The global energy crisis is becoming the biggest investment story of 2021. US consumers are uniquely unaffected so far by spiraling prices for natural gas and coal. Crude oil continues to cause some discomfort at the White House, which regularly pleads with OPEC to offset their own policies by increasing supply. Limited export capacity for Liquified Natural Gas (LNG) is keeping a lid on domestic prices for now, but as more becomes available the huge US discount will narrow, to the benefit of domestic natural producers and the detriment of customers.

It would be wrong to blame this on Britain’s inconvenient recent loss of windpower (see The Cool North Sea Breeze Lifting US Coal). Higher prices are exposing the poorly conceived energy policies of many western governments. By pandering to climate extremists to demonize fossil fuels, the world is now coming up short of energy. High prices for natural gas are stimulating demand for coal. Even in the US, the Energy Information Administration expects the black stuff to regain market share from natural gas in power generation. A decade of reduced emissions due mostly to cheap natural gas is being reversed because of a shift in relative pricing. The Biden administration is likely to find itself explaining why US CO2 emissions are approaching pre-Covid levels by next year’s midterms (see Emissions To Rise Under Democrats).

In February last year, there was a period of a couple of weeks when Covid became the major news story in Asia and Italy but hadn’t yet reached America. It felt like waiting for a distant tsunami to reach our shores. The global energy crisis feels eerily similar. Other than a mild rise in prices at the pump, it hasn’t drawn much media attention.

By contrast, with European natural gas prices up roughly six-fold, politicians are scrambling to deal with the fallout. France plans to cap utility bills, providing what French PM called a “tariffs shield.” Governments across Europe will spend tens of €BNs over the next several months.

China’s Vice Premier Han Zheng reportedly told state-owned energy companies to secure supplies so as to ensure continued power supply “at all costs.” Such a directive will concentrate minds among those receiving the directive – the consequence of failure is likely to be more than just a smaller year-end bonus.

China’s highly motivated coal buyers are competing with many other countries. Over half of India’s power plants are down to fuel stocks (mostly coal) of under three days, well short of the two-week government minimum. A German power plant recently shut down because it ran out of coal.

The scramble is all about acquiring fossil fuels, because they’re reliable. There’s no evidence of a scramble to obtain more solar or windpower. The managers of China’s power supply mandated to ensure reliability are not rushing to buy windmills.

The public policy error committed in many countries including the US has been to pander to climate extremists while disingenuously pretending that transitioning to low carbon energy can be done without disruption or enormous expense. The EU has a form of carbon tax via a cap and trade system, but it’s clearly not onerous enough to affect demand. Instead of fossil fuels generating increased taxes that European governments could redeploy into renewables, they’re going to be heavily subsidizing coal and natural gas use by capping homeowners’ utility bills.

Since no politician has hailed high energy prices as a successful consequence of policies to advance the energy transition, government leaders have concluded that public concern about global warming doesn’t imply a willingness to spend much.

There hasn’t been much serious thought given to the transition. It’s being handled disastrously. Tiresome Greta Thunberg (listen to Greta’s Grandstanding), who admonished the world for jeopardizing her future (“How dare you”) is what passes for climate strategy.

The result is that higher energy prices are headed to the US too.

This will be good for energy investors, but will also challenge the Fed’s belief that elevated inflation will be coming down. Energy prices will feed through to the general price level. German inflation reached a 29-year high of 4.1% in September, and across the eurozone it reached a 13-year high of 3.4%. German workers at a motorhome manufacturer are striking for more pay. The country’s biggest union, IG Metall, is demanding 4.5% pay hikes because “Inflation in Germany keeps going up”.

The Fed believes short term logistical challenges are impeding the supply of goods, and as these are resolved price pressures will recede. They ought to consider whether the 25% of GDP that the IMF calculates the US government has provided because of Covid might be the real issue, along with the Fed’s monetization of much of the debt that was issued as a result.

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

Energy Mutual Fund Energy ETF Inflation Fund

 

A feature of renewables not widely acknowledged is their relatively low capacity utilization. Solar is limited to daytime, with peak generation around midday. Output is typically 20-25% of capacity, meaning a 10 MW solar farm would generate 48-60MWh every 24 hours. The UK’s windpower capacity utilization was 37% last year, higher than is typical. As the chart shows, it bounces around unpredictably.

Offshore wind tends to produce more often than onshore, which is why the UK has been adding installations in the windy North Sea. The recent tranquility has cut wind to 7% of UK power generation, from 24% last year, likely bringing capacity utilization down to 10-11%. The sheep in the photo have evidently learned that windmills can offer relief from the sun at least as often as they produce electricity. It’s true the tower is stationary, but careful examination of the photo also reveals sheep standing in the shadow of the (presumably motionless) blades.

Three years ago efforts to develop fracking of natural gas in Britain were abandoned following relentless pressure from environmental extremists (see British Shale Revolution Crushed: America’s Unique Ownership of Oil and Gas). The UK’s Lord Ridley, a member of the House of Lords, warned that Russia was funding the opposition to these efforts to reduce Britain’s reliance on imported energy. NATO’s secretary general had voiced similar concerns as far back as 2014.

Ridley recently referred to Friends of the Earth, a vocal opponent of fracking in the UK, as “useful idiots” during a radio interview. They shared Russia’s objective of crushing domestic gas production, albeit for different reasons. Now the IEA is calling for Russia to increase such exports to Europe. Russian funding of western environmental opposition to natural gas production has delivered Russia an astronomical IRR, about to be paid for by European governments forced to subsidize household energy bills.

The energy squeeze confronting western Europe is coming at a time when energy demand is usually low. Cooler weather as summer ends is when natural gas supplies are typically built up in preparation for winter. For reasons that include mysteriously low Gazprom exports and a Brazilian drought that has lowered hydropower, global natural gas prices are soaring.

Analysts are warning that Europe faces a real possibility of power cuts if unusually cold weather exposes low gas inventories. Compounding matters, Gazprom CEO Alexey Miller recently said that, “… the Asian market is more attractive for producers and investors despite the record-breaking prices in Europe.”

Asian and European natural gas prices have risen together, with Asian buyers especially keen to avoid a repeat of last January’s winter squeeze. As a result, they are often outbidding European buyers for shipments of liquified natural gas.

European governments are being forced to respond to sharply higher household electricity bills and bankruptcy risk among electricity providers. An Italian government source said, “a plausible amount to tackle the issue [of soaring energy costs] could reach up to €4.5bn.” U.K. Business Secretary Kwasi Kwarteng warned that the country faces a “long, difficult” winter with high energy prices tipping power suppliers into bankruptcy.

So far the UK is not planning to bail out power suppliers that fail, and PM Johnson has refused to scrap “green levies” on power bills even though they’ve helped cause the problem by subsidizing windpower investments.

Since the energy transition is all about new technologies, policymakers need to look beyond intermittent sources of energy. Direct Air Capture of CO2 is another example of what might be possible while allowing reliable electricity generation to continue.

On a different topic, my wife and I were disappointed to find downtown Minneapolis almost deserted on a recent Sunday lunchtime, still reeling from the twin blows of Covid lockdowns and violent protests following George Floyd’s murder. Nicollet is described as “downtown’s core shopping and entertainment artery” on the city’s hopelessly out of date website.

I posed next to the Mary Tyler Moore statue watched by two bored cops and no one else.  A 20 minute drive north, a local strip mall had lost all its tenants except for a Dollar Tree. Afterwards we headed to Duluth, on Lake Superior, which was more vibrant.

We went to Minnesota to visit my wife’s penpal of 45 years, a relationship that began when they were both in middle school. Their friendship through writing predates our own. They had shared life’s events via air-mail letters and birthday cards, retaining this medium even when email because ubiquitous, but had never met until now. Over several very agreeable hours we became friends with a warm and friendly family, typical of the midwest. Our next meeting won’t take as long.

Anyone who’s visited Felixstowe on England’s windy east coast knows that umbrellas enjoy a brief existence in offering protection from the rain. Farther north off the coast of Scotland, the North Sea is one of earth’s most hostile places to drill for oil. Gales are common. Working an oil rig isn’t for the nervous.

Consequently, the North Sea is an obvious location for windfarms. Last year Britain obtained almost a quarter of its electricity from wind, a key element in the country’s drive to reduce CO2 emissions. But even the North Sea isn’t always windy, and a recent period of relative tranquility has caused havoc to European markets for electricity.

Renewables clearly have their place, but the problem of their intermittency increases with their share of power generation. They’re also non-diversified – ten gas-burning power plants operate independently with downtime at one unlikely to affect the others. But if it’s not sunny or windy, a region’s entire renewables supply can be rendered inoperative. One indicator of a grid overly reliant on unreliable power is sharp spikes in electricity prices.

Wholesale electricity prices one day ahead (in effect, the spot market) soared to €331 per Megawatt Hour (MWh) in the UK recently. It’s priced in Euros not Sterling because the UK grid sometimes imports electricity from France or the Netherlands. Britain had to restart gas and coal burning power plants, including one in Nottinghamshire that will be permanently closed by 2024 when the government has committed to phase out coal completely.

There was a ripple effect into European markets. But there are reasons to think this recent price spike is not just a temporary result of unusually calm North Sea weather. In Germany, one year ahead baseload power prices continued their ascent and reached a new thirteen-year high.

German household electricity prices are already the world’s highest, more than double the US and four times China. There are a couple of lessons here – the first is that western societies will clearly tolerate much higher energy prices than we have in the US. Environmental extremists continue to disingenuously promote renewables as cheaper than conventional power. But the biggest users, such as Germany or California, have the highest prices.

The second lesson is that it’s implausible for China to wish to emulate OECD countries’ electricity cost structure. Their commitments on emissions reductions aren’t credible. Progressive Democrats seem to think that with solar and wind the US can alter the climate alone and lower prices. Instead, they should be honestly promoting much higher energy prices as easily affordable and worth paying for. They should also be advocating to confront China on its hollow CO2 commitments.

Less wind in Europe has boosted demand for natural gas, including imports of Liquified Natural Gas (LNG) from the US (see The Bull Market in Natural Gas). This has pushed up domestic natural gas prices to such an extent that the US Energy Information Administration expects gas to provide 35% of power generation this year and 34% in 2022, down from 39% last year.

Coal-to-gas switching has been the biggest source of reduced US emissions over the past fifteen years. Although solar panels and windmills get all the attention, actual progress has come about through increased use of natural gas. The Shale Revolution may not have delivered promised investment returns, but the abundant and cheap natural gas that resulted have driven our CO2 emissions down.

This positive development came about through relative pricing — cheap natural gas caused utilities to use more of it versus relatively higher-priced coal. Today’s increased natural gas prices are causing this positive development to reverse. The good news is that the US has enormous supplies of natural gas that can be profitable below $3 per MMBTU, compared with current prices of over $5.

US coal production has been in steady decline for over a decade. Connected global energy markets have created a link between a windless North Sea and increased US coal demand.

OPEC also revised up their forecast for 2022 global crude oil demand, which they now expect to eclipse the 2019 pre-Covid level of 100.3 Million Barrels per Day. It’s more proof that the world will use more of all energy sources in the years to come.

Last week the northeast US suffered 52 deaths as Hurricane Ida (by then a tropical storm) dumped up to ten inches of rain in just a few hours. Cranford, NJ on the Rahway River is prone to flooding. It’s a couple of miles from Westfield, GHQ for SL Advisors, and it seems like every decade or so hundreds of basements are flooded in those homes close to the river. Garwood is another small neighboring town and source of the striking photos below.  

Seemingly unrelated to the heartbreaking losses caused by Ida, journalist John Kemp noted China’s continued reliance on coal for power generation, which has experienced a Compound Annual Growth Rate (CAGR) of 5% over the past two years. Since Covid caused a drop last year, this highlights the strong underlying trend. Coal futures on the Zhengzhou Commodity Exchange recently traded at $150 per tonne, compared with $85 a year ago. The market is signaling more demand for coal.

Apologists for China herald the 25% CAGR for wind power over this time, and 24% for solar. Hydro output dropped slightly. Don’t be fooled. Thermal power, which is mostly coal since China burns half the world’s output, still provides 72% of China’s electricity as was the case two years ago. Thermal power also met 72% of the increase in demand, hence its static share of the total.

This is why China generates 28% of global CO2 emissions. It plans to continue increasing at least through 2030 before reversing course on an improbable path to zero by 2060 (see Is China Worried About Global Warming?).

Here’s why China’s power output is linked to flooded towns in New Jersey. Ads for solar panels are everywhere, because of generous state and Federal subsidies. As a result, New Jersey electricity customers have so far paid $3BN in higher fees to help pay for solar installations. Future tax breaks for solar are expected to add $800 million annually to utility customers’ bills, rising to $1.4BN by 2030.

Hurricane Ida may or may not be a consequence of climate change. The media interprets every weather fluctuation as caused by global warming. The UN’s report earlier this summer warned of more extreme weather events but attributing any single event to the one degree Celsius increase since the 1850s is impossible.

Nonetheless, if you’re pumping water from your Cranford basement, as you do every decade or so, proliferating subsidized solar panels aren’t much use. Living in a solidly blue state, you’re probably convinced that global warming will cause even more frequent flooding. Having long ago rejected the wholly sensible idea of moving to higher ground, you might like those solar panel subsidies redirected towards improved infrastructure to stop the Rahway River from bursting its banks. Users of the New York City subway would favor mitigation of the sudden indoor waterfalls we saw on news reports and social media.

The widely reported efforts by rich countries to blanket the landscape with solar panels and windmills aren’t having any noticeable impact on global CO2 emissions. Implementation carries local costs while any benefits are shared globally. Californians can feel good about their efforts to shut down natural gas plants, even though it results in more expensive and less reliable electricity. They still get forest fires. New Yorkers may support constraints on new natural gas connections. The subway still had to shut down because of flooding.

We may already be experiencing the climate changing effects of a warmer planet. If so, at some point there’s a valid choice between prevention and adaptation. None of us can control the planet’s CO2 levels. But every community can fortify itself again extreme weather events. The quest to lower emissions is a global social undertaking that relies on widespread participation. It requires community spirit on a worldwide scale. The free-rider problem is likely fatal to success. China is only the most visible emerging economy exploiting this – the world’s biggest producer of solar panels, which it sells to dozens of countries, is also the #1 consumer of coal and generates over a quarter of global CO2 emissions.

The energy transition has lots of momentum. Shifting from coal to natural gas remains the world’s most assured path to reduced emissions. Nonetheless, China’s increase in wind and solar only met 25% of the additional demand for power since 2019. The desire of rich countries to lower emissions remains in conflict with emerging economies’ intention to raise living standards by using more energy.

This misalignment of interests means that eventually a sea wall will be more useful than a windmill. That time is coming.

This week the Fed is holding their annual Jackson Hole symposium – although it will be virtual again because of the Delta variant. Media coverage has built expectations of a sharp internal debate around tapering. The recent minutes show some in favor of reducing the Fed’s bond buying program this year. Boston Fed president Eric Rosengren noted the futility of using low rates to stimulate interest rate sensitive sectors such as housing when demand is already strong (listen to our recent podcast Episode 80: Tapering Draws Closer).

Since former Fed chair Ben Bernanke showed the world in 2008 that Quantitative Easing (QE) could be done safely, the Fed has been a buyer of US treasuries almost all the time. Their balance sheet only shrunk for a year beginning in May 2018 and began growing sharply again early last year in response to Covid.

Bernanke’s original initiation of QE was criticized at the time as likely to cause inflation. He was correct that it wouldn’t, recognizing that Wall Street’s frozen plumbing needed extraordinary help. Once the crisis passed the FOMC struggled to extricate itself from the bond buying program. The 2013 “taper tantrum” when bonds slumped on fears of QE ending continues to hover over today’s FOMC deliberations.

It should be clear that the need for QE is long gone – not least because this time around inflation has surged. Most obviously the $40BN per month of mortgage-backed securities purchases should cease since the housing market is hardly short of demand.

Even when tapering begins it will only slow the Fed’s balance sheet growth, since they’ll still be buying bonds albeit at a slower rate. QE is now part of the Fed’s toolkit, to be used whenever accommodative policy is needed. A decade passed since the 2008-09 Great Financial Crisis before any meaningful reduction in the Fed’s balance sheet occurred.

The Fed’s original exit strategy was to let holdings mature and not replace them. This time around their holdings will likely flatten out around $9TN, 2X the peak from the earlier crisis. It’s hard to imagine the Fed moving to actually sell bonds, so allowing the portfolio to run off remains the most likely outcome, as before.

It’s a good bet that the next crisis will hit before any meaningful reduction in this $9TN balance sheet. The bar has been lowered. QE is being justified in part to promote job creation, part of the Fed’s twin mandate of achieving full employment with stable prices. If a bear market in bonds threatened the economy, it’s likely the Fed would see fit to step in and assure an orderly market. If our foreign creditors sold US treasuries, either for geopolitical reasons or out of frustration with our profligate fiscal policy, the Fed would scoop those up too.

The Fed is now and probably always will be the biggest buyer of US government debt. Their $8.3TN balance sheet includes $5.3TN of US treasuries, almost a quarter of all publicly held US debt. The Fed’s now permanent holding of US treasuries is debt monetization. Only three quarters of the government’s borrowing is being met by a combination of domestic and foreign savings. QE was originally intended as a temporary measure in extraordinary times, but it’s become business as usual. The Fed is enabling The Magic Money Tree (see Modern Monetary Theory Goes Mainstream).

Rep. Alexandria Ocasio-Cortez, a fan of government solutions for everything, said in 2019 that MMT needed to be, “a larger part of our conversation.” AOC and her progressive wing of the Democrats are not on the side of investors.

Our fiscal path virtually guarantees continued growth in the Fed’s balance sheet. Publicly held debt:GDP crossed 100% because of Covid and is on track to double over the next thirty years. This is based on figures from the non-partisan Congressional Budget Office, which doesn’t assume recent uber-profligacy will become endemic. It’s hard to see how The Fed will reduce its holdings when the CBO expects debt to increase annually at $1TN or more for the next thirty years.

This is why inflation is inevitable. QE has morphed into debt monetization, enabling ever larger deficits even while our fiscal outlook is poised to soar beyond past extremes. Bonds have been emasculated of their ability to warn of such excess, because the Fed stands ready to provide support whenever needed.

It’s never been more important to invest with regard to maintaining purchasing power – which means staying well ahead of inflation (see Why It’s No Longer Enough To Beat Inflation).

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

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

Energy Mutual Fund Energy ETF Inflation Fund