As we noted last week, the world doesn’t need another anodyne “2022 Outlook”. So we’ve put together a set of upside scenarios that are plausible but not consensus.

Last week we published The Upside Case For Pipelines – Part 1. This examined factors unrelated to commodity prices that could provide the sector a boost. This blog post considers what might boost oil and gas prices, which would likely provide a lift to the sector.

They fall into four categories – cyclical, geopolitical, Covid and the energy transition.

1) Cyclical factors that are bullish

Reduced growth capex has become a positive habit for the energy industry. Depletion of oil and gas wells is 2-4% of production – meaning that the industry needs to invest in that much new supply just to stay even. Crude oil demand has obviously been volatile over the past couple of years, but looks likely to reach new record levels over the next couple of years, driven by growth in emerging economies. The industry seems poorly positioned to meet this extra demand.

Capex is down 2/3rds from its 2014 peak, and the industry shows little inclination to boost it in spite of high prices and entreaties from the Administration. RBN Energy expanded on this theme in September (see Where Has All The Capex Gone? E&P Investment Down Despite Rising Prices And Cash Flows).

Global oil inventories have been drawing down since early last year, leaving little excess available. Moreover, OPEC countries are producing well within their stated capacity, which leads some to suspect that their actual maximum production capability is less.

The story is similar with natural gas, except that global demand is more clearly rising. Because transportation costs are relatively high, regional prices vary substantially. TTF futures, the European natural gas futures benchmark, are priced at the equivalent of $26 per Thousand Cubic Feet (MCF) for January 2023, lower than the $29 equivalent price of the front month January 2022. US prices are one seventh of this, so the prospects for continued growth in shipments of US Liquified Natural Gas (LNG) to Europe and Asia look good.

Against this positive backdrop for prices, it’s worth remembering that oil services companies shrank payrolls in response to the drop in capex, so even if spending did ramp up it would take time for the industry to rehire and retrain.

Lastly, economies around the world have been improving their energy efficiency. The US is no exception. Adjusted for inflation, it takes 60% less energy per $ of GDP output than was the case in the 1970s. Therefore, energy prices have a smaller impact on the economy today, making it better able to withstand higher energy prices than in the past.

2) Geopolitical factors that might surprise

The middle east remains one of the less stable regions of the world. A fifth of the world’s crude and an increasing amount of natural gas pass through the Strait of Hormuz. Although it’s unlikely Iran could ever cause more than a temporary disruption to supplies, the threat remains, along with the possibility of conflict breaking out elsewhere. The world has very little spare capacity, so is vulnerable to surprises here. A failure in the Iran negotiations over nuclear weapons would keep Iranian oil mostly off the world market.

Russia’s growing military threat to Ukraine is another flashpoint where armed conflict could disrupt supplies of Russian natural gas to western Europe. Nordstream 2, the controversial natural gas pipeline from Russia to Germany, is completed but not yet operational pending German and EU regulatory approval. Conflict in Ukraine might delay its start indefinitely – likely a factor behind the elevated price of January ‘23 TTF natural gas futures noted above.

3) Covid loses its ability to disrupt

The Omicron variant is highly infectious and milder than preceding variants. It is causing far fewer hospitalizations and research shows why it’s causing less severe illness (see Studies Suggest Why Omicron Is Less Severe: It Spares the Lungs).

Economic disruption from Covid has come mostly from the mitigation steps countries have taken to curb its spread. In the near term, Omicron’s fast rate of spread is likely to drive global supply disruptions in a more synchronized matter. Former FDA Commissioner Dr Scott Gottlieb has become a widely followed resource on covid, and he expects in 2022 we will “…go from a pandemic into a more endemic phase,” as countries learn to live with Covid without noticeable disruption.

As the world opens up, energy demand will increase especially in Asia where many borders have remained partially or fully closed. International air travel remains the one weak point in liquids consumption, and a rebound could push crude prices higher. We’ve already seen prices reach $80 recently without these sources of extra demand.

4) Energy transition

So far there’s little sign that renewables are reducing the world’s demand for oil, gas and coal. Higher prices for fossil fuels remain inevitable if consumers are to switch to other forms of energy. The failure of COP26 in Glasgow may lead to renewed unilateral efforts by policymakers to reduce emissions. Curbing coal remains the obvious target – consumption limits or wider use of carbon taxes would drive demand for natural gas as the closest substitute, and to a lesser extent crude oil.

New Year’s Day brought an encouraging report that the EU will classify nuclear power and, in certain cases, natural gas as “green” energy. The requirements for natural gas include that it’s being used to replace coal, and that its emissions are no higher than 270g per Kilowatt Hour (KWh). Natural gas emits 180g per KWh, so even allowing for conversion losses this ought to be an achievable benchmark.

Assuming the news report is comfirmed, EU endorsement of natural gas as part of the energy transition solution is a long term very postive development for the natural gas industry. It will likely add momentum to emerging economies and perhaps even the US to adopt a similar approach. It should be supportive of natural gas demand and correspondingly negative for coal.

The energy crisis of 2021, which exposed some countries’ overly hasty embrace of renewables, showed that traditional sources of energy are vulnerable to sudden price jumps.

Any of the factors above or some in combination could drive oil and gas prices higher, potentially much higher, which would support already improving sentiment in the energy sector.

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

Please see important Legal Disclosures.

Today is Boxing Day. The US is rare among English-speaking countries in not celebrating the day following Christmas. Perhaps the habit was dropped following the War of Independence in a further shedding of the colonial yoke.

Our family continues to enjoy Boxing Day even after nearly 40 years in the US. It is in truth another day to over-indulge, including of Christmas pudding. This is a dark, heavy type of fruit cake liberally fortified with brandy and best served hot, with heavy cream. Americans know it as plum pudding, although it contains no plums.

English Christmas dinner of turkey and all the trimmings is only complete following dessert. Because a Christmas pudding is never as big as it looks, what appears to be a generous quarter slice presents as Scrooge-like by the time it reaches your plate. My opportunities to enjoy it are limited by my wife, who proclaims the ingredients (notably suet, which is fat derived from beef or mutton) deeply unhealthy which is of course why it tastes so good. Because the alcohol greatly extends its shelf-life Christmas pudding can, and often is, made months ahead of time. My grandmother used to make it in September, and once as a special treat served me one in May left over from Christmas.

This history, along with what the uninitiated hold is an unappetizing appearance, has convinced my children to steadfastly reject even a small portion. This is fine with me, not least because my wife’s reported desire to have me around for a good many more years limits the amount available. One consequence is that I offer it to our guests sotto voce with easily constrained enthusiasm while noting how good the chocolate cake looks. At such times my mother’s hearing becomes temporarily acute, and she claims my anticipated second slice. I’m told Christmas pudding is very hard to get, but I suspect if I did the holiday food shopping I’d find it in abundance.

Last week my wife, whose care for my general well-being is only exceeded by her love of a bargain, let me know she just bought two Christmas puddings on sale. She’ll keep them for next year.

Friends often ask me about the history of Boxing Day. Since servants had to work to make Christmas Day memorable for the household, Boxing Day was when they received a Christmas “box” (gift of money) and enjoyed their Christmas feast downstairs. Watch the Downton Abbey Christmas special sometime. For generations the English have coped without household staff, so Boxing Day has served to extend Christmas into a second day.

Boxing Day isn’t just about leftovers. The Premier League (English football) kicks off an intense schedule requiring each team to play three times through January 3^rd. It is a holiday season football festival. Coaches complain about insufficient recovery time but the world’s biggest soccer league supplies what its global TV audience demands.

Omicron is thankfully little more than a minor inconvenience and has not been allowed to interupt proceedings, although some games will inevitably be postponed while infected players self-isolate.  Nonetheless, for just over a week the choice of games to watch seems limitless.

For energy investors this has been a good year, by some measures the best in a decade. Because of this I reached Christmas, already one of my favorite times, in a thoroughly agreeable disposition.

Which is why on this Boxing Day, if your blogger can procure an extra slice of Christmas pudding while watching Arsenal win their first game of the hectic nine-day schedule, it will cap a Christmas as perfect as can be. Encouragingly, their opponents Norwich City languish at the very bottom of the table.

Boxing Day aside, I expect happiness from investing in 2022 will easily exceed the ephemeral pleasures offered by Arsenal and the Christmas repast. If so, few will complain.

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

Please see important Legal Disclosures.

If you weren’t able to join Thursday’s webinar, SL Advisors Midstream Energy and Inflation Outlook, you can watch a recording here.

The media referred to the Fed’s “hawkish pivot” following Wednesday’s revised dot plot and faster taper. More accurate is that chair Jay Powell confirmed that the FOMC was following the market’s earlier revisions to the rate outlook. Eurodollar futures traders and the Fed are once more synchronized over the next couple of years in looking for the Fed Funds rate to reach around 1.5%. Forecasts diverge beyond that, with fixed income traders comfortable that rates will peak, whereas FOMC members expect continued increases. When it comes to forecasting even their own actions, history shows the Fed has much to be humble about.

The great penalty of inflation is suffered by fixed income investors, who conventionally demand a return at least as high to preserve purchasing power. Negative real yields on G7 sovereign debt are muting the market’s concern about value erosion. Persistently low bond yields that result are supporting risk assets such as equities. Buoyant bond and stock markets mean that there has been very little pressure on the Fed to act. The pleas for tighter policy have not come from financial markets, but from well-qualified observers such as former Treasury secretary Larry Summers and former NY Fed leader Bill Dudley. A handful of politicians have expressed concern about inflation, but Congressional enthusiasm for tighter policy will expire before the first rate hike.

The result is that financial markets regard today’s high inflation as relatively costless. Return-oriented investors in US government debt should demand high real rates as compensation for the dire fiscal outlook. But return-insensitive buyers (central banks; pension funds) dominate, and their acceptance of guaranteed value erosion is a subsidy that makes inflation more tolerable.

Five year inflation expectations derived from TIPs yields began the year at 2%, and reached 3.1% a month ago although have moderated recently. The Fed targets Personal Consumption Expenditures (PCE) Inflation whereas TIPs settle against CPI. Technical differences mean PCE inflation runs lower than CPI – about 0.5% since 2000 but 0.3% since 2008. The bond market’s long term inflation outlook is a little higher than the FOMC’s long term 2% forecast even adjusting for PCE/CPI differences.

The consensus interpretation of the yield curve is that raising short term rates to 1.5% will be sufficient to bring inflation back to the Fed’s 2% target. An alternative explanation is that financial markets, and therefore the Fed, will tolerate higher inflation.

The Fed and most analysts expect declining inflation next year. Criticism flows easily when inflation is rising, but if it moderates as expected next year the FOMC will draw a collective sigh of relief. They’ll still taper and normalize rates, but the pressure from opinion leaders will be off. If Owners’ Equivalent Rent (OER), the quixotic survey-based measure of the cost of shelter, increases expect the Fed to look past it as a non-cash expense.

The absence of financial market stress during the current inflationary spurt will lessen the urgency to follow the rate path they’ve laid out. A hint of economic weakness will embolden those wishing to pause normalization. The flat yield curve would steepen.

Spiraling Federal debt and fortuitously low (negative) real rates make moderately higher inflation in America’s interests. The resilience of financial markets affords the Fed flexibility in normalizing rates and tolerance for a slower return to 2% inflation – or indeed inflation settling at a somewhat higher level.

The “hawkish pivot” shouldn’t be confused with a hawkish Fed. They simply followed the market. Their tolerance for temporarily higher inflation in support of full employment, the revised interpretation of their mandate announced last year, represents a more dovish approach to monetary policy. It’s one they’ve been following faithfully ever since.

Midstream energy infrastructure, as we noted in Thursday’s webinar, still offers attractive yields with decent upside through real assets that should provide protection against inflation.

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

Please see important Legal Disclosures.

In March we wrote about start-up Liquified Natural Gas (LNG) exporter, NextDecade (NEXT) (see Making LNG Cleaner). As with Tellurian (TELL) and Cheniere (LNG) before them, NEXT needs to sign up buyers of its LNG before obtaining the financing to complete the liquefaction infrastructure. The rolling global energy crisis which has seen European and Asian buyers paying over $35 per Million BTUs (MMBTUs) for shipments has improved the outlook for US LNG exports. The $25 per MMBTU regional difference with US domestic prices is testament to the constraints posed by limited LNG export capacity. NEXT aims to partially solve that – foreign buyers are eager, although US customers will wind up paying marginally more as increased exports push up prices.

French utility Engie pulled out of discussions with NEXT late last year because they were unhappy at buying Texan natural gas given the prevalence of flaring. Regulators in Texas have interpreted their oversight of methane flaring very broadly, with the result that flaring permits are routinely granted. In 2019 a dispute arose between Exco, a natural gas driller, and Williams Companies over Exco’s application to flare natural gas rather than pay the tariff Williams demanded for pipeline transportation (see Texas Reconsiders Flaring). It showed how Texas’ ready approval of flaring had abandoned the original intent, which was to allow the flaring of associated gas where no infrastructure existed in order to allow crude oil production. Williams argued that the natural gas infrastructure was available, but that Exco didn’t like the price. In September, a judge ruled in Williams favor but that may not be the conclusion.

European LNG buyers are likely to share Engie’s sensitivity to how their product is produced, so NEXT created a “carbon solutions” unit to capture the CO2 associated with their LNG activities. Last week SL Advisors partner Henry Hoffman chatted with management during Cowen’s 2021 Energy Summit.

We think NEXT is under the radar for most investors. They do have some sell-side coverage though. Credit Suisse raised them from Neutral to Outperform in March, which gave the stock a boost. The company has a firm offtake deal with Shell to deliver 2 million tons per annum (MPTA) of natural gas for 20 years. NEXT needs agreements on 9 MPTA more in order to fully sell out capacity for Phase 1 of their proposed Rio Grande facility in south Texas. They are optimistic that they’ll reach this goal next quarter, reporting discussions on volumes well in excess of what’s needed.

The Administration’s Build Back Better legislation, which is currently with the Senate, may boost revenues at Next Carbon Solutions if the CO2 tax credits are sufficient to stimulate additional demand for the new unit’s services.

NEXT is aiming to provide “green” methane, whose production is certified to have resulted in minimum methane leaks along with the capture and sequestration of the CO2 generated in its processing and eventual liquefaction for transfer to LNG tankers.

Henry Hoffman also held discussions with Tellurian’s (TELL) management. TELL’s founder and CEO is Charif Souki, whose weekly Youtube videos have developed a following among retail investors. We like TELL too, but Souki has an unpredictable, risk-seeking streak. He was forced out of Cheniere by Carl Icahn who opposed Souki’s plans to expand into natural gas trading. Why complicate a business with years of cashflow visibility not exposed to natural gas prices?

Last year Souki suffered a margin call on his personal holdings of TELL when the stock collapsed during the Covid rout. He has a healthy risk appetite. We also didn’t like the August secondary offering which was done at a substantial discount to the prevailing price. TELL has a business model that incorporates exposure to LNG prices, which is probably making it harder to finance but allows greater upside if LNG prices remain firm, as Souki believes they will.

TELL told us they were in discussions with private equity investors, which we think could be good as it will improve corporate governance, and get the company closer to having enough financing to begin construction of their LNG facility.

Natural gas remains the most impactful way for the world to lower emissions, by reducing reliance on  coal. Recently an overly hasty effort to transition to renewables in Europe has exposed weaknesses in their energy strategy and created further demand for natural gas. Although $35 per MMBTU is likely unsustainable, the long term demand for LNG is clear.

NEXT and TELL both offer the opportunity to invest in continued global demand growth for natural gas. We are invested in them.

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

Please see important Legal Disclosures.

Please sign up here for our webinar, Making Sense of Rising Inflation and the Global Energy Crisis, on Thursday, December 16 at 12 noon Eastern.

The Administration’s explanation for the less than transitory inflation relies on supply bottlenecks and a faster than expected rebound in energy demand. Both are wrong. The Wall Street Journal recently made an interesting argument that inflation will persist (see Another Reason Inflation May Be Here to Stay).

Personal Consumption Expenditures (PCE) on all goods (i.e. both durable and non-durable) is running well ahead of the long-term trend. March’s $1.9TN covid relief plan marked the end of Joe Biden’s presidential honeymoon. Critics of this and other elements of excessive fiscal stimulus point to the reason goods purchases are so strong with consequent higher inflation. Apparently, government planners expected prior spending patterns to be repeated, but services expenditures don’t show the same above trend trajectory.

In short, more of this $1.9TN was channeled into goods purchased online, and less than expected on services, reflecting that a portion of the population remains wary about going out to dinner, movies and other entertainment.

Services represents two thirds of PCE and goods only one third. So it might seem plausible to assume goods inflation will moderate, reinforcing the discredited transitory narrative.

However, as the Wall Street Journal points out, housing and healthcare make up over half of services PCE. With the government largely picking up the cost of Covid-related healthcare on top of Medicare and other Federally-financed programs, this sector is distorted.

But the Housing and Utilities component is dominated by rents – both actual and imputed. The WSJ notes that leases come up for renewal infrequently, and that eventually the buoyant real estate market will translate into higher rents.

This may be true – but the WSJ overlooks the fact that two thirds of American households own their homes. For them, the cost of shelter is based on Owners’ Equivalent Rent (OER), the often criticized estimate of the value of the shelter (a service) their home provides. This shows up in the services PCE.

For those unfamiliar with the distortions caused by OER, inflation is all about the cost of goods and services, not assets. A home is an asset that provides shelter, a service. Inflation statistics try and separate the two, by surveying home owners on what they think they could rent their house for. This is the estimated value of shelter. Because home ownership is so common in the US, a large chunk of estimated housing costs are based on OER. (for a more detailed explanation, see Why You Can’t Trust Reported Inflation Numbers). The Bureau of Economic Analysis published a revised explanation of housing costs earlier this year.

OER is a creation only a Bureau of Labor Statistics economist could love. It’s not supported by any cash transactions, but it’s used to estimate around $2TN of PCE. As the chart shows, it bears little relationship to the Case-Shiller index which tracks actual house prices – probably because most homeowners are puzzled when confronted with the survey question about rent. A defense of OER is that, over very long periods of time (i.e. a decade or more) it tends to track home prices – and sure enough since the last peak in home prices prior to the 2008 Great Financial Crisis the two series’ have similar returns.

Where next for OER? It’s hard to forecast since it’s drawn from survey responses and not actual transactions. But it’s unlikely to decrease its growth rate, and at least some homeowners might be expected to raise their imputed rent estimate in response to the strong housing market.

A rising OER will drive the services PCE higher, causing its trajectory to return to its prior trend or even exceed it. Although there won’t be any increase in cash receipts as a result, calculated spending on services will be higher and so will inflation, since CPI also derives its housing methodology from PCE.

Easing supply constraints may allow goods inflation to moderate, although there are no signs of that yet. Whether it does or not, services inflation seems likely to move higher. This will maintain the pressure on the FOMC to respond to inflation, even though OER doesn’t impact household budgets in the same way that, say, rising gasoline prices do.

It may even cause some at the Fed to comment about the weaknesses of OER, although strength in this metric would simply be a delayed reflection of the actual appreciation in home prices we’ve all seen.  Either way, inflation is likely to remain persistent not transitory, a term Fed chair Powell retired at his Congressional testimony yesterday.

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:

Please see important Legal Disclosures.