Life Without The Bond Vigilantes

“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:

Energy Mutual Fund Energy ETF Inflation Fund

 

Pricing In A Less Dovish Fed

Bond yields have drifted up 0.25% over the past month. Real yields on TIPs have barely budged from around –1%, so the move in bonds has translated into rising inflation expectations — now solidly above 2.5% for the next decade.

The persistence of negative real yields is surprising – with the Fed likely to finally rein in their bond buying, one might have expected this loss of support to be reflected in TIPs, but so far it hasn’t. Inflation-adjusted returns have been falling for many years. Negative TIPs yields undercut the concern of fiscal hawks about our ballooning debt, since there’s apparently no negative consequence.

The increase in ten year treasury yields has not been evenly distributed across the eurodollar futures curve. Over the past month, the market has factored in a more hawkish FOMC  – one additional tightening of monetary policy by the end of next year (total of two) has been priced in. By the summer of 2023 almost two additional tightenings  have been priced in (a 1% increase in total). The rise in inflation expectations is creating the anticipation of a reaction from the FOMC.

$120BN a month of quantitative easing has continued for too long. The $40BN a month of mortgage-backed security purchases is especially egregious, and the slothful exit from this strategy is turning out to be too slow. Following last month’s payroll report some even questioned whether tapering might be delayed, although the shortfall in employment was due at least in part to a shortage of workers. The FOMC remains focused on restoring the five million jobs still missing from pre-covid, and is willing to risk some inflation in the process.

The move in rates has pulled the market further away from the FOMC’s outlook. This Fed is the most dovish in living memory. It’s easy to see how chair Jay Powell could justify temperance before raising short term rates. In addition to the employment picture, widely acknowledged logistics problems won’t be fixed with higher rates.

Although Democrat politicians won’t accept credit, they’ve engineered rising oil and gas prices through curtailed investment so as to shift consumption to renewables – even if solar and wind aren’t yet up to the challenge (see Why The Energy Crisis Will Force More Realism). Reducing CO2 emissions requires more expensive energy (see Is The Energy Transition Inflationary?). Tightening monetary policy because of a green agenda seems unlikely.

Few policymakers want higher rates, but the “transitory” narrative is looking less compelling. The next public comments from FOMC officials will be worth watching to see if they confirm the more hawkish rate path currently in the market or remain true to their previous guidance. Powell has said they wouldn’t contemplate raising rates until they’d stopped buying bonds. This suggests 2H22 as the earliest they would raise rates, although they could also speed up tapering if necessary.

The net result is that the market is increasingly challenging the Fed’s benign inflation outlook and slow policy normalization. The FOMC’s dovish instincts are being challenged.

On a different topic, liberal commentators have been lambasting Senator Joe Manchin (D-WVa) as the one person thwarting efforts to combat climate change (see As Manchin Blocks Climate Plan, His State Can’t Hold Back Floods). This overlooks the 50 Republican senators also opposed to the Administration’s agenda, so Manchin’s concerns place him in the majority, even if that is inconvenient to progressives. It is democracy in action.

Manchin believes that the voters of West Virginia have more to lose from a system of rewards and penalties for utilities dependent on their adoption of renewables than they do from climate change. This seems rational – the drop in coal demand they fear would hit quickly. The adverse effects of global warming are loosely related – China’s choices on emissions are the most important and are unlikely to be swayed by West Virginia.

Once again we’re seeing the failure of climate extremists to move beyond broad yet shallow support, due to pretending the energy transition is costless. Voters in West Virginia don’t see it that way, which is why a more honest discussion about costs and benefits will be necessary before we make any real progress on the issue. Hopefully that is coming.

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

Energy Mutual Fund Energy ETF Inflation Fund

 

 

 

Why The Energy Crisis Will Force More Realism

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:

Energy Mutual Fund Energy ETF Inflation Fund

 

Inflation Edging Higher

Yesterday the IMF warned central banks around the world to be “very, very vigilant” about inflation. The Fed and its peers employ legions of economists and it’s doubtful the IMF will have triggered a sudden reassessment in marble halls in Washington, Frankfurt or Tokyo. But their outlook will add to the growing concern investors have about inflation and the likelihood of it remaining elevated.

Inflation expectations as derived from the treasury market have edged up in recent days – the ten year forecast average inflation rate as derived from the bond market (ten year  treasury yield minus ten year TIPs) is now 2.50%, close to the high it reached in May of 2.54%. The NY Fed’s Survey of Consumer Expectations also reflects rising inflation fears among consumers. Three years out the median is now above 4%. Although the IMF, like most forecasters, expects inflation to come back down, they revised up their forecasts sharply. Compared with April, they now expect developed country inflation to be 2.8% this year (versus 1.6% in their April forecast) and 2.3% next year (versus 1.7%). Like the Fed, the IMF was way off for 2021 inflation.

Real rates (i.e. the return investors need after inflation) are solidly negative, having reached –1.0% in August before improving recently. The persistent fall in real yields is an important reason why interest rates are so low. Explanations include increasing income inequality (rich people save more) and a growing pool of return-insensitive investors such as central banks who own treasuries for safety and liquidity. Whatever the reasons, the drop in real yields has continued even while the fiscal outlook for the US and others has dimmed. The warnings of deficit hawks look old fashioned.

In Bonds Are Not Forever: The Crisis Facing Fixed Income Investors (2013) I argued that an increasingly indebted society would favor low real returns and tolerate higher inflation, since these are the least painful way to repay less than was borrowed, in real terms. These themes have continued today, accelerated by the Covid-inspired uber-stimulus.

A recent op-ed in Bloomberg made the case that higher inflation (say, 4%) would benefit the US. The writer argues that it would make debt more manageable, and would provide the Fed more room to lower rates in a recession. It’s easy to see how this view could gain support. Record Debt:GDP challenges the orthodox view of fiscal hawks by not presenting any real economic problems. Modestly higher inflation could be the same.

Maintaining income growth at reported inflation is likely to leave one feeling poorer (see Why It’s No Longer Enough To Beat Inflation). House prices are the biggest omission from inflation indices, but quality adjustments also create a result that doesn’t capture changing living standards. When a new iphone is released at the same price as the older version, its new features mean it goes into inflation statistics as having dropped in price. But you can’t buy 95% of an iphone, so there’s no actual saving.

Hedonic quality adjustments are intended to strip out the improvements that constitute rising standards of living, since inflation statistics aim to measure “constant utility.” This is hard to do in practice, especially with services. A recent article noted that the CPI omits “quality adjustments on 237 out of 273 components that go into the index, including the vast majority of services.”

To give one example, on a recent road trip from Charlotte, NC to Naples, FL we noticed that hotels don’t automatically provide daily room make-up service for guests. It needs to be requested, and since some guests don’t bother, the hotel is saving some money. Having to specify the type of service (one hotel offered “full or partial”) each morning is a small drop in quality almost certainly overlooked by the price indices. Quality improvements for services are more subjective – the same article noted longer wait times for service at high-end retail outlets – another reflection of the shortage of workers. Inflation statistics are relevant in that they determine Fed policy and cost of living adjustments for retirees, but they’re so deeply flawed that their use is limited beond that.

The IMF is forecasting US GDP growth of 5.2% next year – substantially more than the Fed’s forecast last month of 3.8% (revised up from 3.3% in June). Although Friday’s non-farm payroll report was a disappointing 194,000, the unemployment rate fell 0.4% to 4.8%. Hourly earnings continued their series of increases, rising 0.6% although the Bureau of Labor Statistics cautioned that large fluctuations in employment across industries since Covid struck complicate the analysis of whether or not wage inflation is setting in.

Fed policymakers normally eschew anecdotal evidence, but the evidence of a booming economy is overwhelming. Help wanted signs are abundant. Worker shortages are being reported across many industries. The housing market remains buoyant, and the FOMC’s ponderous roll-back of bond market support will likely turn out to have been recklessly delayed.

Finally, New York Times columnist Thomas Friedman sounded so intelligent on this recent video that he’s jeopardizing his liberal credentials. He blamed the global energy crisis on insufficient investment in natural gas and too hasty an exit from nuclear power (Germany and California) without first establishing reliable alternatives. His policy prescriptions echoed those often found in this blog – the hope for more pragmatic solutions to CO2 emissions may not be in vain.

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

Energy Mutual Fund Energy ETF Inflation Fund

 

More Energy Discussions In The Palmetto State

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:

Energy Mutual Fund Energy ETF Inflation Fund

 

Discussing Energy Markets In The Palmetto State

In June of last year my wife and I fled the draconian lockdown imposed on New Jersey for the south (see Having a Better Pandemic in Charleston, SC). Whereas back then our autocratic governor had even forbidden a solitary walk in the park, Charleston SC felt like a world apart. We were left awestruck at the sight of diners enjoying an evening out. The welcome freedom was somewhat marred by BLM protests, that being the big news story of the moment. Boarded up storefronts did not present Charleston at its best, and we vowed to return at a more auspicious time.

That moment arrived 16 months later, and we enjoyed a wonderful dinner with long-time friend of the firm Jim Agostini and his delightful wife Lindsay. We found Charleston fully open. In keeping with southern manners, masks were politely requested if non-vaccinated, as opposed to demanded. Few were evident, even among the employees of restaurants and stores sporting such a sign. We all agreed we’re fed up with being required to wear a mask “for your protection” when it’s really to protect the unvaccinated who demonstrate little fear of covid. Most are moving on.

Client meetings are coming back, as financial services’ finds a new balance between the convenience of remote working and the benefits of in-person interaction. Our business went fully and permanently remote a year ago. Face to face client meetings are becoming more frequent, but not yet back to where a full day of meetings on a road trip is possible

I was interested to learn that Lindsay Agostini is a member of Conservatives for Clean Energy (CCE). In fact, Lindsay was recently named a Conservative Clean Energy Champion. CCE promotes innovation along with continued use of nuclear energy and greater adoption of electric vehicles – more pragmatic than the liberal climate extremists who have helped cause Europe’s current energy crisis.

We’ll hear more from Lindsay in the near future.

Meanwhile, the energy sector continues to strengthen, in almost willful defiance of most observers. Many have wrongly concluded that the energy transition makes the sector uninvestable, whereas the policies advocated by climate extremists are behind Europe’s energy crunch. Pushing for reduced capex is achieving the free cash flow growth investors have long yearned for but were unable to engineer themselves.

European natural gas prices continue to reach levels unfathomable in the US. Britain is the new poster child for a mis-managed energy transition, joining Germany and California as examples to avoid. British natural gas prices hit £3 per therm on Monday, the equivalent of $41 per MCF (versus around $6 in the US). The WSJ wrote How Not To Do An Energy Transition to offer some belated advice. Aramco noted that the natural gas crisis had driven oil demand up by 500K barrels per day, more than OPEC’s recently announced production increase.

Recent developments are highlighting the poor planning behind many countries’ headlong rush to renewables. It shows the problems of building policy on soundbites, instead of designing good policies that generate their own slogan. Lessons will be learned, including that the energy transition is far from costless. This should lead to a more thoughtful approach that acknowledges the vital role natural gas will continue to play in providing reliable power for decades to come. The wake-up call for policymakers is good news for energy investors. Electricity can’t be intermittent, and the UK government is paying a steep price for over-reliance on windpower without adequate back-up.

Natural gas is far from the only commodity in a bull market. The Bloomberg Commodity Index tracks 23 energy, metals and crop futures contracts. Even cotton, hardly a target of climate extremists, has rallied sharply in recent weeks.

The inflationary implications of the energy transition were harder for the Fed to forecast than the impact of fiscal uber-stimulus and debt monetization. Rising energy prices offer a graceful exit from the Fed’s transitionary narrative around current inflation, should they choose it. The eurodollar futures curve is priced for a 0.70% increase in short term rates between December 2023 and 2025, a pace of slightly over one tightening per year. Although it’s widened from 0.55% over the past couple of weeks, it still represents an asymmetric bet, since even today’s dovish FOMC is more hawkish than the market. If inflation fails to return to its 2% FOMC target, the risk is for much more tightening in a couple of years than is reflected in current pricing.

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

Energy Mutual Fund Energy ETF Inflation Fund

 

The Global Energy Crisis

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:

Energy Mutual Fund Energy ETF Inflation Fund

 

Energy Policies Are Feeding Inflation

The continued ascent in natural gas prices has transfixed the energy sector but hadn’t much impacted broad market commentary, until recently. Europe has an energy crisis to be sure – a combination of over-reliance on windpower, years of policy discouraging natural gas production and strong global demand for natural gas. If sentiment in the pipeline sector was as sensitive to natural gas prices as it is for crude oil, its performance would likely have been even stronger in recent days. The recent jump in crude prices has grabbed more mainstream attention, propelling energy sector stocks up with it.

The Federal Reserve and other central banks will have to grapple with the feedthrough impact on inflation. Policymakers already exclude food and energy from the inflation statistics they target, on the basis that these are volatile and mean-reverting. However, higher utility bills and increased cost of transportation will have a secondary effect on most areas of the economy.

Wage inflation has historically been the trigger for shifts in monetary policy – wage increases beyond what improved productivity justifies. The same test could be applied to commodities though. A thousand cubic feet (MCF) of natural gas delivers the same one million BTUs whether the price is $3 per MMCF as it was a year ago or $6.25 as it is currently. Even at that level it’s a quarter of the price European and Asian buyers are paying for imports of Liquified Natural Gas (LNG).

The only constraint on US prices is the availability of more LNG export terminals capable of chilling methane so it’s 1/600th of its normal volume. As more LNG export capacity becomes operational, domestic natural gas prices will move higher. Interestingly, European prices for carbon credits have been following natural gas prices higher. Even at €70 per metric tonne, they’re no constraint. Natural gas generates 121lbs of CO2 per MCF, so a power plant has to pay around 3.30 per MCF for CO2 credits. The fact that these credits are rising with natural gas prices reveals the strength in demand.

The FOMC continues to believe inflation is transitory, which is why they’re comfortable with a very gradual reduction of bond market support. It looks as if monthly buying of mortgage-backed securities will continue into next spring, a year after it was abundantly clear that the US housing market was hot (see Federal Reserve Housing Support Has Run Its Course).

Because the FOMC relies on the quirky Owners’ Equivalent Rent (OER) survey of homeowners to gauge the cost of shelter, they don’t see housing inflation (see Why You Can’t Trust Reported Inflation Numbers). The followers of OER are probably limited to a few hundred people, consisting of statisticians at the Bureau of Labor statistics, Wall Street economists and the FOMC. The rest of America looks at house prices. So the Fed is once again feeding a housing bubble by not looking at it.

An unusually calm North Sea was the proximate cause of Europe’s energy crisis (see Europe Follows California Into Renewables Oblivion), but the loss of windpower has exposed years of underinvestment in conventional energy such as natural gas. Higher prices are an obvious consequence and are part of the climate extremists’ playbook. Shifting towards renewables was always going to lead to higher prices (see Is The Energy Transition Inflationary?). This provokes two big questions for markets: (1) will the Fed feel compelled to respond to energy-driven inflation as it becomes clear that it’s not transitory, and (2) does the jump in natural gas prices suggest that we need more supply, or will unreliable solar and wind benefit from improved relative pricing?

On the first question, we’d bet on the FOMC exploring every alternative explanation before concluding that inflation requires changes in monetary policy. They’ll be relieved to see that the sell-off in bonds is mostly driven by rising real yields. The market is adjusting to approaching cessation of Fed buying. Ten year implied inflation has remained in the 2.3-2.4% range.

The second question is more complicated. Investment in new oil and gas production has been declining for years. Rich world policies that discourage fossil fuels and climate extremists’ efforts have constrained energy sector capex. Today’s high prices are the result. Solar and wind power are incapable of filling the void. As Britain has discovered, intermittency remains a huge problem. Back-up battery storage still isn’t available on economic terms. Power grids require substantial upgrades. So, do policymakers correctly accept the inevitability of continued natural gas use for decades to come while seeking technological solutions to emissions, such as carbon capture? Or do they conclude we need even more renewables? Climeworks is a start-up company that sucks CO2 out of the air. It was profiled in a WSJ story describing OPEC’s expectation to gain market share through 2045, helped by global demand growth led by emerging economies and falling rich world production.

New Jersey is one state heading for poor choices. Earlier this week PennEast dropped plans to build a natural gas pipeline from Pennsylvania to New Jersey because of continued regulatory challenges. As a result, New Jersey customers will in years to come face less reliable power.

Public support for the energy transition is about to be tested by higher prices. Polls show voter support until it hits their wallets. Political leaders sure of their footing will embrace today’s energy prices as an important element of the transition.

Meanwhile, higher energy prices will feed into the broader inflation statistics in the months ahead.

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

Energy Mutual Fund Energy ETF Inflation Fund

 

 

Europe Follows California Into Renewables Oblivion

A feature of renewables not widely acknowledged is their relatively low capacity utilization. Solar is limited to daytime, with peak generation around midday. Output is typically 20-25% of capacity, meaning a 10 MW solar farm would generate 48-60MWh every 24 hours. The UK’s windpower capacity utilization was 37% last year, higher than is typical. As the chart shows, it bounces around unpredictably.

Offshore wind tends to produce more often than onshore, which is why the UK has been adding installations in the windy North Sea. The recent tranquility has cut wind to 7% of UK power generation, from 24% last year, likely bringing capacity utilization down to 10-11%. The sheep in the photo have evidently learned that windmills can offer relief from the sun at least as often as they produce electricity. It’s true the tower is stationary, but careful examination of the photo also reveals sheep standing in the shadow of the (presumably motionless) blades.

Three years ago efforts to develop fracking of natural gas in Britain were abandoned following relentless pressure from environmental extremists (see British Shale Revolution Crushed: America’s Unique Ownership of Oil and Gas). The UK’s Lord Ridley, a member of the House of Lords, warned that Russia was funding the opposition to these efforts to reduce Britain’s reliance on imported energy. NATO’s secretary general had voiced similar concerns as far back as 2014.

Ridley recently referred to Friends of the Earth, a vocal opponent of fracking in the UK, as “useful idiots” during a radio interview. They shared Russia’s objective of crushing domestic gas production, albeit for different reasons. Now the IEA is calling for Russia to increase such exports to Europe. Russian funding of western environmental opposition to natural gas production has delivered Russia an astronomical IRR, about to be paid for by European governments forced to subsidize household energy bills.

The energy squeeze confronting western Europe is coming at a time when energy demand is usually low. Cooler weather as summer ends is when natural gas supplies are typically built up in preparation for winter. For reasons that include mysteriously low Gazprom exports and a Brazilian drought that has lowered hydropower, global natural gas prices are soaring.

Analysts are warning that Europe faces a real possibility of power cuts if unusually cold weather exposes low gas inventories. Compounding matters, Gazprom CEO Alexey Miller recently said that, “… the Asian market is more attractive for producers and investors despite the record-breaking prices in Europe.”

Asian and European natural gas prices have risen together, with Asian buyers especially keen to avoid a repeat of last January’s winter squeeze. As a result, they are often outbidding European buyers for shipments of liquified natural gas.

European governments are being forced to respond to sharply higher household electricity bills and bankruptcy risk among electricity providers. An Italian government source said, “a plausible amount to tackle the issue [of soaring energy costs] could reach up to €4.5bn.” U.K. Business Secretary Kwasi Kwarteng warned that the country faces a “long, difficult” winter with high energy prices tipping power suppliers into bankruptcy.

So far the UK is not planning to bail out power suppliers that fail, and PM Johnson has refused to scrap “green levies” on power bills even though they’ve helped cause the problem by subsidizing windpower investments.

Since the energy transition is all about new technologies, policymakers need to look beyond intermittent sources of energy. Direct Air Capture of CO2 is another example of what might be possible while allowing reliable electricity generation to continue.

On a different topic, my wife and I were disappointed to find downtown Minneapolis almost deserted on a recent Sunday lunchtime, still reeling from the twin blows of Covid lockdowns and violent protests following George Floyd’s murder. Nicollet is described as “downtown’s core shopping and entertainment artery” on the city’s hopelessly out of date website.

I posed next to the Mary Tyler Moore statue watched by two bored cops and no one else.  A 20 minute drive north, a local strip mall had lost all its tenants except for a Dollar Tree. Afterwards we headed to Duluth, on Lake Superior, which was more vibrant.

We went to Minnesota to visit my wife’s penpal of 45 years, a relationship that began when they were both in middle school. Their friendship through writing predates our own. They had shared life’s events via air-mail letters and birthday cards, retaining this medium even when email because ubiquitous, but had never met until now. Over several very agreeable hours we became friends with a warm and friendly family, typical of the midwest. Our next meeting won’t take as long.

Climate Extremists Are Losing By Winning

For years environmental extremists have campaigned with increasing success for less investment in fossil fuels. The logic has been that as CO2-emitting sources of energy become harder to access and more expensive, the world would increasingly turn to renewables. Confronting demand for energy has generally been eschewed in favor of targeting suppliers. It’s far easier to demonize a few hundred companies providing the reliable energy that billions of consumers want.

EU governments have been especially keen to increase their reliance on intermittent solar and wind. The combination of reduced supply of fossil fuels and increased use of renewables is the precise result energy policies have been seeking.

The success of this strategy is now delivering to European customers what should have been expected – sky high electricity prices combined with increased risk of supply interruption.

Unusually calm weather in the normally windy North Sea slashed windpower from the UK’s 11,000 turbines by 80%. Deprived of a source that generates more than 20% of its electricity, Britain turned to natural gas and coal (see The Cool North Sea Breeze Lifting US Coal). Europe’s production of natural gas has been in decline for years, even while consumption has been rising. Imports now account for 90% of the EU’s total.

With unfortunate timing, a key undersea electricity cable from France went down because of a fire at a converter station in SE England, giving UK wholesale electricity prices a further boost. Ireland, also coping with uncommonly calm winds, cut power it normally supplies to Scotland.

The result has been European natural gas prices four times the US benchmark, and wholesale electricity prices up by 8-10X from a year ago (see The Bull Market in Natural Gas). Europe-bound Liquified Natural Gas (LNG) shipments from the US have in some cases been diverted to Asia where prices are even higher.

Britain has even seen two fertilizer production facilities cease operations indefinitely, because of the high cost of natural gas, a key input. Although grain shortages as a result seem improbable, higher prices are likely.

Achieving the desired mix of increased renewables and reduced availability of natural gas has not generated the popular enthusiasm environmental extremists might have hoped. Consequent double digit increases in household electricity bills have commanded more attention from governments than celebrating progress in the energy transition.

Instead, the focus has been on protecting consumers from the high electricity prices climate change policies have wrought. Italian households have been warned to expect 40% higher electricity bills in the next quarter, following a 10% hike which would have been twice as big but for a €1.2BN subsidy from the Italian government. In Spain the government plans a €2.4BN windfall profits tax on utilities that benefitted from selling electricity pegged to natural gas prices that came from other sources, such as nuclear.

What we’re seeing is a glimpse of the dystopian future climate extremists are trying to foist on us. Their single-minded focus on solar and wind, rejecting every other power source including emission-free nuclear, is behind Europe’s soaring power prices.

Governments are scrambling to limit the damage from policies they believed enjoyed solid support. It’s increasingly clear that polls reflecting voter concern about climate change fail to measure how shallow such support is. Erftstadt in Germany experienced severe flooding earlier this summer, which politicians quickly blamed on climate change. 180 Germans died from the heavy rains. But polls show the Green party, most clearly identified with aggressive policies to combat climate change, garnering only 15-17% of the vote. Improved infrastructure to prevent flooding must seem more sensible than adding windmills.

Cranford, NJ suffered flooding from Hurricane Ida recently (see Climate Change: Prevention or Mitigation?). It’s unclear whether global warming is to blame; Cranford seems to flood every decade or so. I spoke to someone recently whose weekend was spent in the heartbreakingly familiar task of cleaning out a recently flooded basement. But he drew some solace from an expected $200K FEMA disaster relief payment. His family has received FEMA payments in the past, and while I don’t begrudge them the help, such policies hardly encourage moving to higher ground.

President Biden, having failed to persuade OPEC to increase crude oil output (listen to Joe Biden Wants More Oil), is now looking into why gasoline prices at the pump are so high. You’d think he’d use this as justification for the government’s plan to build 500,000 electric vehicle charging stations. Progressive Democrat policies are designed to drive gasoline higher.

European energy policy is turning into a disaster. Well intentioned efforts to lower CO2 emissions are colliding with the physics of relying too heavily on unreliable, weather-dependent energy. Governments and corporations are responding to the shrill protesters who want conventional energy use stopped dead in its tracks. Climate extremists can celebrate Europe’s heavy reliance on a combination of imported and intermittent energy for which they’ve advocated. They should probably celebrate quietly, because the average European household isn’t that enthused about current energy prices.

It’s hard to believe that the solution must be more renewables. Instead, what’s needed are pragmatic policies that value reliable power as much as finding ways to lower emissions. Europe, like California, is showing the rest of us where climate extremists are trying to take us. The US has more diversified sources of energy and hasn’t experienced the kind of price turmoil and unreliability we’re seeing across the Atlantic, except where poor policies such as those in Sacramento are followed.

Chevron CEO Mike Wirth sensibly said the company would rather pay dividends than invest in low-returning solar and wind. His message was that investors should reap the benefits of Chevron producing reliable energy, and if they choose then reinvest those profits in renewables themselves.

Let’s not follow Europe’s lead on energy. More natural gas availability is the obvious solution.

 

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