“If I seem unduly clear to you, you must have misunderstood what I said” was Fed chair Alan Greenspan’s response during testimony to the Senate in 1987. Transparent communication has come a long way since then. Greenspan continued the policy of obfuscating responses, reflecting a belief that it improved the Fed’s operating flexibility by disguising mistakes. This inspired Secrets of the Temple: How the Federal Reserve Runs the Country, William Greider’s 1989 scripture describing faith-based monetary policy.

Today, the Fed’s projections are public. Their meeting minutes are published. The mystery has gone, although they still are the most important market participant. Transparency allows for comparison between market forecasts of interest rates and the Fed’s. Of course, the latter has the advantage of being able to make their forecasts correct through their actions, should they be so moved. Fortunately, the Federal Open Market Committee (FOMC) is not burdened with excess vanity, so serially inaccurate interest rate projections do not bother them.

In recent years it’s been mildly amusing, in a nerdy sort of way, to show how the FOMC’s long term forecasts for inflation and the Fed Funds rate have followed bond yields lower, conceding the market’s prescience. Fixed income investors have been ahead of this for years, exhibiting greater accuracy about Fed policy than the FOMC itself (see Bond Market Looks Past Fed). Covid made such games irrelevant, but as markets look beyond the pandemic, revisiting FOMC Projection Materials is becoming worthwhile again.

In August, Fed chair Powell gave a speech where he addressed persistently low inflation and how this had caused FOMC members to continually lower their rate forecasts. He explained how 2% inflation remained their definition of price stability, but since recessions typically cause it to undershoot, the FOMC would henceforth be more tolerant of greater than 2% during a strong economy. The inference, reflected in subsequent FOMC projection materials, is that short term rates will remain low for a long time, at least long enough for inflation to exceed 2%.

The chart compares the futures market with the FOMC’s forecasts. There is some judgment involved – the FOMC provides annual estimates through 2023 followed by a long-term assumption. The chart assumes that the long run is five years away. The market, as has been the case for years, is assuming lower rates than the FOMC.

Rates probably will stay low. Betting on higher inflation has been a fool’s game for longer than the average investor’s career. But these are unusual times. M2 money supply growth is 24%, higher even than when we were trying to whip inflation in the 70s and 80s. The fiscal outlook is as bad as ever, with debt projected to exceed the wartime highs of 1945, and stay there.

Modern Monetary Theory (MMT) as explained by Stephanie Kelton in The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy, holds that deficits don’t matter until they cause inflation. MMT has been widely panned by mainstream economists and isn’t regarded as a serious framework for fiscal policy. But the reality is that deficit hawks win few votes nowadays. We are, in truth, already pursuing the unlimited government spending that MMT advocates. Higher inflation is the only remaining obstacle, as we noted on Sunday in Deficit Spending May Yet Cause Inflation.

Low inflation remains likely, so betting against this is unbelievably cheap. The eurodollar futures curve offers precise forecasts of short-term interest rates, which in 2022 are expected to rise only 0.06%; that is, the spread between the December ‘21 and December ‘22 futures contracts is 0.06%.

Suppose that the economy emerges from Covid by the spring, as the vaccines allow a return to our previous lives. Consider whether a desire to live for the present promotes a vigorous economic rebound, as people catch up on experiences, trips and visits long delayed. The Roaring 20s followed the 1918 Great Influenza, although the still fresh horrors of World War I also played a significant role in the zeitgeist.

If inflation does pop above 2% next year, markets will start looking more carefully at near-zero Fed Funds and its longevity. No rate hike until 2023 will look to some like an awfully long time. The 0.06% spread between the December ‘21 and December ‘22 futures contracts could easily move to 0.25%, still representing only a single rate hike over that year.

The question is whether the odds offered by the market are sufficiently different from the odds of such happening, the minimum criteria to justify a trade. The money market curve is unlikely to invert, so the loss if nothing happens is a few basis points. The risk/return on this trade is a long way from 50/50, but the odds of an inflation jump are low too. Call it the MMT trade.

Some investors are already contemplating higher inflation. Bitcoin buyers are among them. There are cheaper ways, with well-defined downside, to express such a view. The eurodollar futures curve is one of the best. Your blogger has already initiated this trade.

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

Technological advances in solar, wind and batteries receive widespread media coverage. Costs are falling and battery back-up is improving, vital to cope with renewables’ intermittency. As Enbridge CEO Al Monaco noted last week (listen to our podcast, Oh Canada’s Pipelines!), the world is going to use more energy, and consumption of every form of energy will increase. While the media focus is on renewables, fossil fuels represent 80% of global energy consumption. Improving what already works, by dealing with emissions, is also a recipient of considerable R&D.

Hydrogen is receiving increasing attention. It has a reputation for being perennially five years away from cost effectiveness – but investors are certainly taking note of anything that’s hydrogen-related. A couple of months ago we noted how New Fortress Energy (NFE) had seen their stock triple this year on little more than vague plans to ship hydrogen (see Hydrogen Lifts an LNG Company).

The emission benefits of using hydrogen depend on how it’s produced. The most common method is methane pyrolysis, which uses heat to separate hydrogen from carbon (methane is CH4). Another process applies electrolysis to water, which separates the hydrogen atoms from oxygen, Both require energy as an input.

Most hydrogen in use today is “gray”, meaning fossil fuels are used in its production. “Blue” hydrogen is derived from methane, with the CO2 that’s produced as a by-product being captured. That’s already a pretty good result. “Green” hydrogen relies on energy from renewables to power the extraction process.

Hydrogen is an appealing solution if costs can be brought down, because burning it produces water, not CO2. Compared with methane it is less dense, and causes the steel used in pipelines to become brittle, which means it can’t currently be moved in a pure form through existing infrastructure.

But hydrogen is already being added in small quantities to existing supplies of natural gas (methane). For example, Los Angeles is currently adding 4% hydrogen to their natural gas supply and is hoping to get to 10%.

Pipeline companies are watching this area closely, awaiting solid evidence that it can be made commercially viable. If hydrogen use does gain traction, today’s midstream infrastructure businesses are well positioned to benefit, since hydrogen transportation will be via pipelines. The industry will surely find a technical solution to the problems caused by direct interaction of hydrogen with steel – perhaps by applying a protective coating to the inside.

Recently, United Airlines announced an investment in 1PointFive, a joint venture between Occidental (OXY) and Rusheen Capital Management that aims to extract CO2 from the atmosphere. Airlines know that renewable energy won’t help them curb emissions – batteries are far too heavy to be built into an airplane. And jet fuel has the added benefit of being burnt as it’s used, decreasing weight.

Aviation is estimated to produce over 2% of global CO2 emissions. Post-Covid, flying is likely to resume its upward path in developing Asia at a minimum, even if a full return to normalcy is five years away as some airline executives fear. Nonetheless, it highlights that solar and wind offer a limited set of solutions, which means ongoing need for liquid fuels.

Extreme weather events have caused a jump in solar panel insurance. Last year a hailstorm in Texas caused $70MM in damage to a solar farm. California wild fires damaged three sites earlier this year. Solar panels are easily damaged, and insurance rates are 20-30% higher than a year ago.

“We have seen projects that were achieving their expected returns no longer able to do that, as a result of the change in the cost of insurance,” said Michael Kolodner, US power and renewables practice leader at Marsh, an insurance broker.

Those who blame these and other extreme weather events on climate change will not appreciate the irony.

Another non-renewable, clean energy solution is NetPower’s emission-free natural gas turbine (see Clean Fossil Fuels May Be Coming). The company explains that their patented “Allam-Fetvedt Cycle burns natural gas with pure oxygen. The resulting CO2 is recycled through the combustor, turbine, heat exchanger, and compressor.”

NetPower says they have, “Multiple projects are in development worldwide for rapid global deployment of commercial units.”

Cleaner ways of burning natural gas; extracting harmful CO2 out of the atmosphere; commercially viable hydrogen. These are all potential solutions to the problem of lowering emissions that don’t rely on solar panels, windmills and batteries. These are the types of breakthrough that could quickly put today’s pipeline companies at the forefront of combating climate change. What’s clear is that innovation is happening in many more areas than simply the use of sun and wind.

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

November was a month of records for stocks, including for the energy sector. The American Energy Independence Index (AEITR) was +20.8%. This year has seen the top two months, and it’s still –16.1% YTD. 

Crude oil grabs most of the attention, but propane is an under-appreciated area of rising production that’s driving higher exports. It’s generally used for heating by businesses, industry and homes, but is also used for cooking in rural areas that are not reached by natural gas (methane).  

Propane exports have been rising steadily for the past decade, growing at a 26% compound annual rate since 2010. We crossed the 1 million barrels per day threshold in 2017. The Covid pandemic is barely a blip. 

One reason for this is increased demand in India. Propane is often produced as a by-product of oil refining, but in the U.S. it’s found naturally in gas wells where it’s separated out from the methane.  

Tens of millions of households in India rely on bottled propane for cooking and heating. The drop in gasoline demand earlier this year lowered local refinery runs, depressing propane production. So India turned to the U.S. for imports (see Energy Does More Than Move People). 

Enterprise Products Partners (EPD), the biggest MLP, is one of the winners from this business. They include propane in their Natural Gas Liquids (NGL) segment, and they’ve participated in this growth as much as any company.  

NGL exports volumes are now similar to crude oil, though few outside those following EPD would know that. Propane dominates the segment. 

This has driven EPD’s margin from NGL pipelines and services to a 9% compound annual growth rate over the past five years. Based on the first 9 months, 2020 looks set to be another record year for NGLs.  

This all highlights the resilience of their business model.  

Nonetheless, EPD’s stock price has lost a third of its value this year, even after a 17% gain in November. This reflects continued loss of appetite among investors for the sector. EPD’s $1.78 dividend currently yields almost 9% and looks secure since the company has bought back $225MM in stock this year out of an announced $2BN program.  

Investors often ask whether EPD will convert to a c-corp. There can be little doubt that, if accessible to a far broader set of buyers, their stock would rally. However, insiders own 32% of the company, and they have concluded that subjecting their profits to corporate taxes doesn’t justify the potentially higher valuation. Although EPD never had to cut its distribution, unlike most of its MLP peers, it suffers guilt by association with many poorly run brethren. CEO Jim Teague usually runs a colorful quarterly earnings call – regular listeners look out for the Vietnam references (i.e. he’s been in tougher spots than 2020).  

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

Renewables receive a disproportionate share of media coverage given their still small size. In 2019, less than 9% of America’s power came from solar and wind. Fossil fuels (mainly coal and natural gas) are over 62%. Moreover, electric power is only 37% of our total energy use. Renewables receive outsized attention because of the hope they will lead to lower emissions. A look at recent daily data on U.S. power generation illustrates the challenges we’ll face in relying on intermittent, low-density sources of energy.  

California is a leader in moving away from fossil fuels. We should hope the rest of America doesn’t seek to emulate them, because Californians pay the most for the least (see California Dreamin’ of Reliable Power). 

The first four charts draw on hourly electricity generation across the lower-48. Solar and wind are both intermittent – solar is fairly predictable,  and wind less so. The challenge for grid operators is matching demand with supply.  

Over a recent seven day period, solar and wind provided 15% of our electricity, but the range was between 8% and 21%. Because their share is still small, this variability is easily managed by dialing other power sources up or down as needed. Natural gas combined cycle (NGCC) plants have the advantage of being easily recalibrated to accommodate fluctuations in nature’s power output. Their flexibility enables increased use of renewables – a benefit Californians are denied because of a purist dogma that has seen them phase out even natural gas power plants. 

In combination, solar, wind and natural gas provided almost half our electricity over a recent seven-day period. What’s especially interesting is that natural gas output is strongly negatively correlated with the intermittent sources. This highlights the symbiotic relationship between the two.  

Power demand isn’t constant – it’s higher during the day and peaks around dinner time. So we need variable sources of power. For example, if we used nuclear power exclusively, its constant output would require either storage or supplementary power to match demand.   

Cost estimates of intermittent power sources need to include either complimentary natural gas power or battery back-up. Breathless media coverage of the topic rarely considers the fully-loaded costs.  

The chart below is from a paper published by the University of North Carolina which compared the cost of electricity from an NGCC with different combinations of renewables and back-up to achieve the same output for the 85% of the time such plants typically run. Solar and wind generally product at about 25% of capacity.  

None of the alternatives are cheaper than an NGCC, although solar with NGCC back-up is the cheapest of the three alternatives considered.  

In recent years natural gas has been the biggest contributor to falling U.S. emissions, and is enabling increased use of renewables. Continuing this success is our best path to combating climate change.   

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