Maslow’s Hierarchy of Needs is a stylized pyramid with food and shelter at the base and self-actualization at the top. Maslow wasn’t around to contemplate where ESG (Environmental, Social and Governance) aspirations sit on his pyramid, but he would likely have placed them near the summit. The people and institutions most sensitive to ESG have already satisfied the other needs on the pyramid.

This is how the EU has come to rely on Russia for 40% of its natural gas while ambitiously pursuing the energy transition and, in Germany’s case, phasing out nuclear power. They perceived the world as post-geopolitical, making climate change a high priority since they identified few other big problems. The green movement’s hostility to reliable energy has stifled investment in new supply without much impacting demand. The consequent high prices have helped fund Russia’s invasion of Ukraine, and the EU’s impotence is most visible in the exclusion of energy from the west’s list of sanctions.

Europe’s energy policy has been a catastrophe.

The reason emerging countries continue to increase emissions is because their populations are lower on Maslow’s pyramid than rich world populations. If like John Kerry you’ve spent the last few decades flying on private jets, you’re afforded the luxury of preaching on climate change because you’ve ascended past all the other needs. The EU and Russia are at different levels on the pyramid, as the tanks rolling through Ukraine have shown. Russians don’t do virtue-signaling.

Geopolitical risk tends to be a right-tailed event for energy investors – a low probability positive outcome. Few sectors have that risk profile – left-tailed events (9-11 attack, 2008 Financial Crisis, Covid) cause all the trouble, and higher energy prices may yet be another financial shock. But it’s positive for the US energy sector.

US shipments of Liquified Natural Gas (LNG) have been heading mostly for Europe in recent weeks as Russian pipeline deliveries were mysteriously lower than expected. Two months ago, this inconveniently coincided with less blustery weather that slashed output from windmills. Many of the buyers of US LNG are trading companies able to direct cargoes to the highest price. China is the world’s biggest buyer of LNG, with Asia representing 75% of global LNG trade. Europeans have had to compete on price to acquire needed supplies, at times driving European LNG prices to 10X the US. Cheniere, the leading LNG exporter in the US, raised 2022 EBITDA guidance by 20% and Distributable Cash Flow guidance by 35% when they reported 4Q earnings last week.

Williams Companies, which operates the Transco natural gas pipeline network, sees an additional 12 Billion Cubic Feet per Day (BCF/D) of LNG demand through 2030. That would almost double our existing exports – that they won’t grow even faster reflects the length of time LNG facilities take to build.

The Russian invasion of Ukraine is a near term positive. Europe’s response may make it a permanent one, if EU countries reassess their energy security. The US, including our pipeline companies, are well positioned to benefit from this. For example, in late 2020 French power company Engie halted LNG negotiations with NextDecade because of concerns over emissions. Today they might react differently.

Higher oil and gas prices will also feed through to inflation. Last year Wells Fargo estimated that around 60% of the pipeline sector’s EBITDA was linked to inflation escalators via tariffs that reprice based on PPI. Six months ago with PPI running at 5.5% they estimated a 3% boost to sector EBITDA for 2022. PPI is currently running at over 13%.

Persistently high inflation doesn’t necessarily mean the Fed will have to boost rates higher – this is a dovish FOMC and there are numerous avenues for them to identify temporary price surges soon to abate, as they did last year. But it does mean that inflation persistently above the Fed’s long term 2% target is even more assured (see Why You Shouldn’t Expect A Return To 2% Inflation). The market has begun looking ahead to another mistake, an overshoot of monetary tightening (see Policy Errors On Interest Rates And Energy). Investors should be concerned that reducing inflation below 3%+ is ultimately deemed too economically disruptive.

The PPI-linked tariffs on pipeline stocks have been a fixture for many years, and in the seductively unexciting days before the Shale Revolution were regarded as positive by income seeking investors. Over-leverage and MLP distribution cuts diverted attention from the PPI linkage, but it never went away and will attract increased attention later this year as earnings reports reflect price increases.

Midstream energy infrastructure is well situated to benefit from Europe’s mistakes on energy policy and elevated inflation. Maslow would not be surprised.

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

Please see important Legal Disclosures.

The last two years have provided an empirical test of Modern Monetary Theory (MMT), the idea that a government can borrow indefinitely in its own currency with no fear of bankruptcy. Stephanie Kelton is the cheerleader for testing the limits of fiscal prudence – I reviewed her book in late 2020 (see Reviewing The Deficit Myth). MMT doesn’t prescribe limitless spending. It is axiomatic that bankruptcy in one’s domestic currency can always be avoided by printing money – having the central bank finance debt issuance – so there’s nothing insightful about that. MMT holds that the economy’s capacity to produce goods and services without generating inflation is the true limit.

Even MMT’s most basic assertion, that non-inflationary consumption financed with debt is harmless, fails cursory scrutiny. Suppose Congress voted a giant July 4^th party with the world’s biggest ever fireworks display funded by issuing 30 year bonds. MMT doctrine would allow this consistent with the inflationary limit. Most would find this absurd. Borrowing to finance transfer payments such as Medicare and social security, as we do now, is an equally indefensible passing of a burden to later generations for no benefit to them.

Fiscal policy has looked very MMT-like since Covid struck, so Kelton and other supporters have been gamely trying to manage the message. A year ago, Kelton appeared on a Bloomberg podcast titled, “How M.M.T. Won the Fiscal Policy Debate.” By last July, she was describing surging inflation as “temporary…growing pains.” Now even the NYTimes is expressing mild skepticism.

More recently, Kelton is distancing MMT from current fiscal policy, arguing that the former can’t be evaluated from the latter. She argues that deficit spending requires a CBO-like assessment to determine whether it will be inflationary, and that faithfully adhering to the economy’s speed limit will allow a country to maximize its non-inflationary spending.

It’s a bit like NAIRU (Non-Accelerating Inflation Rate of Unemployment). Central Bank utopia is keeping the economy close to NAIRU as much as possible. It doesn’t happen – not just because economic surprises inconveniently intrude, but because central bankers never know exactly where NAIRU lies. It’s only ever possible to identify it in hindsight, when the absence of inflation suggests more employment slack than anticipated, or rising wages demonstrate the opposite.

Wage increases that outstrip improvements in productivity are believed by most economists to be a necessary pre-requisite for inflation to become embedded and no longer “transitory” (to use Jay Powell’s now discredited term). Without knowing where NAIRU is, it’s impossible to know how close the economy is to running at full capacity, and therefore to gauge the inflation risk.

Government policy already aims to keep the economy moving at close to its speed limit. The Fed’s mandate is to seek maximum employment consistent with stable prices.

MMT is no more than a statement of the obvious masquerading as a profound theory.

Kelton argues that the spending limits to fiscal policy should be set by the CBO scoring the budget based on whether it would generate inflation or not. We should keep borrowing and spending up until the inflationary point. Calculating the deficit impact of a budget is complicated, but forecasting the inflationary result is a giant step farther. Although the CBO isn’t charged with the task Kelton would set them, the Federal Reserve is.

The Fed concluded that the March 2020 CARES Act ($2.2TN), the December 2020 Consolidated Appropriations Bill ($900BN) and the completely irresponsible March 2021 American Rescue Plan Act ($1.9TN) were not going to cause inflation. The Biden White House also believed this last dollop of fiscal profligacy wouldn’t be inflationary, even though Covid vaccines were already being administered to older Americans by the time it passed.

The Fed went even further and deemed the fiscal response inadequate to the economic challenge, because they maintained their own stimulus via rock-bottom interest rates and partial debt monetization.

It must be obvious to all that government forecasts of continued moderate inflation were dead wrong. Forecasting is hard, although prudent risk management would have seen the Fed curbing their ultra-accommodative stance a year ago, as we noted at the time (see Bond Investors Are Right To Worry). On February 23 last year, Jay Powell said, “At this point, the Federal Open Market Committee is seeking inflation running moderately above 2% for some time.” Following the most recent CPI report showing inflation since then at 7.5%, and 6.0% excluding food and energy, it looks like job done.

Why does Kelton think a CBO inflation analysis would have reached a different conclusion than economists in the White House and the Fed?

In case it isn’t already clear what a wealth-destroying philosophy Kelton promulgates, a recent blog post lists her favorite pre-emptive measures to smooth economic cyclicality and includes the following gem: “Instead of allowing millions of people to fall into unemployment each time the economy falters, workers could transition into a public service job that replaces some or all of their lost income.”

To what useful employment would such a Federal program direct former MMT economists, of which there is already a surplus?

Negative real interest rates have allowed the continued explosion of Federal indebtedness to occur with relatively little pain. MMT has nothing to say on this, but there are $TNs dedicated to fixed income with no need of a return on capital, simply a return of capital. Central banks, sovereign wealth funds, pension funds and others are enabling hitherto unseen levels of US debt accumulation.

If there is an inefficiency to be exploited, it is this excessive supply of cheap financing. The case for testing spending limits rests with the low cost of debt, not some idea that if we could only forecast inflation accurately, we could reach our full economic potential.

MMT was bunk when it was still just a theory. Now that it’s received a full empirical test, savers are left to deal with the consequences.

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

Please see important Legal Disclosures.

Friday afternoon’s warning from the White House that a Russian invasion of Ukraine could come at any time did at least distract attention from Thursday’s CPI. Energy stocks rose while the S&P500 fell – a welcome negative correlation.

Bonds also recouped their losses from the prior day. Over several decades the bond market’s sensitivity to rising energy prices has evolved. In 1990 when Iraq invaded Kuwait, threatening to cut supply of oil to the west, bond yields rose sharply. The memories of 1970s inflation caused by OPEC raising prices was still fresh.

At other times, rising crude has been regarded as a tax hike, since it does represent a wealth transfer from oil consumers to producers. The Shale Revolution altered US sensitivity to oil prices by increasing the portion of the economy that benefits when they’re high. Your blogger has to restrain his glee when friends complain about the price at the gas pump or how much they’re spending on heating oil. During the Covid-induced collapse in the energy sector in early 2020, cheap gasoline provided scant solace for depressed portfolios. We look forward to crude oil continuing its march higher.

Friday saw higher prices for bonds, crude and pipelines, as the rest of the market feared European conflict will hurt growth and sought refuge in energy.

The midstream sector’s strong performance does highlight its resilience to geopolitical risk. Enbridge, North America’s biggest pipeline company, reported earnings on Friday. Enbridge has no assets outside North America, a welcome protection from any global disruption.

Pipeline pricing is often tightly regulated, to prevent gouging of customers. A substantial portion of the industry sets tariffs based on the PPI. Last month the Federal Energy Regulatory Commission (FERC) set the pricing index for the next five years as PPI-0.21%.

Inflation as measured by the PPI Final Demand Goods, the index used by FERC, was 13.6% last year.

This built-in protection against inflation used to receive more attention. Prior to 2014, before the Shale Revolution had led to some dubious capital allocation decisions, MLPs (since that’s mostly where pipelines were housed back then) attracted investors because of their stable yields that came with built-in price escalators.

The tumult of the last few years has not altered this feature, even though it is rarely on the list of reasons investors cite when making an allocation. But over the next several quarters, expect to see increased mention about Cost of service (CoS) adjustments to pipeline tariffs.

Enbridge, to cite one example, says that 80% of its EBITDA comes from CoS contracts. In August we noted that Wells Fargo estimated a 3% lift to sector EBITDA from PPI escalators (see Pipelines Still Linked With Inflation). This was based on a 2021 PPI estimate of 5.5%, less than half the actual result.

What is becoming clear is that when the FOMC reinterpreted their dual mandate of maximum employment with stable prices in 2019, they made a subtle but important shift in favor of full employment at the risk of elevated inflation. Although it seems surreal given last week’s CPI release, three years ago they were concerned at the tendency of inflation to come in below their 2% target, and the constraint this placed on monetary policy to be stimulative without resorting to negative nominal rates.

Within six months Covid stopped the economy dead in its tracks, and Congress unleashed enormous fiscal stimulus through early 2021. The Fed’s prolonged monetary stimulus, synchronized with $TNs of debt-financed spending, reflected their new bias towards employment and willingness to risk inflation.

Following a near-death experience in the early months of Covid, the pipeline sector has been steadily closing the performance gap with the S&P500. On Friday the broad-based American Energy Independence Index (AEITR) recorded another good day, beating the S&P500 by 4.7%. It’s within easy reach of being ahead of the S&P500 from the end of 2019, wiping out the entire Covid-related period of underperformance.

Demand for inflation protection remains strong. Treasury Inflation Protected securities (TIPs) are an example – real yields (i.e. after inflation) are still negative. Big investors are starting to adjust their long term inflation expectations. For example, Blackrock expects inflation to average 3% over the next three years, and five year TIPs are priced for 2.8%. As Americans come to accept that the days of 2% inflation are behind us, it’ll be increasingly difficult for the Fed to bring it back down.

The demand for real assets such a midstream energy infrastructure is driven in part by investors who want protection against the Fed’s new tolerance for a little faster inflation. 3% over the long run is a safer bet than 2%.

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

Please see important Legal Disclosures.

The other day my partner Henry Hoffman was commenting on what his family pays for natural gas to heat their home in Pelham, NY. Winters in the northeast US are not for everyone – your blogger misses most of the worst weather by evacuating to Florida for a few months.

Natural gas is the most common source of heat in most northern homes. The US continues to enjoy the supply benefits of the Shale Revolution, although those benefits are spread unevenly. Pennsylvania became a huge source of natural gas that has kept prices low for those that use it.

US states have significant influence over energy policies. Where climate change is a concern of political leaders, what typically follows are poorly conceived progressive strategies that increase prices and create inconvenience for residents of that state. New Jersey, New York and Massachusetts are three states well positioned to rely on natural gas from the Marcellus shale. Their energy policies could be dubbed “Left-leaning” (NJ), “Liberal” (NY) and “Wacky” (MA).

NJ passed legislation in 2020 mandating an 80% reduction in greenhouse emissions by 2050. Among other steps it is developing offshore windpower. So far, these efforts haven’t been too disruptive to life as we know it. The Energy Administration Information shows that in 2020 NJ’s power mix was 50% natural gas and 2% solar and wind. NJ households are paying 17% less for natural gas than a decade ago.

New York state’s governor wants to ban natural gas connections to new buildings in the state, copying a similar plan enacted in New York City. The Marcellus shale even extends into the state, but no drilling is allowed. New York’s power mix is 41% natural gas and 4% solar and wind. NY households have seen natural gas prices rise 3% over the past decade even though the US is a significant exporter and has some of the world’s cheapest supply.

Massachusetts, which relies on natural gas for 78% of its electricity generation (9% solar and wind) and half of its residential heating, has blocked new gas pipelines coming into the state in spite of the fact that they are so dependent on it. Boston regularly imports Liquified Natural Gas (LNG) from the Caribbean and in the past has even bought from Russia. This forces them to compete with European and Asian buyers who have paid prices 10X or more higher than US domestic prices in recent months. Massachusetts has completely missed the benefits of increased US supply, with prices 9% higher than a decade previously.

Energy policy in Massachusetts has managed to combine heavy reliance on natural gas with impediments to access it. Such masochistic virtue signaling receives scant attention other than from the self-congratulating political leaders who have engineered such an outcome.

The result is that over the last decade or so, average natural gas prices in NJ have trended lower than those in more progressive NY and MA. I hesitate to hold NJ up as an example of enlightened energy policy, because there are Democratic political leaders in Trenton probably envious of what NY and MA policymakers have imposed on their residents. But at least NJ isn’t importing LNG from foreign countries.

US states can learn from Europe, where excessive reliance on renewables has led to an energy crisis with eye-watering prices for natural gas. The UK is an example. It gets around a quarter of its electricity from renewables – mostly wind from the usually reliable North Sea. But northwest Europe isn’t always windy, and that contributed to the UK’s sudden increased reliance on natural gas and coal. Renewables are not just limited to sunny/windy days; when they don’t produce they all go down at the same time. Dispatchable energy sources such as natural gas have diversified uptime risk. Ten independent plants are unlikely to fail simultaneously.

One result is that the UK regulator has approved an increase in the cap on household energy bills that will see more than 50% hikes for many within a couple of months. The government has responded with income-based subsidies to soften the blow, only three months after pressing the COP26 Climate Change conference to eliminate “inefficient fossil fuel subsidies.”

Germany has among the most expensive electricity in the world, also because of their switch to renewables.

These expensive and not very impactful moves away from cheap, reliable energy are swamped by increasing emissions in emerging countries such as China, which doesn’t plan to reduce emissions before 2030. This is because they value raising living standards more than curbing emissions, a reality overlooked by climate extremists attempting to impose dysfunctional policies on western communities.

It’s becoming increasingly clear that the energy transition will be disruptive and expensive. Politicians suggesting anything less are not thinking through the issues.

The EU has been farther ahead in seeking to reduce CO2 emissions. As a result, they’ve confronted more of the problems than most US states, and offer some useful examples. In a triumph of pragmatism over religious fervor, the EU recently defined natural gas and nuclear power as clean energy. There are caveats, such as that the natural gas must be displacing a coal-burning power plant and have CO2 emissions below a reasonably achievable threshold.

It’s a sensible move. So far the energy transition has delivered more expensive, less reliable energy without any discernible impact on emissions. Sharply higher prices will test the strength of public support for climate ambitions. States like New York and Massachusetts would be well served to follow the EU’s lead. Cheap natural gas is right on their doorstep.

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

Please see important Legal Disclosures.

Markets interpreted Fed Chair Jay Powell’s press conference bearishly last week. This was mostly because of omissions – he didn’t rule out raising rates at a faster pace than once a quarter, and he didn’t rule out beginning with a 50bp hike in March. As ever, monetary policy will be data-dependent.

Eurodollar futures flattened further, with a faster pace of tightening being priced in while a cycle peak of 2% remains. The powerful feature of interest rate futures is that market prices rarely if ever fail to reflect available information. For the Fed to succeed in bringing inflation back to 2% without even raising rates above that level seems unrealistically optimistic, but one can scarcely suggest that investors have overlooked this implication. A substantial number must find this plausible. December ‘24 eurodollar futures yield almost exactly 2%, and to us a trade to 2.5% seems far more likely than 1.5%. The data will determine it.

The 4Q21 Employment Cost Index registered a 1% increase in total compensation – down from 3Q21 1.3% but nonetheless a 4% rate for the year.  We all know businesses that are struggling to hire people. Labor is tight. PCE inflation is running at a 5.8% annual rate. Both these reports were better than expected, and bonds consequently recouped earlier losses to finish the week roughly unchanged. The Fed’s languid normalization of monetary policy reflects their expectation, or hope, that incoming data will assuage the sting of criticism from past Fed members Treasury secretaries, and others.

Critics include David Kelly, chief global strategist at JPMorgan Asset Management, who said “They are behind the curve and they are guilty of being too easy for too long,”

Wall Street tightening forecasts are ratcheting up. Goldman and JPMorgan expect five this year; Bank of America seven; Nomura expects 50bps in March. The incongruity in the market is a yield curve forecasting a 2% cycle peak along with ten year inflation expectations of only 2.5%, which with real yields of –0.7% is anchoring ten year treasury yields below 2%. It’s hard to see how both forecasts can be correct – we think inflation is most likely to be higher, but for that reason the rate cycle peak probably will be as well.

Like the Fed, the path of rates will be data dependent.

In other news, US natural gas prices drew attention when front month futures jumped sharply just prior to the February contract expiration. Volumes were low and covering by a few tardy short sellers probably the cause. Europe’s vulnerable gas supplies may be a factor, but the US has limited ability to make up any Russian shortfall because Liquified Natural Gas (LNG) export facilities are running close to capacity. The most likely result of a Russian invasion of Ukraine would be reduced European consumption as energy intensive industries are forced to halt production, either by ruinous prices or government edict.

This is turning out to be more than simply a short-term problem. TTF futures, the European LNG benchmark, have been increasing two years out, exposing the enormous strategic error planners in Germany and elsewhere have committed in relying so heavily on Russia. January ‘24 futures have more than doubled from a year ago. European households will be paying more for electricity.

The price difference to the US is easily sufficient to draw more US LNG exports if they weren’t capacity constrained. However, shipments will increase over the next year or so, which will modestly underpin domestic prices and support volume growth. Forget about what the climate extremists may strive for – global natural gas demand is going to grow, to the benefit of investors in producers and midstream energy infrastructure.

For further confirmation of the energy sector’s newfound fiscal prudence, note the decline in its share of S&P500 capex between 2014 and now. Thanks to Barry Knapp of Ironsides Economics for highlighting this in his very readable weekly newsletter. The White House is caught between proclaiming the demise of traditional energy while pleading with OPEC to increase production. Energy investors are benefiting from higher prices with less spending.

Finally, the ever-colorful Jim Cramer weighed in against the hapless Cathie Wood and her ARK Innovation ETF (ARKK) with a clip that’s gone viral. The Tuttle Capital Short Innovation ETF (SARK) bets directly against ARKK’s holdings, and Cramer memorably emptied a bottle of Cutty Sark over a table of figures representing ARKK. It’s 25 seconds of theatre masquerading as unconventional investment advice – although worth noting that in SARK’s brief existence its investors have done better than ARKK’s, since the latter are net down (see ARKK’s Investors Have In Aggregate Lost Money). Cramer must like Buffet’s quip (“If you’re not going to kick a man when he’s down, when are you going to?”) even at the cost of his chivalrous credentials.

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

Please see important Legal Disclosures.

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