The Fed Is Losing Believers

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.

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.

Bonds Are Getting More Interest

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.

Pipelines Are Part Of The Energy Transition

Last week Kinder Morgan (KMI) reported earnings, which included around $1BN in one-time gains from the Texas power outages in February. Natural gas prices increased briefly by more than 100X. KMI had natural gas available, so profited from selling it to power companies who had commitments to meet. Energy Transfer (ET) is expected to report a large gain for the same reason when they report. Oneok is another candidate. This is part of the optionality that the pipeline business offers.

They also announced a modest dividend increase. The Alerian MLP ETF (AMLP) has cut distributions in half since 2015. Corporations cut by less, and KMI’s 3% hike is another small confirmation that the sector’s dividend cuts are in the past.

If global warming is already causing extreme weather events such as February’s cold snap, then not all the financial outcomes will be negative. KMI and ET may be the first examples of the profits that can be made from weather uncertainty.

Enterprise Products Partners (EPD) benefited last year when propane demand rose sharply. This was the result of a drop in Indian refinery production of gasoline, from which propane is often derived. Once again, a large footprint in the business provides flexibility to exploit market opportunities.

The energy transition offers commercial opportunities, although profiting from weather uncertainty isn’t a reliable business model. As the U.S. Administration increasingly engages more with foreign governments on climate change, the pursuit of practical solutions offers many more opportunities than simply building windmills and solar panels everywhere.

Phasing out coal globally is the biggest. China, the world’s biggest emitter of global green house gases (GHGs), announced that it plans to reduce coal share of power generation to 56% this year – an enormous figure whose only positive attribute is that it’s falling. They still plan to add coal power plants “moderately and rationally.”

An interesting paper was posted on China’s National Energy Administration (NEA) website, authored by their Director. It links the energy transition with energy security, offering a useful perspective on how Chinese policy may evolve. Renewables may be more attractive to China than most countries, because several of the rare earth minerals required are relatively abundant in China (see Some Surprising Facts About Energy). In this way, renewables can improve China’s energy security.

The U.S., which produces enough oil and gas to satisfy domestic demand, faces a loss of energy security in growing its renewables portfolio, a choice that Chinese planners must find mystifying.  China also produces around 93% of the coal it consumes. The NEA paper makes it clear why this is likely to remain a significant source of Chinese power generation for the foreseeable future.

Nextera Energy is well known for its large portfolio of windmills for power generation. But they’re also one of the largest generators of electricity from natural gas in the U.S. They’ve been upgrading some of their power plants to be more efficient and reduce emissions. They’re finding that the reliability of natural gas counters the intermittency of renewables.

President Biden last week hosted a virtual Leaders Summit on Climate. Hs remarks touched on many opportunities to reduce emissions including carbon capture (see Capturing More CO2). KMI operates the biggest CO2 pipeline network in North America, and Section 45Q tax credits are set to reach $50 per ton for CO2 permanently sequestered underground.

Coal is set to gain market share from natural gas over the next couple of years, reversing the main source of U.S. GHG reductions of the past decade (see Emissions To Rise Under Democrats). On current trends the Biden administration will claim many successes but will not be able to show any actual reduction in emissions. Targeting coal power plants remains one of the opportunities to show near term results.

Just about every pipeline company has plans to participate in the energy transition. Coal-to-gas switching, capturing CO2 and perhaps even using hydrogen are among the initiatives being considered. Yields of 7% remain too high given the stability and outlook these businesses offer.

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

The Fed’s Narrowing Definition Of Inflation

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.

The Consumer Is Ready To Spend

“Coiled, ready to go.” is how JPMorgan CEO Jamie Dimon described consumers last week. “Consumers have $2 trillion in more cash in their checking accounts than they had before Covid.” he added. Borrowers are in such good shape that JPMorgan reported a 4% drop in loans when they released their quarterly earnings. Stimulus cash is being directed towards debt repayment.

The inflationary result of a consumer spending boom and low interest rates is the biggest uncertainty confronting investors. There’s plenty to worry about. Federal debt:GDP is set to exceed the levels that followed World War II. The level of Covid stimulus is several multiples of the estimated loss in output. Larry Summers, who headed the National Economic Council under Obama and was Clinton’s Treasury Secretary, has called it “substantially excessive,” and in case his views weren’t clear added that fiscal policy is the “least responsible” in 40 years.

Rising inflation shouldn’t catch anyone by surprise – and sure enough March CPI jumped 0.6%, 2.6% year-on-year. Ex-food and energy it was only 1.6%. Will this be sustained, and at what point will the Fed feel compelled to react?

The base effect – a depressed March 2020 CPI because of the sharp economic contraction – means annual comparisons will look high for several months. This will not trouble the Fed. Prices for all kinds of commodities are rising – hot rolled steel has tripled in a year, and while this reflects a rebound from severely depressed prices, it’s also more than doubled compared with two years ago. Copper, lumber and carboard tell similar stories.

March Retail Sales jumped 9.8%, boosted by spending at bars and restaurants as restrictions are being eased.

Moreover, many small businesses report trouble hiring people, in part because the recent $1.9TN Covid relief plan continues $300 per week Federal unemployment benefit on top of whatever the state pays.

Although signs of pricing tightness are everywhere, a review of Fed chair Jay Powell’s comments on inflation show numerous reasons to ignore them. Year-on-year comparisons simply reflect a rebound from sharply depressed levels. Tight commodity prices are a function of supply challenges that are being erased as people return to work. Consumers’ spending power will boost demand for a few months before dissipating.

Moreover, the Fed will never react to housing inflation, because house prices don’t figure in CPI, or the Personal Consumption Expenditures (PCE) index, their preferred measure. Owners Equivalent Rent (OER), the survey of what homeowners think they could rent their house for, doesn’t track house prices and doesn’t reflect any actual transactions (see Why You Can’t Trust Reported Inflation Numbers). So it’s a meaningless index, and because of the weight OER occupies it artificially depresses CPI by 2% and the PCE index by 1%.

Finally, although the unemployment rate is 6%, it was 3.5% in February 2020 with no discernible impact on inflation. Given the Fed’s focus on ensuring maximum employment, they’re unlikely to raise rates before unemployment drops at least that far again, unless there are clear signs of wage pressure. Any tapering of bond buying is likely to await actual evidence of inflation. This is a subtle but important shift – the Fed isn’t going to act based on a forecast of inflation. They plan to be late.

Financial advisors have few tools with which to protect against rising inflation. Shorting bonds is inefficient because of the large amounts needed to create much protection, and few are licensed to use interest rate futures for clients. Stated inflation is also likely to lag the actual inflation experienced by most people, due to the flawed use of OER noted above.

Not surprisingly, since this is a blog focused on the energy sector, pipelines are one of the few sectors that offer meaningful protection. Dividends are stable, yielding 7%. Announced buybacks across the sector add up to a further 2% return. A drop in yields to 6% would add another 14% in appreciation, so a one year return of 20% or more (7+2+14) is plausible.

In addition, pipelines have tracked the ten year treasury yield reliably this year, with both rising together during 1Q21 and both moving sideways more recently. And if the Fed moves too slowly once inflation finally appears, the commodity sensitivity embedded in midstream energy infrastructure should provide additional upside.

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

Capturing More CO2

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

Energy Policy Meets Reality

Public policy is becoming more important to energy investors. Democrats now own the climate change issue. The desire of progressives to advance a world of solar panels and windmills is confronting pragmatists who’d like to keep the lights on. Rising oil and gas prices are helpful to the energy transition, by improving renewables’ competitiveness. But $4 gasoline would have political repercussions. So the spirit of St. Augustine prevails (“Give me chastity, just not yet”). Last week U.S. Energy Secretary Jennifer Granholm reported “a productive call with Saudi Energy Minister Abdulaziz bin Salman al-Saud” to “ensure affordable and reliable sources of energy.”

The Administration’s proposed $2TN infrastructure plan is likely to rely on reconciliation to get through the Senate, which means it has to look like a tax/spending plan rather than new laws. Eliminating the filibuster would allow more expansive policies, including on climate change, to be passed with a simple majority rather than the 60-vote filibuster-proof margin.

West Virginia Senator Joe Manchin’s (D) power stems from his less than perfect fealty to Democratic ideals. He is against changing the filibuster, which limits the prospects for new laws including on energy. Manchin wants to, “…usher a new era of bipartisanship where we find common ground on the major policy debates facing our nation.” Hence, Congress can spend money on building an electric vehicle charging network, but can’t impose a carbon tax, even though it’s supported by the American Petroleum Institute.

The Administration’s desired path is to show progress without imposing visible costs, since numerous polls show voter concern about climate change stops once the monthly cost competes with their Starbucks budget. Hence the call to the Saudi oil minister.

Energy investors should welcome the increased political debate. It forces the shrill rhetoric of climate extremists to confront reality. For example, the Texas legislature is considering passing the costs of windmill intermittency back to windmill operators. Texas has enjoyed great success in using more windpower, but the grid’s vulnerability to calm days increases with dependence on wind.

Berkshire Hathaway Energy helpfully showed what intermittency costs, by offering to invest $8BN to build ten natural gas power plants. The proposed Texas Emergency Power Reserve would normally remain idle but could meet any plausible power shortfall by ramping up within ten minutes. The cost of ensuring reliable power would be passed on to customers.

Texas state senator Shelly Hancock (R) has argued that renewable energy providers should instead pay the cost of these natural gas power plants whose main purpose would be to provide back-up power for wind. It’s a reasonable suggestion, but is opposed by renewables operators whose investments were based on a socialized approach to the cost of compensating for intermittency.

The power outages Texas endured last month were caused by multiple failures, including of natural gas plants (see Why Texas Lost Power). But wind and solar power plants are chronically intermittent, with typical utilization of only 20-30%. Despite the outages, natural gas was the only source of power in Texas whose output rose. Renewables often get a free ride by providing power opportunistically with no penalty for unreliability.

Although CO2 emissions are a global problem, OECD countries aren’t making it worse. All the growth is coming from developing countries, notably China and India. Climate change is supposedly a bigger threat to those less able to afford mitigation. While this ought to make poorer countries big supporters of lowering emissions, raising living standards is a higher priority. The most vulnerable nations don’t share rich world goals aimed at protecting them from rising sea levels.

India’s Energy Minister Raj Kumar Singh offered an articulate summary, “The developed world has occupied almost 80% of the carbon space already. You have 800 million people who don’t have access to electricity. You can’t say that they have to go to net zero. They have the right to develop. They want to build skyscrapers and have a higher standard of living. You can’t stop it.” In other words, it’s their turn to pursue a western standard of living. Until emerging countries acknowledge the problem, it’ll be hard to induce rich world voters to pay for solutions.

The increased political debate is good news for all except the climate extremists still clinging to purist impracticality. Climate change is all about politics and economics. The technology already exists for carbon capture, hydrogen sourced electricity and other zero-emission solutions. They’re just expensive. The diminishing likelihood of extreme policy responses (see The Bovine Green Dream) is removing the always low-probability existential risk faced by parts of the energy sector.

The components of the American Energy Independence Index yield 7% on a market cap weighted basis, and announced buybacks add a further 2%. This helped the index to a 20% return in the first quarter. Past performance is not indicative of future returns.

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

Reaction To Our Goldman/Archegos Post

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.

Why Goldman Unsurprisingly Avoided Archegos Losses

Goldman almost always sidesteps trouble. That’s one of the conclusions from the Archegos blow-up that is estimated to have cost the firm’s lenders as much as $10BN.

Imagine the discussion among Credit Suisse, Nomura, Morgan Stanley, Goldman Sachs, UBS and Wells Fargo as they considered an orderly liquidation of the hemorrhaging Archegos portfolio. It was a mismatch of men and boys – according to reports, Goldman warned that the market would quickly realize the scale of the problem, depressing the prices of what they were trying to sell and leading to a very disorderly liquidation.

It seems so obvious. Some Wall Street firms are sharper than others. Goldman and Morgan Stanley, who had sensibly adopted the role of observers not participants, evidently relied on this subtle distinction to immediately sell the Archegos collateral they held once they understood the scale of the problem. Nomura and Credit Suisse, in a high stakes version of the Prisoner’s Dilemma, thought time was on their side. They just forgot that Goldman wasn’t.

Goldman Sachs is full of street smart, talented people. In the 1980s and 1990s when I was trading interest rate swaps at JPMorgan, if Goldman was your counterparty to a trade it was worth taking a second look. They rarely seemed to be forced participants – often they’d identified a mis-pricing or arbitrage opportunity. Whenever I found Goldman on the other side of my trades, I often traded less than my full position while I figured out what could be driving their decision to go the other way. Pausing rarely cost the opportunity – markets moved their way more often than not.

In 1998, when hedge fund Long Term Capital Management (LTCM) was blowing up, their biggest swap counterparties gathered to discuss an orderly liquidation. LTCM was our biggest counterparty, but then LTCM was everybody’s biggest counterparty. Their abundance of PhDs and egos had created a colossus that generated tens of millions of dollars a month in profits for the banks trading with them.

I was running interest rate derivatives for Chase Manhattan (later merged into JPMorgan). I received a phone call late one night from a colleague informing me that LTCM was collapsing due to many highly leveraged bets going awry simultaneously. The following morning, our head of credit summarized the exposures we and the other big counterparties had to LTCM. As with Archegos, an orderly liquidation of positions looked to be the best option. But the economic incentives were similar to a cartel – each member was incentivized to secretly cheat.

The LTCM bank group was apparently sworn to secrecy. The information I had been provided made me an insider – it was obvious what trades should be done to generate immediate profits (“pay fixed in ten year swap spreads”) but I respected the rules and waited. Goldman didn’t. I saw them trading on the information they possessed about LTCM’s portfolio.

Goldman never got in trouble. Maybe what they had wasn’t inside information under a strict legal definition – interest rate swaps were bilateral agreements, not SEC-registered securities. Maybe they understood the information sharing agreement to be loose enough to allow trades to be done. What I do know is that they acted differently than we did. David Pflug, the patrician head of credit at Chase, was a man of his word who would never have resorted to legalistic identification of loopholes. Not trading on the information we had required no further explanation. We passed up a hugely profitable trading opportunity – but LTCM had been a money spigot for years.

Derivatives traders use the Greek alphabet (delta, gamma, theta) to identify portfolio risks. David Pflug later commented on the glittering mathematicians of LTCM, “for all their knowledge of Greek, they didn’t understand the meaning of hubris.”

I’ve always felt that Goldman regards legal and regulatory risk as just another risk alongside credit, rate, FX and equity risk. They all offer a risk/return trade-off. Most banks, including the one I worked at, put legal and regulatory risk off limits. There was no such thing as acceptable legal risk. Having watched Goldman over decades, I believe their culture incorporates a highly sophisticated assessment of legal/regulatory risk that allows them to consider the upside of a transgression against the possible penalty. They are very good at it, which is why they so rarely mis-step. The 1MDB disaster is one of the few.

It looks as if Goldman used the Archegos discussions to obtain a clear view of the group’s exposures while retaining the freedom to act. They would have considered their market risk as well as any legal/reputational downside from moving quickly. As skilled risk managers, they quickly decided that your first loss is your best one and sold. Credit Suisse and Nomura discovered they were playing poker at the wrong table.

Credit Suisse is estimated to have lost $3-4BN, and Nomura $2BN. As Warren Buffett has said, if in a poker game you don’t know who the patsy is…

Last Tuesday, Goldman downgraded Nomura’s stock. They noted, “market concerns around risk management issues may persist.” It’s unlikely Nomura will find cause to reciprocate.

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

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