, not demand. Consumers are far less susceptible to changing their behavior in support of reduced emissions. 

Based on how all three stocks reacted, these developments were not enthusiastically received. Shifting investments away from what these companies know to new areas with very different economics isn’t a compelling way to drive higher returns. The real winners are likely to be privately-held oil and gas producers, and OPEC nations who will welcome the increased market share at higher prices that last week promises.  

XOM, CVX and RDS all finished down for the week, lagging crude oil which is usually a reliable barometer of energy sector sentiment. They were also outperformed by North American pipelines, as represented by the American Energy Independence Index (AEITR).  

In the same week Tellurian (TELL) announced a ten-year agreement to sell liquified natural gas to Gunvor, a commodities firm. It shows that demand for natural gas remains strong. Privately-held Gunvor is relatively immune to climate extremists and must regard the strategy shifts forced on the three companies as vindicating their deal. But they and TELL can also claim to be constructively lowering CO2 emissions – without the natural gas they’ll be providing to customers in Asia, it’s likely more coal would be burned to meet the region’s growing demand for electricity. Switching from coal to natural gas is the most effective way for the world to reduce emissions, as America has demonstrated for the past decade.  

As shareholder-activists and litigants force uncommercial strategies on energy companies, it is creating profitable investment opportunities elsewhere in the energy sector. If supply is constrained too far, much higher prices will cause demand destruction and improve the relative pricing of renewables. But it looks increasingly likely we are heading into a Goldilocks period – growth capex sufficiently reduced to boost free cash flow and cause higher prices, but still enough supply to stop prices from spiking ruinously. The key will be to invest where activists don’t, so as to profit from their efforts. 

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

Pipelines Are ESG

ESG is in the eye of the beholder. There are multiple lists of stocks that score well on Environmental, Social and Governance metrics. My favorite is Lockheed Martin (LMT), a perennial member of the Dow Jones Sustainability Index. If building weapons to blow up people and property can be done in a sustainable way, then ESG is a generous mistress (see Pipeline Buybacks and ESG Flexibility).

There are currently 138 ESG ETFs traded on U.S. markets, with almost $90BN in AUM. The most important thing about ESG investing is that it’s growing faster than the market. A cynic might regard the rush by CEOs to demonstrate ESG-ness as driven by asset flows rather than altruism. ESG-driven investors can note with satisfaction the market-beating performance of such funds. The largest ESG ETF is the iShares ESG Aware MSCI USA ETF (ESGU), with $15BN in AUM.

The pipeline sector offers 7% yields, growing free cash flow and strong recent performance. It has been out of favor more often than not in recent years, but Joe Biden’s arrival at the White House has ushered in rising energy prices with less growth spending (see Is Biden Bullish For Pipelines?). Investors are warming to policies that encourage parsimonious funding of new projects, something that eluded them during Donald Trump’s presidency.

Some may avoid pipelines because of historic volatility, although operating performance last year was scarcely affected by Covid. The energy transition deters others, although a pragmatic desire not to wreck the economy means natural gas retains its bright future as part of the solution to reducing emissions. A third cohort thinks fossil fuel companies are bad, even though it’s how the world has reached today’s living standards. There’s a belief that the energy sector has much to apologize for.

It may surprise this last group to learn that ESGU has a 2.5% weighting to energy, virtually indistinguishable from the S&P500’s 2.6%. ESGU holds Kinder Morgan (KMI), Cheniere (LNG), Oneok (OKE), Targa Resources (TRGP) and Williams Companies (WMB), all components of the American Energy Independence Index. Relative to the S&P500 it has modest overweights in Chevron (CVX) and Exxon Mobil (XOM). It also overweights Nextera Energy (NEE), one of the largest producers of electricity from natural gas.

ESGU has some interesting underweights, including Alphabet (GOOG) and Microsoft (MSFT) both companies with plenty to say about their ESG credentials. Clearly ESG-ness isn’t a binary issue, or Facebook’s dual share class would knock them out on the Governance scale. Instead, it trims them to 1.81% in ESGU versus 2.06% in the S&P500. Berkshire Hathaway (BRK) is ESGU’s biggest underweight, at 0.84% versus 1.47%. Those omitted from ESGU are an eclectic bunch, including Tyson Foods (TSN) and Boston Scientific (BSX). The complete absence of airlines in ESGU fueled some of its outperformance. Covid crushed the sector rather than any ESG shortcomings.

These differences are trivial, which means ESGU looks a lot like the S&P500 and tracks it closely. For the past couple of years, their daily returns are 0.99 correlated, and ESGU has outperformed by 2.1% p.a. It’s unlikely that ESG-run companies offer better long-term performance than the market. More likely is that investors just want to own them a little more, which is boosting their stock returns.

Index providers continue to compete to be the market standard for ESG-ness. Current standards vary. Since probably every member of the S&P500 has ESG slides in its investor presentation, it’s hard to avoid virtue-claiming companies.

If ESG doesn’t impact operating results, then eventually ESG funds will underperform the market because buyers will have overpaid. But for now, metrics from the past two years tempt the virtue-signaling investor – good odds of roughly tracking the market, some chance to beat it and the claim to morally higher ground than one’s peers.

The substantial overlap between ESGU and the S&P500 simplifies the choice facing an ESG-motivated investor. ESGU’s portfolio signifies approval of almost the entire S&P500. There’s no discernible difference in virtue between an investor in ESGU or the S&P500 itself. What ESGU does offer is a small bet on continued flows into ESG funds.

ESGU’s energy holdings represent an endorsement. An investor hesitating to take advantage of the high yields and growing free cash flow of pipelines because of a misplaced concern that her liberal friends may frown can point to ESGU for absolution.

Energy, and pipeline companies specifically, sit at market weight or better in many of the biggest ESG funds. They should – coal to natural gas switching in the U.S. has done more than renewables to lower emissions over the past decade. U.S. exports of liquified natural gas offer other countries the opportunity to emulate our success. Pipelines are ESG.

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

2021 Pipeline Outlook

Reviewing The Deficit Myth

Stephanie Kelton’s The Deficit Myth opens with the startling assertion that the only reason today’s fiat currencies have any value is because citizens need to acquire them to pay taxes. Without that requirement, there would be no need to hold dollars, euros or yen. I first heard this argument from Warren Mosler twenty five years ago when he was a partner in hedge fund Illinois Income Investors in West Palm Beach. I found this view quixotic at the time, although our meeting was too brief to fully refute it. Today Mosler is regarded as the father of Modern Monetary Theory (MMT), seized by progressive Democrats as evidence that the Federal government can pay for everything.

To prove that tax liabilities are necessary to give money value, Kelton recounts a story I heard personally from Mosler in the 1990s. Suppose he assigned household chores to his children with payment promised in business cards. With little of value being offered in exchange for the work, the lawn would remain uncut and the car unwashed. But if Mosler the Dad then imposes a monthly tax of 30 business cards from each offspring, on pain of being grounded, they suddenly have value. The work gets done.

From this follows the logic that the government needs to spend money in order to provide the means with which to pay taxes. The government, as the sole issuer of currency, can pay in regular green dollars, or in yellow interest-bearing dollars (i.e. they can borrow to pay their bills). They can never run out. So they can never go bankrupt. Therefore, deficits don’t matter unless they exhaust the economy’s productive capacity, which is inflationary.

I’m still not convinced taxes are necessary to give a fiat currency value, although behind every such currency lies a government taxing and spending it. For much of human history money has been linked to gold. When the US left the gold standard in 1971, the severing of the link ushered in fiat currencies that derived their value from the issuing country’s policies. But it’s definitely clear that a country can never be forced into bankruptcy in its own fiat currency, as they can always issue an unlimited amount to pay their bills. In this narrow sense, debt doesn’t matter.

So far, this is a non-partisan exercise in economic theory.

Kelton then seizes the access to unlimited credit to gorge on a left wing dream of largesse. Trillions of dollars are breezily allocated to student loan forgiveness, upgrading our infrastructure, fighting climate change and dealing with the pandemic. Because the Federal government can never go bankrupt, deficits don’t matter. The twin looming crises of social security and Medicare don’t matter, because the government will spend whatever it needs to, since its ability to borrow in its own currency is unlimited.

It sounds implausible, but here Kelton misses the opportunity to strengthen her case. Today, America’s fiscal outlook provokes widespread hand wringing and dismay. Retiring baby boomers will command an unsustainably growing chunk of Federal spending. There is nothing remotely optimistic to be said on the topic. Yet long term government bond yields remain defiantly low. The empirical evidence that deficits don’t matter exists in Uncle Sam’s continued ability to fund its needs at rates below inflation. An even more brazen MMT advocate would argue low bond yields are the market’s vindication that deficits don’t matter.

The failure of conventional economic thinking to explain apparently costless fiscal profligacy offers at least an opening for the progressives who have hijacked MMT to drive through. Kelton misses her chance.

The risk is of course inflation. If the government tries to pay for more output than the economy is able to provide, inflation will follow. If Mosler the Dad started adding new chores, he’d have to offer more business cards per hour to motivate his exhausted children. Had his progeny begun saving these cards for the future, the resulting inflation would diminish their value. Kelton does admit to limits on spending, but these are imposed by inflation not deficits. She argues that government spending should rise until it’s inflationary, ensuring maximum utilization of the economy’s potential.

That is in effect current policy, administered by the Federal Reserve’s twin objectives of maximum employment consistent with stable inflation. Kelton would prefer the Federal government was explicitly responsible for the twin mandate rather than the Fed. In doing so they would rely on fiscal, rather than monetary policy.

Since inflation has remained so consistently low that the Fed is trying to overshoot its 2% target, it’s a reasonable argument that pursuing NAIRU (the Non-Accelarating Inflation Rate of Unemployment) through interest rate policy alone is leaving millions of potentially productive people out of the labor force. The Fed can be criticized for over-estimating NAIRU, but there’s no reason to think Congress would do any better. They would inevitably synchronize economic booms even more closely with the election cycle, and there would be no reason to expect anything but a bad outcome. This is why independent central banks are part of every well-run economy.

However, Kelton goes further, advocating government spending until everyone has a job, supported by a Federal jobs program for all. “The federal government announces a wage (and benefit) package for anyone who is looking for work but unable to find suitable employment in the economy.” she writes.

Kelton’s faith that a huge program of useful jobs could be run productively without abuse is naive. Would the government fire lazy workers? Under her approach, “It takes workers as they are, and where they are, and it fits the job to their individual capabilities and the needs of the community.”

It would descend into a jobs program for those unemployable in the private sector. Don’t MMT advocates even believe in workers learning marketable skills?

Many questions are left unanswered. Most obviously, what would the Federal government do when its spending caused inflation? If the ability to issue debt in your own currency is so valuable, why do countries give up sovereignty and join currency unions, such as the euro, or peg their currency to the dollar? What does MMT say about serial defaulters like Argentina? What about Germany’s hyperinflation that preceded the rise of Hitler? And while Kelton argues we should not worry about future entitlement obligations, what would MMT prescribe if those future payments ultimately drive up inflation? She fails to identify a single country that has successfully relied on deficits to maximize economic output.

MMT has become shorthand for unlimited government spending to solve every problem progressives can identify. Stephanie Kelton’s expansive vision of MMT’s possibilities cemented the conviction of many that our economy needs protection from the more liberal elements of Joe Biden’s party. It’s the type of thinking that denied Democrats a stronger electoral showing. Warren Mosler is rich enough to indulge such economic fantasies today, but I doubt 25 years ago he would have favored big government on such a scale.

In Lunch with the FT, journalist Brendan Greeley was disappointingly deferential. There’s little insightful in Kelton’s policy prescriptions. The type of profligate government spending she advocates has invariaby led to ruinous inflation elsewhere. If practised here, progressives would likely blame a Wall Street conspiracy for the economic destruction they had wrought. MMT isn’t a new idea, and isn’t a new source of money for liberals to spend. It should drift from the fringes of policy discussion to complete oblivion.


Stocks Are Still A Better Bet Than Bonds

In late April, a month after the low, we noted how stocks were cheap (see The Stock Market’s Heartless Optimism). The Equity Risk Premium (ERP, the difference between the earnings yield on the S&P500 and ten year treasury yields) is a useful barometer of relative value between the two major asset classes.

At the lows in March, the ERP on 2020 S&P50 earnings reached 5.0, and was 6.5 for 2021.

Now that the market has made a new all-time high, capping the briefest bear market in history, it’s no longer cheap although still attractive by historical standards. The 2020 ERP is 3.4 and 2021’s is 4.1.

The rally has mostly been characterized by multiple expansion. No big stock epitomizes this more than Apple (AAPL), which has almost tripled in value since the beginning of last year. It used to trade at a low double digit earnings multiple – it’s now at 30X 2021 Bloomberg consensus earnings. At $2TN in market cap, AAPL is over 7% of the S&P500.

As 2021 earnings forecasts were revised down through the worst of the pandemic, they still never dipped below last year’s. In other words, even at the depths of Covid despair, the earnings story remained that this was a one year hit that would see profits quickly rebound to prior levels.

Earnings forecasts for the following year are typically most optimistic in January. As time passes they are usually revised downward, probably as cautious management guidance gets reflected in analyst estimates. This makes it easier to subsequently beat expectations. But in recent weeks, 2021 earnings forecasts have been revised up modestly. The improved profits outlook has more than offset cautious guidance.

Given the impact on our lives and the relentless media reports of death, the stock market has provided an almost offensively optimistic perspective (see Is Being Bullish Socially Acceptable?).

The ERP shows stocks to be cheap because interest rates remain so low. Stocks are cheap relative to bonds. In the past we’ve illustrated this by calculating how much money invested in stocks would deliver the same ending value as $100 put into ten year treasury securities. The dividend yield on the S&P500 is around 1.8%, 1.2% above the ten year. Dividends grow while treasury coupon payments do not, and dividends are also taxed at a lower rate – at least, for now. The result is that it takes a lot less than $100 invested in stocks to match a ten year bond, assuming stocks don’t wind up lower in a decade.

The contrast is especially stark when applied to pipeline stocks. Enterprise Products Partners (EPD) maintained its payout through the 2014-16 energy downturn and, so far, through the Covid pandemic. Its dividend provides a 9.7% yield, a level that might suggest a high degree of investor concern about their prospects. However, bond investors see little to worry them. EPD recently issued ten year notes that currently yield 1.9%. A 30 year bond issued at the same time yields 3.3%.

Using the assumptions in the table, an investor about to commit $100 to EPD’s ten year debt could instead put just $8 into EPD common shares with the rest in cash (i.e. treasury bills), and achieve the same return. Even in a highly improbably EPD bankruptcy, a loss on the bonds of greater than 8% would still leave the equity as the less risky choice.

This math reflects the tyranny of low rates, and has been driving investors into stocks for years. Inflexible investment mandates that require holding bonds without regard to return are keeping rates low. The stocks in the American Energy Independence Index, of which EPD is a component, yield 8.8%. For those with sufficient flexibility, the stocks of these issuers are far more compelling than their bonds.

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


Natural Gas Is November’s Winner

Citibank published some interesting research recently, making the case for higher natural gas prices in the months ahead. Oil production in the U.S. has fallen sharply as a result of Covid. Gasoline demand has recovered from its low point in April, but remains about 9% below normal.

Natural gas demand has shown much less impact, because it’s not used in transportation. The chart shows that it’s running the same as a year ago, although last week power consumption dipped. Power outages from Tropical Storm Isaias may have been partly to blame.

Citi’s forecast of higher natural gas relies on two factors: the drop in oil production has also reduced output of associated gas, which was most common in the Permian in west Texas. Oil prices drive the economics of drilling in that region. The resulting gas production was pressuring prices as well as causing more flaring (watch Stop Flaring).

The second factor relies on a Biden administration, which is looking the more likely outcome based on recent opinion polls. The thinking is that a Federal initiative to lower CO2 emissions will start with accelerating the phase-out of coal-burning power plants. This trend has been under way for several years, and represents the easiest steps an incoming President Biden could take to fulfill campaign pledges on clean energy.

Deferred natural gas futures pushed higher in recent weeks, reflecting higher prices a year out at the same time as opinion polls continue to show Biden in front.

Natural gas power plants typically release half the CO2 emissions of coal for equivalent energy production, and are also free of particulate matter and other pollution such as nitrogen oxides, sulfur dioxide, mercury and other hazardous substances that the local population inhales.

The Biden Plan for Climate Change targets “net-zero emissions no later than 2050.” However, the Biden-Sanders Unity Task Force says, “Democrats commit to eliminating carbon pollution from power plants by 2035.” A Biden administration would be under pressure from extreme liberals to adopt the more aggressive target, which Citi believes is likely.

Citi Research calculates that retiring the nation’s coal plants at a uniform rate would take approximately 10 Gigawatts (GW) of power offline annually. Assuming these plants are running at 48% capacity, as was the case last year, the country would need to add 4.8 GW of new natural gas power every year, requiring about 1 Billion Cubic Feet per Day (BCF/D).

Foreign demand is also increasing — both China and India have long term plans to use more natural gas. Nord Stream 2, which is being built to supply more Russian gas to Europe, continues to draw U.S. sanctions which may yet impede its ultimate completion.

Last year, the U.S. produced 92 BCF/D of natural gas, consuming 85 BCF/D domestically with the difference made up by exports (5BCF/D) and withdrawals from storage (1.4 BCF/D). Decommissioning coal plants could increase domestic demand by 1% or so annually.

So far, cheap natural gas has motivated the switch away from coal. Citi expects higher prices to reduce the economic advantage, but also believes this will stimulate increased production by 2022.

Although Trump’s election victory was welcomed by energy executives, their enthusiasm for a Republican administration freed their animal spirits in recent years, and investors have borne the cost. A pro-fossil fuel administration has been an excuse for many upstream and a few midstream companies to dump financial discipline and allocate capital with overly optimistic assumptions.

It may seem perverse, but a Biden victory could be good for pipeline investors, because it would impose a more cautious  assessment of new projects. An industry held responsible for climate change by extremists in the president’s party would more likely be parsimonious in spending its cash.

New greenfield pipeline projects are already a non-starter because of relentless legal challenges, which many investors have welcomed (see Environmental Activists Raise Values on Existing Pipelines). Solar and wind projects are just as vulnerable to the same delaying tactics using the court system. New England is famously opposed to new pipelines (see An Expensive, Greenish Energy Strategy). But in 2017 an offshore wind project also fell victim to interminable delays, from property owners defending their ocean view (see After 16 Years, Hopes for Cape Cod Wind Farm Float Away).

Russell Gold recounted in Superpower: One Man’s Quest to Transform American Energy the challenges that defeated Michael Skelly in building high voltage transmission lines to send electricity from windy, unpopulated regions to cities.

New natural gas power plants retain a substantial cost advantage over renewables, even after many years of subsidies. It’s likely that a sharp increase in solar and wind farms, along with the associated power lines, will collide with the same NIMBY opposition through court challenges. Energy infrastructure that is already installed, such as natural gas pipelines, has an advantage.

Much can change over the 79 days until the election, but pipeline stocks have been outperforming the S&P500 since earnings were kicked off by Kinder Morgan last month (see Pipeline Earnings Provide A Boost). Dividend yields of 8-9% are drawing buyers who are looking beyond the opinion polls.

There’s no reason for equity investors in midstream energy infrastructure to be scared of a Biden presidency (listen to our recent podcast, Joe Biden and Energy). Bond investors see little of concern — Enterprise Products Partners (EPD) for example recently issued 30 year debt at 3.2%, while their equity offers a dividend yield over 9%. Compared with the past four years, equity returns are likely to be much better.

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

Pipeline Earnings Provide A Boost

Investors often ask, what will it take to get pipeline stocks moving upwards? Attractive valuations and the prospect of higher cashflows are compelling, but when will investors start acting?

They may already being doing so. Kinder Morgan kicked off earnings after the close on July 23rd. Since then, results for the sector have generally come in as expected, with more positive surprises than negative. The encouraging free cash flow outlook remains intact (see Pipeline Cash Flows Will Still Double This Year). The most positive among the big companies was Williams Companies (WMB), whose earnings scarcely showed any impact of the pandemic (see Williams Has Covid Immunity). Their gathering and processing business held up better than volumes across the country, and WMB took another $100MM off their 2020 growth capex which further cheered investors. WMB was up 8% following the announcement.

The two big Canadians, Enbridge (ENB) and TC Energy (TRP) were both resilient. ENB even added $100MM to their growth capex plans – they’re probably the only company that could do so without seeing their stock sell off. TRP has one of the bigger capex budgets, mostly driven by the perennially delayed Keystone XL. Joe Biden has committed to withhold the required Federal approval of this cross-border project, reflecting a leftward shift in his platform. If he wins the election, Canadian oil producers will suffer but investors in TRP will likely benefit from higher free cash flow without the Keystone spending.

Cheniere Energy (CEI) reported $405MM of cargo cancellation revenues. Cheniere has always maintained that their 100% investment grade customer base and very long term contracts insulated the company from fluctuating volumes. Falling demand for shipments of Liquified Natural Gas (LNG) caused some weakness in CEI earlier in the quarter. The $405MM represents some tangible evidence of the security of the contracts. Typically, when a buyer cancels a contract CEI takes ownership of the LNG shipment and is free to find a new buyer.

Energy Transfer (ET) remains one of the cheapest big pipeline companies – their eye-popping 17% yield is in part because of CEO Kelcy Warren’s opportunistic ethical lapses (see Energy Transfer’s Weak Governance Costs Them). Questions remain around their elevated leverage, which is still above 5X. Some analysts would like to see them cut their distribution so as to delever faster. The company believes they can rely on growing EBITDA, although CFO Tom Long did say, “…the distributions are a topic when we discuss how to get the leverage down.” So that 17% yield isn’t secure.

Oneok (OKE) saw weaker than expected gathering and processing results, and they revised full year EBITA guidance to the low end of the range so they see continuing softness.

We thought Plains All American (PAGP), which is all crude oil, should have done better in their Supply and Logistics (S&L) segment. The dislocation in April was manifested by the negative price for front month of futures. This should have been a perfect environment to own storage assets in multiple locations and the pipes to connect them. Disappointingly, PAGP’s S&L segment adjusted EBITDA came in at only $3MM, and is running at $144MM for the first half of the year. During 1H19 they did $478MM. Management has done a good job at lowering analyst expectations for this business. Enterprise Products Partners’ (EPD) Marketing segment turned storae and contango opportunities into $185MM in 2Q20. PAGP should be aiming higher.

Overall, midstream energy infrastructure earnings were good, and with dividend yields still above 8% it is poised to move higher.

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


Williams Has Covid Immunity

Pipeline company earnings continue to provide reassurance about their ability to grow cash flows (see Pipeline Cash Flows Will Still Double This Year). Yesterday’s earnings call with Williams Companies (WMB) was an example.  

WMB’s 2Q adjusted EBITDA came in at $1,240MM, $48MM ahead of expectations. For the full year they are guiding conservatively to the low end of their prior range ($4.95BN-$5.25BN). 2020 growth capex was reduced by another $100MM to $1BN-$1.2BN. Like other pipeline companies, WMB’s continued trimming of growth capex is boosting their cash flow generation (see Pipeline Opponents Help Free Cash Flow).

Leverage has now come down to 4.31X Debt:EBITDA. Their $1.60 annual dividend still yields 7.5%, even after yesterday’s 8% rally in the stock. 

WMB is among the best positioned pipeline companies – almost 100% natural gas. Its gas transmission business, which is 44% of EBITDA,  is two thirds utilities and 90% investment grade. Gathering and processing, which is the rest of the company, has picked its customers well, growing 3.6% year-on-year even while Lower-48 production is roughly flat.

CEO Alan Armstrong noted what we’ve pointed out recently, that natural gas demand has remained strong and shows little impact from the pandemic (see Energy Demand After Covid-19). Armstrong also mentioned that canceled LNG shipments, the only area of weakness, appear to be moderating in July.  

Armstrong spoke to the complimentary relationship gas-fired power generation has with solar and wind. Pairing always-available gas with intermittent renewables allows for increased use of both and lowers overall CO2 emissions. Since natural gas is crucial to any serious green initiative, WMB has a secure future (see Where America gets Its Power). 

Transco, WMB’s extensive natural gas pipeline network that runs from Texas to NY, sits beneath many dense population centers. Given today’s uncertain regulatory process faced by new projects and successful opposition from environmental extremists (see Installed Pipelines Are Worth More), Armstrong feels that WMB’s extensive existing infrastructure gives them an advantage in expanding to meet growing demand. It’s much less disruptove to add on to an existing network than to embark on a new, greenfield project.

WMB’s business was neither helped nor hurt by Covid. In that respect it offers more visibility, if less excitement, than some of today’s high-fliers that are profiting from the new stay-at-home lifestyle. In effect, WMB is immune to Covid. It looks like a pretty cheap stock.

On a different topic, the owner of Jos A. Banks, Tailored Brands, recently filed for bankruptcy. I have followed Jos A. Banks with interest ever since 2008 when I saw Marc Cohodes, a short seller, explain why “Buy One Get Two Free” was not a sustainable business model for selling mens suits. I recounted this in The Hedge Fund Mirage. Cohodes had a tragically bad financial crisis for a short seller and for a time left Finance in disgust (see A Hedge Fund Manager Finds More to Like in Farming). On Jos A. Banks, Marc was early but ultimately right.

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