SL Advisors Talks Markets

Energy Pragmatism Is Beating Extremism

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As the world’s leaders meet in Egypt at the COP27 climate change conference, there are reasons for optimism among those who yearn for a pragmatic approach to reducing global Green House Gas emissions (GHGs).

The Economist magazine front covers over the past couple of years provide an evolving perspective from one publication that likes to think of itself as a thought leader. In 2020 clean energy was expected to remake geopolitics; the energy shock of 2021 was well underway before Russia invaded Ukraine. Notwithstanding the White House narrative, high gas and gasoline prices are not solely Putin’s doing.

Today there’s a growing recognition that the extremist approach championed by left-wingers and the Sierra Club is an abject failure. The purist solution of having the world transition rapidly to solar and wind is being shown to be a technical and commercial impossibility. Developing nations, responsible for all the growth in global energy consumption, and thereby emissions, aspire to western living standards more than they worry about climate change.

The loss of Russian natural gas exports to the EU did not cause a dash for more windmills. Instead, Germany has snapped up all the available floating storage and regassification units available worldwide to import Liquefied Natural Gas (LNG). The construction of permanent onshore facilities with greater capacity is underway.

The rich world’s desire for lower GHG emissions hasn’t been matched by promised cash payments to help developing nations upgrade their energy infrastructure. Since the 2015 Paris agreement OECD nations have failed every year to deliver $100BN in promised climate finance. It shouldn’t be a surprise; US politicians have rightly concluded there are few votes in writing big checks to China and India where official policy is to maintain GHG growth at least until 2030.

As Namibia’s petroleum commissioner, Maggy Shino, said, “If you are going to tell us to leave our resources in the ground, then you must be prepared to offer sufficient compensation, but I don’t think anyone has yet come out to make such an offer.”  Speaking on the sidelines of the COP27 in Egypt, Saudi Arabia’s energy minister Prince Abdulaziz bin Salman said: “The world is hoping to crucify us.

Reliable energy is well represented at this year’s conference, with a record 636 lobbyists registered to attend. This is a positive development, because the industry best positioned to help guide the energy transition is the one that provides 80% of the world’s energy today. Nowadays, The Economist talks of adapting to climate change as much as mitigation. An increasingly pragmatic assessment will lead to increased use of natural gas at the expense of coal, the dominant fuel for many poorer countries because it’s easily burned for power generation. Growth in demand to support rising living standards also means that coal plants in developing countries are younger and have a longer remaining useful life.

3Q22 earnings for pipelines included strong natural gas results. Last week, TC Energy’s natural gas segment was largely responsible for their beating expectations. They raised full year EBITDA guidance to C$9.76BN. Although the midstream sector’s footprint is almost entirely in US and Canada, TC Energy has partnered with Mexico’s Comisión Federal de Electricidad to build the $4.5BN Southeast Gateway pipeline along the Gulf of Mexico coastline. It will move 1.3 Billion Cubic Feet per Day, helping increase Mexico’s use of natural gas.

Mexico also has ambitious plans to become an export hub for LNG, the supply for which will be US since Mexico produces almost no natural gas of its own. Six of eight proposed export terminals are located on Mexico’s Pacific coast where they would offer sharply reduced travel time to Asia compared with Cheniere’s terminals in Louisiana and Texas. Opposition to proposed LNG export terminals in California and Oregon spurred renewed interest in Mexico. Pembina dropped plans to build Jordan Cove in Oregon following local opposition.

The two-day market rally following Thursday’s better than expected CPI report took the S&P500 6.5% higher. Equity buyers eagerly await anything that suggests the Fed may moderate its tightening cycle. FOMC members were quick to welcome the news, showing that they also would like the data to allow a policy shift.

However, inflation remains a long way from the Fed’s target. The most recent Employment Cost Index is increasing at a 5% annualized rate. Persuading workers to accept 2% raises is critical to getting inflation back to that level, although this means millions of people accepting a drop in real living standards. The pipeline sector may offer a way to protect against inflation that remains stubbornly high.

SL Advisors Talks Markets

Wage Rises Complicate The Inflation Outlook

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Fed chair Jay Powell and the American worker do not have an alignment of interests. In his remarks, following another 0.75% rate hike, Powell said the FOMC is, “acutely aware that high inflation imposes significant hardship as it erodes purchasing power, especially for those least able to meet the higher costs of essentials like food, housing, and transportation.” He always says that, so as to remind that some must sacrifice their jobs due to the Fed’s pursuit of higher unemployment. This will cool the labor market, and inflation, for the rest of us.

The Fed’s inability to engineer a million or two lost jobs renders Powell’s warnings anodyne, because so far the tightening cycle hasn’t claimed any casualties. Reducing inflation requires taming wage growth. The US Employment Cost Index (ECI) for all civilian workers is increasing at 5.0%, the highest since 1984.

This is marginally below the Personal Consumption Expenditures (PCE) deflator which is increasing at 6.2%. For now, the American worker is accepting a 1% drop in real purchasing power. It probably feels worse. CPI inflation is 8.2%. PCE is a more accurate measure because its weights update dynamically, but CPI is more widely used, including for the social security cost of living adjustment which will be 8.7% next year.

It’s unclear why anyone should accept a pay raise below inflation. Why should firefighters, teachers or indeed any worker whose annual income doesn’t include a healthy dose of variable compensation accept reduced purchasing power? Workers didn’t cause inflation. Supply disruptions due to Covid lockdowns, the excessive $1.9TN Democrat stimulus early last year and the Fed’s ponderous restoration of monetary normalcy all played a part. Action and inaction by government agencies are to blame, with reduced real living standards the result. The White House hasn’t articulated the case for restraint in pay negotiations. It’s not an easy one to make. But as long as pay raises are running at 5%, restoring the Fed’s 2% inflation target will be hard.

Powell noted that, “the labor market remains extremely tight, with the unemployment rate at a 50-year low, job vacancies still very high, and wage growth elevated.” This empowers union negotiators to demand more, and they are.

For example, President Biden recently approved a 4.6% raise for Federal employees, more than two times the Fed‘s inflation target.

San Antonio is raising pay for city workers by around 7%, although some will receive raises of up to 20%.

NJ is increasing the minimum wage from $13 an hour to $14.13 (8.7%).

Teachers in many states across the country are receiving their biggest raise in decades. For example, in New Mexico base salaries are going up by 20%.

Railroad workers are threatening to strike, even though the Presidential Emergency Board, which is trying to mediate between the union and the railroad companies, recommended a 24% increase over the next two years.

Europe, as is often the case, is worse. Workers on London’s subway system (“the tube”) have scheduled a series of strikes over a 3% proposed pay raise and pension cuts. Transport For London, which oversees the city’s public transport, sent out an email one day last week that breezily reminded that there are “lots of public transport options” if you have weekend travel plans but went on to warn of “some planned strikes taking place.”

In France, demonstrators have clashed with police as they protest about inflation.

It’s easy to understand why workers left worse off by rising prices are fighting back. The US job market remains very tight. Unless you work at Twitter, it’s reasonable to expect your pay to at least keep up with the general price level. Unions are negotiating higher pay on behalf of their members. But employers are also often having to raise salaries to compete.

This is making it harder for the Fed to bring inflation back down. Unless inflation starts to fall rapidly and soon, it’s likely to strengthen the conviction of workers determined to maintain living standards.

The Fed needs job market softness now, in order to temper the trend towards higher wage increases. Jay Powell has been equivocal in his warnings, but on Wednesday he allowed that, “we may ultimately move to higher levels than we thought at the time of the September meeting.” When asked about the window for a soft landing, he said, “I would say the path has narrowed over the course of the last year.”

While it’s impossible to be confident about the rate cycle peak, continued low inflation expectations present the Fed an ever-present exit ramp. But for now, rates look set to keep rising. Friday’s strong employment report didn’t help. The dynamics of wage negotiations are adding to upside risk for rates.

SL Advisors Talks Markets

How Seaweed Can Fight Global Warming

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A few weeks ago, my wife and I were fortunate enough to attend a wedding quite literally next door at our neighbors’ house. Freed from any concern about driving us both home safely, I was already in a mildly ebullient mood when I met Australian Stephen Turner. Now I may be promoting a stereotype and therefore betraying my absence of woke-ness, but I have yet to meet an Aussie who isn’t worth hanging out with over a couple of drinks. Call it positive profiling.

Upon meeting, we Brits comment on their lineage from 19^th century convicts dispatched to Australia’s penal colony. They immediately remind us of Australia’s persistent cricket victories over England (“the Ashes”). We both chuckle at this predictable introduction and a thoroughly enjoyable evening follows.

Stephen Turner managed to make a discussion of seaweed interesting without in any way shaking my association of Aussies with conviviality. Steve is Chair of Sea Forest, an Australian start-up founded in 2018 that aims to use seaweed to combat global warming. Efforts to reduce Global Greenhouse Gases (GHGs) generally focus on CO2.

Solar power and windmills, electrification of the transportation sector, carbon capture and myriad other efforts are intended to reduce CO2 levels in the atmosphere. But methane (natural gas) is also a potent GHG. Per molecule, it is far more potent than CO2 over a few years, but over decades it decomposes. Scientists generally assume twenty year equivalency between the two, meaning they assume the potency of methane after two decades before converting it into CO2 equivalent.

Methane is around 11% of US GHG emissions, with CO2 the biggest at 79%. The main source of methane is from wetlands through the decay of organic waste, but it also comes from landfills and methane leaks in the handling of natural gas. The US Environmental Protection Agency estimates that over a quarter of US methane emissions come from enteric fermentation – that is to say from ruminants (mainly cows and sheep) burping and farting. The UN estimates that global livestock is responsible for 14.5% of all anthropogenic (human-based) GHG emissions.

In early 2019 we pondered the impact on GHG emissions of a worldwide phasing out of cattle – not slaughtering them but simply stopping their breeding (see The Bovine Green Dream).  We were prompted by material supporting Progressives’ “Green New Deal” which conceded that “…we aren’t sure that we’ll be able to fully get rid of farting cows…” within a decade.

Sea Forest is developing a more practical and humane solution. Asparagopsis is an edible red macroalgae, or seaweed. It is highly invasive and attaches itself to other forms of seaweed such as in the Mediterranean and other warm climates. Hawaiians eat it in fish salad.

Asparagopsis is known to inhibit methane production in ruminants (mainly cattle and sheep). Sea Forest harvests it and produces a form (called SeaFeed) that can be given to farm animals as a feed supplement. It is native to the waters of Tasmania, where Sea Forest aims to cultivate it on a commercial scale. They have found that added in very low quantities (0.2%) it can reduce ruminant methane emissions by up to 98%.

As Sea Forest’s Steve Turner explained, “It works thanks to bioactive compounds that inhibit the enzymatic pathway producing methane at the last stage of ruminants’ digestion. When more energy is available to the animal, instead of being spent in the digestion process, it grows faster and the whole process is more efficient, e.g., less feed is needed.”

SeaFeed customer trials are ongoing with Australian beef producer AA Co, Kingston Wool whose sheep supply MJ Bale’s Tasmanian Merino wool suits and New Zealand dairy co-operative Fonterra.

MJ Bale is an Australian menswear business that promotes its “carbon-neutral fashion brand” because the sheep whose wool the company turns into clothes have processed Asparagopsis added into their feed.

It’s easy to see how this could have broad appeal. Organic food already has a strong following. Many consumers pay more for smaller vegetables because they like to eat food that wasn’t produced using man-made chemicals.

Steve told me one of their challenges is convincing farmers that SeaFeed isn’t harmful to their very valuable herds and flocks. But assuming farmers can be convinced that SeaFeed won’t kill off their assets, “climate-friendly” beef and lamb could become popular. Sea Forest estimates that at commercial scale SeaFeed would cost roughly A$1 per cow per day.

For beef cattle, they calculate that 25% of the cost of SeaFeed would be offset by the GHG tax credit if farm animals qualified (assume A$50 per tonne). More efficient conversion of nutrition into energy means 20% fewer days in the feedlot. The nutrition benefit for dairy cattle is around 11%.

The result is an inconsequential 0.2% increase in the cost of beef. So the economics don’t sound insurmountable. They estimate the total addressable market worldwide at 1 billion cattle generating methane equivalent to 3 billion metric tonnes of CO2.

Although solar panels and windmills gain most of the attention when it comes to reducing GHGs, there is far more going on than simply increasing our dependence on unreliable, intermittent power generation.

Sea Forest is another example of an innovation that may change the world. They have received numerous awards and grants in recognition of their work so far. All of us have a stake (no pun intended) in their success.

SL Advisors Talks Markets

Energy Policies Will Drive Business From Europe

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Poland has stopped producing fertilizer. Natural gas is a key input into the production of nitrogen-based fertilizers such as urea and Urea Ammonium Nitrate (UAN). The European energy crisis has rendered their manufacture uncommercial because of high natural gas prices, which are likely to persist for at least another year or so. Poland produces 6 million tons annually. Elsewhere in eastern Europe another 3 million tons of capacity is idle. In aggregate, 20% of Europe’s fertilizer production is shut down.

That fertilizer production will still be needed. Last year Russia was the world’s biggest exporter of fertilizer, with a 15% market share. That should presumably drop with sanctions, although countries like India (#3 importer) will probably value feeding their population more highly.  The US was #5 exporter with a 5% market share.

CF Industries has been a beneficiary of America’s comparative advantage in energy availability.

Zinc production throughout the EU has ben curtailed or stopped completely. Dutch company Nyrstar, the world’s biggest producer of zinc, has stopped output. 50% of primary aluminum production has ceased. Goldman Sachs estimates that 40% of Europe’s industry, “is at risk of permanent rationalization.”

Arcelor Mittal, Europe’s largest steelmaker, is idling blast furnaces in Germany. Alocoa has cut a third of its aluminum production in Norway. Hakle, a German makes of toilet rolls, is insolvent.

European winter storage levels of natural gas are on pace to be normal, thanks to conservation and increased shipments of Liquefied Natural Gas (LNG). But analysts warn that replenishing stocks next year will require 20% more natural gas than usual. This will present a potentially bigger challenge, since the partial supplies received from Russia in 2022 won’t be repeated in 2023.

This is why the EU is scrambling to add LNG import capacity. Germany has leased its fifth Floating Storage and Regassification Unit (FSRU). These vessels convert LNG from the chilled form in which it’s transported back into a usable state. They can be deployed relatively quickly, but have less capacity than a land-based, permanent LNG import facility. These can take three years or more to build. Italy hopes to build one by next year, with the government bypassing the normal permitting process, provoking fierce opposition from the local community.

The approach of EU policymakers to the energy crisis continues to regard it as a brief diversion on the way to a 55% reduction in greenhouse gas emissions (versus 1990). As a result, they have been reluctant to sign the 20-year LNG supply agreements that are common in the industry. Asian buyers have not hesitated, spurred on by the recognition that they face a new competitor.

Morgan Stanley calculates that agreements totaling over 60 Million Metric Tonnes per annum (MTpa) have been signed since Russia’s invasion in February. European buyers represent just 11 MTpa of this. The Dutch gasfield in Groningen is still scheduled to close by 2024, even though analysts believe it could provide up to half the gas Russia used to supply.

European manufacturers will respond to the energy crisis by overhauling their operations to use less energy. The region’s shift to renewables will receive a further boost from improved relative pricing. But manufacturing will also leave for other parts of the world where energy is cheaper and policies more supportive.

Svein Tore Holsether, chief executive of Norwegian fertilizer giant Yara International ASA, likes the “lower energy prices or green incentives currently offered in the U.S.”

Dutch chemicals firm OCI recently announced plans to expand its ammonia plant in Texas. They plan to use “blue” hydrogen, which is derived from natural gas. They further intend to capture the CO2 emitted in the process, claiming tax credits in the recently passed Inflation Reduction Act (IRA).

No Republican voted for the IRA in either the House or Senate, where VP Kamala Harris had to vote to ensure its passage. It’s ironic that many corporations believe the 45Q tax credits for carbon capture and sequestration are enough to pursue new business initiatives. This includes several midstream companies, generally a group that votes Republican (see Earnings and Pending Legislation Good For Pipelines).

The US stands to benefit from Europe’s energy crisis. It’s likely that manufacturing will receive a boost in parts of the country that offer easy access to energy and a pro-business climate. New England, whose energy policies look decidedly European, is unlikely to be a sought-after destination. Opposition to natural gas pipelines means they regularly import LNG at global rates, now enduring further competition from new European buyers (see Incoherent Energy Policies).

But many other parts of the US including southern states are set to benefit. This should add to demand for domestic natural gas. It shows that energy policy can make a difference.

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SL Advisors Talks Markets

The Losers From Quantitative Easing

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UK Prime Minister (PM) Liz Truss has reached “in office but not in power” in record time. On September 6^th she met with Queen Elizabeth II and formally became PM. Two days later the Queen died, commencing a period of mourning that ended with the monarch’s funeral on September 19^th. Practically speaking, that’s when Liz Truss’s hold on power began. Four days later her government shocked markets by announcing £45BN ($50BN) in tax cuts funded with borrowing.

Sterling collapsed and by September 28^th the Bank of England had abandoned its balance sheet reduction (Quantitative Tightening, or QT) in order to urgently restore financial stability. In the UK bond market pension funds were dumping thirty-year gilts, driving the yield from 3.5% to (briefly) 5%. Conservative party MPs are already discussing ways to dump their new PM.

By Friday self-preservation and market turmoil had forced her to abandon most of the plan, firing her Chancellor of the Exchequer Kwasi Kwarteng for good measure. Truss will henceforth be dodging political regicide following her disastrous start. As the Economist devastatingly observed, her shelf life is about the same as a lettuce.

UK residents are pondering how governmental ineptitude on an epic scale has raised interest rates and made foreign trips more expensive. The rest of us are wondering if it could happen here.

Pension funds and leverage are a poor combination. The solemn trust imposed on those that manage people’s retirement savings requires ensuring market volatility never interferes. Therefore, Liability Driven Investing (LDI), the proximate cause of the turmoil, is worthy of examination. Anytime you see Value at Risk (VaR) included in marketing literature aimed at pension funds, as is the case with LDI, there’s a problem lurking.

Defined Benefit (DB) pension funds are obliged to meet certain obligations in the future, often linked to salary at retirement. Defined Contribution (DC) plans (like 401Ks) are becoming increasingly common, because employers prefer shifting the investment risk to plan participants. The UK has around 5 million people covered by DB plans with assets of £1.8TN ($2TN). For comparison, the US has $16.8TN in DB plans but $13.1TN is in Federal, state or local plans, many of which are underfunded with unclear ultimate outcomes for retirees.

DB pension funds compare their assets with the Net Present Value (NPV) of their obligations to figure out if they have a surplus or deficit. Pensions are among the longest liabilities around, and their NPV is acutely sensitive to changes in the discount rate.

Because US public pension funds follow Governmental Accounting Standards Board (GASB) rather than GAAP, they calculate the NPV of their liabilities oddly, in that they use the rate of return they think they’ll earn on their assets. It creates the perverse incentive to add risky investments since they’ll generally have a higher return, which in turn depresses the NPV of their obligations (see Through the Looking Glass into Public Pension Accounting). The average assumed return on US public pension assets, and therefore the discount rate on their liabilities, is just under 7%. Even though this has been falling, it’s still wildly optimistic.

The UK government issues guidance for DB plan discount rates – currently much lower than the US at  around 2.5% depending on the specifics of the plan.

Treasury Inflation Protected Securities (TIPs) offer a return linked to inflation and are appealing to pension funds with their long liabilities. In the UK index-linked gilts are called “linkers.”

Real yields have been falling for years, and on US government debt have at times been negative. The UK is a more extreme version, presumably reflecting a relatively greater appetite of UK pension funds to immunize inflation risk compared to their US counterparts. The dearth of choices available to UK pension funds is apparent in the 1.5% coupon with which the now plunging 30 year gilts were issued just last year.

Investing at negative real yields guarantees reduced purchasing power. Falling long term rates have hurt UK pension funds by increasing the NPV of their liabilities. In theory equities, which represent a perpetual claim on company profits, ought to compensate. A 1% drop in a thirty year discount rate increases the NPV of a payment due in thirty years by 30% (ie the duration of a 30-year zero coupon bond equals its maturity). Unfortunately, you can’t rely on stocks going up by 30% at the same time.

UK pension plans sought advice on managing their exposure to falling rates, and it was helpfully provided by firms such as Russell Investments in the form of derivatives. Simply put, LDI is a derivatives contract that generates a profit for the pension fund when long term rates fall, the point being that falling rates will lead to a lower discount rate and therefore a bigger NPV of their pension obligations. LDI behaves like an investment in long term bonds, but without the need to spend cash to buy the bonds.

Derivatives contracts, like futures, require counterparties to post margin to one another depending on which side of the contract is in the money. The LDI models on which advice is based are naturally complex and proprietary. Pension funds probably relied on the assumption that losses on their LDI trades would be offset by a reduced NPV of their liabilities, and they could use pension contributions to provide additional margin if required. VaR analysis from their consultants would have provided reassurance.

Two things went wrong. One is that UK linker real yields fell to deeply unattractive levels, causing pension funds to explore risky alternatives. The second is that the new PM’s ill-considered fiscal expansion caught the market off-guard, driving yields up sharply. This in turn shredded VaR assumptions, requiring untimely sales of securities by pensions to cover margin calls on LDI losses. Derivatives create leverage. On one level this is another story of too much risk.

However, the underlying problem is low/negative real yields, and these are caused in large part by Quantitative Easing (QE). Society generally likes low borrowing costs, but every borrower has a lender and pension funds are clearly QE-losers. Central banks have been quicker to grow their balance sheets with QE than to shrink them with QT.

Ironically, the Bank of England provided updated guidance on QT on September 22, the day before Kwasi Kwarteng dropped his fiscal bomb. Six days later they were buying again to mop up the mess.

Buying bonds is now part of the central bank toolkit, and in the US it’s virtually certain that the next recession will be upon us before the Fed has shed its excess $TNs. Although real yields have moved up recently, there’s little reason to think their long term decline has ended. The problems of DB pensions haven’t been solved. But the UK does seem like a unique case of poor investment choices and an impetuous new PM.

Meanwhile the Fed is singularly focused on inflation which increases the odds they’ll make another mistake, upon which they’ll switch back to employment. QE will begin again, becoming a permanent form of debt monetization. 2% long term inflation is a poor bet. This FOMC shuns multi-tasking and fixates on one metric at a time. That will be Jay Powell’s legacy.