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.

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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.

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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.

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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.

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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:

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

Had Jay Powell and the FOMC prudently begun reducing the economy’s degree of monetary support a year ago when the Covid vaccine was already being administered, they’d have more flexibility to manage the economy’s current challenges. From a 2% neutral rate and with the balance sheet shrinking, they’d be able to pivot towards easing or further tightening depending on circumstances. Because of that policy error they’re now having to get back to neutral during high economic uncertainty.

Hence eurodollar futures are anticipating a follow-up error to last year’s which is excessive tightening by the end of next year which then has to reverse in 2024, an election year. Some FOMC members must regret having followed such a reactive strategy.

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The good news for the Fed in Friday’s payroll report was a small increase in the participation rate and flat earnings growth – although changes in the composition of the workforce make month-to-month comparisons difficult.

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Higher energy prices will constrain growth in the months ahead, while also boosting inflation. Food prices are also likely to rise. Russia is almost 20% of gobal wheat exports, and Ukraine 10%. Fertilizer prices will probably also rise.

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Inflation ex-food and energy won’t look as bad, although some of this will pass through via higher transportation costs. The Fed will want to control the inflation that’s caused by excess demand while looking beyond the transitory effects of supply constraints now exacerbated by Russia’s invasion.

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The futures market reflects some risk that the FOMC will fail to judge correctly. Ten year inflation expectations derived from the treasury market edged up 0.25% over the past month. Since higher energy and commodity prices will constrain growth while boosting prices, the Fed will likely have to tolerate higher inflation for longer than they would like. With the FOMC biased towards maximizing employment at the possible risk of higher inflation, signs of economic weakness ought to moderate their path to normalization of policy.

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Financial markets are pricing for slower growth with higher inflation, what became known in the 1970s as “stagflation”. Fortunately, persistently negative real yields are softening the blow by allowing nominal rates to stay lower than they would otherwise be. Next time you run into the trustee of a public pension fund, thank them for unthinkingly financing America’s growing indebtedness for no real return.

On crude oil, the Administration’s anti-fossil fuel posture is translating into higher prices. White House press secretary Jen Psaki responded to a reporter that oil companies should increase production. Meanwhile, members of the Federal Energy Regulatory Commission (FERC) were justifying their recent decision to consider climate change when approving new natural gas pipelines. Senator Joe Manchin (D-W.Va) accused FERC of, “setting in motion a process that will serve to further shut down the infrastructure we desperately need as a country and further politicize energy development in our country.”

Chevron’s CEO Mike Wirth has called for “long-term commitments to support investment in America’s domestic oil industry.” Administration policy has been to dissuade domestic oil and gas production, a strategy that has been a disaster for US consumers. Energy executives understandably see little point in major capital commitments given the Federal government’s stance. It represents a collision between proponents of an overly rapid energy transition and energy security.

Russia is already having trouble finding buyers for its oil, with Shell reporting a transaction on Friday at a $28.50 discount to the Brent benchmark. JPMorgan estimates that 70% of Russian crude exports are struggling to find buyers. Political support is growing for banning US imports of Russian oil, a move the White House probably regards as a trap since it would quickly be followed by calls to support increased US production.

The Administration is unlikely to shift their energy policy before the mid-terms, which means US consumers shouldn’t expect much relief from high prices.

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The outlook for US midstream energy infrastructure is unambiguously good. Large new pipeline projects are almost impossible to complete, so free cash flow continues to grow because spending on new projects remains a third of its 2018 level. And no matter how the conflict in Ukraine plays out Europe will be less reliant on Russia for its energy supplies.

Liquified Natural Gas (LNG) export facilities take years to build. Williams Companies anticipates strong export-led demand for natural gas through their pipeline network.

Amidst considerable uncertainty, prolonged inflation well above the Fed’s target and robust demand for US natural gas both seem likely.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

Who can’t be moved by the pictures of women being trained to fire automatic weapons, and crates of Molotov cocktails being prepared in backyards. The Ukrainian people are drawing the world’s admiration and financial markets’ attention. There are numerous possible paths for the war to follow, and each one brings its own set of investment outcomes with risks. It’s hard to have high conviction on any assessment, because few of us have the background. But run through all the scenarios you can imagine, and every one of them includes Europe finding alternatives to Russian natural gas.

Sunday’s extraordinary meeting of Germany’s Bundestag was a watershed. For decades European nations have underspent on their defense needs – something Trump brought up regularly including in this meeting. Past presidents rarely did.

Now Europe will rearm, starting with Germany’s decision to spend an additional €100BN on defense. And they will build two import terminals for Liquified Natural Gas (LNG). Germany is especially exposed, since Russia provides over half their natural gas which itself constitutes over 30% of total energy consumption. Switzerland, Denmark and Italy all rely on Russia for over a third of their natural gas. Of the four, only Italy has LNG import capability. Landlocked Switzerland doesn’t have that option.

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For an in-depth look at Europe’s natural gas options to prepare for next winter, read Preparing for the first winter without Russian gas.

Even if Putin was implausibly replaced with a non-despot, the shift in European energy security will roll on, because planning takes years and the prior policy has been discredited. Amid all the uncertainties of a war in Europe, their need for alternative LNG and the US’s ability to help provide that is a reliable outcome. Tellurian and NextDecade, two nascent LNG companies with contracts but not yet secure financing, have both rallied strongly on improved expectations that their projects will be completed.

What’s less clear is whether US energy policy will change. Europe’s energy security is suddenly a big concern. Chevron CEO Mike Wirth called for US policy to support investment in our domestic energy industry. It’s too early to tell whether it will become US policy to provide that security through increased oil and gas production. Probably not with a Democrat administration, although Senator Joe Manchin has called for the US to end imports of Russian oil, which is a start.

The west is edging towards placing sanctions on Russian oil and gas exports. It’s a good time to avoid any overly-confident forecasts unless they’re like US midstream where any outcome confirms its increased importance.

Today’s investors in pipelines own a call option on US energy policy shifting in response to Europe’s suddenly changed need. The sector isn’t yet priced for it, so US midstream energy infrastructure can only benefit and has no discernible downside from a policy reassessment.

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What’s also changed is the inflation outlook, which must be higher in almost every scenario. Europe’s pivot on energy policy is bullish for prices. This will feed through to inflation. 2023 eurodollar futures yields have fallen by 0.40% two days, sharply reducing the expected path of short term interest rates. Higher energy prices will constrain growth while boosting inflation.

Given the Fed’s bias towards maximizing employment and greater tolerance for inflation risk, the market’s repricing makes sense. Elevated crude oil because of the energy transition or geopolitics seems the type of upward pressure to which the Fed would find little benefit in responding.

Here again, pipelines with their PPI-linked tariffs represent a good way for investors to construct portfolios with inflation protection. Ten year inflation as measured by TIPs and treasury notes has edged up 0.15% in the past week despite the drop in nominal yields.

The energy transition as pushed by climate extremists offers the antithesis of energy security, since it seeks reduced supply. Proponents of renewables like to argue that they create independence too – the utopian ideal of a countryside packed full of solar panels and windmills would seem to be free of imported fossil fuels from unreliable suppliers. But so far renewables remain insignificant, and the immediate problems are not going to be solved with solar and wind.

The physical security of renewables doesn’t receive much attention, but fragile solar panels are easily damaged by hard objects. If progressive policies had made it to Ukraine so that the country ran on solar, the Russians could have disabled their power supply with airdrops of ball bearings. The energy transition is colliding with energy security. As US consumers pay more to fill up at the pump, they’ll demand more oil not more windmills.

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The American Energy Independence Index (AEITR) has been outperforming the S&P500 ever since its March 2020 Covid low. The reassessment of energy policy triggered by Russia’s invasion has given AEITR a further boost, so it’s now recouped all its relative underperformance since pre-Covid. Last week’s events make an investment in the sector even more compelling.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

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.

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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.

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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.

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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.

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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:

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

Last week JPMorgan forecast that the Fed will raise rates at their next nine meetings, resulting in a 2.25% hike in short term rates by March 2023. They warned that inflation is entering a “feedback loop”, whereby higher wages demanded by workers to compensate for eroding purchasing power feed back into higher prices.

Over the past month, the eurodollar futures yield curve has inverted from September ‘23 out. Although monetary policy remains highly accommodative, and the Fed is still buying bonds, forward-looking markets are anticipating another policy error. Having kept rates too low for too long, excessive tightening is looming as the next risk.

For the rate cycle peak to occur below the FOMC’s 2.5% assumed neutral rate suggests that the neutral rate is lower. The economy’s resilience to rising rates seems to have weakened with each recession. Since 1980, the two year treasury note yield has peaked at successively lower levels. CPI inflation has generally followed, with the current jump clearly breaking that pattern.

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Financial markets are priced for the assumption that the history of declining rate cycle peaks will persist through this one. In November 2018 two year treasury yields reached 2.98% before declining. They’re currently half that, at just under 1.5%.

The contrast with past cycles speaks for itself.

Whatever the outcome over the next couple of years, the Fed’s forecasting ability has already taken a knock. If the current yield curve turns out to be prescient, inflation will have moderated with the Fed barely tapping the brakes. Betting on higher rates still seems like an asymmetric bet.

Former NY Fed chair William Dudley noted an unusual side to the political challenges likely facing the Fed as they raise rates. Federal Reserve profits historically come mostly from seignorage, the income from printing and distributing currency. But as the Fed’s balance sheet has neared $9TN, they’ve earned increasing amounts on the spread between the yield on what they own and their cost of funding (close to 0%). Dudley explains more in an op-ed delightfully titled U.S. Treasury’s Golden Fed Goose Is About to Get Cooked. Shrinking their balance sheet will reduce the Fed’s interest income, and monetary tightening will increase their own cost of funding, by raising the rate they pay on bank reserves.

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Dudley estimates that the Fed may start posting losses by next year, which would require funding from Congress. The Fed always remits profits to the US Treasury, so the political optics of the reverse happening are untested. At a minimum expect Congressional hand-wringing over the Federal budget subsidizing monetary policy which by then may even be harming employment. Whether this will hamper the Fed’s desire to push rates higher remains to be seen, but traders expecting a rate cycle peak below 2.5% probably anticipate such an issue.

Russia’s bellicose posture towards Ukraine complicates things – it’s bearish for most equity sectors except energy, since it’s boosting oil and gas prices. Conflict is rarely good for bonds because wars are expensive and the US may yet start incur costs in providing weaponry to Ukraine. At the same time, the imposition by the US and EU of ruinous sanctions on Russia is dampening growth prospects. Further complicating the issues facing policymakers, elevated energy prices will not help reduce inflation in the near term.

The energy crisis roiling Europe has reaffirmed the need for reliable natural gas through sharply higher prices. European buyers have scrambled to access additional sources, mostly from the US via shipments of Liquified Natural Gas (LNG). This is to compensate for the poor planning that has left the EU reliant on Russia for up to 40% of its natural gas. Recently up to two thirds of US LNG shipments have gone to Europe, highlighting the flexibility and market responsiveness of this resource. Windmill prices have not been similarly boosted. European fears about energy security are most obviously bullish for the US energy sector.

The US Federal Energy Regulatory Commission (FERC) is moving in the opposite direction. FERC revised the standards under which they evaluate new pipeline proposals to consider the impact on emissions from the oil or gas to be transported.

Building new pipelines is almost impossible in the US anyhow, because environmental extremists have figured out how to create endless judicial roadblocks. Demand for reliable energy continues to grow, representing the complete failure of climate extremists to convince consumers of the need pay higher prices in support of the energy transition.

Meanwhile five European energy companies are suing EU governments for €4BN in damages over traditional energy resources that may not be fully utilized under current EU climate policies intended to phase out fossil fuels. This is happening under the hitherto obscure Energy Charter Treaty (ECT) originally crafted during the Cold War. It is likely to further complicate European efforts to reduce emissions.

While additional US impediments to new energy infrastructure are disappointing to pipeline executives, for investors they represent a further optimization of free cash flow since constrained spending opportunities leave more cash available for dividend hikes and buybacks. As long as progressive policies don’t impede our access to reliable, dispatchable energy they can be regarded as pro-investor. National security is once again becoming a factor in energy policy.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

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.

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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:

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

European policymakers are being forced to reassess energy policy. Premature reliance on intermittent renewables came up short last Fall (see Europe Follows California Into Renewables Oblivion). More recently, the EU’s reliance on Russia for 40% of its natural gas imports is being exposed as especially unwise with Russian troops poised to invade Ukraine.

Britain has moved steadily to use wind power, and when the normally windy North Sea was inconveniently calm they turned to imports of Liquified Natural Gas (LNG) because they have been phasing out natural gas storage.

Horizontal fracturing (“fracking”) is mostly limited to the US. In 2018 we chronicled Cuadrilla’s ill-fated attempt to drill for natural gas in Lancashire, northwest England (see British Shale Revolution Crushed: America’s Unique Ownership of Oil and Gas). With British households bracing for a 50% hike in power bills because of high natural gas prices (see Learning From EU Mistakes On Energy Policy), being more self-reliant for natural gas looks smart.

Hence the right wing Daily Telegraph is making the case that fracking would have shielded Britons from the worst effects of the energy crisis. Members of Britain’s ruling Conservative party are pressing PM Boris Johnson to relax rules against fracking. The country’s unrealistic aspirations to give up reliable energy are facing a reality check.

Meanwhile Germany is considering legislation to force increased storage of natural gas by utilities in time for next winter. Germany has rated reducing emissions ahead of energy security, a prioritization that looks poorly considered.

European leaders have embraced renewables faster than many American states. Reducing emissions is a laudable goal, but many of these policies betray little serious thought about the consequences for reliability or cost.

New Jersey’s Democrat legislature passed the Global Warming Response Act (GWRA) in 2007, and updated the law in 2019. It requires an 80% reduction in annual CO2 equivalent emissions (i.e. converting other greenhouse gases such as methane into CO2 equivalents based on their warming impact and rate of degradation) below the 2006 total by 2050 (dubbed “80X50”). This requires a reduction by then of 96.5 million tonnes per year.

China plans to increase emissions until 2030, and only then start reducing them to zero by 2060. New Jersey’s population is around 0.6% of China’s, and the reduction under the GWRA is approximately 1% of China’s current emissions.

Maybe liberals are poor negotiators. The government officials that negotiate climate change agreements are probably more worried than average about the planet – that must be why western countries have agreed to continue reducing emissions while the biggest emitters like China are still increasing theirs. Shouldn’t we all be reducing CO2 at the same time, rather than creating capacity for others to keep generating more?

The people implementing NJ climate change regulations are playing fast and loose with the data. A recent proposal that buildings replacing fossil-fuel fired boilers would have to install electric ones instead estimated “the operational costs for an electric boiler may be between 4.2 and 4.9 percent higher.”

A subsequent correction quietly conceded, “The Department’s analysis indicated that operational costs for an electric boiler would result in a 4.2 to 4.9 times increase (rather than 4.2 to 4.9 percent increase).”

It’s a trivial typo, except that the proposed regulation must be uneconomic following the correction. This reflects the same absence of cost-benefit analysis that has led the EU to depend so heavily on renewables and Russian natural gas for energy. The Europeans are reassessing the energy transition and pragmatic changes will follow.

It’s in nobody’s interests for energy policy to be run such that everything is examined through the single lens of its impact on emissions.

The good news for investors is that when idealistic plans collide with realism, natural gas is often the winner. An example is Europeans buying more LNG from the US, reducing their vulnerability to Russia’s capricious supply decisions and intermittent renewables.

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Natural gas power generation is most flexible in reacting to shifting demand. NJ offers an informative example. During the summer when power demand goes up because of air-conditioning, natural gas responds. Natural gas based power production is 94% correlated with the total. Renewables at a 4% share aren’t relevant but have a similar low correlation to nuclear – neither is able to change output when customers need them to.

The energy transition means electrification. Natural gas, which is reliably 40% of US power production, will continue to benefit from this shift in NJ and elsewhere – as long as the bureaucrats don’t follow New England where new pipelines are blocked with LNG regularly imported rather than transported by pipeline from Pennsylvania (see Why Staying Warm In Boston Will Cost You).

We’ll be watching carefully.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

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.

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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:

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

Mohamed El-Erian maintained his criticism of the Federal Reserve, with an op-ed on Monday morning (see Fed and ECB still behind the inflation curve). It’s remarkable that the ECB’s “hawkish pivot” simply resulted in a fourth quarter tightening no longer being off the table. The Fed meanwhile moves ahead in their predictable fashion even while their predictions about inflation are wrong.

It’s easy to criticize the Fed’s delinquent normalization of policy, but also worth acknowledging that they have engineered a booming economy with full employment, rising asset prices and unmet demand for almost everything. It seems churlish to complain about inflation under such circumstances – given the labor market, many workers can simply demand higher pay to compensate for rising prices.

Last Friday’s employment report showed that’s roughly happening – average hourly earnings for all employees rose 5.7% over the past twelve months. A week earlier, the Employment Cost Index (ECI), which is released quarterly, showed compensation of private industry workers rose 4.4% last year. Pay increases across groups ranged from 3.5 percent for management, professional, and related occupations to 7.1 percent for service occupations.

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CPI inflation is running at 7%. Without food and energy, it’s lower at 5.5%, but excluding these now makes little sense because everybody uses energy and eats. These two components can swing around which is why economists like to exclude them, but currently they’re going up like everything else.

Some will always find reasons to be despondent, but asset prices and employment are high while interest rates remain low. The drop in labor force participation is partly due to higher than average numbers of new retirees, enabled by swollen 401Ks and downsizing to a smaller home on better terms than they ever expected. A more popular president would be emboldened to quote Britain’s former PM Harold MacMillan, who in 1957 said his countrymen had, “never had it so good.” Hold on to this economic moment – it will one day be a fond memory.

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Economic orthodoxy dictates that we embrace the hair shirt of higher rates as penance for such good economic fortune. So we will. But the Fed will need to create a headwind to all these positives long before inflation is back down to its 2% target. It’s implausible that this will happen without short term rates moving above 2%. Being a Fed critic is satisfyingly self-indulgent, but not as useful as figuring out how to profit from their actions.

Last month in Why You Shouldn’t Expect A Return To 2% Inflation we noted the incongruity of well-contained ten year inflation expectations with a modest 2% rate cycle peak, all as derived from the bond market. The yield curve hasn’t shifted much since then – an ECI report slightly better than expected was later neutralized by the strong payroll report.

Today’s FOMC interprets its dual mandate of maximizing employment consistent with stable prices in a way that is more risk-tolerant of inflation while more desirous of seeing everyone employed. Americans’ willingness to tolerate a Fed-induced slowdown in pursuit of price stability is untested in over 30 years. Fed chair Jay Powell often says, as he did last month, “We will use our tools to support the economy and a strong labor market and to prevent higher inflation from becoming entrenched.”

For now, Biden has provided political cover for the Fed by endorsing their long-awaited policy shift. Nonetheless, it’s easy to imagine Powell’s Congressional critics once unemployment starts to rise: coping with 7% inflation is bad enough when you’re employed, but harder when you’re out of work.

We’ve been warned for decades that fiscal profligacy will lead to disaster, and so far Stephanie Kelton’s Modern Monetary Theorists are winning that debate (see Reviewing The Deficit Myth). Why is 2% inflation any more vital to our economic wellbeing than a Debt:GDP ratio below 100%? We’ve already abandoned the latter with no apparent consequence.

AOC and her squad are ready to pounce.

Esther George, President and CEO of the Kansas City Fed, gave a speech recently in which she cited research showing that the Fed’s bulging balance sheet is depressing long term bond yields by as much as 1.5%. Take away that support, and ten year treasuries would yield almost 3.5%, forecasting a rate cycle peak easily above 2%. The presence of such support limits the impact of rising short term rates on the economy, requiring an even higher cycle peak than would be the case if the Fed’s balance sheet was back at pre-2008 levels.

The actionable trade is to bet on a higher cycle peak – shorting treasury securities or eurodollar futures with a three to five year maturity is the most efficient. They should eventually price in a Fed Funds rate of 2.5-3%. If by then the economic pain is audible in Congress, tolerance of 3% long term inflation will start to look more likely than a 3% overnight rate. But one or the other is assuredly coming – and probably both. This week’s CPI report may be a catalyst.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

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).

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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.

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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.

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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:

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.