“The Fed’s an inflation creator, not an inflation fighter.” So said Paul Tudor Jones last week in an interview on CNBC. It’s doubtful that charge has been leveled at the Fed in at least half a century. William McChesney Martin ran the Fed for almost 19 years (1951-70) during a period that set the stage for the inflation of the 1970s, so it’s possible contemporaries were similarly critical. But it’s not a criticism that could have been made of Paul Volcker, Alan Greenspan or Ben Bernanke. Janet Yellen also avoided such a label although as Treasury Secretary she’s a high profile cheerleader of current policy.

Larry Summers also weighed in, expressing concern at the Fed’s apparent embrace of climate change and income inequality as policy issues that should concern them. Summers argued the Fed should stick to their core mission of monetary policy – a task he believes they’re not mastering at present.

Faster tapering is the obvious change required of Fed policy. The Federal Reserve balance sheet sits at a record $8.5TN. Current expectations are for the Fed’s $120BN of monthly bond buying to be reduced by $15BN per month before the end of the year, which means they’ll add almost another half a trillion dollars to the world’s biggest balance sheet in the meantime.

It’s increasingly clear that the supporters of current monetary policy are an exclusive group living within the DC beltway and attending Democrat cocktail parties. Inflation doesn’t benefit any specific income group, but higher interest rates are never sought by the party in power and the Fed’s management of monetary policy no longer appears independent.

Job openings hit a new record in July — like the Fed’s balance sheet, this metric has doubled since the lows of Covid. The symmetry is compelling and one more confirmation that hiring is vibrant. Measuring the unemployed is straightforward since they file for unemployment – counting open jobs understates demand for workers, because many jobs aren’t advertised. Therefore, the unemployed usually exceed open jobs – which makes today’s situation so unusual.

With nearly 11 million positions open, the highest on record, and 8 million unemployed, it strongly suggests a mismatch between skills or location. Neither of these can be resolved by the blunt instrument of monetary policy.

In the past, a combination of rising inflation, tight labor market and easy monetary policy would have sent bonds into a tailspin. I well remember how in the summer of 1987 incoming Fed chair Alan Greenspan was regarded by some as a lightweight, unwilling to impose the tough interest rate medicine of his predecessor Paul Volcker. Establishing one’s “inflation fighting credentials” required responding to the bond vigilantes.

That’s no longer the case. Bonds long ago ceased to offer any value for return-oriented investors. Today’s buyers are central banks and others with inflexible investment mandates. Inflation doesn’t seem to curb their demand. Therefore, today’s FOMC is under no market-oriented pressure to respond to rising inflation fears, because bond yields remain low. Markets are nonetheless pricing in a faster tightening of monetary policy, as if the Fed’s transitory narrative on inflation will be abandoned. Low real rates, helped in part by the Fed’s own buying of bonds, are muting the messenger which affords them a more leisurely normalization of policy than might otherwise be the case.

Tightening sooner means less later. The yield curve has been flattening sharply, pricing in monetary policy more than 0.5% tighter than the FOMC’s projections within two years, yet lower than FOMC projections by 2025. It reflects the possibility of a policy error – the yield curve can be interpreted as warning of overly aggressive monetary tightening causing a slowdown in growth.

Fed officials have had little to say recently on this adjustment — future comments will need to either move away from the transitionary narrative or confirm they’re still comfortable.

In fact, it may be harder than many think for the Fed to slow the economy with higher rates. Ten year treasury yields at 1.6% already incorporate the anticipated loss of Fed buying of bonds next year, and short term rates at 1.5% within a couple of years. Long term rates would probably have to increase a couple of percent from here to have any significant economic impact. That would presumably require short term rates also a couple of percent higher than currently priced in.

Moreover, negative real yields on bonds mean that persistent inflation poses less of a financing problem for the Treasury — if inflation settled in at, say, 4%, today’s TIPs yields of –1% suggest the cost of US debt would gravitate towards 3%, which doesn’t seem that onerous.

It’s not hard to find support for modestly higher inflation (see America Needs Higher, Longer-Lasting Inflation for example), and if the government remains able to finance its enormous debt at rates below inflation, that could be an attractive outcome. The losers would be holders of low-yielding debt, which is foreign central banks, sovereign wealth funds and pension funds – not a group likely to attract much sympathy.

The bottom line is rates seem likely to rise slowly. Bond market concern about inflation is limited by return-agnostic buyers, and the FOMC has made clear their willingness to risk inflation for numerous objectives not limited to employment. Don’t look to this Fed to protect the dollar’s purchasing power.

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

The two front covers from The Economist, thirteen months apart, represent an overdue liberal education. Much of the mainstream press has heralded the energy transition to renewables as a source of jobs, innovation and everything else good including lower CO2 emissions. In September 2020 The Economist ran a leader titled Is it the end of the oil age? They excitedly continued, “As covid-19 struck the global economy earlier this year, demand for oil dropped by more than a fifth and prices collapsed. Since then there has been a jittery recovery, but a return to the old world is unlikely. Fossil-fuel producers are being forced to confront their vulnerabilities.”

Today, the US Energy Information Administration (EIA) expects total liquids demand to be 36% higher by 2050. OPEC expects crude oil demand in 2045 to be 108 million barrels per day, versus around 100 currently. In covering the energy crisis engulfing most of the world, The Economist now warns, “the first big energy scare of the green era is unfolding.”

It shouldn’t have been hard to see coming. Climate extremists have disingenuously promoted solar and wind as the only acceptable sources of electricity. They have glossed over intermittency and the reliance of weather-dependent energy on back-up (usually natural gas or coal) to make it work. They’ve ignored that electricity provides only 17% of the world’s energy, assuming that the other 83% could be electrified and all supplied by renewables.

Oil and gas production has been demonized to such an extent that public companies have pulled back from making new investments, causing today’s rising prices. Over 80% of the world’s energy comes from fossil fuels. Vaclav Smil, a prolific multi-disciplinary writer, has explained in detail why energy transitions take decades to play out, and why this one will be no different.

Finally, political leaders have been keen to demonstrate their green credentials by using every opportunity to curb new production of oil and gas, but hypocritically reluctant to welcome the higher oil and gas prices that result. Energy systems will shift mostly based on economic signals. With Europe and Asia paying 3-5X more for imports of liquified natural gas than a year ago from Qatar, Australia and the US, liberal politicians could claim that their policies are working. Instead, European leaders are pleading with Russia to dispatch more natural gas. President Biden wants OPEC to increase oil production even while he promotes policies to curtail domestic production.

With inconvenient timing, the COP26 climate change conference will be held next month in the UK, where coal plants have been restarted to compensate for a windless North Sea and prior policy decisions that slashed the UK’s natural gas storage capacity. Although energy prices are rising, nobody is bidding up solar panels or windmills.

We’ve been writing about the unrealistically narrow focus of climate policies for several years. Emerging economies want higher living standards, which mean increased energy consumption, more than they want to reduce CO2 levels. Climate extremists oppose everything that works even including nuclear. Advocates claim that solar and wind are the cheapest form of power, implying that utilities are stubbornly retaining legacy energy systems and foregoing higher profits in the process.

The juxtaposition of the two Economist front covers represents the start of a more realistic debate over the energy transition. Now their editors recognize that “the mix must shift from coal and oil to gas which has less than half the emissions of coal.” A year ago, The Economist argued that solar and wind could reach 50% of global power generation by 2050. Last week, the EIA’s International Energy Outlook 2021 predicted a more sober 40% share. Even that figure relies on robust 8.7% and 4.7% annual growth for solar and wind respectively over the next three decades. Today’s chastened Economist editors now concede that, “More nuclear plants, the capture and storage of carbon dioxide, or both, are vital to supply a baseload of clean, reliable power.” A year ago they mentioned neither.

Most people who give the issue much thought favor reduced CO2 emissions. But political discourse has been simplistic, which has led to bad policy. Germany and California are leaders in renewable power. Their residents pay the world’s highest electricity prices and in the Golden state suffer third world reliability. Sales of diesel-powered generators have risen 22% in California in the past year, as residents seek protection from their unreliable grid. Nobody should want to emulate their model. Meanwhile China goes on burning half the world’s coal and producing 28% of emissions, content to sell OECD countries the solar panels and windmills they crave.

Transitioning to an energy system that generates less CO2 will be very expensive – if it’s worth doing, it’s worth the cost. Policymakers should be honest with voters and explain why concern about climate change means accepting higher energy prices. We should be using more nuclear; switching from coal to gas; using carbon capture; introducing hydrogen; and including solar and wind only to the point where relying on their opportunistic supply model doesn’t destabilize power markets.

An example of new technology is Air Products, which is building a “blue hydrogen” plant that will produce 750 million cubic feet per day. For reference, the US produces around 90 billion cubic feet per day of natural gas. The new facility will use natural gas as feedstock, and sequester the resulting CO2 underground.

Hydrogen is expensive to produce, so initiatives like this need higher energy prices in order to compete. Democrat policies are helping do just that, even if their political leaders won’t take the credit. For energy investors, the unfolding energy crisis is great news. As public policy becomes more realistic, the outlook for natural gas and US midstream infrastructure keeps improving.

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

Covid introduced us to first-time meetings over Zoom. Last week I had the pleasure of meeting Jack Jeffords and Adam Bloomberg, from Mount Pleasant, SC, in person after having first met them both via a video call several months ago. Recognizing a familiar face along with the person’s voice reinforced how helpful it is to chat on a screen when traveling to a meeting isn’t practical. Like it or not, zoom is now an adjective (although we prefer Microsoft Teams).

Over a convivial lunch reflecting southern hospitality, we chatted about the long term outlook for natural gas, the main focus of our energy investing nowadays. Conveniently, the US Energy Information Administration’s (EIA) International Energy Outlook 2021 (IEO2021) was released the following day. Long term projections such as these are why we’re confident that US pipelines will be in use for decades to come.

As an aside, we learned that port congestion is also an issue at Savannah, with some two dozen ships waiting offshore. Truckers and port warehouse workers are reported to be in short supply.

The energy transition brings together two opposing forces – the desire of developed countries (i.e. OECD) to lower emissions, and the intention of emerging countries to raise living standards, which requires increasing their energy use.

The trajectory of global population and GDP growth means the latter of these conflicting forces will dominate. Even if the US and the rest of the OECD countries cut CO2 emissions in half over the next three decades, the world would still be emitting more CO2 than it does today. The inevitable reality of population growth dictates that emerging economies will drive energy demand for the foreseeable future.

The upcoming COP26 global climate change conference is well timed as it coincides with a developing global energy crisis (ex-USA). This is largely the result of years of policy aimed at dissuading investment in new production of oil and gas, which has directly led to today’s high prices. Europe’s demonstrated vulnerability to supply shortages should inject some overdue humility and realism into the COP26 deliberations (see Europe Follows California Into Renewables Oblivion). They don’t need any more of Greta’s grandstanding.

China has ordered its coal mines to increase output — not good optics for a country that already burns half the world’s coal heading into COP26. India is experiencing blackouts as some of its power stations run out of coal. Energy security supersedes climate change for these countries.

The result is that, for all the relentlessly positive media coverage about increases in solar and wind, renewables will fail to satisfy the growth in world energy demand. Therefore, we’ll be using more of everything – sadly including coal.

Even in the power sector, which most easily lends itself to increased solar and wind, these two intermittent energy sources will fail to cause a contraction in fossil fuels – in part because increased use of weather-dependent power will necessitate more dispatchable (i.e. there when you need it) sources to compensate for cloudy, windless days.

Perhaps most surprising is the strong outlook for “petroleum and other liquids.” It’s set to grow at 1% p.a. over the next three decades, with growth in every region even including Europe which is farthest ahead on decarbonization. In spite of increasing uptake in electric vehicles, far more conventional automobiles will be bought as living standards rise in emerging economies.

The last chart illustrates the challenge facing policymakers. India’s electricity output is expected to increase five-fold over the next three decades. Enormous increases in solar and wind will still fall short of meeting this growth. This, along with the continued need for conventional power sources to compensate for renewables’ intermittency, explain why India’s coal consumption isn’t likely to fall. Canada’s electricity transmission is on track for zero emissions, but India’s power output is likely to be 10X Canada’s by 2050.

The EIA outlook is based on current policies and technology, which they call their “Reference Case.” The contrast it presents with where most of the world says it wants to go is so jarring that one has to expect some policy changes to come out of the COP26. Nonetheless, it highlights the enormous difficulty the world will have in achieving the IPCC emission goal, which is to reach zero by 2050. The IEO2021 forecasts CO2 emissions going from 34 to 42 Gigatons over that period. We may do better, but zero seems implausible. Given our dependence on energy supplies that work, technologies such as carbon capture will likely become a more important solution, which augurs well for today’s investments in natural gas.

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

The global energy crisis is becoming the biggest investment story of 2021. US consumers are uniquely unaffected so far by spiraling prices for natural gas and coal. Crude oil continues to cause some discomfort at the White House, which regularly pleads with OPEC to offset their own policies by increasing supply. Limited export capacity for Liquified Natural Gas (LNG) is keeping a lid on domestic prices for now, but as more becomes available the huge US discount will narrow, to the benefit of domestic natural producers and the detriment of customers.

It would be wrong to blame this on Britain’s inconvenient recent loss of windpower (see The Cool North Sea Breeze Lifting US Coal). Higher prices are exposing the poorly conceived energy policies of many western governments. By pandering to climate extremists to demonize fossil fuels, the world is now coming up short of energy. High prices for natural gas are stimulating demand for coal. Even in the US, the Energy Information Administration expects the black stuff to regain market share from natural gas in power generation. A decade of reduced emissions due mostly to cheap natural gas is being reversed because of a shift in relative pricing. The Biden administration is likely to find itself explaining why US CO2 emissions are approaching pre-Covid levels by next year’s midterms (see Emissions To Rise Under Democrats).

In February last year, there was a period of a couple of weeks when Covid became the major news story in Asia and Italy but hadn’t yet reached America. It felt like waiting for a distant tsunami to reach our shores. The global energy crisis feels eerily similar. Other than a mild rise in prices at the pump, it hasn’t drawn much media attention.

By contrast, with European natural gas prices up roughly six-fold, politicians are scrambling to deal with the fallout. France plans to cap utility bills, providing what French PM called a “tariffs shield.” Governments across Europe will spend tens of €BNs over the next several months.

China’s Vice Premier Han Zheng reportedly told state-owned energy companies to secure supplies so as to ensure continued power supply “at all costs.” Such a directive will concentrate minds among those receiving the directive – the consequence of failure is likely to be more than just a smaller year-end bonus.

China’s highly motivated coal buyers are competing with many other countries. Over half of India’s power plants are down to fuel stocks (mostly coal) of under three days, well short of the two-week government minimum. A German power plant recently shut down because it ran out of coal.

The scramble is all about acquiring fossil fuels, because they’re reliable. There’s no evidence of a scramble to obtain more solar or windpower. The managers of China’s power supply mandated to ensure reliability are not rushing to buy windmills.

The public policy error committed in many countries including the US has been to pander to climate extremists while disingenuously pretending that transitioning to low carbon energy can be done without disruption or enormous expense. The EU has a form of carbon tax via a cap and trade system, but it’s clearly not onerous enough to affect demand. Instead of fossil fuels generating increased taxes that European governments could redeploy into renewables, they’re going to be heavily subsidizing coal and natural gas use by capping homeowners’ utility bills.

Since no politician has hailed high energy prices as a successful consequence of policies to advance the energy transition, government leaders have concluded that public concern about global warming doesn’t imply a willingness to spend much.

There hasn’t been much serious thought given to the transition. It’s being handled disastrously. Tiresome Greta Thunberg (listen to Greta’s Grandstanding), who admonished the world for jeopardizing her future (“How dare you”) is what passes for climate strategy.

The result is that higher energy prices are headed to the US too.

This will be good for energy investors, but will also challenge the Fed’s belief that elevated inflation will be coming down. Energy prices will feed through to the general price level. German inflation reached a 29-year high of 4.1% in September, and across the eurozone it reached a 13-year high of 3.4%. German workers at a motorhome manufacturer are striking for more pay. The country’s biggest union, IG Metall, is demanding 4.5% pay hikes because “Inflation in Germany keeps going up”.

The Fed believes short term logistical challenges are impeding the supply of goods, and as these are resolved price pressures will recede. They ought to consider whether the 25% of GDP that the IMF calculates the US government has provided because of Covid might be the real issue, along with the Fed’s monetization of much of the debt that was issued as a result.

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