Happy Covid Freedom Day (Almost)

Last week a friend called to wish me Happy Independence Day. He added “Down with the British” in recognition of my immigrant status. My accent betrays my British childhood, even though I moved here in 1982. July 4th barbecues usually provoke a few joking reminders about beating the British. The obvious response is that had the War of Independence instead been the defeat of the colonial uprising, there would have been little reason for me to emigrate from the UK some two centuries later.

It is typically American that the descendants of that war’s losing side are so readily welcomed, especially on the anniversary of its kick-off.

While the U.S. will fall short of its goal to give at least one dose of Covid vaccine to 70% of adults, we can still celebrate that life is almost back to normal. After a stuttering start, once America took on Covid we were going to win. America always wins. As Churchill once said, “You can always count on the Americans to do the right thing after they have tried everything else.”

The fact that international travel is virtually impossible is a reminder that while Covid may be over in this country, it remains a dominant feature of everyday life in many others. Much as I would have loved to travel to London and watch England beat Germany at Wembley last week, testing and self-quarantine requirements made it impractical.

The economic consequences of Covid are still with us. The Fed’s full-on monetary stimulus and bond buying are barely different from a year ago even though the economy has come roaring back. Friday’s payroll showed another 850K jobs added and the unemployment rate only edged up because more people are being drawn back into the workforce. 1.6 million people report the pandemic is preventing them from looking from work, down from 2.5 million a month ago. The question hardly needs asking any longer, and the end of Federal unemployment benefits will help.

Nonetheless eurodollar futures prices rose, reflecting slightly lower tightening probabilities.

OPEC fears a crude surplus by the end of 2022, which is complicating their discussions to continue phasing out the supply cuts they implemented in May of last year. They’re evidently not too concerned about high oil prices weakening demand. By contrast, the Fed remains at full throttle, providing ever more stimulus.

Finally, for those enjoying the Euro 2020 football tournament, the photo reminds that the game doesn’t only produce moments of brilliance.

Happy Independence Day.

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

Federal Reserve Housing Support Has Run Its Course

The red-hot housing market is a topic of cocktail conversations, at least among those comfortable to take that step back to normalcy. The S&P/Case-Shiller U.S. National Home Price Index (C-S) sports a 14.6% year-on-year increase through April. Residential real estate benefits from numerous sources of government support. Property taxes are tax-deductible up to $10K (although in NY and NJ the benefit is derisory because taxes can be 2-3% of a home’s value). Mortgage interest is also tax deductible, and the Federal government underwrites the credit risk of conforming mortgages which lowers their interest rate. Add to that the $40BN in monthly MBS purchases, part of the $120BN in long term bonds the Fed is buying which acts to further depress rates. So on top of the various tax subsidies and guarantees, the Federal government is lending almost half a trillion dollars a year to home buyers. It’s no wonder home prices are rising.

The Fed measures housing inflation by relying on a survey by the Bureau of Labor Statistics on what monthly rent homeowners think their home could command if rented. It’s safe to say that Owners Equivalent Rent (OER) is not the subject of the abovementioned excited cocktail chatter because it’s a theoretical concept – the only element of the inflation statistics not derived from actual transactions. Its weaknesses are well documented and we won’t belabor them here (for more detail, see Why You Can’t Trust Reported Inflation Numbers). Suffice it to say that OER doesn’t reflect the cost of housing for the two thirds of households who choose to own their home. The S&P/Case-Shiller U.S. National Home Price Index has risen at an annual rate of 4.4% over the past two decades, versus 2.6% for OER. The Fed’s use of OER means it has persistently ignored inflation in the biggest expense households face.

Although the FOMC is more in thrall to progressives than bond vigilantes nowadays, their full-on spiking of the punch bowl is making some increasingly uneasy. Boston Federal Reserve Bank president Eric Rosengren is worried that a housing “boom and bust cycle” will threaten financial stability. It’s hard to find any serious support for the Fed’s continued buying of MBS in the financial community. Even the liberal wing of the Democrat party must conclude that few beneficiaries of housing inflation are likely to be found among their core supporters.

The continued strong housing market speaks to the imminent conclusion of at least this element of the Fed’s $120BN monthly bond buying. Expect the FOMC to curtail it during the third quarter, as a growing chorus of economists and investors warns of another housing bubble. Eurodollar futures priced in earlier monetary tightening following Powell’s press conference a couple of weeks ago, so that the yield curve now more closely resembles the forecasts from St. Louis Fed president James Bullard than Jay Powell (see The Fed, Thinking Fast Or Slow). But there’s still more downside price risk than upside for futures.

Switching to energy markets, those of us outside California will appreciate this priceless headline:  California Asks Residents to Avoid Charging Electric Cars Amid Power Grid Strain. The Golden state is pursuing altruistic energy policies – swearing off everything but solar and wind, yet unable to provide reliable power. One problem is they’re ahead of most of the world in shifting as quickly as possible to largely renewable power (2018 was 34%). Global greenhouse gas emissions continue to rise, mostly due to rising living standards and energy consumption in developing countries. To the extent that climate change is responsible for the heatwave across western states, Californians are enduring both the results of global warming and the costs of mitigation without any visible benefit.

Of course renewables aren’t directly responsible for California’s power shortages, although had they redirected solar and wind investments to modernizing their existing grid and boosting conventional power sources they’d be in a better place.

The energy transition is a multi-generational marathon. It’s not an endeavor that lends itself to a declaration of victory, although defeat will be recognizable. This will be a problem for politicians, but it’ll be interesting to see how enduring popular support is to phase out fossil fuels in California and elsewhere. The effort will need to last decades while the connection with changing weather will remain tenuous. Few other states will see much to emulate in their approach.

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

The Fed, Thinking Fast Or Slow

Interest rate markets became a lot more interesting this year. Uncertainty around inflation and the Fed’s likely response are creating undulations in the yield curve whose precise forecasts are sometimes a trading opportunity.

For example, late last year the spread between the December ‘21 and December ‘22 eurodollar futures contracts was around 5bps. Since the Fed typically moves its policy rate in 25bp increments, this projected a one in five probability of one tightening in 2022. This turned out to be too low. A rebounding economy combined with profligate fiscal stimulus has led to upward revisions to growth and inflation this year.

The FOMC’s Summary of Economic Projections (SEP) showed that FOMC members had brought forward their estimated timing of higher rates. By early June the spread was at 20, showing an 80% of a 2022 year-end tightening. Six months ago, taking the one in five odds by buying the spread (long December ‘21 and short December ‘22) was a good bet.

A week ago, following the June FOMC meeting, St. Louis Fed president James Bullard revealed that he is forecasting a 2022 tightening. He is one of seven (out of 18) FOMC members with that view, two of whom expect two tightenings. So we know where Bullard’s blue dot sits. Our eurodollar spread moved further, and now sits around 34 where it is priced for at least one tightening by the end of next year and around a 40% chance of a second.

Imagine sitting down with FOMC members while they tell you whether eurodollar futures are correctly priced or not. Were James Bullard to visit SL Advisors’ GHQ and enter into such a conversation, he would likely endorse the market’s pricing. Getting here was the Bullard trade. He favors a faster pace of tightening than some other FOMC members.

The slow, or dovish camp is led by Fed chair Jay Powell. 11 of the 18 FOMC members expect no tightening next year. If Powell accepts this invitation to visit SL Advisors and discuss eurodollar futures, he would say that the market is wrong. He goes to great lengths to downplay the significance of the blue dots in the SEP.

Powell regularly reminds us that the unemployment rate in February 2020 just before Covid was 3.5%, so today’s 5.8% suggests we remain far from full employment. We’re still over 7 million jobs short of where we were, and Powell wants to give those people every opportunity to return to the labor force. He expects inflation to moderate from its temporarily high level and sees little likelihood of the Fed having to hike rates next year. The market is currently skeptical of this view.

The Bullard view is currently in the ascendancy. He favors a faster path to higher rates, which by moving earlier in the economic cycle suggests less need for tightening later on. Eurodollar futures more closely reflect this outcome. Fed chair Powell may be among the majority of FOMC members, but financial markets disagree. What always makes such contrasts especially fascinating is that futures prices are telling the FOMC they disagree with their forecast. It would be bold of a bond manager to tell the Fed chair’s he’s dead wrong, but the market’s collective estimate is doing just that.

By 2023 most FOMC members expect higher rates, but there are still five who forecast no hike and two looking for just one. Powell is likely in one of these two groups – it therefore must be galling to have watched the December 2023 eurodollar futures yield climb almost 30bps from where it was prior to their meeting. At 1.15% it’s pricing in 3-4 tightenings, whereas Powell is likely expecting only one. He must think December ‘23 futures are cheap.

Powell might be right, and certainly has more influence over the outcome than most others. His term as Fed chair ends in February, but if he’s not reappointed an equally dovish replacement is likely. The bond market is no longer as powerful as when Clinton’s campaign manager Jim Carville said he’d like to be reincarnated, “…as the bond market. You can intimidate everybody.”

What this means is that while we’ve had the Bullard trade, the Powell trade is possible. This is where markets price in a more delayed tightening, meaning more later on. Looking farther out on the curve, the spread between the December ‘23 and December ‘24 eurodollar futures in forecasting less than two tightenings in 2024. The FOMC has a longer term, equilibrium rate of 2.5%, although eurodollar futures don’t forecast we’ll reach this level within even five years.

Markets expect the Fed to start tightening by 2023. It seems implausible that, once in motion, the Fed will move less than at least once per year. The Dec ‘23/Dec ‘24 spread has narrowed almost 25bps from its widest levels, mostly because the Dec ‘23 has moved farther from the FOMC. The Powell trade would be to buy this contract and sell Dec ‘24, betting on delayed tightening but ultimately two or more annually. At 43, it’s not yet a compelling opportunity but is worth watching in case it narrows a little more.

Eurodollar futures currently offer a rich source of information, and the occasional trading opportunity, by comparing market forecasts with those of the FOMC.

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

Carbon Capture Gains Momentum

Recently Pembina and TC Energy announced a joint venture for Carbon Capture and Sequestration (CCS), aimed at CO2 emissions generated from Canada’s tar sands oil extraction activities. Canada has an ambivalent stance on climate change policies. Like all signatories to the Paris Accord, they claim to have set aggressive targets for emissions reductions. Canada also has a carbon tax, a sensible measure to place a price on emissions that has little support in the US.

But Canadians also have one of the highest per capita rates of energy consumption in the world – almost a third higher than Americans, who are often regarded as the world’s energy gluttons. A Canadian’s emissions are about the same as an American’s, because of their greater access to hydropower. But Canada’s emissions have been stable, not falling as in the US where coal to natural gas switching has been the main source of reductions in the past decade. 2020 emissions fell everywhere because of lockdowns, but are rebounding.

Part of Canada’s struggle with emissions is a result of its long winters. But tar sands oil production is another. This is an energy-intensive process that involves heating bitumen with natural gas to separate out the crude oil. It’s fair to say that Albertan energy workers are less concerned about climate change than their liberal neighbors in Ontario and Quebec, even though western Canada supplies eastern provinces and generates substantial tax revenues.

Images of tar sands production facilities were sufficiently emotive to sustain extremist opposition to the proposed Keystone XL pipeline for a decade, until Biden finally killed it off last month.

Canada will continue to produce oil from tar sands, even though transportation to market has become a chronic problem. Its crude will move by rail, instead of cheaper and safer pipelines. But the Canadians recognize they have an image problem, hence the recent announcement on carbon capture.

The Alberta Carbon Grid (ACG) will initially capture CO2 generated from the extraction of crude from tar sands. But there are also plans to connect with areas of industry elsewhere in the province and to power plants as well. It will use existing oil pipelines that will be retrofitted to transport CO2, and will add new infrastructure on to it.

Estimates are that the initial system will capture and sequester underground 60-80,000 metric tonnes (hereafter “tons”) of CO2 daily. One advantage of Canada’s cool climate is that it’s easier to inject the CO2 underground into porous rock when daytime summer highs are typically in the 60s. The JV has identified an underground reservoir near Saskatchewan with capacity to eventually store over 2 Gigatons of CO2, which will take several decades to fill.

The projected annual volumes equate to around 4% of Canada’s total 2019 CO2 emissions of 730 tons, which seems quite impressive for a single project. By contrast, Exxon Mobil’s planned CCS in Texas is projected to sequester 50 million tons annually beneath the Gulf of Mexico. This is 60% bigger than the ACG but less than 1% of US 2019 emissions.

CCS is drawing more attention. Its appeal to the fossil fuel industry is that it offers a way to continue today’s energy mix while reducing emissions. Climate extremists oppose such thinking because they’re passionate about a world of solar panels and windmills. But when you work through the math, the cost of capturing all the CO2 emitted from the combustion of natural gas is not an insurmountable figure. Its implementation is also much more plausible than carpeting the landscape with intermittent renewables along with the extensive high voltage power lines required to move it from rural areas to population centers. Massachusetts can’t even buy hydro-electric power from Quebec because New Hampshire won’t allow the necessary power lines to be built in their state.

The tax code already pays a $50 per ton credit for permanently sequestered CO2. The Clean Air Task force thinks it should be higher, and has estimated the cost of capturing CO2 from different sources – ranging from as little as $39 per ton for CO2 produced in gas processing to $100 per ton in cement production. Industrial emissions with more concentrated CO2 allow for cheaper separation of the CO2.

The table shows that even at a substantially higher cost of $150 per ton, the CO2 emitted from burning natural gas could be captured with an increase in our overall energy spend of less than 20%. A new CCS industry would create jobs just as the president promises ramping up renewables would. Anyone truly worried about global warming and not simply proselytizing for renewables would surely embrace this as worth the cost.

The energy transition is about economics, not technology. The solutions are mostly known. Costs can be reduced through scale and innovation continues, but it’s about society’s willingness to pay for the cost. The point of the table is not to try and persuade climate extremists, but to show that substantial emissions reductions are possible without our power supply failing us when most needed, as in California for example.

Today’s energy companies have a lot riding on the outcome, which is why CCS is gaining more attention. As their solutions become more visible, the sector will continue its recovery.

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

Fed Hikes Inflation Outlook By 1%

Fed chair Jay Powell appeared slightly less confident at Wednesday’s press conference. He acknowledged that their forecast of temporarily higher inflation might be wrong, and it was hard to say when it would moderate. He repeated his warning that, “forecasters have much to be humble about.”

This humility must apply to the Fed. One of the most striking updates in the Summary of Economic Projections was the FOMC’s upward revision to 2021 inflation, from 2% in March to 3% now. In his March press conference, Powell spoke about upward price pressures over the near term but assured there would be only “transient effects on inflation.”

Clearly FOMC members were surprised by the inflation reports since then, hence the sharp upward revision. They’re not good at forecasting — certainly no better than a below average private economist. But FOMC forecasts matter because monetary policy and the ongoing debt monetization are managed with reference to those forecasts of moderating inflation.

Powell often downplays the dot plots even while the media examines them in detail for comparison with interest rate futures. Seven out of 18 FOMC members expect at least one rate hike next year, up from four in March. The median of their 2023 forecasts is for two hikes, up from zero in March. Interestingly, the forecast ranges for inflation (2.0-2.2%) and unemployment (3.2-3.8%) for 2023 are both unchanged. Taken together, it looks as if the FOMC is slightly less comfortable with waiting for full employment before lift-off.

Prices for 2023 eurodollar futures adjusted down following the press conference, and now more closely reflect this new interest rate forecast.  Three month Libor currently sits within the policy rate range, but when the Fed starts raising rates money market rates will probably build in a positive spread. The risk remains asymmetric but following last week’s jump in yields the compelling risk/return on shorting has gone.

If the FOMC’s more hawkish rate outlook with an unchanged economic outlook means they’re embracing a modicum of humility, this is a positive development. It means the long overdue ending of the $120BN in monthly bond purchases is within sight.

Inflation is far from a purely US problem. Central banks in Russia, Turkey and Brazil have all raised rates in recent weeks. Norway’s central bank expects to raise rates by 1% over the next year. The UK is experiencing higher than expected inflation, and is engaged in a similar debate about how transitory it’s likely to be.

The irony is that the US is dropping most Covid restrictions earlier than almost any other country, has the most accommodative monetary and fiscal policy and the fastest GDP growth.  Jay Powell referenced inflation 16 times in his prepared remarks and employment 15 times, a carefully calibrated balance that was probably no accident. He still sounded quite dovish, prioritizing getting everyone who wants a job into one over keeping inflation at 2%. He believes inflation expectations remain, “broadly consistent with our longer-run inflation goal of 2%.”

But the forecast of earlier tightening embedded in the dot plot shored up Powell’s message. Inflation expectations, which had modestly declined over the past month, fell another 4bps. On Friday, Federal Reserve Bank of St. Louis President James Bullard said inflation was stronger than anticipated. I suspect Fed chair Powell is more dovish than the median on the FOMC.

We’ve noticed that eurodollar futures and inflation-sensitive stocks such as the energy sector have developed a changed relationship. This year yields rose with commodities, pulling pipelines along with them. But the positive correlation between interest rates and energy is showing signs of evolving into a more complimentary relationship. Over the past month prior to Wednesday, pipeline stocks rallied strongly at the same time as eurodollar yields fell, reflecting declining expectations of 2023 tightening. Following Powell’s press conference eurodollar yields moved sharply higher. James Bullard gave them a further push on Friday. The market is adjusting to a slightly more hawkish Fed and consequently moderating inflation fears. Commodities and energy fell as a result.

The Fed’s posture of extreme monetary stimulus synchronized with profligate fiscal support raised inflation fears. A step back from that has moderated such concerns. It may be that rates and energy will adopt more of a yin and yang relationship, although in our view both are likely to be higher a year from now.

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

Swiss Reject California Living

On Sunday, Swiss voters narrowly rejected increased taxes on users of fossil fuels. The measure was promoted by the government as necessary to ensure Switzerland can meet its commitment under the Paris climate accord. Following the government’s defeat, plans to meet Switzerland’s 2030 emissions goals have been derailed.

8.5 million Swiss people emit around 0.1% of global CO2, roughly 1/300th of China, so they’re scarcely much of a problem. Switzerland already generates two thirds of its electricity from hydropwer, so although the infrastructure of modern renewables is mercifully not ubiquitous in the picturesque Alpine valleys, the Swiss can claim to be doing their bit.

But the vote does reveal the shallow support climate policies have once they come with a price tag. The energy transition should cost money because renewables are far less efficient than conventional energy. Otherwise the landscape would already be carpeted with solar panels and windmills. And there’s a good case that rich countries should be willing to spend more for cleaner energy, as a sensible risk mitigant acknowledging the possibility of future climate damage. But environmental extremists have failed to make a persuasive case. Joe Biden talks about green jobs and disingenuously glosses over costs. If it’s urgent it should be worth paying for.

The energy transition is fundamentally bad news whose enormous cost true believers in a threatened climate should loudly embrace. But the message that this generation should accept lower living standards to save tomorrow’s isn’t a reliable pathway to electoral success. Greta Thunberg hissing “How dare you” was theatre at the UN, but so far hasn’t reached too many bumper stickers for political office. Politicians are loathe to deliver bad news.

On the same day Swiss voters rejected paying to help lower emissions, managers of California’s power grid pleaded for households to conserve energy during a forecast heatwave so as to avoid power cuts to their parsimoniously supplied population. ERCOT, which runs the Texas power grid, did the same. It’s no coincidence that two states heavily reliant on renewables can’t provide enough electricity.

The Golden State has some of the most expensive power in America as well as its least reliable. Few would want to emulate their model, which is hurtling towards intermittent sun and wind  while abandoning everything else that works, including nuclear. With Californians selflessly enduring expensive electricity tenuously delivered, this relieves others of the need to emulate them — including China and India, whose growing emissions are partly accommodated by California’s altruism.

Perhaps Swiss voters don’t want to live like Californians.

Meanwhile energy demand keeps rising, driving prices higher and exacerbated by environmental extremists who press for less investment in new oil and gas production. Energy investors are grateful (see Profiting From The Efforts Of Climate Extremists).

On another topic, this week’s two-day FOMC meeting has drawn increased interest. The Fed’s aggressively accomodative monetary policy, which includes buying over half the government’s debt issuance since Covid began, is widely criticized. Economists expect the FOMC to indicate an eventual winding down of QE. Paul Tudor Jones said he thought a failure to do so would drive investors into inflation sensitive assets such as commodities, gold and bitcoin. But he added that tapering would also hurt bonds, which sounds like a bearish stance on fixed income in either scenario.

We agree. The eurodollar December 2021 — December 2022 spread (“Dec red Dec”) at under 20 reflects around a 75% chance of a 1Q23 tightening. That isn’t far from consensus, which means it doesn’t provide any premium for the possibility markets conclude the Fed has overdone the debt monetization. Taking the opposite side of this trade is like selling under-priced put options on the Fed’s reputation for accurate forecasting. The Dec red Dec spread should be wider.

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

Global Natural Gas Demand Is Rising

This past winter included some tumultuous weather events with implications for global energy markets. Winter storm Uri exposed vulnerabilities in the Texas power grid, and left millions without heat during an unusually cold snap (see Why Texas Lost Power). All power sources provided less than needed – some blamed the state’s excessive reliance on windmills, many of which iced up rendering them unusable. Others note that natural gas also came up short, although it was the only energy source able to increase its output.

Texas has its own power grid (overseen by the Electricity Reliability Council Of Texas, or ERCOT) which is lightly regulated. Electricity is cheap, but providers aren’t required to guarantee 100% continuous supply. The February price spike in natural gas created a windfall gain for some pipeline companies including Energy Transfer and Kinder Morgan (see Why The Energy Transition Is Hard). It was the only source of energy able to respond to price signals.

Renewables are intermittent, working best when it’s sunny and windy. Bad weather can take all solar and wind offline simultaneously. For grid managers this is analogous to owning a portfolio of investments that provide diversification except during a big market fall, when it’s most needed. Solar panels and windmills generate power only 20-30% of the time, operating at far lower capacity than combined-cycle natural gas power plants. Reliable power means natural gas.

North east Asia also endured a surprising cold spell in January. The JKM benchmark price for Liquified Natural Gas (LNG) exceeded $20 per Million British Thermal Units (MMBTUs). US natural gas prices are remarkably stable, generally not moving too far from $3 per MMBTU.

The Asian spot LNG price rose 10% last week to $12 per MMBTU amid continued robust demand. Looking ahead to prices for January 2022, both the JKM Asian benchmark and the European TTF futures have been rising in recent months, widening the spread with the US Henry Hub benchmark. The price difference is comfortably enough to cover liquefaction, transportation and regasification of US natural gas to markets in Asia and Europe. American energy will be helping keep Asians warm this winter.

As a result, American exports of reliably cheap LNG are drawing the attention of global buyers. Tellurian (TELL) is a recent beneficiary, having signed ten-year agreements with Gunvor and Vitol to provide each with 3 million tons per annum of LNG (see Profiting From The Efforts Of Climate Extremists). These commitments have improved the odds that Tellurian will be able to finance and build the Driftwood LNG export facility in Texas.

Green energy policies are helping – TELL CEO Charif Souki has noted that European carbon taxes act as a floor on local natural gas prices by penalizing coal. TELL’s previous strategy was to sell natural gas to buyers at a price linked to the US benchmark, but foreign buyers prefer to lock in prices against their local benchmark. TELL’s recent deals have retained this spread risk for the company,

The market is taking advantage of cheap US natural gas. This helps lower emissions, both by reducing coal consumption but in some cases by providing reliable back-up for increased use of renewables. If the logic of this strategy penetrates the thinking in the Biden administration, they may start advocating for increased exports of US LNG, which could raise domestic prices.

However, building LNG export capacity is costly and time-consuming. Environmental extremists in Oregon have thrown up enough roadblocks to Pembina’s planned construction of the Jordan Cove LNG export facility that it’s unlikely to be completed. So while the arbitrage spread between US and foreign natural gas markets ought to close, physical constraints on US exports may allow it to persist for several years.

On a different note, the International Energy Agency (IEA) drew headlines last month when they published Net Zero by 2050. Director Fatih Birol said, “The pathway to net zero is narrow but still achievable. If we want to reach net zero by 2050 we do not need any more investments in new oil, gas and coal projects.” Driving up fossil fuel prices by constraining supply is a logical way to increase renewables demand, by improved relative pricing.

Last week the IEA showed how confused they are by saying that, “OPEC+ needs to open the taps to keep the world oil markets adequately supplied.” This is their recommended response to rebounding oil demand. That they are advocating for reduced long term supply but more short-term supply betrays an incoherent thought process not worth the attention they get. St. Augustine’s spirit, (“give me chastity, just not yet”) often resolves the internal conflict in switching from today’s efficient energy sources to intermittent, less efficient “green” alternatives. A more thoughtful IEA would advocate for more natural gas supply over all time frames, to reduce coal consumption and support electrification. They’re just not there yet.

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

Is The Energy Transition Inflationary?

This is an assertion made by economist Roger Bootle. Two decades ago he argued the opposite, in The Death of Inflation: Surviving and Thriving in the Zero Era. But now the founder of Capital Economics regards, “the environmental emphasis and in particular the drive towards net-zero” as the single biggest factor pushing inflation higher.

The Administration’s ready embrace of deficit spending to finance a laundry list of progressive Democrat priorities is one source of inflation. Negotiations with Congressional Republicans over an infrastructure plan appear to be stalling, which will result in another enormous round of spending approved by reconciliation so as to avoid a Senate filibuster.

Stephanie Kelton gave us the fiscal policy blueprint in The Deficit Myth (see our review here). Because the government can’t default in its own currency, any amount of spending is good until it’s inflationary. The corollary is that spending to fix everything is inadequate until it’s inflationary. This includes financing the energy transition. Democrats have embraced her ethos with enthusiasm.

In a narrow sense, inflation can be defined as price increases in excess of the utility provided. When workers received a 5% pay increase with no change in output per worker (i.e. Improved productivity), that became the 1970s definition of inflation in Britain’s union-ravaged economy. It seems straightforward when applied to labor, but prices of all kinds of goods and services rise without causing an inflationary spiral. College tuition and healthcare defy gravity, but in the past year commodity inflation has become widespread too.

Copper is an example. Goldman Sachs estimates that an electric vehicle requires five times as much copper wiring as an internal combustion engine, and a 3-megawatt wind turbine (enough to power around 800 homes) uses up to 4.7 tonnes of the metal. Electrification of everything is central to the energy transition, which has pushed copper prices to the highest in a decade. Oddly, this isn’t yet stimulating increased investment in new production, which on current trends will drop by half over the next five years.

For different reasons, crude oil prices are rising – here, the rebound from Covid is colliding with reticence among the large publicly owned energy companies to invest in new production. Because the average oil well’s output falls at 3-5% per annum through decreasing pressure, that much new output is needed annually just to maintain supply. Exxon Mobil, Chevron and Royal Dutch Shell are all likely to spend less than previously planned, which is improving market fundamentals for those unburdened with climate extremists as owners, such as OPEC and Russia (see Profiting From The Efforts Of Climate Extremists).

Although the media breathlessly forecasts imminent peak oil, demand continues to grow. The world is likely to return to its pre-Covid 100 million barrels per day level by year’s end.

The increases in copper and oil are both inflationary, even though they’re the result of opposing energy transition effects.

Inflation is rising and concern is widespread. The Fed is enabler-in-chief. They’re actively seeking higher inflation while brushing away any evidence it’s rising. Commodities are tight because of logistical issues that will be resolved; energy is volatile and should be ignored; housing inflation is measured by the quixotic approach of surveying homeowners on what they could rent their house for – a truly dumb construct unmoored from reality (see The Fed’s Narrowing Definition Of Inflation). Only an economist could love it.

Criticism is growing, including from former Federal governors. Kevin Warsh warned about The Fed’s Risky Fill-the-Punch-Bowl Strategy. Warsh notes that the Fed has bought 56% of the government debt issued since the pandemic began. They don’t even need Stephanie Kelton on the FOMC — her philosophy is already mainstream. Warsh says the Fed, “… should stop buying mortgage securities immediately. Soon after, it should slow its purchases of Treasury debt. It should not tolerate Fed-financed fiscal expansion.”

Bill Dudley, NY Fed president 2009-18, says, The Fed Is Risking a Full-Blown Recession in a recent Op-Ed. He argues that the Fed’s three criteria for raising short term rates (employment has reached its maximum sustainable level, inflation has reached 2%, and inflation is expected to remain above 2% for some time) mean they’ll be late. Dudley bluntly warned markets have underpriced the likely path of short term rates, a stinging rebuke from a former FOMC member.

The energy transition will increase prices. Where renewables are a bigger source of electricity, it’s either more expensive (Germany), prone to weather-induced disruption (Texas) or both (California). It shouldn’t need pointing out, but if renewables were cheaper than gas and coal they’d be ubiquitous and China wouldn’t be building new coal plants equal to current U.S. coal-burning capacity. Vaclav Smil, prolific author of many thoughtful books on energy and related topics, estimates that a new combined cycle gas turbine will still be 75% cheaper over its life than solar or wind (see the chapter Why Gas Turbines Are The Best Choice in his new book Numbers Don’t Lie).

Blackrock’s Larry Fink said, “If our solution is entirely just to get a green world, we’re going to have much higher inflation, because we do not have the technology to do all this, yet.” He continued, “That’s going to be a big policy issue going forward too: Are we going to be willing to accept more inflation if inflation is to accelerate our green footprint?”

The energy transition is likely to be inflationary because energy will cost more. To some degree this might be a price worth paying for sensible climate risk management, although climate extremists are purists with no regard for cost-benefit analysis. Smil’s figures suggest a full-blown rush to zero emissions might cause prices to quadruple or more. Since energy prices affect everything, the consequences will be broadly felt.

Because the Fed is monetizing a good portion of the debt used to finance government spending, this has the potential to magnify the inflationary impact of higher prices.

It’s no surprise that inflation is the topic most often raised in discussions with investors. Midstream energy infrastructure offers a potential source of protection.

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


Pipeline Rally Exposes Lagging MLP Sector

Last week the Alerian MLP and Infrastructure Total Return Index (AMZIX) finally recouped its Covid losses. MLPs have returned to where they were at the end of 2019, when few knew what a coronavirus or N95 mask was. MLP investors have had a miserable decade. The Shale revolution turned out to be an investment bust through overinvestment; the energy transition cast a growing shadow over terminal values; finally, Covid hit demand. As if this wasn’t bad enough, MLP closed end funds endured what leverage and a big market drop inflict (see MLP Closed End Funds – Masters Of Value Destruction).

Although MLP investors can celebrate finally recouping their Covid losses, North American pipelines (which are mostly corporations, not MLPs) reached this threshold three months earlier. Energy is experiencing one of the least celebrated rallies of any sector in recent memory. Few investors will forget the breathtaking drop of March 2020, which at one point registered down almost 60% for the year. Although no pipeline company ever looked remotely close to bankruptcy, it seemed as if a recovery would take years.  

The rebound has turned out to be more rapid than many expected. It’s taken a year, but fund flows have now turned positive. These are still not meme stocks so caution prevails. But the growing free cash flow story is drawing more interest. The energy transition is driving oil and gas prices higher as well as limiting growth capex. Several firms are exploring opportunities in Carbon Capture and Sequestration (CCS). Gathering the CO2 where it’s produced by power plants or the manufacture of steel and cement may offer new opportunities. The tax code will soon pay $50 per ton for CO2 permanently buried underground. Pipeline operators possess many of the required skills and some useful infrastructure.  

Moreover, green policies are helping (see Profiting From The Efforts Of Climate Extremists). While Exxon Mobil, Chevron and Royal Dutch Shell all received clear direction to further curb emissions, Tellurian (TELL) showed that global demand for U.S. Liquified Natural Gas (LNG) is vibrant, and probably stronger with the biggest oil and gas companies set to invest less in future supply. TELL has recently signed 10-year agreements to provide LNG to Gunvor and Vitol, two commodities firms that see a benefit in securing supplies now for customers in Asia and elsewhere.  

Investors are slowly warming to the positive fundamentals. MLPs long ago stopped being the dominant corporate form in the pipeline sector. Beyond the three big ones, Enterprise Products Partners, Energy Transfer and Magellan Midstream, MLPs offer a selection of mostly non-investment companies. The AMZIX has to limit the biggest names because there are too few to create a diverse portfolio.  

MLPs are now around a third of the North American midstream infrastructure business (as defined by the American Energy Independence Index, AEITR), and performance has lagged over numerous timeframes. MLP distributions on the Alerian MLP ETF (AMLP), which invests in AMZIX, have been cut by more than half over the past five years. The K-1 tolerant high net worth U.S. taxable investor has for the most part abandoned MLPs, although some remain because of the tax-deferred nature of the distributions. Corporations have handily outperformed MLPs because of the broader investor base.  

For years, AMLP’s status as a tax-paying corporation caused it to lag its index. At times this creates asymmetry – when it has unrealized gains its upside is held back by taxes, but when it has unrealized losses it falls with the market. Shorting AMLP around this inflection point can be an interesting trade, one your blogger has done in the past (see Uncle Sam Helps You Short AMLP).  

In recent years MLPs have performed so poorly that AMLP has been a long way from having to carry a deferred tax liability. But if the sector’s current trend continues, it will once again become a taxpayer and fail to track its index. And if Democrat proposals to raise the corporate tax rate are enacted, the tax drag will be even more expensive.  

We’ve started to see investors once again switch out of AMLP and into more tax-efficient, RIC-compliant vehicles. They recognize that the pipeline sector is attractive, but they’re in the wrong product.

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

Unsettling The Climate Change Consensus

Do scientists spin the truth in order to explain complex answers simply? That is the suggestion scientist Steven Koonin makes in his new book Unsettled: What Climate Science Tells Us, What It Doesn’t, and Why It Matters 

Koonin speaks with some authority – his career includes being BP’s chief scientist 2004-09 followed by serving in the Obama administration as Under Secretary for Science 2009-11. He has a PhD from MIT in Theoretical Physics. Koonin applies his scientific background to the complex area of climate change.  

Koonin is no climate denier. He readily acknowledges that human activity is increasing CO2 emissions, warming the planet. From there, he walks the reader through two huge uncertainties – how much global warming have we caused, and how bad will it be anyway.  

The UN’s Intergovernmental Panel on Climate Change (IPCC) has issued a series of reports which led to the 2015 Paris agreement, where countries agreed that limiting global warming to 1.5 degrees Celsius above pre-industrial levels was necessary to avoid irreversible damage to the planet. Humanity’s future hinges on this binary outcome. 

In a world of soundbites, “The Paris Accord”, “Zero by 2050” and “Saving the Planet” have all become shorthand rallying cries galvanizing action by governments, corporations and investors worldwide. The implication of certainty grates with Koonin’s scientific mind which accepts degrees of uncertainty around virtually any forecast. Using computers to model the climate (as distinct from weather) taxes the powers of even today’s supercomputers.  

Global warming is likely to raise sea levels – but it turns out this has been the case since at least 1900, long before human use of fossil fuels drove CO2 levels higher. While it’s true that the 3mm rate of annual increase over the past twenty years is higher than over the past 100, the 1930s saw a similar rate.  

The media often blames extreme weather events on climate change – we’re better at measuring hurricanes, which before satellites were only recorded where they encountered people on land or at sea (assuming they survived). Nonetheless, it’s hard to see any link between the fluctuations in hurricanes and rising CO2 levels.  

None of this is intended to eliminate the likelihood that we’re warming the planet – simply to demonstrate that the consequences are hard to isolate.  

Moreover, Koonin notes that weather-related catastrophes are killing fewer people, drawing on research from Bjorn Lomborg’s book False Alarm; How Climate Change Panic Costs Us trillions, Hurts the Poor, and Fails to Fix the Planet 

Food production, which we’re warned will collapse with warmer temperatures, has risen with a warmer planet.

The UN reported record world cereal production last year. Inconveniently, rising CO2 levels are improving plant growth. The UN cites a report that satellites show a marked increase in leaf coverage for 25-50% of vegetated areas.  

The U.S. Global Change Research Program (USGCRP) is a Federal agency charged with assessing the impact of climate change. Their Fourth National Climate Assessment was published in 2018, and is full of warnings. But the economic consequences, as Koonin notes, seem insignificant.  

The Assessment estimates the economic cost of different scenarios. Although the chart  extends as far as a 15° F temperature increase by 2100, most serious forecasts of inaction are in the 3-5° range. Assuming 2% real GDP growth, the U.S. economy will grow from $21TN to $102TN by the end of the century. If climate change makes it 2% smaller (i.e. $100TN), that would mean annual growth was 1.97% instead of 2%. The chart looks dramatic, but the plausible economic cost seems inconsequential.  

This really gets to Koonin’s point, which combines uncertain climate forecasts with unclear consequences to ask why there isn’t any cost-benefit analysis done on the world’s response to rising CO2. Bjorn Lomberg and Alex Epstein (the latter in The Moral Case for Fossil Fuels) make similar arguments. Increased energy use has improved living standards for billions of people. Koonin notes that the World Health Organization has said that indoor cooking with wood and animal waste is the most serious environmental problem in the world, affecting up to three billion people. This will not be solved with solar panels and windmills in rural areas of emerging countries.  

The science is uncertain, and the range of possible outcomes includes some very dire ones too. Prudent risk management of the only planet we have demands some steps towards mitigation. Perhaps some of the scientists who do this work, despairing of the difficulty in communicating complex uncertainty, have resorted to simplifying the message in order to promote changed behavior they sincerely believe is needed.  

 Koonin explores this. In the USGCRP’s Fourth Assessment, they include a dramatic chart that shows more record daily high temperatures. This is why hot days cause the media, and our friends, to blame global warming. But the construction of the chart is odd. It takes the number of new record highs divided by the number of new record lows and plots this ratio. Koonin shows that what’s actually happened is that the average coolest temperature has increased, while the average hottest is about the same as in 1900. Our nights have been getting less cold – our days are not warming. The climate is getting milder.  

The chart begins in 1930, so you’d expect a lot of record highs and lows at the beginning of the sample period. This will keep the ratio of the two close to 1.0. As decades pass, the growing prior history will make new records less common, which will also cause the ratio of new highs to new lows to fluctuate more.  

Fewer record cold days with unchanged record highs has caused the ratio of the two to rise sharply. But why display the information in this way? Taking the ratio of new highs to new lows from a fixed date in the past is not at all intuitive, and it portrays a very different picture of temperatures than the actual data. At best it’s an example of sloppy work, and at worst it’s an effort to present a biased picture so as to prompt more urgent action.  

Because political discourse requires you to be for or against, critics call Koonin a climate denier, That is to ignore his thoughtful embrace of scientific uncertainty, and his advocacy for informed choices that try and balance cost/benefit. Too few climate extremists read the science, and if they truly believed humanity’s existence was threatened they’d quickly embrace natural gas power generation so as to phase out coal, and far greater use of nuclear energy.  

The obsession with solar panels and windmills belies lack of serious thought and is why global emissions keep rising – most people care until the energy transition costs them money, which it most assuredly will or we’d have already transitioned. Steven Koonin’s book is a welcome contribution to more informed debate about climate change.  

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