SL Advisors Talks Markets

The Fed’s Aspirational Base Case

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There were few places to hide last quarter. The S&P500 was –4.6% with nine of its eleven sectors losing. Energy sparkled at +39% and Utilities were +4.8%. Bonds were even worse, with the Bloomberg Aggregate –6.2%. Close to our hearts, pipelines (as defined by the American Energy Independence Index) were +24.5%.

Low yields have underpinned stocks for many years, so a deteriorating Equity Risk Premium (ERP) is weakening the case for “TINA” (There Is No Alternative). Although bonds remain a long way from offering a fair return, yields have risen far enough that stocks no longer look compelling. Factset bottom-up estimates for S&P500 EPS growth are 9%, putting the ERP close to its 20 year average. As a successful and now retired bond trader used to say, 3% on the ten year note is only a nine iron away. This would make stocks look decidedly neutral.

Correctly calling interest rates is of greater import to one’s equity portfolio. JPMorgan produced an interesting chart that shows bond yields and equity returns are more highly correlated when rates are low. There’s no doubt low rates have driven investors to assume greater risk. Inconveniently, most of this relationship is since the Great Financial Crisis (GFC), so it’s unclear if the correlation has risen because rates are low, or because something changed structurally following the GFC. If ten year yields move above 3.6%, JPMorgan’s chart suggests the correlation will turn negative, meaning rising rates would be good for stocks. It’s hard to imagine, but inflation is changing many things.

Larry Summers and Bill Dudley are competing via erudite blog posts for the title of most articulate Fed critic. Dudley recently said that The Fed has made a U.S. recession inevitable thanks to its slothful removal of monetary support. Jamie Dimon said in his annual letter that “the medicine (fiscal spending and QE) was probably too much and lasted too long.”

Summers warned investors, The stock market liked the Fed’s plan to raise interest rates. It’s wrong. He took issue with the recently released FOMC forecast, which presents an impossibly optimistic outlook. He notes that the Fed is expecting inflation to moderate while pushing Fed Funds barely above their neutral target, all while maintaining close to full employment. Should Jay Powell and his FOMC colleagues pull this off, they will have threaded the proverbial needle and challenged economic orthodoxy. It’s more correctly an objective, or an upside case, rather than a forecast. No business could submit a budget with such hopeful outcomes.

This makes the future path of interest rates quite wide. If inflation doesn’t moderate, will the Fed push rates high enough to cause higher unemployment? How willing will they be to risk a recession?  In August 2020 chair Powell revealed a subtle but significant change in how they regard their dual mandate of maximum employment consistent with stable prices.

Decades of declining real rates and an unemployment rate that continued to fall without causing wage pressures persuaded the Fed to allow inflation more upside than in the past. Since that symposium two years ago in Jackson their policy, “emphasizes that maximum employment is a broad-based and inclusive goal.” Data shows that minorities suffer employment more quickly than the general population, so the Fed is presumably now more sensitive to minority rates of unemployment. This isn’t necessarily a bad policy, but it is a modification and comes with increased tolerance for inflation.

The Fed now assesses “shortfalls” not “deviations” from maximum employment, since “employment can run at or above real-time estimates of its maximum level without causing concern.” And most notably, “following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”

Both Dudley and Summers impose a traditional Fed policy function on today’s situation. That would regard our current inflation spike as a manifest policy error demanding a prompt response. By contrast, Powell has admitted that inflation is too high but has yet to concede a policy error. Their revised consensus statement allows for some inflation risk in pursuit of getting everyone a job, so 7.9% inflation is less of a mistake than if, say, Paul Volcker was in charge.

If the FOMC projections turn out to be correct, stocks will do very well. The risk for equities is that inflation doesn’t moderate as expected – will an FOMC stung by their error tighten too much in response? Or will they place greater importance on near term maximum employment, always waiting for another month of hopefully better data? It’s unclear, but if Larry Summers is right that the FOMC forecasts are short on “intellectual rigor and honest realism” the Fed’s fealty to their reinterpreted mandate will be tested.

Perhaps because we cover interest rates and energy markets, connections often leap out. It’s politically correct (even “woke”) to assume wildly unrealistic assumptions about renewables, because it suggests endorsement of the policies required. So JPMorgan includes a chart showing global primary energy from renewables reaching a 60% share by 2050 from under 5% today. Fossil fuel use collapses so that oil, gas and coal in aggregate are less than 20% of primary energy use in 2050 versus 78% today.

Because JPMorgan is not quite as idealistic as the chart suggests, an extensive footnote warns that it’s based on the Net Zero outlook from this year’s BP Energy Outlook. The Net Zero scenario, which isn’t BP’s central case, roughly aligns with the UN’s goals. In other words, it’s what many climate scientists believe should be happening, not necessarily what they expect.  JPMorgan adds that forecasts are “not a reliable indicator of future performance.” In other words, it’s not their forecast.

Ten years ago JPMorgan published a series of charts based on work by highly regarded polymath Vaclav Smil on the slow pace of energy transitions. It took coal 60 years after reaching 5% to provide half the world’s energy. Oil and natural gas still haven’t reached that level and probably never will. The forecast that renewables will provide half the world’s energy within two decades is aspirational, and even less likely to be accurate than the Fed’s. Any serious effort to reduce emissions will use more natural gas instead of coal, increase nuclear power substantially and incorporate carbon capture. Improbable forecasts that are presented as Base Case are never good. Larry Summers would agree.

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

Please see important Legal Disclosures.

Most US energy investors are familiar with Cheniere, America’s leading exporter of Liquified Natural Gas (LNG). Founded in 1996, the company was originally dedicated to increasing domestic supply, first as an oil & gas exploration business and then as an LNG importing company, which looked unlikely to keep up with growing demand. The Shale Revolution turned America into an exporter of cheap natural gas. Cheniere pivoted from importing to exporting, and currently ships just under half the LNG that leaves US facilities.

Natural gas is much trickier to move than oil or coal. Unless it’s traveling through a pipeline it has to be cooled and compressed. LNG export facilities cool methane and reduce it to 1/600^th of its volume, while regasification plants at the receiving end warm it up for use by customers.

Not surprisingly, LNG facilities take years to construct. This makes it possible to project US export capacity out several years, based on existing projects either under construction or approaching Final Investment Decision (FID).

NextDecade was founded in 2010 by Kathleen Eisbrenner who took the company public in 2017 before retiring a year later. Their journey to building an LNG export facility has been long. In 2020 French utility Engie ended negotiations to become an anchor buyer due to concerns about flaring and methane leaks associated with US natural gas production.

This prompted NEXT to reposition themselves as a supplier of responsibly sourced gas that is chilled and compressed via a zero-emissions process. They even created a new division, Next Carbon Solutions, to lead this effort and explore selling their carbon capture expertise to other companies.

Data from the International Energy Agency (IEA) suggests that US exports of LNG have done more to reduce global CO2 emissions than any other project, including Germany’s drive into renewables (“Energiewende”). Last year the US Energy Information Administration (EIA) noted switching from coal to natural gas was the biggest driver of reduced CO2 emissions, a fact ignored by climate extremists.

Global coal consumption continues to increase, largely in emerging economies. Switching to natural gas for power generation remains the world’s most realistic hope for emissions reductions.

The outlook for US natural gas, already positive, received a further boost when Russia invaded Ukraine (see Russia Boosts US Energy Sector). Within days Germany had acknowledged its strategic error in relying so heavily on Russia for natural gas. Two new LNG import facilities are now planned on Germany’s north coast, and construction is expected to be fast-tracked. They are negotiating a long-term purchase agreement with Qatar.

Markets were quick to anticipate what Europe’s abrupt shift in energy policy means for US natural gas. Since February 1, Cheniere is 20% ahead of the S&P500 and 10% ahead of the American Energy Independence Index (AEITR). NextDecade and Tellurian, another company planning to export LNG, have both rallied over 60%. The odds of these two obtaining the necessary financing have improved sharply.

We had an opportunity to talk with Michael Mott, Senior VP, Next Carbon Solutions. Michael described a process that will capture up to 90% of the CO2 involved in LNG – both the pre-combustion when CO2 and other impurities are separated from the methane, and the CO2 emissions generated from energy use in chilling the methane for loading and transportation as LNG. He believes this will be the world’s first LNG facility that uses Carbon Capture and Sequestration (CCS), resulting in the “greenest LNG in the world.” NCS is planning to market its technology for capturing CO2 from the combustion of natural gas to others.

NextDecade’s Rio Grande site where they plan to build trains 1 and 2 of their LNG facility has all the necessary permits in place and is “shovel-ready”. They expect to secure financing to allow FID in 2H22. The war in Ukraine has added urgency to potential LNG buyers to secure supplies. Mott described the current market as the “strongest I’ve ever seen” and noted that analysts were still only belatedly catching up with how tight supply conditions will be in the years ahead.

NextDecade is taking a traditional approach to pricing, in that contracts are typically linked to the Henry Hub or a Brent crude-related benchmark and where NextDecade earns a set margin. This is similar to Cheniere’s approach, and by reducing NextDecade’s direct commodity price risk it makes securing financing easier.

FERC recently included resulting emissions as an additional factor they consider in approving pipeline projects. This is controversial to many in the industry – Kinder Morgan and Enbridge have both publicly criticized FERC’s changed posture. Mott believes this is an increasing trend, and that NextDecade is positioning itself to offer solutions.

The failed Build Back Better legislation included increased 45Q tax credits for CCS, and many expect this element to ultimately be passed. Mott said the industry believes a carbon price of at least $100 is necessary to incentivize investment and thinks that will eventually become a reality with direct payments being preferred over tax credits. CCS could eventually become a big source of growth for the pipeline sector.

NextDecade is a company worth watching. For the full version of our conversation with Michael Mott, check out our next podcast.

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

Please see important Legal Disclosures.

Investors have endured several body blows this year. Inflation was already rising due to the strong rebound from Covid exacerbated by last year’s $1.9TN Covid relief spending. The long heralded and late removal of excessive monetary accommodation is about to start.

More recently, Russia’s invasion of Ukraine has abruptly upended decades of western engagement, ushering in sanctions, European rearmament and urgent diversification of energy supplies. As if this isn’t enough, China placed the 17.5 million residents of Shenzhen into lockdown after new virus cases doubled nationwide to almost 3,400. The rest of the world has resigned itself to living with Covid – China’s lone insistence on complete suppression seems futile but not yet abandoned.

There’s no shortage of articles, some quite thoughtful, on Russia’s invasion and its consequences. The Weakness of the Despot is an interview with historian Stephen Kotkin who has written two volumes on Stalin (he’s working on a third). Kotkin argues that Russia’s history repeatedly shows “its capabilities have never matched its aspirations” as a great power. In Possible Outcomes of the Russo-Ukrainian War and China’s Choice a Chinese academic argues that once it becomes clear Russia has blundered, Chinese interests will draw them back towards economically successful western nations, cooling relations with Russia.

Tempting as it is to become an expert on wars and geopolitics, the more useful insight we can offer is that Russia’s estrangement from most of the world is going to last years if not decades. We can be more confident on this forecast than the conflict itself or China’s next moves, because the fact and manner of Russia’s invasion can’t be undone.

For example, Christopher Smart, chief global strategist and head of the Barings Investment Institute, said “Until you have a new leader in Russia, one who apologizes for invading Ukraine and who writes a check for reparations, these sanctions are going to remain in place. And I don’t see any of the three things I just described happening.”

Some predict that Russia’s economy will be set back thirty years. The global oil giants were only the first in a long line of western companies to announce the exit or abandonment of their Russian operations. So far more than 300 of the world’s best known brands have announced plans to leave. The port of Hamburg reports that container traffic with Russia is “approaching zero,” compared with “hundreds of thousands annually” before the invasion.

CNBC noted that, “none of the experts who spoke to CNBC for this story believe that any of the current sanctions against Russia or Belarus are going to be eased or lifted for at least the next three years.”

As upwards of 300 companies deal with messy exits and the inevitable write downs, corporate memories will be scarred.

The change in trade flows as much of the world turns away from imports of Russian oil, gas and wheat represents as significant a change as we can recall to the world economy. The recent drop in crude oil was caused by the Chinese reminder that Covid remains with us, even if they’re alone in still trying to wipe it out. The rest of the world has moved on. “Remask between bites and sips,” the offensive demand on US commercial airlines to constantly adjust facegear while eating and drinking, is redundant and virtually the only restriction left while the CDC takes yet another month to review its policy for public transport. Bites and sips. Ugh.

After the kind of run the energy sector has had, it’s reasonable to ask if it’s still cheap. On an Enterprise Value/EBITDA (EV/EBITDA) basis midstream is still well below its long term average. If the current 10X EV/EBITDA re-rated to 12X, assuming 50/50 debt/equity that would mean a 40% price increase from here. For several years the fear that the energy transition would lead to the early retirement of pipelines weighed on the sector, lowering terminal values. As it becomes increasingly clear that this transition, like those before it (wood to coal, coal to oil/gas) will take decades, equity investors should adopt the more realistic assessment that bond investors in the sector have always retained (see Pipeline Bond Investors Are More Bullish Than Equity Buyers).

The US Energy Information Administration (EIA) forecasts continued growth in production of natural gas, crude oil and renewable power through 2050. Few have noticed that since 2017 the EIA has revised up its forecast long term output of natural gas nearly as much as renewable power. Crude oil has been revised up even further. The renewables increase matches the reduction in coal output. The numbers tell a different story than much of the liberal media.

Wells Fargo estimates that adding ten years to the expected economic life of midstream infrastructure provides a 1.0X uplift in EV/EBITDA, which we estimate is worth 20% on equity prices.

Moreover, the energy sector’s weighting in the S&P500 has almost doubled from its low of 2.1% reached in 2020. As it recovers, the cost of an underweight becomes more significant, something abundantly clear to investors so far this year. There are anecdotal reports of generalist investors adding to energy exposure.

The sector still has a long recovery ahead of it.

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

Please see important Legal Disclosures.

Last week the US Energy Information Administration (EIA) published their 2022 Annual Energy Outlook. Solar and wind output are expected to grow at 4% pa, reaching 12% of our total energy production by 2050, triple their share today. This is an impressive growth rate, although less than the media coverage of renewables would suggest. It’s higher than in the EIA’s 2017 annual outlook, which looked for solar and wind to have a 9% market share by 2050.

In other revisions, the EIA has also boosted its forecast of natural gas production, which is now expected to grow by 8 Quadrillion BTUs (QBTUs). This puts 2050 production at the equivalent of 121 Billion Cubic Feet per day (BCF/D) versus a forecast of 89 BCF/D for 2022.

Many will be surprised to learn that the energy equivalent increase in natural gas production through 2050 is close to the increase from solar and wind (9 QBTUs). This reflects cheap natural gas, the slow pace of energy transitions and continued growth in domestic energy consumption, which is expected to increase by 7 QBTUs, from 99 to 106. In effect solar and wind will do a little more than cover increased demand.

Another surprise will be the revisions to crude oil production. Over the past five years, the EIA has boosted its 2050 forecast of US oil production by the equivalent of almost 3 million barrels per day. This is more than revisions to solar/wind, or natural gas. Coal is the one area where they’ve lowered expected production.

There are other surprising trends. The non-fossil fuel share of electricity production is expected to increase relatively slowly through 2050, from 42% to 58%. This adds back hydropower and nuclear, both sectors unlikely to grow much. The best locations for hydropower were identified and used long ago, while nuclear plants face debilitating opposition. There are signs climate extremists in Europe are becoming more amenable to nuclear, a welcome sign of pragmatism versus the purist view that requires running everything with solar and windmills.

The natural gas share of power generation is not expected to change much – from 30% to 29%. Coal will absorb most of the losses, representing the most realistic path to reducing emissions. By contrast, Germany recently brought forward the deadline by which they plan to reach 100% renewable power, from 2040 to 2035. The US is on track to reach 56% by then after which little change is forecast.

Russia’s invasion of Ukraine has suddenly made Europeans more aware of energy security. Renewable power is almost always domestic, so increasing this makes sense on top of buying more LNG from other countries including the US. But so far Germany’s headlong rush towards windpower hasn’t been something to emulate. We’re fortunate that the US isn’t moving at the same speed. It would only serve to accommodate China’s persistently increasing emissions. Russia isn’t helping much either.

The EIA’s outlook on emissions shows generally steady state for the next three decades – a slight dip through 2035 followed by a modest increase. High oil prices and slower growth might cause a bigger reduction  – a combination we are likely to experience based on recent events. But until voters accept higher-priced energy as necessary to reduce emissions, we’re unlikely to see much change.

Neither political party has offered appealing solutions – Progressives implausibly want the whole world to run on solar and windmills. Conservatives see little appetite among voters to pay more to reduce emissions. US states play a big role, which has led to more modest steps reflecting popular ambivalence on the issue.

That contrasts with the Administration’s stated goal of cutting CO2 emissions in half by 2030, although they haven’t yet provided any details on how they plan to do that. The infrastructure bill that recently passed included $8BN in funding to establish four hydrogen hubs, which would enable greater use of the clean-burning fuel by the power and industrial sectors. Hydrogen is 2-3X the price of US natural gas, but the right economic incentives would boost its role. The EIA projects almost no hydrogen use even by 2050. Europe is farther ahead because natural gas prices before the Ukraine war made it competitive.

The EIA annual outlook reminds that US natural gas output has a bright future, likely to grow for decades. It’s why we invest in the sector – the economics are more attractive than renewables, helped by the widely-held erroneous belief that fossil fuels are going away. Over the past five years the EIA has revised fossil fuel production up by more than renewables. Europe’s sudden realization that they need to import more LNG isn’t factored into the EIA’s report, prepared as it was before Russia’s invasion.

Investors are starting to recalibrate their expectations, like the EIA.

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

Please see important Legal Disclosures.