Inflation Concerns Remain

The fall in treasury yields can be misinterpreted as implying that inflation expectations are moderating. Although ten-year treasury yields have dropped 0.40% over the past three months, almost all of that has been through lower TIPs yields. Inflation expectations (nominal yields minus TIPs) have hardly budged.

Given the Fed’s outsized role in the bond market, it’s hard to discern market expectations absent their activity. They’re buying 54% of all net supply this year, and as we noted a couple of weeks ago (see Behind The Fed’s Benign Inflation Outlook) they bought 85% of net new supply in July. Over the next couple of months, reduced maturities and increased issuance combined with the Fed’s regular $80BN in monthly purchases will draw on increased purchases by others to balance the market.

Friday’s payroll report kept us on the interminable path towards tapering and an eventual cessation of Fed debt monetization. Former NY Fed president Bill Dudley was interviewed on Bloomberg and noted that restoring the Fed’s $8TN balance sheet to more normal levels will take many years.

Prior to 2008, quantitative easing via Fed buying of bonds was an unknown tool. Former Fed chair Ben Bernanke unlocked it to good effect, but the Fed’s balance sheet continued to grow for several years after the 2008-09 financial crisis. It took almost a decade for assets to start rolling off meaningfully. Covid hit within a year, and the Fed’s assets soon doubled.

It is a partial monetization of our debt, no matter how Fed chair Powell may describe it otherwise. Society’s tolerance for this is one more proof that inflation has few opponents nowadays. Monetary policy aims, “to achieve inflation moderately above 2 percent for some time” according to the FOMC’s most recent statement, and the bond buying will continue until, “substantial further progress has been made toward its maximum employment and price stability goals.”

While the Fed aims to boost inflation, fiscal policy is striving for the same. The $1TN infrastructure plan working its way through Congress will add $256BN to the deficit according to the non-partisan Congressional Budget Office, even though negotiators claimed that it would be revenue neutral.

Expect very little outcry over this, since low bond yields reflect the inconsequential cost. With fiscal hawks long gone, excessive deficit spending will continue until it causes inflation. The stock market’s brief pullback in mid-July was arrested in part because of the “Biden put” — a severe drop in economic activity would draw another multi-$TN fiscal stimulus.

Although bond yields have remained near their recent lows, eurodollar futures yields rose during the week as the odds of a tightening in short term rates by the end of next year increased.

The yield curve nonetheless remains too flat. Median FOMC projections of short-term rates as well as the most dovish forecasts both suggest a sharper rate of increase from 2023 on. The FOMC’s forecasting record is abjectly poor. But this Fed is unashamedly dovish, so FOMC forecasts that are more aggressive than the market continue to look like an opportunity to bet with the FOMC by positioning for a steeper yield curve in eurodollars 2023-25, or that the 0.55% spread between two and five year treasuries is too narrow.

In other news, the Economist magazine recently ran a piece called A 3°C world has no safe place. It presented a sober contrast between the (mostly unmet) pledges of countries to reduce CO2 emissions and the scientific modeling that predicts the consequences. Rich countries committed $100BN per year to help developing countries adapt, although even this sum has not been delivered. Even though such promised transfer payments get virtually no coverage in US media, political leaders in countries like South Africa can be found on TV telling viewers that much larger sums are needed to pay for the energy transition.

As we noted in a recent podcast (Episode 79: The Bill For The Energy Transition), South Africa believes $750BN per year is needed from OECD to emerging economies, which would work out to $250BN from the US if apportioned among rich countries based on relative GDP. This is almost 4X what we spend on Medicare and Health, or over 40% of our defense budget. It’s as well that such discussion doesn’t make it to the US, because it would at a minimum cast a pall over the Adminstration’s excited talk about green growth opportunities.

One of the most striking features of the Economist article was how slowly the climate changes. Models, which have a checkered past of making climate predictions although presumably are better today than ever, forecast dire consequences by 2100. None of the people likely to be impacted by this can read the article, while the people who must make sacrifices in the meantime to reduce emissions will have mostly died by then.

It’s why developing countries like China and India are more concerned about increased energy use to raise living standards now, and don’t share the concern of OECD countries about global warming.

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

Absurdity Abounds In The Energy Sector

Williams Companies (WMB) announced 2Q21 earnings on Monday. Results were largely in-line with expectations; Adjusted EBITDA came in at $1,317MM, $11MM ahead of forecasts reflecting the stability of their business. Their dividend is +2.5% YoY and is now expected to be 1.9X covered by Available Funds From Operations (analogous to the Distributable Cash Flow metric often used in the past by MLPs). The $1.64 dividend yields 6.6%. Under the old ~90% payout regime MLPs used to follow, WMB would yield over 11%.

6.6% is an attractive yield by any measure. Transco, WMB’s extensive pipeline network running along the eastern US, has investment grade bonds outstanding to 2050 that yield 3.06%. The equanimity with which bond investors accept equity-type risk for comparatively little is not unique to the pipeline sector. Rigid investment mandates partly explain the bifurcated market for WMB’s securities, and emphasize the continuing opportunity for equity buyers. Leverage (Net Debt:EBITDA) is expected to reach 4.2X by year-end, down from 4.35X the prior year.

The energy transition notwithstanding, natural gas volumes passing through WMB’s pipeline network showed continued healthy growth. Of particular note was the 30% jump in natural gas for export, either as Liquified Natural Gas (LNG) or via pipeline to Mexico.

WMB is planning to invest $2BN to bring an additional 1.8 Billion Cubic Feet per Day (BCF/D) of natural gas to customers, mainly in the northeast. Careful examination of the map shows that the expansion only reaches as far as NJ and Pennsylvania. Massachusetts, which could surely use more natural gas, is currently debating whether to require that new construction omit natural gas connections (see Towns Trying to Ban Natural Gas Face Resistance in Their Push for All-Electric Homes). All-electric homes don’t sell as quickly as regular ones, reflecting a market push-back against the imposition of new regulations.

Residential power supplies are already prone to outages during bad weather, so it’s understandable that the prospect of becoming fully reliant on electricity even while utilities add intermittent renewables is not appealing. Natural gas never goes down.

Meanwhile, South Africa is sensibly looking to natural gas as a way to reduce its CO2 emissions (see Coal-Reliant South Africa Is Turning to Gas Power). They estimate electricity produced using natural gas will cost 3X as much as from the coal plants that are nearing the end of their useful lives. Renewables may even be cheaper, but tellingly South Africa is willing to spend more for reliability.

In preparation for the COP26 UN meeting in Glasgow in November, environment ministers have been discussing the level of financial support OECD countries should be willing to provide to emerging economies to help them pay for the energy transition. It’s a valid debate, but not one that has yet caught the public’s imagination. South Africa’s Environment Minister recently suggested that $750BN per year would be needed in financial support from rich world countries. Assuming this burden was shared according to each OECD country’s share of OECD GDP, the US would be on the hook for about a third.

The prospect of the US paying $250BN per year to poor countries to speed their energy transition is sharply at odds with Joe Biden’s message that it was all about well-paid union jobs. There’s zero prospect that Congress would approve anything like this – but the fact that such figures are floated exposes the gulf between practical solutions and underlying political support. OECD countries have already failed to meet a $100BN pledge for 2020.

Returning to WMB, like most pipeline companies they self-funds their growth plans. Cash generated now goes to dividends and capex. Rising EBITDA reduces leverage and investors do not expect any dilutive secondaries.

This is in marked contrast to many utilities, which are spending $BNs on renewables and delivering negative Free Cash Flow (FCF) in the process. Today’s market forgives them because they’re investing in green projects. But battle-scarred US energy investors will recall the same willingness of Wall Street to overlook negative FCF during the early years of the Shale Revolution.

Germany has demonstrated that too much reliance on renewables leads to much more expensive electricity. California has managed to combine high prices with unreliability. Many of the utilities currently outspending their cash flow may find that expensive intermittency isn’t highly valued if they go too far, at which point the years of negative FCF will not look so smart.

Banning new natural gas hookups, outspending cash flow to build renewables and poor countries demanding GDP-sized payments to help reduce emissions; the energy sector is witnessing much that is absurd. Fortunately, natural gas pipeline transmission continues to grow reliably.

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

Pipelines Still Linked With Inflation

The link with crude oil is a familiar topic for investors in pipelines, who have often been told that the two are uncorrelated only to experience both inconveniently plunging together.

Since the Covid bottom in March, crude oil and midstream energy infrastructure have conveniently tracked each other higher – until the last several weeks during which the sector has slid while crude oil has held its gains. Visually, the last 16 months looks as if the two are closely linked. But the correlation of daily returns over that period is surprisingly low at only 0.28.

Episodes such as April 2020, when the two diverged sharply as crude went briefly negative, have an outsized impact on this statistic. As we’ve also noted, 2020 operating performance for most big pipeline companies came in within a few % of pre-Covid operating performance. It remains the case that stock prices move far more with oil than cash flows.

One reason for the relative weakness in midstream recently has been the drop in bond yields. The rise in inflation expectations increased interest in businesses with pricing power, and many pipelines have agreements that link price hikes to PPI. The ability to increase prices with inflation used to be an attractive feature years ago when MLPs were bought for their stable yields.

The volatility ushered in by the Shale Revolution took focus elsewhere, but this feature of contracts has remained and will likely become more important in the years ahead. In research last month (see Market Underprices Rate Hike Risks), Wells Fargo calculated that 60% of midstream EBITDA was exposed to inflation escalators, and with a 5.5% 2021 PPI estimate they calculated a 3% lift to sector EBITDA.

The recent moderation in inflation fears reflected in lower bond yields has similarly depressed the pipeline sector. This is likely to be temporary. As we noted last week, Fed bond buying took up almost all available net new supply in July (see Behind The Fed’s Benign Inflation Outlook). Inflation concerns are everywhere, with both fiscal and monetary policy being managed without regard to rising prices. The government will get what it wants, and the coincident drop in bond yields and pipelines serves to confirm the latter’s use as protection against inflation.

On a different topic, the International Energy Agency (IEA) recently issued a report on global electricity demand growth. It’s easy to conclude that renewables will soon be providing the majority of our power based on today’s popular press. The IEA noted that global electricity demand is increasing faster than renewables-supplied power. Since the power sector is renewables’ most important target, inability to even match demand growth reveals how unrealistic it is to think windmills and solar panels are going to fully solve the problem of climate change.

Moreover, because the growth in global electricity demand is centered in emerging Asia where coal use is high, this dirtiest form of energy is benefitting from strong demand. China represents half the worlds’s growth in power demand. Even last year they saw healthy growth, contrasting with widespread reductions due to Covid.

40% of this year’s growth in electricity demand will be provided by coal. China’s refusal to agree to a G20 communique phasing out coal is easily understood when considered alongside these figures from the IEA.

Even though coal continues to retain its outsized share of world electricity production, the opportunity for natural gas to offer a meaningful alternative remains immense.

Tellurian CEO Charif Souki mentioned this in a recent video. Confirming the positive long term outlook for natural gas, Shell became the third company to sign up with Tellurian to purchase 3 million tons per annum of natural gas.

The American Energy Independence Index (AEITR) includes North America’s biggest pipeline companies. We believe the sector offers solid inflation protection as well as continued upside from growing global demand for US natural gas.

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

G20 Confronts Environmental Reality

Last week’s meeting of G20 environment ministers to discuss global warming exposed fault lines in the rich world/poor world debate about climate change. Most notably, they couldn’t agree to phase out coal, even though this is the most effective step nations could take to reduce emissions of Global Greenhouse Gases (GHGs). Coal burning power plants can be replaced with natural gas. The US has done this successfully for over a decade, although progress has stalled this year due to higher natural gas prices.

China draws accolades for its huge investments in solar and wind. Last year they reportedly added 120GW of solar and wind power, although analysts were skeptical about the about the figure’s veracity. China has adopted a goal of being carbon neutral by 2060, so you would think that phasing out coal would be consistent with this goal.

But China’s refusal to make such a commitment reveals their other climate commitments to be less than solid. From the origins of the Covid pandemic to supporting cyberattacks, the Chinese government provides plenty of reasons for their public statements to be disbelieved.

The pie chart shows the magnitude of the problem. China burns half the world’s coal. The challenge of global warming pits the desire of OECD countries to limit emissions against the drive for higher living standards in the developing world. These two objectives are in conflict, as the G20 meeting showed.

The irony is that rich countries are far better equipped to protect themselves from the consequences should they occur, such as rising sea levels and more extreme weather, than poorer ones. In effect, America’s climate czar John Kerry is telling the developing world, let us help you by all reducing emissions since the results will be worse for you than for us. Those potential beneficiaries are responding that raising living standards for their populations, which requires increased energy consumption, is more important.

Seven years ago, John Kerry in a speech in Jakarta exhorted Indonesians to, “Make a transition towards clean energy the only plan that you are willing to accept.” At the time, an estimated 36 million Indonesians didn’t have access to clean water (see The Moral Case For Fossil Fuels). They have different priorities, appropriately so.

It’s positive that these opposing views are being brought into the open, because it makes eventual progress more likely. John Kerry’s view is hopefully less condescending than it was back then, having confronted reality.

India published a dissenting statement alongside the official communique, urging countries to reduce per capita emissions down to the global average. This is where political support quickly evaporates. For the US, this would require a 70% cut in GHGs, and therefore energy use. Joe Biden understands Americans have little tolerance for constrained access to energy. The White House recently lobbied OPEC to raise production so as to slow the increase in gasoline prices, even though higher prices are both necessary to reduce emissions and a consequence of his administration’s policies.

The White House has stopped short of seeking to phase out coal in the US, although it has a plan to “Invest in Coal and Power Plant Community Economic Revitalization” which aims to support areas “hard-hit by past coal mine and plant closures and vulnerable to more closures” (italics added). Phasing out coal in the US would be more easily done as part of a global consensus to do so which was sadly absent.

OECD countries are reducing emissions, but the world overall is not, other than through last year’s Covid recession. Climate extremists would have us shift to intermittent renewables even while the world’s biggest emitter, China, continues to add coal burning power plants at a dizzying pace. China’s planned coal plant additions outnumber the entire US fleet. They’ll more than offset any progress we make in this country. The G20 conference just concluded did at least expose the conflicting goals.

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

Behind The Fed’s Benign Inflation Outlook

This week the FOMC meets on Tuesday and Wednesday. Most recently released minutes suggest that the gradual cessation of the $120BN in monthly bond buying ($80BN in US treasuries and $40BN in mortgages) is getting closer. Given the history of prior efforts to wean the bond market off Fed support, popularly referred to as “taper tantrums,” careful consideration is being given to every aspect of the decision.  

Unilever added to the list of companies reporting pricing pressure last week. CEO Alan Jope reported that, ““We are facing very material cost increases,” He provided examples, noting year-on-year increases in palm oil (up 70%), soyabean oil (up 80%), crude oil (up 60%) and ocean freight (up 40%).  

Procter and Gamble, which is in many of the same markets as Unilever, has already warned of price hikes to come in September. Operating chief Jon Moeller said,” “This is one of the bigger increases in commodity costs that we’ve seen over the period of time that I’ve been involved with this, which is a fairly long period of time.” 

The housing market continues to be red hot. One client told us he plans substantial increases in rents on properties he owns on Long Island, NY. This is in part to compensate for the difficulty in evicting delinquent tenants. Although the CDC’s eviction moratorium, which has been the subject of court challenges, expires at the end of July, New York State has issued their own moratorium.  

More expensive real estate is pushing up rents. Data from Zillow shows that rents are up 7% across the country from a year earlier.  

House prices are up too. The most recent Case-Shiller US National average rose 2.1% in the previous month, +14.6% for the year. It is the topic of cocktail conversation among the lockdown-liberated. The Fed’s $40BN a month of mortgage buying is boosting home prices by holding mortgage rates down. 

The FOMC will discuss the frothy housing market but may draw comfort from other data. For example, Owners’ Equivalent Rent (OER) is showing a 2.3% year-on-year increase. As we’ve noted, OER is drawn from a survey that asks homeowners what rent they believe their house would command in the market (see Why You Can’t Trust Reported Inflation Numbers). Most homeowners have only a vague notion of what this figure is, or OER would be rising along with actual rents and house prices.  

Moreover, how is the FOMC to regard OER if it belatedly starts rising, especially if the actual market for housing and rents starts to cool? OER is never tested against the market, since it’s not based on actual transactions. A homeowner can theoretically offer an aspirational rent estimate in response to a survey from the Bureau of Labor Statistics even if their home would never rent at that level. It’s likely that this dovish FOMC would dismiss rising OER as inconsistent with other data and not reflective of cash transactions. So it’s a useless component of the CPI, albeit a significant one with a 24% weighting. The Fed prefers the index of Personal Consumption Expenditures which uses OER but at a smaller weight.  

Dumping the OER concept and relying on actual cash expenditures on shelter would usher the Fed into the world the rest of us inhabit. 

The FOMC may also draw some comfort from falling bond yields. Ten-year inflation expectations, derived from the difference between nominal and real yields on US treasuries, have fallen from 2.5% in late May to 2.28% currently. Fed chair Jay Powell has repeatedly assured us that the rise in inflation is transitory, so he may point to the bond market as confirming this belief. The FOMC remains convinced that there remains plenty of slack in the labor force. Interestingly, the non-partisan Congressional Budget Office believes we are closer to potential GDP, which in their view implies less economic slack than the Fed believes.  

Chair Powell may peruse recent work from Citi Research, which takes monthly gross issuance of US treasuries, deducts redemptions and Fed buying to arrive at the net supply to be absorbed by other buyers. July’s $94BN of net supply is the lowest figure of the year, a third less than the monthly average of $150BN. Citi argues that bond scarcity was behind the recent drop in yields.  

At first, I thought this seemed too simplistic. Surely the buyers, who are largely central banks and sovereign wealth funds and others with inflexible mandates, must nonetheless be aware of this seasonality and adjust their buying accordingly. But then I realized that our own central bank doesn’t even do that. Their monthly purchases are fairly consistent.  

In July, Fed buying will take up 85% of net supply, versus 54% on average during the year. In May the Fed bought up only 45% of net supply. 

Therefore, the recent drop in inflation expectations that will cause some relief among FOMC members may be in part their own doing. Combined with their failure to accurately measure housing inflation, the FOMC looks increasingly divorced from the real economy.   

September is a heavy issuance month, and the Fed will only be buying around 44% of net supply. If they’ve begun tapering by then, it could be even less. Managing portfolios while the FOMC tries to elegantly exit their ongoing partial debt monetization will require deft risk management for the rest of us.  

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


Was That A Delta Head Fake?

Crude oil fell sharply on Monday, hit by the long-awaited confirmation of increased production from OPEC and growing concerns about the Delta Covid variant. Pipeline stocks dropped along with the energy sector. Financial markets’ concern coincided with the dropping of all remaining Covid restrictions in the UK (although visitors still face mandatory testing and/or self-quarantine, depending on where they’re coming from). After a strong rally for most of the year, some investors were clearly caught out by the market’s sudden concern with the Delta variant. Although infections are rising, there are far  fewer hospitalizations than before in developed nations because of widespread vaccinations and acquired immunity.

Lockdowns and other measures that seek to protect populations continue to inflict much damage. Deaths from drug overdoses in the US rose by 30% in the past year, a jump at least partially blamed on Covid lockdowns. Moreover, CDC data shows that 87% of all deaths among all age cohorts above 40, even including those 85 and older, didn’t involve Covid. All those people who died since January 2020 endured a lousy last year of life trying to avoid Covid, but the vast majority succumbed to something else.

Although oil garners most attention, natural gas is at least as important to North American midstream, energy infrastructure. Global prices have been rising, even recently when oil prices have weakened. The JKM benchmark for Japan and South Korea continues to trend higher, as does the TTF European benchmark. This has improved the economics for exports of US Liquified Natural Gas (LNG), and volumes continue to grow.

Even last year, global LNG volumes were flat, contrasting with crude oil where global demand was down 7%. The US saw the biggest growth in LNG exports, +1.5 Billion Cubic Feet per Day (BCF/D) to 6.5BN. Following a fall last summer as the world endured its brief Covid recession, volumes rebounded in October.

The outlook for LNG exports looks very strong. The International Energy Agency (IEA) recently forecast that global power demand would rise 5% this year following a drop of just 1% in 2020. This is driven by emerging economies, particularly in Asia. Just under half of the increase relies on fossil fuels, especially coal. The continued importance of the dirtiest of fossil fuels in Asian power generation represents a huge opportunity for natural gas. Switching from coal to natural gas would lower emissions, emulating the success the US has had doing just that. Global use of natural gas for power generation is expected to rise 1% this year and almost 2% next, following a 2% drop in 2020.

Over the past five months US exports of LNG plus pipeline exports to Mexico have averaged over 17 BCF/D. After a slow start, Mexican demand is picking up and looks set to grow at 10% pa over the next four years. Even though US power sector demand for natural gas is moderating as higher prices cause switching back to coal, export demand is more than making up the difference.

Recent floods in Germany have become an election issue, with all the major parties attributing this extreme weather event to changing climate. Germany is about 2% of global emissions, so even if voters demanded a swift move towards carbon neutrality, German weather wouldn’t change perceptibly as a result. However, a sensible result of increased German concern about climate could be pressure on China and other emerging countries in Asia to lower their use of coal. Natural gas would stand to benefit.

It’s only a couple of years since the TTF benchmark was under $4 per Million BTUs (MMBTUs), less than a third of today’s price. This is drawing more long-term buyers of US LNG, which has in turn caused leading LNG exporter Cheniere to sign a 15-year purchase agreement from Tourmaline, Canada’s biggest producer of natural gas. Tellurian’s CEO Charif Souki has said he expects to announce additional LNG offtake agreements to add to the two recent ones they signed (see Pipeline Rally Exposes Lagging MLP Sector).

The volatility of crude oil and its consequent impact on energy sentiment distracts attention from the long term commitments being made for natural gas.

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


Market Underprices Rate Hike Risks

Bob Rubin was US Treasury Secretary from 1995-99 under Bill Clinton. Early in his tenure, the US$ came under severe downward pressure. Market pundits kept calling for the Treasury to provide US$ support, to stem the slide. This evoked memories of 1987, when a growing trade deficit caused persistent US$ weakness which pushed up bond yields and eventually led to the October stock market crash.

Relying on his almost three-decade career at Goldman Sachs which culminated in co-chairman, Rubin waited, allowing the US$ to continue falling. He recognized that even the US Treasury couldn’t stand in the way of the FX markets. He waited until the US$ sell-off paused, and then retraced for a couple of days, in the kind of move analysts call a “healthy correction.” Just as the small bounce is the US$ was testing the conviction of shorts, the Treasury launched a coordinated intervention with Japan, Germany, and Switzerland. The consequent trading losses inflicted on FX speculators took a while to heal, and traders were more cautious about shorting the US$ afterwards.

Today’s Federal Reserve does not possess such a deft hand. Perhaps it’s because the FOMC has to agree on policy, constraining them to decisions at their meetings rather than allowing chair Powell to act opportunistically. In any event, the Fed is missing the opportunity to begin an elegant exit from its $120BN monthly bond buying program. Surely the ten-year treasury note yielding 1.3% is proof of sufficient demand elsewhere and that the continued debt monetization is no longer needed.

If Bob Rubin was Fed chair, his planned exit from the Fed’s bond buying would be timed for when the market no longer needs it. Given a choice between tapering now, when yields are falling, or later when continued economic strength is driving yields higher, the former is clearly less disruptive.

But that’s not the FOMC’s game plan. Their strategy is to exit when they see full employment and 2% inflation expectations (or higher). We are to expect ample and timely communication, but they will nonetheless most likely be reducing their buying into a falling market. There’s probably no easy way to scale back over $1.4TN in annual bond buying, but the FOMC’s plan looks decidedly market-insensitive.

Eurodollar futures are priced for 0.75% of tightening by the end of 2023. The most dovish of the blue dots on the Fed’s Summary of Economic Projections (SEP) expects policy to still be unchanged by then. Although the median is higher, the FOMC’s composition will likely become even more dovish over the next year (see Trading Futures With The Fed).

Jay Powell has promised that, if required,“… we will use our tools to guide inflation back down.” This is the bare minimum commitment of any Fed chair, and he’d clearly rather not have to. Powell is all-in on the belief that the inflation rise will be transient.

It may be, in which case the 1% yield on December 2023 eurodollar futures is too high. But if the FOMC is wrong, and inflation expectations become anchored well above 2% as a reasonable reaction to rising prices, the Fed will likely have to move more than just once a year, which is what’s now implied by the 52bps spread between Dec ‘23 and Dec’25 eurodollars.

It’s hard to envisage the type of economic environment by then that would justify the slothful monetary tightening currently priced into the market. It would likely require a persistent shortfall in employment, inflation back below 2% and little or no new fiscal stimulus, an unimaginable degree of Congressional restraint.

The SEP blue dots suggest a tightening pace of twice that.

The yield curve it too flat. It’s currently possible to bet with the Fed’s forecast of a very slow normalization of monetary conditions in a trade that should also work if it turns out they’re moving too slowly. It’s a way of betting with the Fed while having insurance in case circumstances move against them. The trade is to go long Dec ‘23 eurodollar futures and short Dec ‘25 futures, at a spread of 52 bps.

Inflation concerns are coming up regularly in conversations with investors. Wells Fargo recently calculated that 60% of the pipeline sector’s EBITDA is subject to tariff escalators linked to PPI, which is likely to exceed 5% this year. For liquids and NGL pipelines that could add up to a more than 3% increase in cashflows in 2022 – a benefit that requires no incremental capex, and is not just a one-time gain as it’ll become embedded into the tariff structure. We believe midstream energy infrastructure offers one of the most attractive ways to invest for inflation protection.

Finally, we liked a WSJ op-ed (see The Climate-Change Agenda Goes Out With a Bang) that noted the increasing pushback from voters around the world against the agenda of environmental extremists because of cost. Swiss voters have rejected an increased fuel tax; Britain’s cabinet is split over previously announced plans to ban gas-fired home heating; a proposed French diesel tax in 2018 helped create the “yellow jackets” protests. From Joe Biden on down, political leaders have downplayed the cost of the energy transition, instead of explaining that if something’s worth doing it’s worth paying for. Hopefully this will introduce a little more realism into policy debates.

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

Biden’s Hasty Keystone Cancelation Draws $15BN Lawsuit

The Keystone XL pipeline extension (KXL) became a political football years ago. Canada has long struggled to transport its crude oil from Alberta to markets overseas. Three years ago Kinder Morgan (KMI) found themselves embroiled in an inter-provincial dispute, when British Columbia refused to allow added capacity to the TransMountain Pipeline (TMX) that links Edmonton, Alberta with Vancouver and the Pacific. Having concluded the project had become too political, KMI fortuitously sold TMX to the Canadian federal government just weeks before a court issued a ruling that added further substantial delay (see Canada’s Failing Energy Strategy).

The Keystone Pipeline System runs from Alberta to Cushing, OK and on to the Gulf of Mexico. In 2008 planning was started for KXL, which was needed to add 830K barrels per day of additional capacity, albeit following a different route which would have allowed it to pick up oil in North Dakota too.

KXL’s size made canceling it a goal of environmental extremists. Because it was to cross the US-Canada border, the State Department was involved in its approval. Obama imposed delays for several years, but in 2017 newly-elected President Trump approved it. TRP brought in Alberta as a partner, so as to share risk with the government entity best positioned to benefit. Court challenges caused further delays, but in March 2020 TC Energy (TRP), the owner, announced plans to proceed with construction.

In January on his first day in office, newly-elected President Joe Biden issued an executive order canceling the permit for KXL. Last week TRP announced they’re suing the US for $15BN under the United States-Mexico-Canada Trade Agreement (USMCA) that replaced NAFTA.

It was a dumb move full of theatrics to play to progressive Democrats. Most of the oil that KXL was going to transport will still get to market, albeit by rail and truck which are (1) more expensive, (2) worse for the environment, and (3) not as safe as pipelines. KXL opponents presumably expect that the higher transportation cost will result in less crude being produced. That may be true, but given the second and third considerations listed above we may have higher emissions and more spills than if KXL had been built.

While environmental extremists hailed Biden’s decision, they may come to hope that TRP prevails in court. Capital investments whose timeline extends beyond a single presidential term need certainty that permits issued under one administration can’t be revoked under a later one. Just as an individual can’t simply change his mind over a prior legal commitment, neither can a country.

TRP’s lawsuit revolves around whether the US was permitted to change its mind about KXL. The concept that a permit lawfully obtained under a prior administration is nonetheless subject to subsequent revocation is not free. If allowed to stand, the capricious flexibility so allowed would inject uncertainty into a wide range of capital projects. Investors would need to consider the possible impact of an election, which would increase the required IRR to justify an investment. Corporations would become more deeply involved in elections in order to protect their investments.

Moreover, it’s entirely possible that a new Republican administration in 2025 could rescind Biden executive orders that were intended to support investment in infrastructure to support renewables. If TRP loses its lawsuit, capital commitments in support of the energy transition that rely on today’s executive orders will ultimately deliver more expensive energy than otherwise – if they even reach completion.

The US has adopted an arrogant stance to its northern ally on this issue, something easily done for a superpower. KXL and oil exports were always going to be more important to Canada, and Americans famously care little for their northern neighbors’ feelings anyway.

But there’s a lot more at stake than a lost pipeline investment in TRP’s lawsuit, which if they were to be awarded the full $15BN would amount to over $100 per US household. If the US prevails, required IRRs will rise on many projects, including renewables that could become political flashpoints. NIMBY opposition is already growing to the onshore placement of solar farms, windmills and the high voltage power lines necessary to move power from rural areas to population centers.

It may turn out that seeing TRP prevail in court will be more beneficial to the goals of the Sierra Club, flawed though they are, than uncertainty over the longevity of future presidential permits. If so, maybe their members will pay towards the $15BN they’ll have cost the rest of us.

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

Trading Futures With The Fed

Last week’s big story was the sharp drop in bond yields. Ten-year treasuries dropped below 1.3% on Thursday, down 0.30% on the month. Big moves in bonds usually have a visible catalyst, but there was no obvious driver of last week’s move. Inflation expectations dropped somewhat, which is typically reflective of a change in the economic outlook. But around half the drop in bond yields has been caused by falling real yields, which are typically less sensitive to economic data. Today’s investors in ten-year treasuries are willingly accepting a loss, after CPI inflation, of almost 1%. Non-commercial buyers, including central banks and pension funds with rigid investment mandates that require fixed income allocations are setting bond prices today.

Eurodollar futures continue to provide a fascinating counterpoint to the FOMC’s Summary of Economic Projections (SEP). The infamous “blue dots” from the SEP are overlaid on the eurodollar yield curve below. They show the median forecast for the Fed’s overnight policy rate – the blue dots provide annual readings for 2021-23, and a long-term forecast. So we’ve assumed the equilibrium real rate of 0.5%, what the FOMC calls “r*”, is reached by 2026. With their 2% inflation target, that results in a 2.5% neutral Fed Funds rate.

We’ve also added in Fed chair Jay Powell’s blue dots. The SEP doesn’t disclose dot ownership, so we’ve simply assumed he’s the most dovish dot in each year which is consistent with his public comments.

If Jay Powell was allowed to trade eurodollar futures, he would surely bet on a steeper yield curve from 2023-2025. Even though he constantly warns us not to pay too much attention to the dot plot, he provides a forecast himself like the other FOMC members.

We’re told they will move slowly in raising rates, and the most dovish dots are 0.75% below eurodollar yields for 2023 even after the recent bond rally. But five years out even the most dovish FOMC member is 0.25% above eurodollars. The discrepancy was more pronounced on Thursday morning when the bond market’s recent rally faltered.

Although FOMC doves think the market is ahead of itself in anticipating the beginning of monetary tightening,  it’s also too relaxed about the pace of tightening once the FOMC gets started.

This shows up in calendar spreads. On Thursday the spread between December ‘23 and December ‘25 eurodollars narrowed to 0.55%, implying the Fed will be on a pace of barely more than one 25bps hike annually during that time. This is historically very slow, and at odds with what FOMC members expect. In March, the market was priced for almost five tightenings over this two year period. By the end of the week, this spread had widened back out to 0.65%.

For those who are familiar with the colors of each year of futures, the Jay Powell trade is to go “long the green Dec gold Dec spread.”

Betting against the FOMC made sense early this year, when the yield curve was too flat. Six months ago the market was priced for only a one in five odds of a tightening by the end of next year. Today, seven out of 18 FOMC “blue dots” are forecasting such, and the market has adjusted accordingly.

But the opportunity is shifting towards later rather than sooner, which is in line with Fed chair Powell’s view. Former NY Fed president Bill Dudley noted that the employment situation is likely to remain unclear until Federal unemployment benefits fully expire in September and children finally return to in-person school. So it’s going to be at least another couple of months before the Fed can conclude “substantial further progress” towards full employment has been made.

Being an inflation hawk has gradually gone out of fashion, not least because persistently low inflation has rendered such a stance out of touch. But even today’s dovish FOMC expects to raise rates within two years – their internal debate will be one of speed.

Joe Biden will have an opportunity to influence the FOMC’s composition. Fed chair Powell is up for reappointment next year and looks likely to stay. Vice chairs Richard Clarida and Randal Quarles are also both up for reappointment, and one of the seven Fed board seats is vacant, with a term that expires in 2024.

This offers the president an opportunity to modify the FOMC somewhat to reflect his views. Don’t expect anything so crass as public advice on monetary policy from the White House, but subtle pressure out of the spotlight is likely. This makes a slow pace of monetary tightening more likely, because the FOMC’s dovish tendencies will be reinforced.

Chair Jay Powell is likely to have a say in any appointments. He’s already suggested that monetary policy has a role to play in reducing income inequality. There are many considerations the FOMC could include in setting rates, and they’re all likely to lead to more dovish outcomes than a simple focus on inflation.

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


Is Biden Vulnerable At The Gas Pump?

Voters have a history of blaming the president for high gasoline prices, even if the White House has limited power to change them. When OPEC tripled oil prices following the Iranian revolution in 1979 it was one blow too many for Jimmy Carter, who was swept aside by Reagan in 1980. The Arab world’s opposition to US foreign policy in the Middle East was one of the causes of high crude.

Although Joe Biden wasn’t at the OPEC meeting that just collapsed over the UAE’s insistence on an increased production quota, the continued bull market in oil which got a further boost can be partly traced back to his policies. Goaded by the progressive wing of the Democrat party, the Administration has a hostile attitude towards new oil and gas production.

Growing political pressure on energy companies to cut back oil and gas production is having an impact. Large publicly traded companies are especially vulnerable to such pressure. Exxon Mobil and Chevron both recently had to modify their spending plans in response to shareholder pressure, while Royal Dutch Shell was ordered to do so by a court (see Profiting From The Efforts Of Climate Extremists).

One consequence is that OPEC’s influence over oil prices is growing, as non-OPEC producers have less spare capacity. Demand is currently running at 97 Million Barrels per Day (MMB/D) and looks set to reach 100 MMB/D by year’s end. There’s no reason to expect demand to stop increasing at that point, as rising living standards in emerging Asia are likely to push it above pre-Covid levels.

The US energy industry’s newfound financial discipline is also helping. Domestic production is not rising nearly as much as in past cycles. This is all great news for energy investors. Having endured excessive capex with low prices, the pendulum is now swinging back the other way. Morgan Stanley expects the group of independent US shale producers under research coverage to boost Free Cash Flow (FCF) by a third over the next year, where they’ll have a FCF yield of 15%. We expect North American pipeline companies to generate $49BN in FCF this year, up 27%, and $56BN in 2022.

Environmental extremists are very happy with rising oil prices. There will be no energy transition unless renewables are competitive, and this helps. They tend to be more city-dwellers than rural, so gasoline prices don’t have much impact.

Energy investors are also happy, as the unlikely alignment of interests with the liberals has led to a mutually desired outcome. But what about the rest of America? Gasoline prices are now higher than at any time during the Trump presidency. This is yet another incongruity with continued fiscal and monetary support for the economy which clearly no longer needs it. Biden can quietly turn to the disillusioned progressives who think he’s abandoned them and claim credit for the high oil prices they want.

So far the energy transition has had limited impact on consumers. Apart from power outages in states where renewables have risen to an unwieldy share of electricity generation (see California and Texas), disruption has been minimal. Rising gasoline prices will eventually test society’s willingness to pay more for energy. We should pay more. The energy transition is expensive. If lowering CO2 emissions was easy we would have already done it. If it’s a worthwhile endeavor, it’s worth paying for.

The problem is that the energy transition hasn’t been marketed as such. Candidate Biden promised us green employment opportunities that would be well-paying union jobs. It’s all been disingenuously promoted as an exciting opportunity. Instead it’s an eternal slog to avoid carpeting the landscape with intermittent solar panels and windmills until pragmatism dictates the adoption of new technologies: carbon capture and sequestration to allow increased use of natural gas (see Carbon Capture Gains Momentum); blending of hydrogen into the natural gas supply (see Europe’s Nascent Hydrogen Industry); and perhaps one day we’ll revisit nuclear, if society truly wants to solve the problem.

Although Biden gasoline prices are higher than at any time under Trump, they reached $4 a gallon in 2014 under Obama. It wasn’t much of a political issue back then, because the president hadn’t done much to cause it. That was also the peak in the energy cycle, since the Shale Revolution’s supply shock followed and prices duly fell.

This suggests that the pain threshold for rising gasoline prices is above where they are today, which is good news for energy investors. It means environmental extremists can continue shifting oil supply to foreign governments and privately held firms, continuing the publicly traded industry’s virtuous cycle of reduced capex and growing FCF. Biden’s vulnerable on gas prices because his policies are intended to push them higher, but we’re not there yet. Pipeline stocks still have plenty of upside.

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