Is Biden Bullish For Pipelines?

The Trump presidency was unequivocally good for investors. The S&P500 returned 14.9% p.a. during his four-year term. There will be strong opinions on either side, and we’ll leave that debate for others. But it’s fair to say that this beat the expectations held by many when he was elected.

Energy executives cheered the loudest when Trump won in 2016. This is an industry where Republican views dominate. Few energy investors were expecting such a miserable subsequent four years. Even before Covid decimated crude oil demand, the American Energy Independence Index (AEITR) had returned 3% p.a., versus 16% for the S&P50 through 2019. On the day voters elected Biden, the numbers for Trump’s term were –4.9% and +14.9% respectively.

Trump’s policies were energy-friendly – he eased regulations, pulled out of the Paris climate agreement and promoted American “energy dominance”. The problem was energy executives. They over-invested, over-produced and, in the case of some pipeline companies, overbuilt. The lesson for energy investors is that when management teams get what they want, look out!

It’s still early to assess the Biden impact on pipelines, but the signs are encouraging. Democrats are naturally anti-fossil fuels, but the ones in power recognize that keeping the lights on is important to staying in office. The energy transition is a long one. We’re not yet fully reliant on intermittent solar and windmills and should hope we never are. Democrat policies are oriented towards constraining the supply of what they dislike, not demand.

This is turning out to be investor-friendly. Every energy company has a few ESG slides in their presentation. They all discuss the energy transition. Some are even investing in solar and wind, although wouldn’t unless the IRR on such investments was supplemented by the benefits of a greener image. On their recent earnings call, Energy Transfer (ET) co-CEO Mackie McCrea revealed that, “… we’re struggling with wind quite honestly, it’s hard for us to figure out how to make that work. And we’re not going to do anything that doesn’t make good economic sense for unitholders.” He then added, “I don’t know if we’ll ever get involved as far as investing in a solar project because the returns are …so much less than what we can achieve with other opportunities we have.”

Financial discipline is acting as a constraint against boldly leaping into renewables. At the same time, traditional pipeline projects on a large scale are becoming too risky to contemplate. When Biden canceled the Keystone XL, he reversed a prior executive order approving it and gave scant attention to our ally Canada’s need to find export routes for its crude. TC Energy (TRP) had already brought in the province of Alberta as a partner in case a Democrat president canceled the project. Alberta’s CS1.5BN investment is likely to be lost.

Kinder Morgan (KMI) similarly offloaded the Trans Mountain Pipeline project to the Canadian federal government in 2018 when they tired of navigating Alberta and British Columbia’s conflicting views on its completion (see Canada’s Failing Energy Strategy). Enbridge’s Line 3 Replacement is also at risk from U.S. government opposition, although most expect it to be completed.

Pipeline construction risk has become almost unquantifiable, because Democrat leaders are willing to over-turn previous approvals. Court challenges from environmental extremists can add substantial delays. Renewables projects advance PR objectives, but low IRRs limit their scope. The result is pipeline companies’ assessment of new investments reflect economic and political realites. Democrats have achieved something that long eluded investors, which is to limit growth capex. Smaller projects are still being done. The Energy Information Administration (EIA) yesterday noted new gas pipelines with 4.4 billion cubic feet per day of capacity entered service between November and January.

Reduced capex among upstream companies is constraining oil and gas supply, which is contributing to rising prices. Although pipeline companies have limited direct economic exposure to commodity prices, they reflect sentiment and overall economic activity. High energy prices are good for energy investors.

Gasoline prices are well above the $2.57 per gallon average of the Trump presidency and are on the verge of exceeding the range of his four-year term. Since the Administration felt compelled to provide a $1.9TN fiscal boost to the economy, it’s likely that gasoline prices are headed higher. The EIA expects domestic oil production to recover slowly, and for the U.S. to revert to being a net importer of crude next year.

The pandemic dominated energy prices last year and has permanently impacted production. Maybe U.S. output would be on the same modest growth path if Trump had won re-election.

Nonetheless, Democrat policies are oriented towards less spending and higher energy prices, both very pro-investor policies. With the emphasis on impacting supply not demand (i.e. no carbon tax), these trends are likely to continue. They’re consistent with efforts to combat climate change. They’re also good for the energy sector. The Biden administration has become an unwitting friend of pipeline investors.

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

 

Pipeline Cashflows Continue Higher

Covid accelerated a trend already in place in the U.S. energy sector, which is to grow Free Cash Flow (FCF) rather than production. Chevron’s Investor Day last week promised 10% annual increase in FCF through 2025. This return to shareholder-friendly metrics is attracting investors – including recently Berkshire Hathaway.

Midstream energy infrastructure has grasped this as readily as their upstream E&P customers. Full year 2020 earnings have been reported. The companies in the American Energy Independence Index, the best representation of the North American pipeline industry, grew FCF to $25BN last year. This is almost three times their 2019 performance, a result that seemed implausible a year ago when Covid drove panic selling.

Continued reductions in growth capex are the reason – Distributable Cash Flow (DCF), equivalent to cash from operations minus maintenance capex, was flat last year. Pre-Covid, DCF was expected to increase from $54BN to $60BN, but Enbridge (ENB), Enterprise Products Partners (EPD), Kinder Morgan (KMI) and TC Energy (TRP) each came in $1BN or more below target. However, capex reductions were widespread during the year, and these largely offset the drop in DCF which is why FCF came in around target.

The result is the bridge chart shown below, which continues to track a path towards higher FCF for the industry. On current trends we should exit 2021 with a FCF yield of over 10%, more than twice the S&P500. Having rallied so far, one might conclude that the sector’s mis-valuation prevailing last year has been eliminated. The FCF yield shows this isn’t the case.

The biggest single variable in the industry’s capex figures is Enbridge’s planned replacement of Line 3. This is a 1,000 mile crude oil pipeline oroginally built in the 1960s that runs from Edmonton, Alberta to Superior, Wisconsin. Canada has long struggled to find economic ways to get its crude oil to market. The proposed new pipeline will more than double capacity, from the current 370 thousand barrels a day (MB/D) to 760 MB/D. ENB recently raised the estimated total cost of this project by almost $1BN, to $7.3BN.

Predictably, environmental extremists are opposing the pipeline, although it’s a safe bet that they drive regularly, including to their protests. With Biden having canceled the Keystone XL project shortly after his inauguration, the Line 3 Replacement (L3R) has become a new target. So far, ENB and most analysts expect the project to proceed. Our estimate of 2021 growth capex for the industry is $4.5BN higher than we forecast in December; $3.5BN of this relates to L3R.

For 2022 and beyond, the pipeline sector is on track to further reduce growth capex.

Energy executives provided quarterly updates over the past few weeks, which included updating their capex guidance. On the energy transition, typically they acknowledge it and have plans to reduce their company’s carbon footprint. The prevailing view is that global energy consumption will increase for all forms of energy, including oil and gas.

Consider the following: China’s oil consumption is about two thirds the U.S. But China’s per capita consumption is only 15% of the U.S. Its population is growing at around 0.4% p.a., versus about 0.6% for the U.S. China’s per capita consumption of crude is growing at 4.3%, and total consumption at 4.7%.

If China’s per capita oil consumption grows over the next decade at the same rate as it has for the past five years, China would be consuming more than the U.S. if we kept consumption flat. If the U.S. wanted to lower consumption to offset China’s growth, our per capita consumption would need to fall by almost 10% p.a. Currently it’s growing at 0.9%.

Even in this implausible scenario, crude oil consumption is unchanged – it’s simply shifted from the U.S. to China.

This is the daunting math that confronts efforts to reduce emissions. Electric vehicle penetration is higher in China, and they drive around a quarter as many miles as Americans. But 1.4 billion Chinese striving for western living standards is going to require a big adjustment from 330 million Americans, if crude oil consumption and emissions are to fall.

There are many more variables to consider, but this simple example illustrates why Exxon Mobil and Chevron think oil still has a future.

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

Electric Vehicles Are Picking Up Speed

Last month saw U.S. Electric Vehicle (EV) sales up 40% year-over-year. Every Tesla owner I know loves their car – although the February jump was helped by the launch of Ford’s Mustang Mach-E. EV market share (which includes hybrids as well as all-electric vehicles) rose from 1.8% to 2.6% in February. Nonetheless, EV sales fell last year due to Covid, from 331K to 296K.

Forecasts of booming EV sales are so common as to scarcely be news anymore. It’s possible to go back and find old forecasts that were way off. This one from 2011 looking ahead to 2020 includes a few the authors would like us to forget. Deutsche Bank’s forecast of U.S. sales was off by 2X. However, McKinsey’s global estimate was only slightly high.

David Victor recently published Energy Transformations in association with Engine No. 1, the activist investor pushing for Exxon Mobil to respond more quickly to the energy transition. The chart below is from his report – the small chart in the inset is a 1992 forecast from Shell on EV sales which has turned out to be wildly inaccurate. But the point of the main chart is that sales really are going to take off over the next decade.

It’s possible to find other old forecasts that were wildly inaccurate. Futurist Tony Seba predicted in 2017 that by 2030 100% of auto sales would be autonomous (self-driving) EVs (see A Futurist’s Vision of Energy). It’s still nine years away, but for autonomous EVs in the U.S. to reach that level would require their market share to double approximately every 20 months.

Growth in renewables and EVs have been about to break out for years. The world will need more energy – the U.S. Energy Information Administration (EIA) expects global energy consumption to increase by 50% over the next three decades. They expect every source to increase, including coal.

High among Elon Musk’s many talents is marketing, because he’s successfully linked EVs with clean energy in the minds of consumers. America generates around 60% of its power from coal and natural gas, with renewables (including hydro) and nuclear each providing around a fifth.

There are substantial variations – California is required to reach 100% emission-free power by 2050, and is about two thirds of the way there, even if their grid sometimes fails (see California Dreamin’ of Reliable Power). The state leads in EV sales. But Wyoming residents who buy a Tesla thinking they’re contributing to a cleaner planet overlook that over 80% of the state’s power comes from coal.

America’s coal consumption is heading in the wrong direction – the EIA expects coal’s market share of power generation to rise from 20% last year to 23% this year and next, matching the growth in renewables. Some of the growth in coal is due to higher natural gas prices – Democrat policies are intended to raise energy prices, although using more coal is an unintended result. And nuclear continues to drop, which is a big missed opportunity.

EV sales globally reached a 6.9% market share last year. President Biden is planning for the U.S. government to only buy EVs in the future. As my partner Henry pointed out, today’s internal combustion engine automobiles are built around a small power generator, which does seem less efficient than simply a battery.

Although insufficient charging stations and the time required to recharge remain impediments for many buyers, these challenges can be surmounted. A battery that lasted an entire day’s drive would certainly help. There are also fewer moving parts, which keeps maintenance costs down. And every EV owner loves the acceleration.

EVs are selling because they’re providing consumers what they want, and are growing market share as a result. By contrast, growth in renewable energy is more reliant on utilities increasing the portion of the power they supply from solar and wind. The absence of a carbon tax from the Democrats’ planned clean energy legislation reveals that, although many voters express concern about climate change, they’re unwilling to spend much to solve the problem.

Meanwhile, pipeline operators such as Williams Companies (WMB) have found that increased use of renewables is boosting natural gas demand – weather-dependent power needs something reliable when it’s not sunny and windy.

Increased EV penetration is part of the electrification of the transportation sector. Since natural gas remains America’s biggest source of power generation, this trend will tend to constrain growth in crude oil demand in favor of natural gas, although the impact remains years in the future. In emerging countries, EV growth adds to the urgency to lower their dependence on coal for power generation. The energy transition continues to rely on natural gas.

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

Energy Stocks Continue To Lead

Fed chair Jay Powell wasn’t to blame for Thursday’s equity market sell-off, no matter what journalists thought. His comments were dovish, reaffirming the Fed’s desire to see meaningful improvement in employment before moderating their bond buying. Tightening is nowhere in sight. Had he said the opposite, markets would have probably fallen further, which simply means bonds are in a bear market.

Powell’s comment that he would only be concerned about bond weakness if it led to tighter financial conditions suggested that the Fed would be inclined to counter such a development, perhaps by increasing their own bond purchases. He expects any increase in inflation to be temporary. Fixed income investors aren’t so sanguine and are demanding fair compensation for increased risk. To own bonds at current yields requires a faith in the Fed’s forecasting ability not supported by their track record. They have no insight that isn’t found in many private sector forecasts; but they do have the power to act.

The Fed’s beige book provided a mildly encouraging outlook, but mentioned the word “shortage” 31 times, the most in a decade. It applied to difficulties in filling many different job types, petrochemicals and chips used in automobiles. CNBC reported that raw materials costs for a new car had risen $1,152 in the past year. Today’s Fed cares more about unemployment than adequate returns to bond buyers. It’s correct and democratic, but translates into inadequate interest rates.

We were also surprised to see evidence of very strong new business formation. Thanks to Barry Knapp of Ironsides Macroeconomics for pointing out the surge in IRS issuance of Employer Identification Numbers (EINs), one of the first steps in launching a new business.

Stocks are attractive but, in some sectors, vulnerable to higher rates. This is most apparent among growth sectors such as technology, which has been supported by low rates for years. Ten year treasuries at 2%, 0.5% higher than now, still wouldn’t make bonds a buy. But because the net present value of a growth stock is more reliant on distant cashflows than is the case for the overall market, rising rates hurt more. If you think of a growth stock as analogous to a zero-coupon bond (returns backloaded) and compare it with a similar maturity coupon-bearing security, you’ll appreciate that growth stocks have greater interest rate sensitivity (duration), just like a zero-coupon bond.

OPEC’s decision not to increase supply for now gave a further boost to the energy sector. Pipelines are providing useful protection against rising rates, since both are going up with the reflation trade. After several years of negativity, it’s a long way from a crowded trade. We expect Free Cash Flow (FCF) to continue growing this year, such that pipelines will offer a FCF yield of 10% by year’s end; double the S&P500. The American Energy Independence Index (AEITR) is now back above its pre-Covid 2019 year-end level, and is narrowing the performance gap with the S&P500.

Exxon Mobil (XOM) has doubled in price since October. Its dividend, increasingly secure as crude rallies, still yields over 6%. It’s hard to see a strong bearish case even following such a strong rally.

The strength in energy has coincided with weakness in solar stocks. The Invesco Solar ETF (TAN) is –7% YTD, versus the AEITR which is +20%. Over the past year, solar stocks have outperformed significantly, but as growth stocks they’re vulnerable to rising rates.

Maybe solar investors have considered the two maps showing the global disposition of coal-burning power plants, which vividly portrays where the world’s increased CO2 emissions will be coming from. Developing countries, many of them in Asia, will be adding significant power capacity reliant on coal. Increasing global trade in natural gas is preventing this damaging development from being even worse.

The hype around renewables makes it seem as if America can singlehandedly save the planet if we’d just shift to 100% solar and wind. New York’s mayor Bill de Blasio wants to ban natural gas hookups for new buildings by the end of the decade. If you’ve visited New York recently you may conclude that de Blasio’s chronic mismanagement is curbing the need for much new construction anyway. But he epitomizes the simplistic view that is oblivious to what’s actually happening.

The world’s going to use more of all kinds of energy in the next several decades, as economic growth in emerging economies drives up demand. We’ll use more renewables, natural gas and, unfortunately, more coal. Unless we can flip those dots, each of which represents a new source of coal-based emissions, to something cleaner (natural gas is the obvious choice), we’d better plan on living with more CO2.

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

The Fed Mutes The Messenger

U.S. bond investors would do well to remind themselves that the Fed’s objective of stable prices is linked to maximizing employment. They have a twin mandate. In theory these goals are aligned, but not all the time. From 1980-82 the U.S. endured two sharp recessions as interest rates were hiked to vanquish inflation. Today, maximizing employment is the more important of the Fed’s linked goals. They’re willing to take a little risk with inflation, as Fed chair Jay Powell noted last week (see Bond Investors Are Right To Worry).

Boosting employment is why the Fed launched Quantitative Easing (QE) during the 2008 financial crisis, to good effect. It turned out that monetizing debt, via the Treasury selling directly to the Fed, wasn’t inflationary. It’s become a permanent fixture. Sluggish improvements in employment meant that the Fed’s balance sheet continued growing until 2014 when it reached $4.5TN. It only began to shrink in 2018. Then Covid hit, and it quickly jumped to $7TN. It’s been growing at $28BN a week for the past three months.

Inflation expectations have been rising at the fastest pace since 2009 as the economy emerged from the last recession. Forward estimates of the five-year inflation rate five years from now (i.e. 2026-31) are around 2%, not yet especially worrying since that’s the Fed’s target.

Such estimates are derived from the yields on treasury securities. The Fed’s increasingly large holdings of debt instruments distorts their message. For example, their position in inflation-linked bonds has risen sharply over the past year, such that they now hold 20% of the outstandings.

To the extent that these purchases depress real yields, the nominal minus real yield spread would widen, indicating markets expect higher inflation. However, their purchases of regular bonds have also been increasing, creating the opposite effect.

The bottom line is that the Fed’s large holdings make the bond market’s precise forecast of future inflation less reliable. Nonetheless, rising bond yields suggest investors are recalibrating their own expectations.

Increasing labor force participation by drawing discouraged workers back into the jobs market has gained more attention in recent years, both at the Fed and within Congress. This is no bad thing – it shows the twin mandate with Congressional oversight working.

But in a subtle way, the Fed has been shifting its focus. Inflation isn’t a problem; unemployment is. The returns to bond investors have been a low priority for years, as central banks around the world drove long term rates lower. Now there’s a risk that rising inflation will further erode returns.

Bond yields have been rising globally, reflecting the recovery from the pandemic but also, in the U.S., plans for fiscal profligacy. Central banks don’t like the market message they’re receiving. Australian ten year bond yields have doubled this year, from under 1% in December to almost 2% last week. The Reserve Bank of Australia has acted to counter this trend, recently announcing they’d buy A$3BN of longer-dated debt.

U.S. fixed income markets are communicating an important signal, that a robust recovery is coming. The Fed’s bond buying serves to moderate that message. Yields would clearly be higher, perhaps even affecting the political debate around whether we need $1.9TN in additional covid relief spending. America’s fiscal response to Covid will reach 25% of GDP as a result, regarded by many as more than sufficient. The Fed is muting the bond market’s response.

QE was originally conceived to extend easy monetary policy out along the yield curve. Yields were falling, but not as far as the Fed desired.

Today’s global yields reveal no shortage of return-insensitive buyers of bonds. In his annual letter published on Saturday, Warren Buffett warned that, “Fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future.” QE is evolving to counter the prevailing trend in bond yields – the Fed is rejecting the collective analysis of bond buyers who are demanding higher returns for what they perceive as increased risk. The Fed’s QE isn’t helping these investors. Withdrawing the support will be hard. Watch out if they do.

Protecting portfolios against rising interest rates is hard for most investors. The ETFs that are designed to profit from falling bond prices are very inefficient and costly. Some shelter in bank debt, where their focus on short maturities linked to Libor insulates against rising bond yields. But the underlying issuers are non-investment grade, so this means swapping interest rate risk for credit risk. Interest rate futures are the best choice, but many are put off by the leverage. America’s bifurcated regulatory structure means financial advisors shorting eurodollar futures for clients would then come under CFTC oversight as well as FINRA.

Since the market bottomed almost a year ago, the recovery trade has transitioned into the reflation trade, spurred on by the first vaccine announcement in early November.

Pipeline stocks have tracked the ten year treasury yield higher over the past year, a connection that makes sense since renewed economic activity is driving both higher. Midstream energy infrastructure offers a source of return as rates move higher. It also comes with an attractive yield, something long absent from the bond market.

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

Bond Investors Are Right To Worry

“At this point, the Federal Open Market Committee is seeking inflation running moderately above 2% for some time.” Fed chair Jay Powell, Senate testimony February 23.

The Fed is walking a fine line, and it’s easy to take this comment out of context. Inflation can be too low, and in order to ensure they adhere to their dual mandate of maximum employment consistent with stable prices, the Fed is willing to take a little risk with price stability. Nonetheless, if the marble hallways of the Federal Reserve building in Washington DC display carved quotes from Powell’s predecessors, this one is unlikely to be added.

The Democrats have embraced Modern Monetary Theory (MMT) in all but name (see Democrats Will Test The Limits On Spending). The only theoretical limit on government spending is when it’s inflationary, and until it is one must conclude spending plans weren’t bold enough. Today’s low bond yields are a piggybank to be raided for Covid relief, infrastructure spending and the energy transition.

Fixed income investors have been abused by paltry yields for years. The biggest question in finance today is why long-term rates have remained so persistently low for so long. Real yields have been falling for at least a generation. Inflexible investment mandates for institutional investors such as pension funds, which mandate a fixed income allocation regardless of return prospects, are part of the reason.

Bond investors’ passive acceptance of diminished returns has made Democrat spending plans possible. $2.8TN in the Fed’s expansion of its balance sheet, $3.4TN in deficit-financed spending, plus the latest $1.9TN Covid relief plan add up to over $8TN in stimulus.  As Barry Knapp of Ironsides Macroeconomics notes, this is to offset the estimated $1.1TN nominal GDP output gap caused by the recession. In other words, we’re plugging the economy’s hole by a factor of over 7X. There’s little risk that the government’s financial response to Covid could be criticized as inadequate.

Against such a backdrop, even though Powell was simply repeating past comments on desiring higher inflation, it did betray a lack of sensitivity to bond investors still contemplating the 7X noted above. Under these circumstances, when the Fed wants inflation above 2% “for some time,” why would a return-oriented investor hold ten year U.S. treasuries yielding only 1.5%?

Inflation expectations have been drifting higher, recently breaching 2% for the first time in two years. Powell noted that, “… forecasters need to be humble and have a great deal to be humble about frankly.” Such humility must be abundant at the Fed, whose forecasts of short-term interest rates published in their projection materials were too high for most of the past decade (see Bond Market Looks Past Fed).

The bond market’s forecast of the “neutral”, or longer run Fed funds rate was consistently lower than in FOMC projections for years. The Fed steadily followed the market’s forecast lower. Predicting interest rates is hard. The Fed’s not very good at it. But their persistent failure to correctly forecast a rate that they set is amusing, for those who follow such things.

Now the situation is reversed; fixed income markets are beginning to price in higher short term rates by late next year, whereas the FOMC expects to keep rates low at least through 2023.

It’s unwise to bet against the Fed. But with $8TN of stimulus going up against the FOMC’s forecasting record, it’s likely that the Fed’s reputation will remain intact.

Inflation may not rise at all, in which case the bond market’s hissy fit will have been just that. However, Powell expects it to rise later this year before falling, which will be far more interesting.  The period of time during which inflation is above target may seem interminably long for investors positioned for it to be temporary. Bond yields will reflect how closely investors share the Fed chair’s breezy confidence.

The eurodollar futures market reflected this change in expectations over the past week. Risks are more correctly priced in than before. However, there is no limit to the amount of stimulus that Washington will provide. If a Covid mutation creates a setback, the response will be predictable (see The Biden Put). Ten year treasury yields at 1.5% still don’t reflect that reality.

Rising rates aren’t necessarily bad for stocks, unless they move sharply.

For example, pipelines have performed well so far this year. The sector is more insulated than many to bond market risk – if rates do move substantially higher, it will be because demand for most things including energy is booming. Investors are beginning to recognize this, since the sector (as defined by the American Energy Independence Index, AEITR) has become a reflation trade, tracking bond yields higher.

Pipeline company dividend yields remain very attractive. Consider natural gas pipeline behemoth Williams Companies (WMB), whose equity yields almost 7%, a level still suggesting still some risk to the security of the payout.

Last week they announced they’ll be increasing it by 2.5% this year. Pipeline stocks still offer attractive upside.

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

The Biden Put

Inflation fears are percolating. The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) had its biggest ever stretch of outflows over the past six weeks. There are plenty of warnings signs. Commodity prices are booming. This is happily driving up midstream energy infrastructure, with the American Energy Independence Index up 15% YTD, well ahead of the S&P500 at up 4%. Cyclical and value sectors are drawing renewed interest. Energy has been outperforming technology since November’s vaccine announcement.

M2 money supply is growing at 26% year-on-year, the fastest since records began. The link between inflation and money supply broke years ago. Money velocity is down sharply, which is why inflation isn’t surging. The Fed isn’t worried. They would be happy with inflation running above their 2% target for a while. For those of us whose careers include the 1980s, when inflation and interest rates peaked, this is quite an an adjustment.

Covid figures are collapsing, which will likely unleash pent-up spending that interminable lockdowns have stifled for a year. The CDC counts 474K deaths involving Covid, less than the 500K figure seen elsewhere because the CDC waits for official death records to be uploaded by the states. This is without doubt a tragedy.

Over the same period, 3.3 million Americans died without Covid. They spent their last months or year alive constrained by all the restrictions we know so well. To pick one cohort, 99K people aged 65-74 died with Covid, but 631K of the same group died without it. 21K aged 45-54 died with Covid, reflecting their low risk profile, but 183K in this group died from other causes, while enduring pandemic restrictions like the rest of us. Even for those 85 and older, who are almost a third of all Covid fatalities, 87% of deaths in this group were non-Covid.

A friend of mine I’ve known since elementary school died on Saturday from a heart attack, which probably caused me to consider the figures in this way. The lost final year of life for the non-Covid fatalities denied the normalcy of dinners out, companionship with friends, travel and so on is another tragic element of the pandemic, but doesn’t get much attention. Do you know anyone who isn’t ready to get out there and live once more?

Money market funds hold around $5TN, a figure that’s slowly declining but still nonetheless $1TN higher than a year ago. This has low velocity while it’s sitting there but could easily be deployed in a recovery of consumer spending. Examples of rising prices include crude oil, copper and resins used to manufacture plastics. Pipelines, which move with commodity prices and reflect ownership in physical assets, offer more protection than most sectors in this environment.

Meanwhile, the Administration wants to spend $1.9TN on Covid relief – even if that figure is negotiated down, the vaccine rollout and falling hospitalizations suggest that the worst is behind us. A weekend article in the WSJ even suggested that the U.S. was nearing herd immunity. It’s predicated on an estimate that 0.23% of people who get infected die. Assuming that’s a reliable statistic and the 500K Covid fatalities is also accurate, it suggests 217 million Americans have been infected (500K divided by 0.23%). That’s approximately two thirds of the country. Add the growing vaccinations and you can see the country could be at 70-80%.

It’s a controversial assessment, and friends/readers who know more than us on the topic will be moved to respond. Fauci isn’t so optimistic. Virus mutations may cause a setback. But it’s not possible to definitively reject the optimistic conclusion, only to say it’s unclear.

Once the Covid relief plan is approved and money being sent out, Biden will turn to infrastructure – another $1TN. Climate change will justify at least that in addition. There are no longer any fiscal hawks (see Modern Monetary Theory Goes Mainstream).

Although there are plenty of warning signs that inflation will rise, we’ve had almost three decades where it hasn’t. Many worried about the inflationary effects of Quantitative Easing when it was first deployed following the 2008 financial crisis. To Ben Bernanke’s credit, he knew it wouldn’t and he was right. The economists at the Fed are similarly confident today. They’re expected to keep short term rates low for at least the next couple of years.

Betting against the Fed is usually wrong. But today, betting with them doesn’t offer much upside. The eurodollar futures curve remains extremely flat, so an investor in two year securities will do scarcely better than holding overnight deposits for the same period of time. Fed chair Powell reiterated his cautiously optimistic outlook yesterday with no need to raise rates anytime soon.

The Federal government is pouring fiscal and monetary stimulus into the economy simultaneously. And if a virulent Covid mutation sets back the current path to re-opening, more $TNs will be forthcoming.

People used to refer to the Bernanke “put”, recognizing that the Fed would respond to sharp economic weakness by easing, giving equity investors effectively a put option on their holdings. Nowadays we have both the Powell Put and the Biden Put. Bond yields are too low to properly reflect the new reality.

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

Not Just Another Billionaire With A Plan

Bill Gates readily concedes that the world isn’t short of “rich men with big ideas” in How To Avoid A Climate Disaster. He brings an intellectual honesty to the climate change debate that is absent from Democrat policy prescriptions, and often ignored by Republicans. Gates has done his homework, producing a book spilling over with facts and insights. The climate impact of each human activity (use of power, making things, moving around) is presented, along with its contribution to the 51 billion tons of Greenhouse Gases (GHGs) emitted annually. He presents the issues in an easily understood framework that many readers should find engaging and accessible.

Although Bill Gates is surely a Democrat, it’s unlikely progressives will welcome his contribution. He dismisses Democrat orthodoxy by showing that the energy transition will be very expensive. He feels we should be motivated by the moral obligation to counter planetary warming because it will harm poorer countries the most. Rich countries can afford to manage rising sea levels (see Netherlands).

Since the Gates Foundation is focused on disease and malnutrition in the developing world, his altruistic view isn’t surprising. And the moral argument is a respectable one. But it exposes the enormous political challenge in gaining popular support for higher domestic energy prices to stop, say, Bangladesh flooding. Last week Joe Biden rejected a French proposal to redirect 5% of our Covid vaccines to poorer countries until all Americans have been vaccinated. It was a minor acknowledgment of political reality. Few have the means or inclination to dedicate themselves to solving poor countries’ problems before their own.

How To Avert A Climate Disaster reaches positive conclusions because it argues that current technology and innovation make solutions within reach. It provides policy prescriptions but deliberately avoids the politics. In many cases Gates calculates a “green premium”, reflecting the cost of converting transport, power generation, cement or steel production to be emission-free. Not surprisingly he favors a carbon tax to create price signals that fully reflect the externalities of burning fossil fuels.

Renewables figure far less prominently than in the Green New Deal (see The Bovine Green Dream), a document Gates would likely view as fantasy if he didn’t studiously avoid such engagement. He illustrates the fundamental problem of solar and wind intermittency by considering the battery back-up a Tokyo 100% reliant on windmills would require to maintain power during a not-uncommon three-day typhoon. Even with optimistic assumptions about improved technology, the cost would be prohibitive. Gates concedes to have, “…lost more money on start-up battery companies than I ever imagined.” He knows a bit about the subject.

Although efforts to curb emissions around the world generate enormous energy and press coverage, any actual improvements to date have come mostly from coal-to-gas switching for power generation (i.e. the U.S.) or last year’s drop in global economic activity due to Covid. U.S. energy costs haven’t risen noticeably, although California’s energy policies have managed to combine high costs with unreliability (see California Dreamin’ of Reliable Power).

Gates believes poor countries should be allowed to increase emissions, since energy consumption is inextricably linked to improved economic well-being. “We can’t expect poor people to stay poor because too many rich countries emitted too many greenhouse gases” he argues from the lonely moral high ground.

Reaching zero emissions by 2050 requires western democracies imposing substantial new regulation and costs on economic activity for decades. Meanwhile, the world’s building stock will grow mostly in poorer countries, requiring cement, steel and all the other emission-producing byproducts of human advancement. This construction will add the equivalent of another New York City every month for decades.

Gates asserts that climate change will inevitably cost – inaction will lower GDP, and action will take lots of money. It’s well he doesn’t consider how governments will sell this to voters if an honest discussion ever occurs, because by comparison the technical challenges are more easily solved.

Recognizing the political impracticality, Joe Biden instead disingenuously talks about “…tackling climate change and creating good union jobs here” (his emphasis).

The technology already exists to capture the carbon dioxide emitted by burning fossil fuels, whether to generate electricity (27% of global GHGs) or produce steel (manufactures also including cement and plastics in total are 31% of GHGs).

Gates estimates that emission-free power in the U.S., to include gas and coal with carbon capture, would raise prices by 15%. The green premium to make ethylene (plastic), steel and cement without CO2 emissions would raise prices by around 12%, 23% and 110% respectively. We could already start implementing such policies if the support was there. But political leaders avoid such talk, recognizing that voters’ concern about climate change doesn’t include much tolerance for higher prices.

An energy investor today has to assess plausible outcomes, ignoring the shrill rhetoric of climate extremists unburdened by the costs, facts and technological challenges Gates lays out.

Emerging economies will continue to grow, feeding all the increase in global energy demand as they seek OECD living standards. Their GHG emissions will rise. How tolerant will western democracies be of rising costs for virtually everything while we save the planet and allow poorer countries to catch up?

Bill Gates is an unfailing optimist – invariably the most pleasant posture for living. But your blogger found the comprehensive list of what needs to be done dauntingly improbable. Mitigants of the results of global warming are probably a better investment than betting on decades of extended selflessness by 1.3 billion OECD citizens, the rich world whose collective actions Gates believes will save all 7.6 billion of us.

There are already bold options available. We could phase out coal. We could require carbon capture on industrial use of fossil fuels. We could use more nuclear, whose safety record per unit of power generated is unmatched. Instead, more solar and wind is the climate extremists’ mantra in spite of intermittency and the NIMBY challenges of building transmission lines to move power from sparsely populated solar and wind farms to population centers (see Review Of Russell Gold’s Superpower for an example of how hard this is).

Burning less coal, carbon capture and compensating for renewables’ unreliability all support growth in natural gas demand. Gates argues against a shift to natural gas for power generation. He fears the 30-year life of a typical combined cycle power plant would embed its CO2 emissions for too long. It would show progress to 2030, while putting zero by 2050 out of reach. But if tangible results within the timeframe of election cycles are needed, it’s hard to see a better way.

If in a decade that’s how things have turned out, Gates the pragmatic optimist will hail it as success. We should too.

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

Why Texas Lost Power

Debate continues over the cause of the extended power cuts in Texas last week. Predictably, party affiliation colors views. Republican Governor Greg Abbott said, ““the Green New Deal would be a deadly deal for the United States of America.” Two former Energy Secretaries, Rick Perry and Dan Brouillette blamed frozen wind turbines, and over-investment in renewables at the expense of ensuring more robust infrastructure.

It’s true that the extreme cold curtailed output from coal and gas power plants and even one nuclear facility. It’s also true that windpower works in cold northern latitudes. The state’s energy infrastructure just wasn’t prepared for such low temperatures. And the Texan power market, overseen by ERCOT, is a free-wheeling bazaar with hundreds of power providers all vying for business. Households routinely switch from one provider to another. As a result, the average retail price of electricity in Texas is 82% of the national average. But the market structure clearly doesn’t value 100% reliability.

Both of these problems – winterizing equipment and altering market incentives for power providers, can be fixed.

Texas generated 17% of its electricity from wind in 2019 (most recent figures available). They are easily the leading state. At 83 Gigawatt Hours (GWh), they are 28% of the U.S. total and well ahead of #2, Oklahoma at 29 GWh. Wind power in Texas has been widely regarded as a success.

Was over-reliance on windpower to blame, as Republican politicians claim? Or did the cold weather show no favorites, with natural gas, coal and nuclear plants all going offline as well?

Perhaps the chart showing power generation by source can be interpreted to favor either side, but an objective view would surely conclude that natural gas generation soared when needed, uniquely among all power sources albeit not by enough to avoid power cuts. Wind power became negligible. It’s hard to argue that more wind power would have solved this problem.

Climate extremists will argue that more extreme weather is an early warning of the adverse effects of global warming. This alone adds urgency to the energy transition. But if Texas had already converted their power generation to be 100% emission-free, that would remove around 200 million metric tonnes of CO2 emissions, 0.5% of the total emitted worldwide annually. The weather in Texas wouldn’t change. Advocates would argue that such leadership might induce behavior elsewhere. It would need to be in China and other emerging countries to make a difference.

In How to Avoid a Climate Disaster, Bill Gates offers a pragmatic view loaded with useful facts. We’ll be writing a review soon, but he notes the low power density of wind, which produces 1-2 watts of power per square meter. Solar is 5-10, while fossil fuels are 500-10,000. Wind takes up a lot of room.

It may simply be coincidence, but following California’s heatwave-induced blackouts last year (see California Dreamin’ of Reliable Power), two big states with a heavy reliance on renewables have suffered power outages. Since it’s not always sunny and windy, solar and wind have their place but are unwise beyond a certain threshold.

Both states could have redirected capital outlays from renewables to making their existing power supply and grid more reliable. In this way, environmental extremists’ obsession with growing unreliable sources of energy contributed to the blackouts. Gates argues that intermittency limits their ability to provide a significant portion of our power.

Texas is 26% renewables and California 29%. Few states should want to emulate them.

The deception of climate extremists is that renewables are cheaper and will create jobs. If that was true, the oil and gas industry wouldn’t exist. Energy today is cheap, perhaps unsustainably so. Technologies already exist to capture CO2 emitted from the manufacture of steel and cement, as well as from electricity generation. Implementing them will cost money and raise prices, but that should be no surprise.

A serious effort to reduce emissions will impose regulations or additional costs on fossil fuel emissions, which will create the necessary incentives to install equipment that curbs emissions, just as coal plants are required to do for the sulfur they emit. Natural gas will fare well, since it’s cheap, not intermittent and relatively clean burning. That’s why long term forecasts of energy use show natural gas enjoying continued growth.

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

Lone Star State Loses Power

Bill Gates, in an interview two years ago, asked how Tokyo would cope with a typhoon if it was fully powered by renewable energy. Compensating for the loss of solar and wind for two to three days would require enormous battery back-up that would sit mostly idle, other than once every few years. He noted the economics would be unworkable.

Texas is a leader in wind energy. It’s tempting to blame the recent blackouts prompted by exceptionally cold weather on the intermittency of wind power. A photo of a helicopter de-icing windmill blades  became an iconic reminder of the opportunistic nature of renewables. Widely circulated on social media, it turned out to be from Sweden several years ago.

Texas uniquely has its own power grid, overseen by the Electric Reliability Council Of Texas (ERCOT). Power suppliers compete to provide electricity to the network, and while free markets have much in their favor, reliable power in that market is clearly under-valued. Wholesale electricity prices reached $9,000 per MWh, the limit set by ERCOT. Average U.S. residential prices are 13 cents per KWh, equal to $130 per MWh. Some Texan households will be getting a shockingly high utility bill.

Wind power collapsed leading into the Presidents Day weekend. This wasn’t an unfortunate coincidence, but was a result of icy temperatures that caused power demand to spike. Rolling power cuts extended well beyond Texas, and some natural gas power plants also went offline because cold weather restricted their operations. Nonetheless, natural gas power generation soared when needed. It’s negatively correlated with wind power output, a valuable quality for portfolios of power generation as well as stocks.

The energy sector responded by continuing its strong rally. The American Energy Independence Index, which consists of North America’s biggest pipeline companies, is up 15% YTD, 10% ahead of the S&P500. This could simply be a response to rising oil and gas prices, but it may also reflect a growing awareness that the world will need all sources of energy for the foreseeable future. Solar and wind are prone to go offline during extreme weather events. California’s drive to expunge everything but solar and wind led to rolling blackouts last year during a heatwave (see California Dreamin’ of Reliable Power). Renewables are developing an unfortunate reputation for being there until demand surges, when they’re most needed. Providing back-up adds significant expense.

It’s too early to judge the public response to this failure. Texans are still trying to stay warm. But a cooling dose of realism poured on the single-minded focus on renewables is long overdue.

U.S. foreign policy is now configured to take account of our climate goals, which is a positive development. However, the charge of hypocrisy is easily leveled against both people and countries trying to persuade others to change their ways.

For example, the U.S. plans to halt funding for overseas fossil fuel projects, so as to highlight China’s continued bankrolling of coal projects among poorer countries. China is doing more to warm the planet than any other country – they burn half the world’s coal and are promoting its use among others. With poorer countries less able to cope with rising sea levels, we’re in the odd position of promoting behavior that we find more in their interests than they do. And while reduced coal use is a good objective, the U.S. is forecast to increase its coal consumption this year and next (see Emissions To Rise Under Democrats).

Past years switching from coal to natural gas are being reversed, because natural gas isn’t as cheap as it used to be. Democrat policies are designed to increase energy prices, with sometimes unintended consequences. American leadership would mean phasing out our own use of coal.

Moreover, Joe Biden’s emissary to convince the developing world to use less coal is John Kerry, whose lifetime of private jet travel must make his personal carbon footprint the envy of those he would persuade.  Climate change is a serious issue but is not yet receiving a coherent policy response.

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

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