Asset Classes: There’s Nowhere to Hide

If you feel like it’s been a tough year in the market, you’re not alone. In 2018, virtually no asset class has provided safety. At -3%, US equities are down less than many other asset classes. Developed market equities have slumped 16%, similar to emerging markets equities (-17%) and energy (-15%). The Trump Administration strategy of using tariffs to alter terms of trade is blamed for growing concerns over global growth. The U.S. economy’s huge domestic market renders it less affected by trade than most others. Nonetheless, lower global growth is having an impact.

No Place to Hide: Asset Classes Down in 2018

In a startling survey, CNBC found that almost half of U.S. corporate CFOs expect a recession to begin within twelve months. 82% expect a recession within two years. One doesn’t normally consider Federal Reserve members wildly optimistic, but in September they revised their 2019 GDP forecast up modestly (from 2.4% to 2.55%). Although they expect a slowdown by 2020, they’re still forecasting around 2%. The Fed is more bullish than corporations.

Bonds have not provided any protection either this year, with returns of -3%. Unusually, about the only asset class to provide positive returns is cash. The last time this happened was 1969.

The recent sharp drop in stocks has led to fund outflows. Last week’s $39 billion pulled from global equity funds was a record, and it was accompanied by $8 billion in withdrawals from investment grade bonds. Asian stock and bond funds are on track for their first year of net outflows since the 2008 financial crisis.

For a while, rising interest rates were felt to be the biggest threat facing the economy. The Fed is still projecting short term rates of around 3.5% next year, but the recent market turmoil has lowered ten year yields back below 3%. Two year yields of around 2.7% show the market thinks rate hikes next year are unlikely.

The Fed continues to unwind its balance sheet.  Beginning with $10B/month in the fourth quarter of last year they’ve increased the pace to $50B/month as quantitative tightening is now in full swing.

That leaves trade tensions as the meaningful source of investor angst. Given how traders react to Presidential tweets suggesting a resolution, a deal with China could provide quite a boost. Although it’s hard to forecast with any confidence, both sides must recognize that they benefit from reduced trade barriers. Given the decision-making freedom afforded both leaders, a compromise could come at any time and be arrived at quite quickly.

Earlier this year, growth concerns were limited to emerging markets, where tariffs and the strong dollar have greater impact. But the S&P500 has fallen 13% since its September all-time high. Although it’s not yet a bear market (defined as down 20%), emerging markets and oil have both passed that threshold.  Within the S&P, more cyclical sectors including financials, materials and energy have also reached that threshold signaling market concern around a slowing economy while the less economically sensitive utilities sector is near its highs for the year.  Although the steady cash flow businesses of midstream MLPs & energy infrastructure companies more closely resemble utilities they have traded with energy stocks.

2019 S&P earnings are expected to grow by 12% according to Factset. Bond yields below 3% scarcely offer much return, and equities continue to look relatively attractive based on the Equity Risk Premium (see Bonds Still Can’t Compete with Stocks). The bearish outlook of corporate CFOs is troubling, but isn’t yet showing up in, for example, lower capital spending. As long as that remains the case, relative valuation will continue to favor equities.

 

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

Leaderless Britain Stumbles Towards Brexit

Although it’s 36 years since I last lived in England, I retain a deep affection for the country where I grew up, as well as my English accent (so say my American friends, anyway). I’m often asked my opinion of Brexit – I have British friends on both sides of the Leave/Remain divide. While I would have voted to stay in the EU, I can understand the opposite view, even while Leavers willfully ignore the strong economic arguments against their position.

Few Americans would accept the loss of sovereignty required by EU membership. Freedom of movement means in theory all 440 million EU citizens not living in the UK could move there without the government being empowered to stop them. It’s not the only issue, but the biggest. Regulations imposed by Eurocrats in Brussels cover mind-numbingly trivial standards for goods and services, all in the interests of creating a seamless market. Many of them are easily criticized and sometimes stupid. Nonetheless, the EU remains in Britain’s interest, in spite of these substantial drawbacks.

A thoughtful essay in the Wall Street Journal (The Great Brexit Breakdown) insightfully noted that “You can have national sovereignty—and that’s fine. Or you can have economic integration—and that’s fine. But you can’t have both.” America has always been the EU’s vision. Its enormous domestic market and free movement of people are fully integrated, which partly explain faster productivity growth. Texans have no sovereignty (though some in the Lone Star state will disagree). But Europe is older and far more tribal. Texans share more values with New Yorkers than the English do with neighboring France. For an island nation, centuries of repelling European invaders isn’t easily replaced with passive acceptance of rule from “the Continent” (how the British refer to the rest of Europe).

Since Britain voted by 52%-48% to leave the EU in the ill-considered June 2016 referendum, negotiations have plodded forward in a predictable, crisis-free fashion. The UK is not alone of course in drifting towards regional political affiliations. As with the U.S., voting patterns were strongly linked to demographics, income and education. London and other major cities voted overwhelmingly to Remain, embracing Europe because of their ethnic diversity. Rural, older voters wanted to Leave. The more white your neighborhood, the less you liked Romanians arriving in your country, even if you rarely encountered them. It was also Old versus Young; those with less life ahead of them imposed their desire for yesterday’s Britain on others with decades still ahead.

Brexit has already been a most awful own goal. Conservative PM David Cameron called the referendum expecting to win handily, thereby ending a corrosive debate within his own party. His subsequent resignation ushered in Theresa May, who had campaigned for Remain like most MPs. Echoing her predecessor’s poor judgment, she gambled on an early election to increase her parliamentary majority, and lost it completely. Her government is propped up by the votes of a small Northern Irish party whose allegiance was bought with higher government spending in their region.

Theresa May has conceded on the major points, as was inevitable to anyone who considered the two sides’ relative negotiating strengths. The result was that the Brexit deal she negotiated with Brussels united both camps in opposition. Facing overwhelming parliamentary defeat, she cancelled a vote she would have lost heavily. Britain has almost no high cards to play, while the EU can’t tolerate a departing member skipping happily into the sunset. Although it’s hard to imagine how anyone could have made a success of negotiating Brexit, she has failed to reach even low expectations.

If Brexit happens (still not certain), it will be on EU terms. The EU rarely makes crucial decisions without the clock ticking down to midnight. Politically, the March 29th deadline (when Brexit is scheduled to happen) remains a long way off. A wide range of outcomes is still possible, including an early election, a second referendum, reopening negotiations with the EU and even no Brexit.

Few in Britain will care to consider how a Trumpian PM would have handled the issues, but they would not be facing today’s unattractive options. PM Trump would have responded to domestic concern over free movement of people attracting too many east Europeans by imposing a unilateral halt. Disliked EU court rulings would have been ignored. It would have caused a different type of crisis than the current one, but the British would have known someone was in their corner, fighting for them. Instead, Leavers promised what was undeliverable. Theresa May has clung to power at the expense of her principles, while passively negotiating Britain onto a path of permanently weaker growth. The country of my youth has been poorly led. It’s a terrible shame.

 

Steel Tariffs Show Up in Surprising Places

The G20 meeting on the weekend produced a mildly surprising rapprochement between the U.S. and China on trade. Most commentators regard the Administration’s serial imposition of tariffs negatively. Stocks certainly liked the possibility of a lower temperature around this rhetoric.

In spite of the U.S.’s many trade disputes, the economy shows little sign of suffering. Unemployment is 3.7% and interest rates remain supportive, with ten year treasury yields at 3% offering scant competition for equities (see Bonds Still Can’t Compete With Stocks). Consensus expectations are that next year S&P500 earnings will increase by 10%.

Nonetheless, tariffs do have an impact. Steel shipments have been a controversial topic, with many developed countries accusing China of selling below cost (“dumping”). The Administration has imposed tariffs on steel imports from a wide range of countries, on the grounds of national security. Commerce Security Wilbur Ross said, “Economic security is military security. And without economic security, you can’t have military security,”

Tariffs have their effect in subtle ways. They are a form of sales tax, and taxes are borne both by the producer and the customer in proportions determined by their relative elasticities. For example, if a buyer of a product now subject to tariffs had no alternatives available and had to have the product, the price would go up by the amount of the tariff. The more choices a buyer has, the less impact the tariff has on the product’s price, meaning more is absorbed by the producer.

The Federal Reserve Bank of St. Louis shows that steel prices have risen by around 17% since the 2016 election, the point at which steel buyers and sellers might have begun to contemplate tariffs. The tariffs ultimately implemented were 25%, which suggests that buyers have borne more of the cost than producers. Domestic producers were able to raise prices protected by tariffs. Since the 17% increase relates to all steel whereas the tariffs were only imposed on imports, producers benefitted further at the expense of buyers. The Bureau of Labor Statistics forecast that steel prices would rise by 21%, so further price hikes may be ahead.

Steel Inflation

Few of us buy steel directly so the impact appears inconsequential. A recent report by CoreLogic, who advise the insurance industry on construction costs, showed steel prices rising at 14% year-on-year. Property and casualty companies will factor this in to the cost of insurance coverage for buildings that use steel – excluding one-to-four family houses, most other structures require it. So apartment dwellers and office building owners will see an incremental cost increase through insurance premiums higher than they would otherwise be.

Steel Prices Drive Insurance Premiums Higher

Another example relates to energy infrastructure. Plains All American (PAGP) was inadvertently caught up in the tariffs because of specialty steel they had ordered from Greece to complete their Cactus II crude oil pipeline. In effect it was a retroactive tariff, because they’d placed the order long before the imposed tariffs resulted in a $40MM charge. Their appeal for a waiver was denied.

Capacity on the pipeline was fully committed by February, before the tariffs were formally announced.  The increased cost of the pipeline will be borne by shippers, to the extent contracts allow the tariff to be passed on, and the excess by PAGP stockholders.

In both cases the tariffs represent a redistribution of income, from customers to the Federal government (which is why it’s a tax) and to domestic steel producers through higher prices. The effects are both subtle and numerous, as these examples show. The Administration has defended tariffs as a short-term, negotiating tool and not part of a long-term strategy. Whatever the merits of tariffs on domestic politics, equity markets clearly look forward to the time when the goals of tariffs have been achieved.

We are invested in PAGP.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

Lower Volatility Stocks Gain Favor

Low volatility is outperforming. In a rising market, taking more risk usually pays off. The recent reversal has investors seeking tangible value.

Nothing exemplifies intangible value, or more accurately ephemeral value, better than Bitcoin. The great Risk On trade began the day of Trump’s election victory, when an overnight market swoon quickly reversed. Bitcoin buyers embraced the new mood more exuberantly than most, running the price briefly as high as $20,000 by last December, from $730 at the time of the election.

Bitcoin Bubble Bursts

As a currency, Bitcoin has spectacularly failed the “store of value” test. Its proponents assert that freedom from government oversight ensures its value cannot be manipulated for political purposes. It’s similar to the argument made by gold investors, although fiat money (what followed when Nixon suspended convertibility of the US$ into gold in 1971) has done pretty well. Bitcoin is a solution in search of a problem. Among the many risks that Bitcoin investors face is that their exchange is hacked, with scant protection from the governments whose protections they skirt.

Bitcoin has now lost 80% of its peak December 2017 value. Wherever speculators take it from here, the case for a new currency free of government control and protected by no-one is lost.

By contrast, low volatility stocks, possessed of more tangible value than Bitcoin, are enjoying a resurgence. The rapid exit from momentum that Bitcoin previewed a year ago is rippling across equity markets (see FANG Goes Bang). The beneficiaries include consumer staples, such as Clorox (CLX), Kimberly-Clark (KMB), McCormick (MKC) and Procter & Gamble (PG). The sector was boring when CNBC was debating the relative merits of FANG stocks Facebook (FB), Amazon (AMZN), Netflix (NFLX), and Google (GOOG), but earnings stability can be attractive too.  The S&P Consumer Staples Index has a beta of 0.69 and dividend yield of 2.75%, whereas the FANG stocks have an average beta of 1.47 and pay no dividends.

Low Vol Stocks vs SP 500

The Low Beta Anomaly examines a weakness in the Capital Asset Pricing Model (CAPM), a widely used framework for valuing securities. It relies on the sensible premise that more risky investments should generate a higher return. History shows this isn’t true, and numerous academic papers offer reasons why. A compelling explanation is that active equity managers, paid to beat the market, are drawn to stocks that move more than the market (“high beta”). New clients are most easily found when the averages are rising, and relative outperformance helps. The result is that in aggregate, investors pay more than a CAPM-derived price for high beta, lowering the subsequent return on such stocks and correspondingly driving up the return on less-sought low beta names.

It’s Wall Street’s version of the tortoise and the hare. Consumer staples stocks are solidly in the low beta, or low volatility category. As the post-2016 election endorphins subside (admittedly, it’s taken a long time), less risky stocks look better. After lagging for much of the year, low volatility has caught up with the S&P500 (which is burdened with a healthy number of high beta names). The new darling sector is the one that grows slowly, albeit reliably. It’s the antidote to Bitcoin and FANG-fueled excitement.

Our portfolio of low volatility stocks has a beta of 0.49 and a dividend yield of 3.2%. Most of the names have decades of consecutive annual dividend increases. Although its yield is half that of energy infrastructure (the American Energy Independence Index has a dividend yield of 6.3%), the absence of high volatility is drawing more buyers.

We are invested in CLX, KMB, MKC and PG

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

FANG Goes Bang

“FAANG” stocks (Facebook, Amazon, Apple, Netflix and Google, now called Alphabet) were rising for most of the year. For investors who didn’t find that exciting enough, BMO Capital Markets Corp helpfully issued the MicroSectors FANG+ 3X Leveraged ETN (FNGU). As the name suggests, it gives you three times the daily return on these, plus another five for good measure (Alibaba, Baidu, NVIDIA, Tesla and Twitter). That I don’t personally know any buyers reveals more about the sedate company I keep, because there’s clearly a ready market for leveraged ETNs. Last week DGAZ, Credit Suisse’s ETN designed to provide 3X the downside to natural gas, collapsed as natgas soared, losing 81% of its value over the past month.

The Fact Sheet for FNGU warns it’s, “not suitable for investors with longer-term investment objectives.” What other investor types are there? Because such securities maintain constant market exposure, they have to rebalance every day. Leverage magnifies the effect of compounded returns. A stock that rises and falls by 1% on alternate days will lose half its value in 13,860 days. If it moves 2% this only requires 3,465 days, while 5% takes 553 days. You get the picture. One can think about the half-life of these leveraged products – how long would it take them to lose 50% given historic volatility. With daily moves in natgas of 1.2%, DGAZ had a half-life of 1,087 days. The recent spike in prices has hastened its demise.

It’s not only DGAZ buyers who lost big. The author of The Complete Guide to Option Selling posted a video on YouTube in which he tearfully explains why his hedge fund has just been wiped out by the “rogue wave” in natgas.

Leveraged ETFs and ETNs have their critics, and scarcely need one more. SEC officials have individually criticized them but stopped short of withholding approval.

The point is that the violent losses in FNGU highlight far more substantial recent losses for investors in the underlying stocks, and more broadly in growth-style investing. Since the 2016 Presidential election, equity returns have been dominated by a narrow group of growth stocks. At its peak in June, the FANG+ index had risen by 125% from its election-day level. Although the FANG+ group has been in retreat since then, the S&P500 Growth ETF (SPYG) continued to outperform. As recently as late September, SPYG had risen by 52% since the 2016 election, beating the S&P500 Value ETF (SPYV) by 22%.

Growth Stocks Lose Election Luster

Since then, SPYG’s lead over SPYV has been halved. We are approaching correction territory, defined as a 20% pullback from the highs. FANG+ is already there, at -23% from its June high. The Nasdaq Composite Index not far away, down 15% from its high set in August. while SPYG is -12%. The S&P500 has pulled back 10%, with SPYV falling a more modest 8%.

There’s a shift under way. With growth investors certainly having had the better of things in the past couple of years, there are still profits to protect. But it’s rarely easy valuing former highfliers when momentum is turning. Value stocks by definition have firmer valuation support. In addition, their investors are less likely to sell in a falling market. They own what they do because they like the valuation, and are less dependent on others liking it more to generate a return. Low volatility stocks, having lagged the S&P500 by 5% for the year through September, are now outperforming the S&P500 by 4%.

This leads to one of today’s great value opportunities – U.S. pipeline stocks. The names in the American Energy Independence Index offer a 10.9% yield on 2019E Distributable Cash Flow (DCF, which is free cash flow ex-growth capex), up 13% over 2018. This is analogous to the Funds From Operations (FFO) commonly used in real estate, as we showed in a recent blog (see Kinder Morgan: Still Paying for Broken Promises). The index has a current dividend yield of 6.25%, and we expect dividends to grow 8% next year.

Growth stocks may resume their upward trajectory, but the recent volatility has shown how quickly two years of outperformance versus value can quickly reverse.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

 

Crude’s Drop Makes Higher Prices Likely

Crude oil just set a record of sorts, by falling for eleven consecutive days (as of this morning). Fears that sanctions on Iran would cause a supply shortage, leading to a price spike, now seem unfounded. Not long ago, many were surprised at the high degree of compliance. France’s energy giant Total’s CEO said it was, “…impossible for big energy firms to work in Iran.”

The big stick America wields on this issue is access to the U.S. financial system. If a company is deemed to be trading with Iran, it can find itself unable to conduct financial transactions in US$. This is a surprisingly powerful tool, since a substantial amount of trade is conducted in our currency. Total concluded that being unable to transact in US$ would be too disruptive to contemplate.

In the summer, the U.S. appeared to be taking an uncompromising approach, and Iranian crude exports were forecast to fall from 2.5 Million Barrels per Day (MMB/D) to as little as 1 MMB/D. Crude oil futures correspondingly rose. Pressure was put on Saudi Arabia to provide offsetting increased output, as the Administration fretted over high gasoline prices before the midterms.

More recently, waivers granted by the White House to eight importers of Iranian crude have calmed fears of a price spike. China and India, who are both continuing to buy Iranian crude as a result, imported over 1 MMB/D last year. As a result, the January ’19 Brent Crude month futures contract has slid from $86 in early October back to $68 where it was in the Spring. For now, it seems that the Iranian sanctions aren’t that significant.

Crude Oil Futures Dec '20

Saudi Arabia probably expected the U.S. to be stricter in following through on sanctions, and was surprised by the waivers. They have just reduced December exports by 0.5 MMB/D. The Saudis surely expected to be selling oil at higher prices a month ago. Recent data shows that Saudi exports to the U.S. have been falling, and floating storage (i.e. crude on tankers in transit) is the lowest in four years. Some believe that Saudi Arabia is unable to sustain production above 10.6 MMB/D or so without damaging their oilfields.

Although the gyrations of the front month futures contract have commanded attention, crude prices farther out have moved much less. The December ’20 futures contract fell from $76 to $70. Fear of sanctions had caused backwardation (near contracts higher than farther out ones), and this has corrected.

Upstream Spending for Big Oil

Investments in conventional oil production are driven by the price of crude expected to prevail over the life of the project. The front month gets the attention, but it doesn’t drive the decision. Because new oil projects take several years to reach production, many in the industry continue to worry that falling investment levels will eventually cause higher prices. The International Energy Agency (IEA) recently released their World Energy Outlook. They warn of a looming supply crunch, with the world seemingly too reliant on increasing U.S. production to meet demand growth. Investment spending collapsed during the 2015-16 industry downturn, and remains more than one third lower than it was in 2014. Discoveries of conventional hydrocarbon reserves are correspondingly down.

Crude oil along the futures curve is still at levels that have drawn repeated warnings of future supply shortfalls. Moreover, Saudi Arabia is finding that the U.S. administration ultimately wants low prices, with Trump recently tweeting, “Hopefully, Saudi Arabia and OPEC will not be cutting oil production. Oil prices should be much lower based on supply!” Expecting Americans to tolerate higher pump prices so as to pressure Iran is an unlikely strategy for any president to pursue. But Saudi Arabia needs higher prices to balance their budget. These conflicting goals will continue to impact oil prices.

Low investment means higher prices are likely over the intermediate term; perhaps sooner, based on the drop in Saudi exports.

What the Midterms Mean for Stocks

Equity returns are historically strongest in the year following the midterms. Conspiracy theorists will judge that politicians in office focus on market-friendly moves that aren’t limited to government spending in order to stay in power. Whatever the reason, the effect is quite remarkable. Since 1960, the S&P500 has risen by 15.9% on average in the third year of a Presidential cycle, almost twice the 8% average across all years.

Election Cycle S&P Returns and Earnings

When equity returns in the year following midterms have been poor, the White House has often changed hands. In 2015 stocks were flat and Trump’s victory followed. Eight years earlier, modest losses in 2007 provided Obama with his opening, and the 2008 financial crisis confirmed the pattern.

Many people feel that a divided government is preferable since it requires both parties to compromise in order to achieve anything. With the House of Representatives shifting to Democrat control, legislation will require support from both parties. However, the numbers don’t support this, with such returns in the year following midterms 1% lower if one of the two houses of Congress is controlled by the party not in the White House.

So history suggests 2019 should be a good year for stocks.

But much about the Trump presidency is different. Looking at S&P500 earnings by year presents a different picture. Earnings growth in a midterm year is 8.3%, approximately the average. Earnings tend to be strongest in Presidential election years. That’s partly what drives good returns following midterms, because investors look ahead to stronger profits the following year.

S&P Returns and Earnings under Trump

2018 S&P earnings are coming in at +22%, fueled by the cut in corporate taxes. That’s likely to be the strongest profits year of the four year cycle, and it’s come two years ahead of what typically happens.

So it’s possible the election cycle effect may have already peaked; last year’s 18% rise in the S&P500 was looking ahead to this year’s jump in earnings. The new administration completed tax reform following its first full year in office.

Factset is forecasting 10% earnings growth for 2019 – still higher than the 50+ year average albeit down sharply from this year.

In addition to the votes for elective office, many states included ballot questions for voters to consider.

Colorado included a proposal (Proposition 112) that would mandate a 2,500 foot setback for oil and gas development (including gathering & processing plants and pipelines) from “vulnerable” areas (residential neighborhoods, schools, parks, sports fields, general public open space, lakes, rivers, creeks, intermittent streams or any vulnerable area). Analysis showed that it would essentially ban oil & gas development on non-federal lands. It was a keenly contested issue, with one side claiming that energy extraction is endangering air quality while the other noted the jobs at risk from such a move.

Voters rejected it 57 to 43, which is a relief for Colorado’s oil and gas industry. Strikingly, Weld County, home to most of Colorado’s drilling, voted against 112 by a resounding 75/25. If the people closest to it are so strongly in favor of its continuation, it’s not clear why a statewide ballot was the right approach.

Proposition 112 was in any case likely unconstitutional, since leaseholders losing their property (i.e. their foregone right to drill for oil and gas in affected areas) would have sued the government for compensation. It illustrates why direct democracy is such a clumsy instrument, since “yes/no” public questions aren’t easily translated into coherent legislation. Politicians in the state had previously failed to act, which created enough public support to get the question on the ballot.

Even though Proposition 112 lost, it reflects the ambivalence of many regions over the development of America’s hydrocarbon reserves.  The energy sector spent money on commercials highlighting the threat to the local economy, given 112’s stifling provisions. Colorado’s legislature is now likely to take up the issue and pass legislation intended to address the concerns of the proposals supporters. It means existing energy infrastructure already in service has a little more value, given increasing challenges to development.

New York Times Forecasts the 2014-16 Energy Sector Collapse

One official says the shale industry may be “set up for failure.” “It is quite likely that many of these companies will go bankrupt,” a senior adviser to the Energy Information Administration administrator predicts.

This is from the New York Times. However, it wasn’t part of The Next Financial Crisis Lurks Underground, Bethany McLean’s recent article promoting her upcoming book. In 2011, the NY Times ran a series of articles by Ian Urbina that was critical of many aspects of the Shale Revolution, including the shaky finances underlying its companies. In the ensuing seven years, U.S. crude oil production has doubled and we’ve moved from planning imports of Liquified Natural Gas (LNG) to exporting it. Behind the Veneer, Doubt on Future of Natural Gas, Urbina’s June 2011 article predicting failure, was spectacularly wrong.

Hydraulic fracturing (‘fracking”) is how shale extraction of oil and gas has revolutionized America’s energy security. It has its opponents, whose worries include water contamination and earthquakes. We are environmentalists too – it is everyone’s environment. We like the reduced CO2 emissions made possible by natural gas substituting for coal-burning power plants (see Guess Who’s Most Effective at Combating Global Warming). Robust regulation is in everyone’s interests, so that the Shale Revolution’s benefits can continue to outweigh its costs. The NY Times has a long history of criticizing fracking.

Ms. McLean’s essay was appropriately in the Op-Ed section, which acknowledges that it’s not intended as a news article. Her previous book, The Smartest Guys in the Room, recounted the collapse of Enron and was published six years after Skilling and Co’s demise. Similarly, Ms. McLean is forecasting a crisis in the energy sector after it’s already occurred. From June 2014 to January 2016, the Energy SPDR ETF (XLE) dropped 44%. An over-leveraged industry was hit by falling crude oil, which plummeted from $110 per barrel to $26. Investors complained that cash was being excessively reinvested in new wells, leaving too little available to be returned to investors via dividends or share buybacks.

Moreover, the energy sector endured its collapse pretty much alone. The rest of the U.S. economy shrugged. There was no recession, and the broader stock market averages meandered mostly sideways. During this period, Alerian’s MLP Index fell by 58.2%, more than during the 2008 financial crisis. It’s hard to imagine a more adverse scenario for America’s energy sector, and it suffered in isolation with no collateral damage. Bethany McLean may have missed all this; she might just as well breathlessly announce that the Philadelphia Eagles are about to win their first Super Bowl (note to non-U.S. readers – the Eagles did this in February).

Since then, leverage has been falling, profitability rising and investors have been receiving more cash (see U.S. Oil Producers Continue To Chart Path to Long-Term Growth). Ms. McLean pays this little heed. She notes that, “By mid-2016 American oil production had declined by nearly a million barrels a day” although this relatively modest drop testifies to the resilience of the business, not its frailty. To assert that, “…the Federal Reserve is responsible for the fracking boom…” because of low interest rates sounds as if the Fed’s bond buying program included the debt issued by energy companies. Fed policies have increased risk appetites for equity of all kinds, increasing the competition for capital from non-energy sectors.

The energy sector is slowly recovering from its 2016 low, and the first question of potential investors is about a repeat of $26 oil. Free cash flow yields on the American Energy Independence Index are 9.5%, almost twice the S&P500 (see Reliable Yields Are the Best). This doesn’t look like a bubble.

The fast decline rate of shale wells that Ms. McLean criticizes are in fact a substantial risk mitigant. It’s how shale drillers earn back their invested capital more quickly, and is why the world’s biggest oil companies are substantially investing in North America (see The Short Cycle Advantage of Shale).

Because The Next Financial Crisis wasn’t published in 2015, it’s of little actionable use. However, the upcoming book from which it’s drawn (Saudi America; The Truth About Fracking and How It’s Changing the World) may well be interesting. It’ll probably be more useful as history than as a forecast.

Could Oil “Super-Spike” Above $150?

In July, Pierre Andurand’s hedge fund, Andurand Capital, lost 15% on bullish crude oil bets. Oil was weak in July, but is up 21% in 2018. Notwithstanding this correct outlook, his fund is -5% for the year. Few things are more frustrating for a manager or his clients than losing money on a profitable call.

Putting aside the challenges of hedge funds, which we have amply covered in years past (see The Hedge Fund Mirage; The Illusion of Big Money and Why It’s Too Good To Be True), a bullish outlook on crude enjoys solid fundamental support. Andurand once ran a hedge fund that profited mightily during the 2008 financial crisis, only to fold following large losses in 2011. More recently though, his calls on oil have been better than most (see Fund Chief Survives Oil’s Swings), including correctly forecasting the 2014-15 collapse. Few of his peers successfully navigated this period. Reportedly, Andurand sees a multi-year bull market that could eventually reach $300 a barrel. Bernstein Research, whose deep investment analysis is widely respected, has warned of a “super-spike” above $150 a barrel.

Both supply and demand for crude oil are relatively inelastic over periods of a few quarters or so. Global transportation relies heavily on refined petroleum products. Higher prices discourage some trips, but for the most part miles driven and flown don’t dip much with higher prices. Bringing on new supply typically takes several years. So over the short run, small shifts in demand or supply disproportionately move prices.

Global crude oil demand rose by 1.7MMB/D (Million Barrels per Day) last year and in 2016, up from the ten year average of 1.1MMB/D. Demand growth is driven by developing countries, especially China and India. But far more important to a balanced market is depletion of existing oilfields, something that receives little attention. Output from most plays peaks early in their operational life, when underground pressure is most effective at pushing oil to the surface. Thereafter, production steadily declines. Estimates vary, but most analysts agree that 3-5MMB/D is the global drop in annual production from existing plays, absent any new recovery-enhancing investments.

This year the Energy Information Administration (EIA) estimates that the world will consume 100 MMB/D, a record. In order to offset depletion plus demand growth, new supply of around 5-7MMB/D is required.

Following the oil price crash 2014-15, energy companies adopted greater financial discipline and planned for lower oil prices in the future. The combination of higher required returns and lower assumed prices has had a chilling effect on investment. The U.S. Shale Revolution is at least partly responsible. U.S. output barely dipped during the 2014-15 collapse.  Although low prices weren’t sustained for long, the episode caused subsequent projects to be evaluated against the possibility of a repeat. For example, in April BP’s chairman said they were, “still working with the assumption that this is going to be a world with an abundance of oil.”

Major oil projects have always had risk to input costs and demand over the ensuing decade or longer. But today, those risks are even harder to quantify. It’s generally believed that oil demand will peak within a generation, yet growth in recent years has been as high as ever. Although Electric Vehicles (EVs) have many enthusiasts, sales growth of gasoline-chugging cars easily outpaces EVs in China, which is why crude demand keeps growing.

Improved financial discipline, wariness of a second Shale-induced price collapse and uncertainty around EV growth are three significant factors impeding investments in new supply. Taken together, these three factors have created greater risk aversion than the industry has shown in the past.

Consequently, capital invested in conventional projects remains low and projects are more modest. Companies are favoring “short-cycle”, whose smaller up-front investment consequently gets repaid more quickly with greater IRR certainty.

However, there just aren’t enough short-cycle projects available, which is causing concern within the industry. Schlumberger CEO Paal Kibsgaard warned that, “It is, therefore, becoming increasingly likely that the industry will face growing supply challenges over the coming year and a significant increase in global exploration and production investment will be required to minimize the impending deficit.” Bernstein Research concurred, “Investors currently calling on exploration and production companies to return more cash to shareholders at the expense of funding future production may also come to regret their strategy.”

There are many examples of countries underinvesting in maintaining existing levels of production.

Because less risky, short-cycle projects are mostly shale plays in the U.S., a stark difference in financing has opened up between America and Europe. EU bank financing for Exploration and Production, always far smaller than in the U.S., has collapsed in recent years.

Although Saudi Arabia is believed capable of producing as much as 12.5 MMB/D for a few months, many observers feel this is unsustainable. U.S. shale is one of the few areas of growth. Permian output in west Texas is expected to average 3.3 MMB/D this year and 3.9MMB/D in 2019. Yet, infrastructure constraints recently caused the EIA to trim its outlook for U.S. 2019 production from 11.8MMB/D to 11.7 MMB/D, up 1 MMB/D versus this year. Concern that U.S. production could lead to another price drop is limiting new global investment – yet, the most optimistic forecasts of U.S. output show that significant additional new supply beyond US shale is going to be needed.

A determination to avoid past mistakes of unprofitable oversupply is likely to lead to the opposite; an undersupplied oil market. The question is, how high must crude go to satisfy the new profitability goals and other concerns of the integrated oil companies. Many fear that $100 a barrel will be insufficient – and the market is poorly positioned for any supply disruptions, perhaps caused by Iran or some other geopolitical shock. Another Shale-induced price collapse, falling demand due to EVs and new-found financial discipline represent long-term concerns inhibiting the search for new discoveries.

Oil needs to be high enough to compensate for all three risks. Since today’s prices aren’t high enough to stimulate enough new investment, oil should move higher. This will encourage conventional investment, but will also test the limits of the U.S Shale Revolution in growing output.  To bet on increasing oil and gas volumes in the U.S., invest in the network of infrastructure that moves these supplies to market.

The components of the American Energy Independence Index are growing dividends at 10% per annum.

Guess Who’s Most Effective at Combating Global Warming

When it comes to limiting CO2 emissions, the results are not always what you’d expect.

Debates about climate change often draw zealots on both sides. The common accusatory opener, “Do you believe in global warming?” betrays the binary, almost religious argument between those who think we’re wrecking the planet and those who don’t. Pragmatism is rare on either side.

The science of climate change is complex, and we won’t attempt to assess man’s contribution to global warming. For a thought-provoking view of the issue, read Alex Epstein’s “The Moral Case for Fossil Fuels”. In one section, Epstein comments on U.S. Secretary of State John Kerry’s 2014 plea for Indonesia to cut carbon emissions to fight global warming. From 2006-16 Indonesia’s CO2 emissions grew by 3.1% annually, the Asian average. It’s no coincidence that in 2016 Indonesian life expectancy reached 69, up by 17 years over the previous half century.

As in much of the developing world, Indonesians are living longer. This is because increased energy use supports cleaner water and food, improved hygiene and better medical care, staples of developed country life. Because fossil-free energy is not yet price-competitive, its adoption implies using less energy. This in turn means shorter life expectancy for Indonesians and citizens of other developing countries. If the science around man-made climate change was unequivocal, it would imply acceptance of briefer lives today so that subsequent generations may live longer. But the science isn’t clear, and a warmer planet may be manageable. Moreover, climate prediction models have consistently overestimated actual warming. Epstein’s book offers a rare, stimulating perspective and seizes the moral high ground assumed by the anti-fossil fuel crowd. He defines improving human life as the standard against which to test climate change policies. By this measure, greater energy use has been a success.

The BP Statistical Review of World Energy 2018 reports on emissions of carbon dioxide, a greenhouse gas. It has some surprising facts.

Global CO2 emissions continue to rise, reaching 33.4 Billion tons last year. Yet, many will be startled to learn that America easily leads the world in reducing CO2 output. Our reduction of 794 million tons over the past decade is a 1.4% annual rate of decrease. The Shale Revolution has certainly helped, although U.S. CO2 emissions peaked in 2005, long before Shale started to have its positive impact. Improved energy efficiency is one reason. More recently, cheap natural gas, combined with regulatory constraints on coal-burning utilities, have favorably altered the mix of hydrocarbons burned to produce electricity. Regrettably, the Trump Administration’s weakening of Obama-era coal constraints will moderate this positive trend.

Another surprise is that the UK managed the second biggest ten-year drop in CO2 emissions, at 170 million tons. This represents a 3.5% annual reduction rate, easily the best for any big country. Lower coal use is similarly the cause here, caused by exhaustion of commercially accessible coal reserves.

The 2015 Paris climate accord represents the world’s desire to combat climate change through reduced greenhouse gas emissions. The U.S. withdrew from it last year. The Climate Action Network, an EU-sponsored NGO, finds that only five EU members are even halfway on track to meeting their obligations under the Paris accord. Some of the most vocal Paris supporters have been the biggest laggards.

For example, Germany has famously managed to be a leader in renewables while failing to lead in emission reductions. Heavy dependence on solar and wind requires baseload electricity generation for when it’s not sunny or windy. In Germany, that’s primarily coal (see It’s Not Easy Being Green). As an unfortunate consequence, Germany plans to increase its reliance on Russian natural gas via the Nord Stream 2 project.

Spain, Italy and Greece have all managed very credible 2-3% annual reductions in CO2 emissions. However, this is due to chronically weak economies: over the past decade, Spain has managed only one quarter of GDP growth above 1% and Italy none, while Greece has been in economic purgatory. By constraining growth in southern Europe, the Euro has been environmentalists’ most effective tool.

China produces 28% of the world’s CO2 emissions, spewing out 9.2 Billion tons which is 50% more than second placed America. This is almost four times India’s emissions level, even though they have similar sized populations. However, India is catching up, with a CO2 growth rate twice China’s.

Over the past decade, China’s increased CO2 output of 2.02 Billion tons was 60% of the global increase. Clearly, lowering CO2 won’t happen without China’s help. That will require reconciling conflicting objectives: developing countries are striving to achieve developed country living standards and longevity, which requires more energy use. Developed country advocates of reduced emissions are, in effect, seeking to slow this progress.

Thoughtful advocacy of renewables recognizes the symbiosis with natural gas in providing reliable electricity generation. The purity of thought required of renewables advocates has them rejecting even those fossil fuels that can help achieve lower overall emissions. Few would enjoy a world in which the Sierra Club had achieved all its goals.

Fossil fuels aren’t equally bad. Electricity generated by burning natural gas results in around half the CO2 output as does coal, and far less damaging particulates. Some may be surprised to learn that investing in fossil fuel infrastructure can be consistent with desiring a cleaner planet. But that’s where your blogging team sits, occupying the lonely, pragmatic middle ground and advocating natural gas as an environmental solution.

Natural gas is going to be a vital part of our energy mix for decades to come. Although movements in crude oil prices drive sentiment around U.S. energy infrastructure stocks, we have over 300,000 miles of gas transmission pipeline compared with 79,000 moving crude oil. The American Energy Independence Index provides broad exposure to the U.S. energy infrastructure network. It has a long, bright future ahead of it. We expect 10% annual dividend growth this year and next on its constituents.

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