For the past few months the eurodollar futures market has steadily priced in the FOMC’s abandonment of “transitory” in its assessment of inflation. More often than not the Fed follows the market. The typical absence of public comments that precedes FOMC meetings was extended while Biden contemplated renewing Powell’s term. In short order, Powell’s reappointment was announced, several Fed governors publicly contemplated faster tapering and the release of minutes revealed a lively debate. “Transitory” has become a derogatory adjective in finance betraying cognitive dissonance. As in, “The hedge fund manager described his losses from shorting meme stocks as transitory.” Something is transitory, until its permanence becomes painfully obvious.

President Biden and Fed chair Powell had their discussion during which no doubt Biden hoped for a lethargic policy response to inflation while Powell demurred. With Powell’s reappointment secure, all that was left was for the next FOMC meeting to make the taper briefer, in preparation for three to four rate hikes beginning next spring.

B.1.1.529, the new Covid mutation identified in South Africa, has scrambled everything. The World Health Organization has assigned it the Greek letter “Omicron” since that’s the next one in the alphabet. The $8 drop in crude oil will be welcomed by the Administration which will likely claim partial credit since it so closely followed the release from the Strategic Petroleum Reserve. Eurodollar futures removed one projected tightening from next year.

The energy sector modestly outpaced the S&P 500’s 2.2% fall, dropping 2.6% (defined as the American Energy Independence Index).

Last year when investors asked for our outlook on midstream energy infrastructure, we’d often note that the path of Covid would be an important factor. We all became amateur virologists in attempting to project investment returns. The vaccine ushered in economic growth powered by an excessive fiscal response, with the removal of monetary accommodation (albeit very late).

How much has changed?

As before, the near-term direction depends on the virus. If existing vaccines prove ineffective, economic activity will slow until a new one is created and distributed. Some fear the new mutation may require a new vaccine. It’s a science question not an economic one.

The pipeline sector has just reported solid 3Q21 earnings. Cash flows continue to grow, buoyed by recovering volumes and continued financial discipline. Progressive energy policies have been more constructive than expected – impeding sufficient supply of oil and natural gas has improved prices and sentiment. COP26 revealed the gulf that exists between the climate goals of OECD countries and the growth objectives of emerging countries. Unilateral policies to accelerate the energy transition increase prices for consumers and mostly serve to accommodate increased emissions from China, India and others.

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Given the uncertain near-term direction, it can be helpful to remember the long-term growth outlook for US energy consumption. Although renewables command excessive media attention, the chart shows that the big energy story of the past decade was the huge drop in coal consumption which was mostly offset by increased natural gas.

The Energy Information Administration expects the US to increase consumption of renewables, natural gas and even petroleum products over the next three decades. “Other renewables”, which is mostly solar and wind, is forecast to grow from 7.5 quadrillion BTUs to 17.5 by 2050. Even then it’ll still provide less than half the energy of natural gas.

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Energy transitions are slow, and forecasters have a long history of overestimating the speed of change. Just over four years ago we noted Tony Seba’s forecast (see A Futurist’s Vision of Energy) that by 2030 US consumers would only be buying Electric Vehicles (EVs). Their share is currently around 4%, with Tesla dominating. Although we expect EVs to grow like most forecasters, reaching one third market share (defined to include hybrids) as expected by LMC Automotive seems more realistic. Electricity produced from natural gas will still be the dominant source of power generation. Incidentally, Exxon Mobil’s 2030 EV market share forecast back in 2017 was 10% — likely to be low. Forecasting adoption rates for new technology is hard.

Near term market direction will depend on the Omicron variant. Over a year or more, we still expect the constructive fundamentals of the US energy sector, especially natural gas, to drive cash flows and stock prices higher.

Join us on Thursday, December 16^th at 12 noon Eastern for a webinar where we’ll provide an update on the midstream sector during rising inflation.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

On Monday the Energy Information Administration (EIA) announced that 27.3 Gigawatts (GW) of natural gas power plants will be added to the US fleet over the next three years, representing a 6% increase from current capacity. The US is blessed with abundant supplies of natural gas, sufficient to power the country for many decades.

Many US states are pursuing sensible energy policies designed to maintain reliability and affordability, as well as diminish our reliance on coal. The map below shows where these power plants are being added – generally close to existing natural gas supplies. New York state is conspicuously not taking advantage of this opportunity, since its energy agenda has been hijacked by progressives.

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The COP26 in Glasglow revealed the divide we’ve often chronicled between OECD countries who want lower CO2 emissions and emerging economies that are focused on raising living standards, which requires more energy. The inability of COP26 to produce anything meaningful exposed the ambivalence of countries like the US to an overly rapid energy transition. Higher crude oil has brought solicitations to OPEC to increase supply and now sales from the Strategic Petroleum Reserve (SPR).

The first failure of climate extremists is their inability to convince consumers that they should give up reliable fossil fuels and opt for higher-priced intermittency.

The most important development this year in US power generation is the resurgence of coal demand at the expense of natural gas. After several years of losing market share, domestic demand for coal has rebounded because of improved relative pricing.

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US natural gas for January ‘22 delivery touched $6.50 per Million BTUs (MMBTU) a month ago, before retreating to its current level of around $5. US consumers are not immune to the policy errors in other countries (see Why The Energy Crisis Will Force More Realism) but are thankfully being spared from the type of Greta-inspired outcomes endured in the UK (see U.K. Power Prices Soar Above £2,000 on Low Winds). The new natural gas power plants noted by the EIA are an example.

By contrast, nothing newsworthy is happening with US solar and wind. They continue to grow — since January 2018 solar’s market share of US power generation has increased from 1.2% to 2.2%, and windmills have gone from 6.0% to 7.5%.

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It’s possible to create some impressive numbers from this – solar output has a Compound Annual Growth Rate (CAGR) of 20% since January 2018, and wind has 9%. But as the charts show, if both disappeared tomorrow, we mostly wouldn’t notice. Coal use is up 12% in the past year, and currently generates almost twice the power of solar and wind combined. Vaclav Smil has shown that energy transitions play out over decades. Renewables will be small with a high CAGR for many years to come.

US energy-related CO2 emissions are forecast to be +7% this year – not just because energy consumption is rebounding from covid-depressed levels, but also because of this adverse fuel mix. Next year is forecast to be +1%, in part due to a shift back towards natural gas by utilities.

This leads to the second failure of climate extremists – their refusal to differentiate among fossil fuels has impeded their effectiveness. Had they pushed public policies that encouraged utilities to switch from coal to natural gas, perhaps with a carbon tax, the trend towards natgas would have continued this year and CO2 emissions wouldn’t have jumped as much. Instead, their purist approach has left market forces through cheap natural gas to drive most of the reduction in CO2 emissions the US has achieved.

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The US even declined to join 40 other countries in pledging to phase out coal within two decades. This puts us alongside China, the world’s biggest emitter and consumer of half the world’s coal.

American voters want to reduce emissions as long as it doesn’t lead to higher energy prices. Administration efforts to jawbone crude oil prices lower reflect that reality. High gasoline prices should incentivize switching to electric vehicles (which are more likely to rely on natural gas power plants than any other fuel). Instead, the White House is trying to diminish this incentive with sales from the SPR. Foregoing the coal pledge is another example of pragmatism over-ruling progressives.

Pragmatic policies in many states and the White House’s incoherent energy strategy are helping us avoid the poor planning of the UK, Germany and California. Many states such as Florida are adding natural gas capacity in order to preserve reliability. It’s one more reason why migrants from New York state with its poorly conceived energy policies will continue to move to the sunshine state.

Join us on Thursday, December 16^th at 12 noon Eastern for a webinar where we’ll provide an update on the midstream sector during rising inflation.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

It’s easy to criticize the Fed. They’ve maintained their uber-accommodative monetary policy for probably a year longer than needed. Once the vaccine breakthrough was announced last November, prudence dictated that they anticipate an economic rebound and begin normalizing rates.

Instead their bond buying has had the effect of partially monetizing Federal debt issued to fund the huge fiscal response to the pandemic. The March stimulus package was clearly an additional $1.9TN in buying power that consumers collectively didn’t need, which is why personal consumption expenditures on goods are running well above the long term trend.

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The relevant quote from former Fed chair William McChesney Martin, Jr., as lifted from his written speech is, “The Federal Reserve…is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.” Instead, current chair Jay Powell and his colleagues have been pouring in the Absolut.

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Housing is another example. The FOMC must be the only group of Americans unaware that suburban residential real estate is red hot, making it more expensive for the two thirds of American households who choose to own their home to find shelter. Owners’ Equivalent Rent (OER) allows them to pretend that nothing untoward is happening, in willful defiance of the S&P/Case-Shiller U.S. National Home Price Index (C-S).

By coincidence, since the last housing peak in July 2006 both indices have increased by approximately the same amount. The real estate market has felt a lot different to consumers versus the number crunchers at the Bureau of Labor Statistics who produce OER. They might even argue that this shows OER is a decent proxy for housing. However, the C-S is +20% over the past year.

The Fed is still buying $40BN of mortgage-backed securities every month. Even though they’re winding down, at their current tapering pace they won’t be completely out of the market until June.

It’s easy to criticize the Fed. Markets have priced in a significantly more rapid tightening than the most recent FOMC projection materials, with almost no public comments from officials that such was likely. With inflation running at 6.2% it’s easy to see why.

So it’s interesting to consider the defense of the Fed, one that the Fed chair may offer once Biden has announced his choice.

Reports that the White House is considering replacing Powell with Lael Brainard are likely all optics, and although some commentators perceive Brainard as more dovish, the FOMC has maintained the monetary gusher without much public dissent. They’re all doves.

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It starts with financial markets – one of the more interesting recent charts is the one showing an unprecedented drop in the correlation between short term and long term rates. The bond market used to be a real-time measure of Fed policy, but inflation expectations and monetary policy seem to play less of a role than in the past. This may be why the correlation has dropped.

Anchored by central bank buying and other return-oblivious investors, bonds seem impervious to rising consumer prices.

Ten year treasuries at 1.6% are hardly onerous unless you think you’re entitled to a return on your money, a requirement bond investors have abandoned. TIPs yield –1.1%, so the ten year inflation expectation is 2.7%. This is somewhat higher than the Fed’s 2% target but not out of control, and not inconsistent with the Fed’s optimistically transitive narrative.

The recent shift in tightening expectations has been almost exclusively reflected in the short end of the curve. The precise market forecasts offered by eurodollar futures show that traders expect any tightening to be completed within two years or less, with stability thereafter. Ten year treasuries yield the same 1.6% as they did in May.

The Fed’s $8.5TN balance sheet has helped depress bond yields, but now the buying will slowly stop and the market knows that. There’s no shortage of other return-insensitive buyers for debt of a profligate government, starting with Japan ($1.3TN) and China ($1TN).

Interest rates are the transmission mechanism by which lenders receive compensation for inflation. In a world of negative real yields, perhaps the economy can tolerate some inflation.

The buoyant stock market is another financial market indicator that current and expected inflation aren’t creating any big problems. Quarterly earnings show that many companies seem able to pass through higher costs to their customers.

There are numerous signs that the jobs market is strong, with September job openings of 10.4 million just below August’s record of 10.6 million. Workers are increasingly willing to quit for a better job, and companies routinely complain of difficulties hiring enough qualified workers.

Unusually, inflation has become a political problem before becoming a markets problem. More common, for those of us old enough to remember tightening cycles, is for bond yields to rise, compensating investors for the risk of higher inflation and pressuring stocks. The administration, usually subtly, pushes back.

Today talk of inflation is everywhere, but anyone invested in stocks is still ahead of the game. For my part, stopping at a gas station has become a cause for unseemly celebration as I happily fork over an extra $40 while smiling at the bull market in pipeline stocks.

Borrowers are also benefiting from continued low rates.

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The point is, today’s inflation is not an economic problem but a political one. Raising rates so as to drive up the unemployment rate won’t produce more truck drivers and will only appease the talking heads who are the visible pressure for action. An FOMC that has willingly monetized debt, synchronized easy policy with enormous fiscal stimulus and promoted a housing bubble doesn’t look like a group to willingly cause economic damage by hiking rates precipitously.

The FOMC will likely move slowly, because there’s plenty of justification for doing so. However, vice-chair Richard Clarida suggested on Friday a speedier tapering, which would allow faster tightening in line with current market prices. We think the FOMC’s dovish tendencies will incline them to move slowly – the market is priced for a more aggressive response.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

We often get questions on the correlation between pipeline stocks and crude oil. Most investors intuitively believe they are linked – and inconveniently they seem especially so when prices are falling. March of last year is a recent example.

Pipelines are a volume business — the “toll model” has often been used to describe the fact that it’s volumes passing through the pipelines, not the value of the commodity, that drive midstream economics. To the extent that high prices imply increased production it can appear that they should be related.

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This year pipelines and crude oil have both marched higher, propelled by the strong economic recovery from covid and restrained investment in new output by energy companies. US oil production remains 1.5 Million Barrels per Day (MMB/D) below its pre-covid peak. The volume-driven pipeline industry ought to be suffering with less crude oil passing through its infrastructure – except that the industry’s new financial discipline has driven free cash flow higher.

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Lower volumes are a result of constrained growth capex, both among the upstream customers of pipelines as well as the midstream sector itself.

Although visually crude oil and pipelines (defined here as the American Energy Independence Index, AEITR) move together, the correlation isn’t that high. Over the past decade the average 90 day rolling correlation of daily returns is 0.41. As the table shows, year by year it doesn’t stray too far from that.

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In 2015 when crude oil and pipeline stocks were falling, some clients asked us if we’d considered hedging by shorting crude oil futures. It was a reasonable question, since the sector seemed to follow oil prices relentlessly lower. But the correlation shows that it’s really a weak relationship. And the devil is in the details – any hedge would require a hedge ratio. How much crude oil should a portfolio short in order to hedge its equity exposure? The unstable relationship means that the choice of hedge ratio would depend on the past time period examined, revealing it to be a somewhat arbitrary choice.

Unable to identify a reliable hedging strategy we rejected the suggestion. In mid-2017 such a fund was launched (see Oil-Hedged MLP ETF Launches at Propitious Time) but it’s since closed, confirming how hard it is to get the hedge ratio right.

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Natural gas is a more important source of cashflows for pipeline stocks than crude oil, but here the correlation is non-existent. The US is fortunate to possess decades worth of reserves of natural gas. Moreover, because exports of Liquified Natural Gas (LNG) are limited by the availability of specialized infrastructure to chill it down to 1/600^th of its volume so it can be pumped onto an LNG tanker, US consumers have been mostly insulated from the energy crisis sweeping through Europe and Asia. EU governments and the UK have committed a series of policy errors in recent years. These include: becoming too reliant of intermittent solar and wind; cutting back local production and storage of natural gas; and relying too heavily on Russia’s capricious supply schedule.

Unexpectedly quiet weather in the normally blustery North Sea has once again cut electricity generation from windmills (see U.K. Power Prices Soar Above £2,000 on Low Winds). The £2,000 price per MWh cited should be compared with the $75-$140 range that US customers pay. Converted to US$, UK electricity is being sold for as much as $2,700, 20-36X times as much as American wholesale prices. Even the policymakers in California haven’t been able to screw up as badly. The UK government is subsidizing prices to avoid the political outcry that would quickly follow, so in effect the entire country is paying for past energy policy blunders.

Lowering CO2 emissions is a worthy goal, but examples of the folly of pursuing the agenda of climate extremists keep piling up.

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One of the most positive developments of the year for the pipeline sector has been the steady recovery in natural gas volumes. High crude prices have buoyed investor sentiment, but the return of domestic natural gas output to its pre-covid high represents a tangible benefit that has boosted earnings at companies such as Williams and Cheniere.

COP26 showed that emerging economies such as China and India continue to value raising living standards over reducing CO2 emissions. India’s per capita GDP is $1,900, compared with the US at $63K. Hundreds of millions of Indians live in poverty. Fighting global warming isn’t resonating with them or their government. The US can help by encouraging India and other countries to buy more natural gas and use less coal. That’s the pragmatic solution, and America is well positioned for it.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Following last week’s 6.2% inflation print, eurodollar futures fully priced in 0.75% of tightening by the end of next year. The approximate rate path envisages tapering by the summer, and rate hikes commencing around the same time. Beyond December ‘23 the curve is so flat that in effect the market expects the tightening cycle to be more or less completed, eighteen months after it began.

Ten year projected inflation edged up to 2.7% as derived from the treasury market. Although this is the highest it’s been, that figure doesn’t suggest the market believes inflation is out of control. With ten year treasuries still below 1.6%, it’s more accurate to say that the market expects the Fed to concede defeat on the transitory narrative and raise rates, even though the long term inflation outlook isn’t that far from the Fed’s 2% target.

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The Fed may follow the market’s lead. The FOMC is notoriously poor at forecasting and for years projected a higher neutral rate than futures. Public comments suggest increasing discomfort among some FOMC members with persistently elevation inflation.

And yet, with their new policy regime targeting maximum employment with increased tolerance for a short term inflation overshoot, reversing the improvements achieved in the labor market will be a tough pill to swallow. The Warren/AOC wing of the Democrat party is likely to be a vocal critic of rising rates.

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Hence the Administration’s growing focus on inflation. Although higher energy prices and supply constraints are two major symptoms, the real cause is surging demand boosted by the $1.9TN covid relief stimulus passed shortly after Biden’s inauguration. This is seen most clearly in the overshoot of personal consumption expenditures on all goods.

White House discussions with companies about logistics and pleas to OPEC to raise production overlook the fact that the US fiscal response to Covid was initially correct but became profligate once the welcome vaccine news was released a year ago. Both Congress and the Fed have overdone it.

Modern Monetary Theory (MMT) holds that because a government cannot go bankrupt in its own currency, deficits don’t matter. The constraint on unlimited fiscal largesse is found when Federal spending outruns the economy’s ability to provide goods and services without causing inflation.  We have found that limit – and Congressional Democrats appear set on pushing even further unless Joe Manchin provides a brake.

MMT purists should by now be advocating fiscal restraint to offset the uber-stimulus, but they will not. So the White House sees a brief window to convince Americans they have inflation under control, before they fear the Fed will be compelled to act. The market forecast of three 2022 tightenings by next year may be right, but this is a very dovish FOMC. There isn’t much economic pressure for a Fed response, since bond yields remain low and stock prices close to all-time highs.

Some economists think the Fed should tighten. The market is conceding they will but not for long. The yield curve is at the extreme. It wouldn’t take much to cast doubt on the projected 0.75% of hikes next year.

Many readers enjoy the travel photos from past trips, so see below from last week. The Grand Canyon needs no explanation – we hiked in both directions along the south rim trail and each view was more spectacular than the last. National parks have a mask mandate indoors that even extends to certain outdoor areas too. It was mildly irritating and widely ignored.

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Several people recommended a visit to Sedona. Boynton Canyon with its sheer red rock walls attracts hikers, many of whom find the location spiritual and settle down to meditate. Someone we met referred to it as “Everyone’s Cathedral”.

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We ended in Las Vegas, and what happened in Vegas will remain in Vegas. I am not a gambler – it’s hard enough finding attractive odds in financial markets. When I told one friend that losing $50 in a casino would ruin my day, he said I’d be unlikely to find a table offering such low stakes.

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The pipeline sector and inflation trades offers far better odds.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Democrat policies have so far been more positive than many expected for the energy sector. Those regions and countries that have aggressively pursued renewables have demonstrated the challenges that arise when power is too reliant on unreliable, weather-dependent sources. Crossing a 20% share from solar panels and windmills seems to be the threshold at which problems occur.

Liquified Natural Gas (LNG) shipments continue to change hands at $35 per Million BTUs (MMBTU) in Europe. Underinvestment in natural gas supply and storage is one of the reasons.

The infrastructure bill that passed the House last week includes $73BN to upgrade the nation’s power grid, along with $7.5BN each for electric vehicle chargers and low-emission buses and ferries. Shifting transportation to run on electricity rather than gasoline is key to lowering CO2 emissions.

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Natural gas provides 36% of America’s electricity. This is down from 39% last year, mostly because higher natgas prices have caused utilities to switch to coal, whose share has risen from 20%-24%. It’s not a trend that climate extremists will welcome, but every protester against pipelines and natural gas production has helped make this happen. Non-hydro renewables are slowly picking up market share, and are expected to reach 15% next year. Notably, the US did not join more than 40 countries in pledging to phase out domestic coal consumption. On this we joined with China, revealing the ambivalence of US climate policy and the importance of Joe Manchin (D-WVa). The White House needs Manchin’s support and West Virginia produces more coal than any other US state other than Wyoming.

Although natural gas has lost some ground in electricity generation, rising LNG exports have made up the difference. Moreover, the US Energy Information Administration sees continued growth in domestic consumption, driven by increased demand from the power and industrial sectors. Although it’s not obvious to a casual follower of renewables developments, in three decades natural gas is still projected to provide twice as much energy to Americans as renewables.

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This doesn’t take account of exports, which are virtually certain to grow as emerging economies use more energy to raise living standards. Cheniere provided confirmation of this trend in recent weeks with several announcements of long term LNG supply agreements with foreign buyers (see It Takes Energy To Keep Up With Inflation). On most forecasts the world’s energy needs are likely to increase faster than renewables generation, so although solar panels and windmills will gradually pick up market share we’re likely to use more of everything. The COP26 doesn’t seem to have done much to change that.

The infrastructure bill has supporters on both sides. Investing in transportation through fixing roads and bridges and improving the rail system. The Build Back Better bill, whose passage is still not assured, includes home energy tax credits and up to $12,500 for electric vehicles manufactured by US union workers. My partner Henry once noted that conventional automobiles using an internal combustion engine are in effect built around a small generator. If we were designing personal vehicles today, we might start with battery-powered instead.

The bottom line is that increased focus on electrification of transportation looks very positive for natural gas and the infrastructure that supports it. The energy transition is going well for the energy sector.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Pipeline earnings last week provided further support for the bull market in energy. Cheniere is +67% so far this year. The strong global market for Liquified Natural Gas (LNG) caused them to increase their 2021 EBITDA guidance to a midpoint of $4.8BN, up $0.1BN. They also provided 2022 guidance of $5.8-6.3BN. The company has signed several long-term LNG contracts recently – Friday’s press release announced a 17 year deal with Sinochem to provide up to 1.8 million tons per annum. In recent weeks they’ve announced 13 year deals with Glencore and ENN LNG of Singapore.

Cheniere continues to be an attractive investment in spite of this year’s sharp rise. The completion of a sixth “train” (the name given to an LNG liquefaction unit) at Sabine Pass looks to be on track for 1Q22. Their growth capex needs are falling sharply, which driving free cash flow.

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Morgan Stanley produces a chart of estimated sustaining capex as a % of EBITDA – what each company needs to reinvest annually to maintain its profitability. Cheniere’s situation is the best in the industry. Their stock price doesn’t yet reflect these very strong fundamentals.

The energy crisis engulfing much of the world has prompted Asian buyers to lock in long term supplies of LNG. It demonstrates that natural gas is uniquely situated among fossil fuels to benefit from the energy transition – when burned it generates typically a third to a half less CO2 than coal and doesn’t cause the same type of local pollution. Natural gas power plants are also easy to start up when weather-dependent renewables suddenly stop producing.

Alex Epstein, who wrote The Moral Case for Fossil Fuels and routinely exposes the sloppy thinking of environmental extremists, refers to solar and wind an “unreliables”. Epstein lives in California, so has some experience with expensive and unreliable power. The Golden State recently announced plans to increase its natural gas storage capacity to assure reliable power this winter. They’re finding the limits to weather-dependent power.

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Oil and gas are higher because of rebounding demand, but the energy transition is another important factor. For years public policy and climate extremists have warned of stranded assets as renewables render reserves of traditional fuels uneconomic. Al Gore, who’s been warning us about climate change for decades, describes oil and gas reserves as “a subprime carbon bubble of $22 trillion, based on an absurd assumption that all of those carbon fuels are going to be burned.” Although Al Gore doesn’t drive energy sector capital allocation, extreme views like his are boosting returns by curbing new investments.

High energy prices are contributing to elevated inflation. Although Fed chair Jay Powell is retaining the “transitory” narrative, supply chain problems did not drive LNG shipments as high as $56 per million BTUs in Asia (see Energy Demand Drives Earnings Higher). Equivalent US prices are under $6. Pipeline investments have performed well as a hedge against inflation since the market low of March 2020. Although the S&P500 has rallied strongly since then, the American Energy Independence Index (AEITR), representing the North American energy infrastructure sector, has a visually better fit with inflation expectation (defined here as ten year forward inflation derived from the yield on ten year treasuries minus TIPs).  Daily returns on the AEITR versus inflation are correlated at 0.43 during this time, versus only 0.31 for the S&P500.

In his press conference last week, Chair Jay Powell once again emphasized that the FOMC expects inflation to moderate, although some commentators assessed slightly less conviction in his delivery. Eurodollar futures continue to forecast short term rates 0.65% higher by the end of next year, although a week ago expectations were even higher. The sharp flattening of the yield curve in several markets appears to be at least partially due to some hedge funds exiting losing trades in a hurry (see Balyasny, BlueCrest, ExodusPoint Ground Traders Over Losses). Nonetheless, the market is still expecting the Fed to concede a policy error and quickly raise rates.

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Compared with past interest rate cycles, the Fed is in a pretty good position. Neither the energy transition nor drawn out supply problems are issues to be resolved by raising short term rates. Those states and countries that have high renewables penetration (California, UK and Germany) also have high prices. Efforts to reduce CO2 emissions will result in more costly power, and the Fed shows no inclination to lean against this.

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Moreover, negative real yields on treasury securities are leading to persistent low interest rates. Although the Fed has made a mistake in waiting until now to curb its bond buying, there has been no visible penalty in terms of slumping bond prices. The traditional pressure from bond vigilantes is absent, because so much return-insensitive money is invested in fixed income. Stocks make new highs almost every day. So although financial professionals are taught about the evils of inflation from an early age, the pressure on the Fed that’s often cited is limited to criticism from Larry Summers and others. Absent any clear economic or market stress from rising inflation, the case for maintaining low rates until the pre-Covid level of employment is reached must seem compelling to Powell and many others on the FOMC.

What this means is that the Fed’s tolerance for inflation is likely to be higher than fixed income markets perceive. Combined with negative real rates, we’re a long way from where the bond market will offer an adequate return. This implies that stocks, and especially inflation-sensitive stocks, will remain the only plausible means of maintain purchasing power for a long time to come.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

The global energy crisis is turning out to be the catalyst driving the sector higher. Years of under-investment in new oil and gas output are finally colliding with relentless demand growth. Energy investors are enjoying growing free cash flow because of reduced capex. The credit for this shareholder-friendly behavior should be shared with climate extremists – although Wall Street has lost interest in non-accretive production growth, executives have also been forced to acknowledge the reality of the energy transition by a relentless barrage of protests, court challenges, noisy activists and media.

The consequent improvement in financial performance has investors cheering while management teams proclaim that they were always planning to adapt. The irony is that the resurgence of the energy sector on the back of high prices is one of the most tangible results of Greta et al. The inability of oil and gas producers to respond to rising energy demand by increasing output was supposed to be made irrelevant by greater penetration of solar and wind power. That traditional fuels have seen their prices rising while solar panels and windmills are not reported to be in short supply highlights both the effectiveness of climate extremists as protesters and the ineffectiveness of their policy prescriptions.

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Williams Companies (WMB) reported another strong quarter after Monday’s close. Natural gas volumes in their gathering business (14 Billion Cubic Feet per Day, BCF/D) and pipeline transportation segment (23.8 BCF/D) underpinned results. Asian buyers have paid as much as $56 per Million BTUs for shipments of Liquified Natural Gas (LNG), an enormous premium to US prices of around $6. China has returned as a significant buyer of US LNG exports, and is likely to replace Japan this year as the world’s biggest importer.

The price gulf reflects constraints on US liquefaction infrastructure. Adding capacity takes years. Cheniere, America’s biggest LNG exporter, is one of the biggest beneficiaries. They are now reducing growth capex with commensurate improvement in free cash flow after many years of developing its export facilities.

US LNG exports averaged 9.3 BCF/D during September – down from August but the most ever for that month. Poor weather in Louisiana delayed some shipments and Cove Point was down for annual maintenance.

Given the price differential, foreign buyers are desperate for higher volumes from the US. The Energy Information Administration expects LNG exports to average 10.7 BCF/D during the winter months, buoyed by continued global demand.

Regular readers know we have long favored natural gas over crude oil pipeline exposure. Natural gas has a more visible growth path. The shift to electrification of energy consumption provides strong support, as does weaning power stations off coal. Growth in renewables also increases the need for “dispatchable” power — i.e. electricity that can be transmitted when needed and not just when the weather co-operates. Most serious long term forecasts of global natural gas demand show growth of 1-2% p.a. for the next three decades (generally the forecast horizon).

I spent the last couple of days visiting with clients in SW Florida. Bigger firms are seeing close to normal return to the office. Commutes in the Tampa Bay area are typically less than 30 minutes – a far cry from the 75-90 minute twice-daily trip I endured commuting between NJ and NYC for 25 years – so the case for remote work is less compelling.

In conversations with Investors, it’s clear that the income offered by pipeline stocks is regaining its former appeal. Dividend coverage continues to grow. For example, WMB expects its adjusted funds from operations to exceed dividend payments and growth capex. Their dividend is +2.5% on a year ago and they announced a $1.5BN stock buyback program.

The COP26 climate change conference in Glasgow is exposing the fault lines between OECD countries, that generally want lower CO2 emissions now, and emerging economies like China and India that prioritize raising huge swathes of their populations out of poverty. This requires increased energy use, most starkly shown by China and India’s refusal to curb domestic coal consumption.

Just as attendees at the Davos Global Economic Forum appear tone-deaf by arriving in private jets to preach reduced emissions to the proletariat, so are political leaders in Glasgow. Photos of dozens of limousines with their engines idling and President Biden’s 85-car motorcade on a recent tour of Rome suggest that lifestyle changes are still expected to apply to others.

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One might think that rich world efforts to reduce emissions would lose momentum if the world’s #1 and #3 CO2 generators plan to keep increasing theirs. What seems more likely is that developed countries will maintain their efforts to decarbonize. Therefore, energy demand is likely to keep rising as living standards improve in poorer countries while publicly held oil and gas companies maintain their relatively parsimonious control over capex budgets. Higher prices over the medium term seem inevitable. Bank of America expects crude oil to reach $120 per barrel by next summer. BP said global demand is back to 100 million barrels per day and is likely to be higher next year. US production remains 1.7 MMB/D below where it was when world demand was last at this level, as drillers remain cautious about capex.

Methane leaks from natural gas production face new more stringent regulation in the US from the EPA, which is another constraint on new infrastructure investments to support higher production.

Firm oil and gas markets combined with still attractive valuations and continued financial discipline are why midstream energy infrastructure remains a compelling investment.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

A significant interest rate move has taken place in recent days that has received scant coverage from mainstream financial media. The market has priced in a more aggressive pace of Fed tightening over the next couple of years, while simultaneously moderating the outlook beyond that. This flattening of the yield curve has been reflected in the spread between two and five year treasury securities, which reversed a steepening trend. The change in yields appears unremarkable. Eurodollar futures incorporate the same rate expectations but with greater precision, because they reflect market expectations of Fed monetary policy in three month increments.

Over just a few weeks, projected tightening of rates has been brought forward by at least a year. Ten year treasury yields have risen just a few basis point on the month, whereas eurodollar futures two years out have jumped 0.50%.

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As a result, the trajectory of Fed policy has shifted even farther from guidance set out by the FOMC and many analysts.

For over a decade the Fed has sought to be more transparent about their decision making. This has included publishing minutes, holding regular press conferences and releasing projection materials on their economic outlook. The Fed’s projections have not always been accurate. The “dot plot” which sets out what FOMC members individually expect for short term rates has in the past been revised to match those reflected in the yield curve.

The Fed’s “neutral” rate is the level of Fed Funds at which they’re not seeking to provide stimulus or restraint. For many years it was 1-2% above long term bond yields, even though they should theoretically be similar (see Bond Investors Agree With the Fed…For Now). The two finally converged in 2018, mostly via the Fed consistently revising their figure down. The discrepancy returned after Covid and still exists today to a lesser degree.

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The central bank’s past failure to correctly forecast its own actions is a source of amusement for those who pore over such minutia. Fed chair Jay Powell has said in the past that forecasters have much to be humble about, an observation most applicable to the FOMC.

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So it’s not the first time the market and FOMC have disagreed. Based on history you’d have to favor the collective wisdom of millions of investors over the Fed, even though the latter makes the decisions. Nonetheless, futures prices now anticipate short term rates 0.65% higher by the end of next year. As recently as late September, nine of 18 FOMC members thought monetary policy would still be unchanged at that time.

The Fed continues to buy $120BN of bonds per month. Next week they’re expected to announce tapering, and past comments have suggested a measured reduction of $15BN per month which would take until June 2022 to complete. They won’t tighten while they’re still buying bonds, which would mean no sooner than 2H22. Market forecasts of earlier tightening rely on faster tapering or a series of rapid moves as soon as July.

Either scenario is at odds with an FOMC whose public comments maintain inflation is transitory and that the employment situation still needs improvement. Interest rate futures are priced for Jay Powell to express less confidence in the “transitory” narrative around inflation.

Wednesday’s press conference following the FOMC’s two-day meeting should resolve the discrepancy for now. If Jay Powell confirms market forecasts, that will represent a concession that earlier confidence on moderating inflation was misplaced. If he sticks with his theme, at least some of the recent curve flattening will reverse.

Recent data has been mixed. US 3Q GDP rose just 2%, held back by the delta virus in some states and continued supply difficulties. Apple’s earnings on Thursday were a case in point. But the Employment Cost Index rose 1.3% over the prior quarter, up 3.7% over the past year. Healthy wage growth suggests strong employment

Total employment of 147 million remains five million below pre-covid levels, a metric Powell has often cited as evidence that the employment component of their mandate remains unfulfilled. Nonetheless, record high job openings noted in last Sunday’s blog post (see Life Without The Bond Vigilantes) suggests demand for workers is being frustrated by a skills or location mismatch.

Rising energy prices are a predictable part of the energy transition (see Is The Energy Transition Inflationary?), even if progressives whose policies have constrained oil and gas supply won’t claim credit. Tighter monetary policy isn’t much help for consumers paying more to fill up their cars and heat their homes. The COP26 climate change meeting is well timed to grapple with the challenges unrealistic climate extremist energy policies have created.

The real issue is that consumption is running well ahead of trend, because the fiscal and monetary response to Covid was disproportionate. That could justify tighter policy, but isn’t a reason that’s received much attention.

A few central banks have already begun to withdraw stimulus. Canada abruptly stopped their bond buying last week. The UK’s Bank of England has said they may consider raising rates. Short term rates in Brazil have reached 7%.

Last week the European Central Bank (ECB) maintained their large bond buying program, and ECB President Lagarde said markets were incorrectly pricing in a tightening next year. Traders were non-plussed, and yields rose further. The Fed and the ECB are the two heavyweights not yet willing to abandon the transitory narrative.

Some commentators suggest that stubbornly elevated inflation may force central bankers to concede to the market’s forecast of higher rates, sooner. But the bond market has lost its ability to cower policymakers into submission. Persistently low bond yields and record high stock prices suggest that the Fed has plenty of time to continue their single-minded pursuit of maximum employment.

Next week’s Fed press conference and the conclusion of COP26 will provide important guidance for investors in bonds and energy.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

We spent last weekend in Boston with our daughter, who’s at school there and just turned 21. We visited the Mapparium, a glass spherical room that has the visitor standing inside the globe, with the world’s countries as in the 1930s (i.e. much of Africa was controlled by European powers and India had not yet gained independence from Britain).

It’s a cool experience. The Mapparium highlights features often not apparent on a 2D map – Greenland and Madagascar are approximately the same size; Britain is further north than Nova Scotia but enjoys a milder climate thanks to the Gulfstream; Russia sits at roughly the same latitudes as Canada; and Naples, FL is approximately on the same latitude as Riyadh, Saudi Arabia, even though the latter is often at least 20 degrees F hotter. Visiting the Mapparium, in the Mary Baker Eddy Museum, can be done in an hour or less and is worth the visit.

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Visiting New England reminded me of the region’s dysfunctional energy policies. Unwilling to allow natural gas to be transported by pipeline from the Marcellus shale in Pennsylvania, Boston has in the past relied on imported Liquified Natural Gas (LNG) from Russia. The US has been mostly spared the impact of the energy crisis engulfing Europe and Asia.

This winter that will change as high natural gas prices increase the cost of heating homes and businesses. New Englanders will feel it more acutely than most based on futures prices.

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Favoring imports from our geopolitical rival rather than Pennsylvania means they’ll soon be following LNG prices in Europe and Asia, since that’s who they’ll be competing with to stay warm.

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Once again, energy policies designed with little more thought than a Greta soundbite will see the region paying 2-3X what they could for natural gas if they favored domestic supply over foreign. Residents are getting used to it (see An Expensive, Greenish Energy Strategy).

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On Monday, the New England Independent System Operator (ISO) reported 74% of its power was being generated using natural gas and 8% renewables. It’s remarkable they can still access that much natural gas given opposition in the region from environmental extremists, but they need to keep the lights on even at the risk of their ESG credentials.

Of the 8% that was from renewable sources, the biggest share was from refuse. Solar and wind were providing around a quarter of renewables so 2% of the ISO’s power — about the same as wood, the burning of which can be more harmful than coal.

New England has the same misguided strategy as Britain (see The Cool North Sea Breeze Lifting US Coal) of believing renewables would compensate for self-imposed reduced access to natural gas. Theirs is another example that should inspire no emulation. But as natural gas pipeline investors, we find ourselves in broad alignment with their results (higher natural gas demand) if not their goals.

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Switching gears, the chart showing Personal Consumption Expenditures (PCE) on durable and non-durable goods provides further evidence that enormous fiscal and monetary stimulus have put the US economy on a faster, more inflationary growth path than pre-Covid.

The trendline over two decades provides a reasonable estimate of the drop in PCE (all goods) caused by Covid. The area beneath the trendline represents $860BN of purchases. Since then, Federal stimulus has driven an excess of consumption over this trendline of $7.6TN, almost 9X the shortfall. And that’s so far – future consumption is unlikely to immediately revert back to trend.

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It’s another example of how the initial US fiscal and monetary response to Covid, which was appropriate, morphed into an enormous handout which continues to distort much of today’s economy. Labor and housing are the two biggest examples. The unprecedented number of openings as detailed in Sunday’s blog shows that the labor market is struggling with a skills/location mismatch not a shortage of jobs (see Life Without The Bond Vigilantes). Everyone except the FOMC seems to understand that the housing market has been goosed higher by continued buying of mortgage backed securities.

The Federal Reserve is losing any credibility it may have had on inflation. Their singular focus on restoring the shortfall of five million jobs lost since pre-covid is creating all the upside risk on inflation that is confronting investors.

In recent months the energy transition and the exposure of the Federal Reserve’s inflation-seeking agenda have come together as twin threats to the stability of purchasing power. The term “irrational exuberance” was famously coined by Alan Greenspan in the late 1990s to describe the dot.com bubble, and it’s become part of the investment manager’s lexicon. For example, we often describe the pipeline sector as being completely devoid of any exuberance whatsoever, which is why it’s likely to keep rising. Similarly, one of Jay Powell’s less damaging contributions to financial history will be the re-defining of “transitory”, to mean something that is likely to persist longer than expected.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund