Archive for category: Midstream Energy Infrastructure

This Friday’s non-farm payroll report is more important than normal. With the Fed in single-minded pursuit of half their twin mandate (maximum employment), the stable prices objective is receding. The recent stalling in the bond market sell-off doesn’t correspond to equanimity over inflation. Declining real rates have accompanied the drop in nominal ones. In April, ten-year treasury yields dropped by 9bps, but TIPs yields fell by 0.13%. So inflation expectations edged up by 4bps. Investors now expect CPI inflation to average 2.42% over the next decade.

The Fed has a stated goal of 2% inflation over the long term and plans to tolerate inflation above this level during a recovery in order to anchor expectations at 2%. Investors are increasingly skeptical. Moreover, real yields are now solidly negative. They crossed below 0% for the first time during Covid early last year and have never recovered. With the Fed buying $120BN in bonds per month, partial debt monetization in support of higher employment is government policy. Stephanie Kelton’s book, The Deficit Myth, explains all (see Modern Monetary Theory Goes Mainstream).

It is a populist policy – voters are more aware of the cost of borrowing than the return on lending. And stocks are near all-time highs, so there’s little obviously wrong. But rising inflation expectations are a warning that the Fed will at some point need to confront a policy that has gone too far. The FOMC is not good at forecasting (Bond Investors Are Right To Worry).

In Fed chair Powell’s recent press conference, he said, “So it seems unlikely, frankly, that we would see inflation moving up in a persistent way that would actually move inflation expectations up while there was still significant slack in the labor market.”

Powell added, “…for inflation to move up in a persistent way that really starts to move inflation expectations up, that would have to—that would take some time and you would think it would be quite likely that we’d be in very strong labor markets for that to be happening.”

Put together, Powell doesn’t expect inflation expectations to rise until (a) actual inflation is rising, and (b) we are approaching full employment. Inflation expectations have been rising for over a year, and passed through the Fed’s 2% long term definition of price stability in early January. His comments sound as if he believes expectations will respond to actual inflation, whereas markets are forward-looking.

It sounds as if Powell doesn’t believe inflation expectations are rising.

On Saturday, Warren Buffett responded to a question by noting, “This economy right now, 85% of it is running in super high gear, and you’re seeing some inflation…” In another response, he said, “We’re seeing very substantial inflation. It’s very interesting. We’re raising prices. People are raising prices to us, and it’s being accepted.” Even Treasury Secretary and former Fed chair Janet Yellen said, “It may be that interest rates will have to rise somewhat to make sure that our economy doesn’t overheat…”

The list of those who share Jay Powell’s  perspective is shrinking.

Anecdotal evidence of rising inflation is stacking up. Since the Fed is focused on maximum employment, every non-farm payroll report will be scrutinized for signs that this goal is within reach. Only wage inflation will justify a shifting monetary stance – all other forms are temporary (supply constraints), mean reverting (food and energy) or ignored completely (housing).

One could interpret persistent negative real yields as an indication that the Fed’s bond buying has continued too long. Credit doesn’t seem tight – the high yield bond market remains firm. It’s almost as if the Fed selectively accepts only data that supports its view. To listen to Jay Powell’s frustration with constant questions on inflation, a behavioral finance expert might diagnose overconfidence. The FOMC has misplaced high conviction around current policies.

Last week Dallas Fed president Robert Kaplan said, “At the earliest opportunity, I think it will be appropriate for us to start talking about adjusting those purchases,” He’s the first to openly break ranks.

JPMorgan expects Friday’s non-farm payroll report to show an increase of one million jobs. Jay Powell noted that 8.5 million fewer jobs exist than was the case pre-Covid. The actual slack in the economy may be less than that – Friday’s report will provide further evidence of the economy’s strong recovery.

Pipeline stocks have performed well as a hedge against rising inflation expectations. That’s likely to continue.

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

One of the most important questions for investors is whether interest rates will remain low. Persistent paltry yields still aren’t fully explained. Inflexible investment mandates affecting trillions of dollars are a partial explanation. For example, the equity risk premium favors stocks sufficiently that it’s possible to replace a ten-year government bond with as little as 20% of the money reallocated to stocks and 80% in cash (see Stocks Are Still A Better Bet Than Bonds).

The resulting barbell has a very high likelihood of delivering the same return or better than bonds, but conservative assumptions still fall short of a guaranteed outcome. Even though low yields should induce investors to allocate more to stocks, pension funds, central banks and others with rigid fixed income mandates continue to hold vast amounts of bonds with derisory yields.

Related to this is the continued drop in real yields. It’s a phenomenon that’s lasted several decades. The series below shows real yields on the average of U.S. government inflation-indexed bonds (TIPS) for over twenty years.

The decline in real yields led the FOMC to change how they implement monetary policy. A couple of weeks ago Federal Reserve Vice-Chairman Richard Clarida explained that the decline in real rates had also led FOMC members to steadily revise their forecast equilibrium policy rate lower. It’s fallen from 4.25% in 2012 to just 2.5% now. Even at that level, given the FOMC’s 2% inflation target it implies a neutral real policy rate of +0.5%, whereas long term TIPS yields are negative. That means that the FOMC may eventually revise their neutral policy rate lower still.

The reduced neutral short term rate is why the FOMC is willing to tolerate inflation modestly above 2%. Low rates offer less room to cut during a recession. The FOMC felt this risked inflation remaining below 2%, too close to damaging deflation for them to be comfortable.

Back in the 80s and 90s bond markets were interesting. Fed policy moved with economic cycles. Eurodollar futures could be traded. Since then, interest rates have offered many years of comparative boredom, with the 2008 financial crisis and Covid recession offering a brief respite from the slumber that enveloped fixed income.

We are likely entering a much more stimulating era. Bond markets are becoming interesting again and will command more attention from investors.

Excesses are building up. The government acknowledges few limits on spending (see Modern Monetary Theory Goes Mainstream). There are no fiscal hawks left in Washington. The Federal Reserve is partially monetizing the debt, by buying around $120BN per month. They have somehow convinced themselves that left unchecked bond yields would constrain economic activity, even though rates globally are low by any reasonable measure.

The FOMC is actively seeking higher inflation, insisting that when it appears it’ll be temporary and therefore insufficient to draw a policy response. They’ve also ruled out inflation in food and energy (always temporary and mean-reverting), housing (they always ignore this – see Why You Can’t Trust Reported Inflation Numbers), and many commodities (Covid-related logistical problems that will resolve themselves) as sources of concern.

Only rising wages will prompt them into action (see The Fed’s Narrowing Definition Of Inflation). The doctrine driving monetary policy is that it’s better to be late than early in tightening. Prior tightening cycles were often preceded by a concern that the Fed was late. Such fears may last longer than in the past, since this time tardiness is their intent.

Such circumstances create uncertainty about the outlook for interest rates, a key support under equity markets. They also make it more important for investors to consider inflation separately from interest rates, since the FOMC is relaxing the tether that historically connects them.

For much of the past five years nominal and real interest rates stayed close, reflecting stable inflation expectations. Covid and the resulting uber-stimulus have altered the relationship. Real interest rates have stayed negative – an implicit forecast of stealth monetization of debt.

In 2013 I published Bonds Are Not Forever: The Crisis Facing Fixed Income Investors. It forecast continued low interest rates and negative real yields as a relatively painless solution to excessive debt. Circumstances have continued in that direction, with Covid accelerating the trend. Currency debasement has a long history, as I recounted in the book. A client recently suggested I write an update.

The rise in ten-year treasury yields this year has prompted more investors to consider how they should respond to higher inflation expectations. The recent drop in nominal yields hasn’t been caused by moderating inflation fears – real yields have also dropped.

One could infer from this a growing realization by the market that the Fed won’t be quite as ready as in the past to protect purchasing power. Negative real yields should prompt greater urgency in the search for assets that will provide inflation protection. Investors need to look after themselves, since the Fed won’t.

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

The ascent in lumber prices is the most spectacular of many commodities that reflect the pandemic recovery. Recently a general contractor I know lamented that the wood for his typical newbuild construction had doubled over a few months.

High lumber prices are not only caused by booming suburban real estate markets — new household formations are up too. Although the monthly figures reflect a sharp jump last summer followed by a drop, smoothing out the fluctuations reveals a clear increase in the underlying trend.

Stinson Dean, Deacon Lumber CEO, also blamed Canada’s decision several years ago to reduce the amount of lumber harvested from western forests, to levels believed to be more sustainable over the long term.

Lumber is experiencing inflation. But like most items that are rising in price, it won’t bother the Fed. That’s because lumber doesn’t show up directly in the CPI or the PCE  (the Fed’s preferred measure), which are both indices of finished goods and services (lumber is included in PPI). Since house prices (a finished good) are rising in part because of lumber, one might assume it’ll show up there. But house prices aren’t in CPI or the PCE Index either – because a house is an asset, and the Bureau of Labor Statistics (BLS) is trying to measure the cost of shelter, the service a house provides (see Why You Can’t Trust Reported Inflation Numbers).

Owners’ Equivalent Rent (OER) is how the BLS measures the cost of shelter afforded by home ownership, by surveying homeowners on how much they think they could receive by renting out their house. In theory, rising house prices should induce higher rents, but the OER estimates the BLS obtains move improbably without regard to home prices. In any event, if OER did jump, as the only non-cash item in the CPI it’s implausible that monetary policy should ever respond to it. Nobody ever pays OER, and homeowners can’t spend it. OER is an obscure and meaningless concept, only loved by the BLS statisticians who invented it.

Inflation indices also incorporate quality improvements as price decreases, since more value for the same price is equivalent to a price reduction. The “Telephone hardware, calculators, and other consumer information items” component of CPI has fallen at a 9.8% compound annual rate for the past decade. In 2011, the iPhone 4S retailed for $660, compared with around $1,000 for an iPhone 12 today. They are dramatically different devices – due to its greater functionality,  the newest iPhone enters the CPI as a price cut, even though it costs more. This is how inflation indices are designed to work, although most find it counterintuitive.

Published inflation figures have little in common with consumer expenses. The Fed has long dismissed changes in food and energy because they’re volatile. They’ll ignore price hikes in many consumer products, including those announced recently by Procter and Gamble, Kimberly-Clark, Hormel Foods and JM Smucker.

The Fed is prepared to ignore inflation in most areas of the economy, except for one — rising wages, nowadays the only source of inflation that could justify a policy response. Their twin mandate, defined last week by Fed vice-chair Richard Clarida, is, “maximum employment as the highest level of employment that does not generate sustained pressures that put the price-stability mandate at risk.” In other words, maximize employment until labor shortages cause wages to rise. As he noted in his speech, estimating the natural level of unemployment, beyond which further employment gains are inflationary, is a “long-studied topic” not currently resolved.

So the Fed will want to see wage inflation as confirmation that the natural rate has been achieved. Today’s 6% unemployment rate is still only back to the levels of late summer 2014. It reached 3.5% in February of last year, with no discernible impact on wage inflation, before the pandemic hit.

Last summer the Fed revised its operating model to target 2% inflation through a cycle, meaning they would now tolerate inflation somewhat higher at times. Because real interest rates have been falling for many years, this was a recognition that a lower equilibrium short term rate (because of falling real rates) provides less room to cut rates in a recession. Hence the explicit willingness to tolerate “inflation moderately above 2 percent for some time in the service of keeping longer-term inflation expectations well anchored at the 2 percent longer-run goal.”

The Fed’s evolving posture reflects a thoughtful response to changed circumstances and their dual mandate. When inflation rises, communicating their objectives will be complex and will draw criticism. But it’s clear they’ll be late in tightening monetary policy, and because tardiness is an explicit objective, markets may conclude the Fed is beyond simply sociably late.

Inflation expectations remain anchored close to 2%, although they’re trending higher. At some point the Fed may be caught between the market’s concern about rising inflation and the absence of wage inflation that would confirm the natural employment rate had been reached. When this happens, they’ll still be buying $120BN or so of government bonds every month. It could be more if to that point they’ve assessed rising bond yields as imposing unnecessarily tight conditions rather than reflecting investors’ pricing in greater risk.

Persistent bond buying, a slow monetization of Federal debt, represents the most vulnerable element of the Fed’s posture. They could easily have justified withdrawing such support as the size of the fiscal response to Covid became apparent. They are now left with no elegant exit strategy. It’s becoming a narcotic. Bond yields globally are already so low, they are scarcely impeding the recovery. The Fed’s new policy framework will test their communication skills. It will offer a fascinating spectacle.

Inflation, even as measured by the BLS with its shortcomings and downward bias, is heading higher. The Fed and Congress (see Democrats Will Test The Limits On Spending) have synchronized their policies with this same objective in mind. Investors should position their portfolios accordingly.

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

What if CO2 emissions could be captured before they entered the atmosphere? Sulfur dioxide is already removed from the emissions of coal-burning power plants. Why not CO2 from burning natural gas for power, steel or cement production? The endless hype over solar panels and windmills, overstating their competitiveness, downplaying their intermittency – none of this would be needed any more if we could just keep using the fuels we do without the harmful emissions.

It turns out the technology does exist to partially do this, via Carbon Capture and Utilization or Sequestration (CCUS). Although it’s not a solution for the transportation sector, it can be applied to power generation and some industries. As with most aspects of climate change, the problems are mostly economic and political rather than technological. If there was popular support for higher energy prices to combat climate change then CCUS would already be widely used. But as we noted in Energy Policy Meets Reality, polls show limited support for higher utility bills. Public concern is broad but shallow.

From 2010-17 CCUS investment fell since tax incentives weren’t high enough to support the cost. But CCUS is getting cheaper, and governments are creating greater incentives to curb CO2 emissions. Global development of new CCUS facilities began rising again following the 2016 Paris Agreement. Currently a record 21 facilities are operational worldwide, with another 44 at various stages of development.

Ten of the operating CCUS plants are in the U.S. Their main use is to provide CO2 for Enhanced Oil Recovery (EOR). This involves pumping CO2 into mature oil wells to increase pressure, boosting production. Because of this, CCUS hasn’t historically been linked with combating climate change, although EOR does at least keep the CO2 out of the atmosphere. But CO2 could simply be stored underground without being used, and this is where CCUS promises to be part of the climate solution.

Congress has promoted CCUS for years. In 2008 the Internal Revenue Code Section 45Q provided a $10 per ton tax credit for sequestered CO2 used for EOR and $20 for “geologic storage.” Under current law the tax credit will eventually reach $50 per ton for underground storage by 2026.

The 2020 U.S. Energy Act signed late last year directed R&D at CCUS and directed the Energy Secretary to identify, “… tools the Federal Government can use to advance deployment of carbon dioxide removal.”

A tax credit isn’t as effective as a tax – tax credits can encourage production unless carefully regulated, whereas a tax acts as a direct cost. But tax credits are more palatable in the U.S., where a carbon tax is a political non-starter. Other countries are increasingly imposing a carbon tax. Canada’s is currently $30 ($23.70) although set to rise to C$170 ($134.30) by 2030. 17 EU countries have a carbon tax — Ireland’s is the median at €25.60 ($30.46).

Exxon Mobil claims to be the market leader in carbon capture, taking credit for 40% of all the world’s captured CO2 since 1970 and 23% of the CO2 captured in 2019. However, their 9 million tons of annual “carbon capture capacity” barely registers against the world’s 36 Gigatons (1 gigaton = 1 billion tons) from human activity*. Current U.S. CCUS capacity is estimated at 25 million tons annually, around 0.5% of what we produce.

In December Congress extended the deadline for planned CCUS plants to qualify for 45Q tax credits by an additional two years. CCUS enjoys bipartisan support in Congress. Last month legislation was introduced (the SCALE Act) to increase financial incentives for CCUS and spur greater investment.

This is increasing activity around CCUS.

For example, last month Valero, Blackrock and Navigator Energy Services launched a JV to build a 1,200 mile CO2 pipeline in the Midwest that will move 5 million tons of CO2 annually into permanent underground storage. In addition to Exxon, other big energy companies such as Total, Aramco and Repsol are investing in CCUS capabilities.

Some pipeline companies are already in the CO2 business. Kinder Morgan (KMI) has provided CO2 for EOR for years, where fluctuating oil prices cause swings in demand. We and other investors have long criticized this business segment for its low returns (see Kinder Morgan: Great, But Stick to Pipelines), but increasing tax credits may offer salvation. Enbridge (ENB) and TC Energy (TRP) are considering CCUS investments. Canada’s carbon tax will support the economics.

The White House’s proposed $2TN spending on infrastructure promises to, “… establish ten pioneer facilities that demonstrate carbon capture retrofits for large steel, cement, and chemical production facilities…” and to expand the 45Q tax credit so that it’s, “… easier to use for hard-to-decarbonize industrial applications, direct air capture, and retrofits of existing power plants.”

CCUS today is small but growing. Cost has usually been the biggest barrier to widescale deployment. But a Democrat Administration looking for tangible results on climate change is likely to improve financial incentives for its further development. This creates another pragmatic alternative to erecting windmills everywhere and is good for the pipeline industry.

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

*excludes land use

Our blog post on Sunday, Why Goldman Unsurprisingly Avoided Archegos Losses drew a wide range of comments, both on social media and via direct emails to me. Many observers dislike Goldman – their continued success and adept avoidance of mistakes made by others leads to grumbling of sharp practice. I recounted an experience of my own from 1998 when hedge fund Long Term Capital Management (LTCM) collapsed. Former colleagues with whom I’ve remained friends recall that episode similarly. But it was a long time ago and is only one event.

Another former JPMorgan colleague, lamenting the lost code of honor that he recalls existed in banking, described being the victim of a collateral grab of dubious legality later in his career at another firm. The perpetrator was JPMorgan. Reputations vary among big banks, but they’ve all written hefty checks for regulatory or legal failings.

While there’s a popular cynicism towards Wall Street with Goldman regularly in its crosshairs, finance professionals who have done business with them hold a more nuanced view. Some will report a negative personal experience, but grudging admiration is more common. One recalled Goldman “breaking norms” when he was liquidating bond positions related to the Drexel Burnham bankruptcy in 1990, but also regrets not accepting a job there almost two decades later. I suspect the vast majority of critics would jump at the chance to work at Goldman.

My intent with the blog post was to highlight Goldman’s skill in extricating themselves from a situation far more elegantly than their peers. The previously estimated $3-4BN loss at Credit Suisse has turned out to be $4.7BN. Several senior executives have lost their jobs as a result. Avoidance requires good systems to understand the exposures, but also good judgment on what to do. Goldman has both.

“Any sufficiently advanced technology is indistinguishable from magic.” was the comment from one individual better informed than most on this episode. Maybe to Credit Suisse and Nomura that’s how it looked. Another comment was that when a client doesn’t return calls asking for margin, it should be clear what to do next. Not all risk management is high tech.

Most controversial was the suggestion that Goldman is willing to take some legal or regulatory risk depending on the circumstances. This resonated with many outside observers.

Warren Buffett once said that if you follow anyone around all day long you’ll eventually find them doing something wrong – even if it’s failing to completely stop at a stop sign. I have been pulled over for this in Naples, FL, but was let off with a warning by a typically friendly Naples patrolman. I maintain that it’s simply an excuse to search for drugs or guns, whereas my wife thinks I should drive properly.

One respondent in a position to know rejected my suggestion that Goldman regards taking legal/regulatory risk as sometimes acceptable depending on the upside. He believes they are more conservative than most, and is better placed to know than I am. My view is based on years of observation, but not derived from direct experience other than in 1998. Just as technology can look like magic, perhaps astute judgment can appear to exploit regulatory grey areas.

In any event, the most important part of the story is that Goldman didn’t lose $4.7BN, or indeed anything material. They’re too good for that. Archegos exposed a gulf in competence between Goldman and some others. Perhaps the best judgment was exercised at my old firm JPMorgan, by avoiding the whole sorry mess.  

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