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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Last week was hailed as a big victory for climate activists. In a 1-2-3 punch on Wednesday, a Dutch court ordered Royal Dutch Shell (RDS) to further reduce emissions from its products; Exxon Mobil (XOM) shareholders elected two new directors proposed by an activist hedge fund against management’s recommendation; Chevron (CVX) shareholders approved a proposal to reduce emissions caused by its customers. 

All three companies will become less invested in future oil and gas production than they were previously. For those who regard energy companies as the cause of global warming, rather than the billions of individuals who buy their products, Wednesday’s three events were a watershed. 

Vanguard, Blackrock and State Street are XOM’s three biggest shareholders and also members of the Net Zero Managers Initiative which is committed to “net zero greenhouse gas emissions by 2050 or sooner.” It’s often believed that you can do well by doing good, and a popular narrative is that ESG funds are delivering good returns because ESG-oriented companies deliver better operating performance.  

The biggest ESG fund (ESGU), run by Blackrock, is imperceptibly different from the S&P500 (see Pipelines Are ESG). XOM and CVX are both holdings in ESGU. Blackrock’s ESG definition is flexible, like most proponents. Lockheed Martin is a perennial member of the Dow Jones Sustainability Index, so pretty much every company claims ESG-ness. Big natural gas pipeline corporations really are ESG, since they are helping displace coal for power generation in the U.S.  

Engine No 1, the activist shareholder in XOM, argued that the company was risking its very existence by continuing to provide the world with oil and gas. This is a non-ESG view based on an assessment of the company’s business prospects, but conveniently aligned with the climate change goals of its three biggest shareholders. XOM will presumably now chart a course that directs more investment to renewables.  

CEO Darren Woods clearly wants to keep his job – he has welcomed the new board members, even though in the past he’s questioned XOM’s strategic advantage in pursuing renewables. The business of fossil fuel extraction, processing and distribution (geology, refining, petrochemicals, retail gasoline) would seem to offer few synergies with building solar farms and windmills. Woods has in the past noted that they have little more than money to offer to such efforts.  

Perversely, all three developments from last week make the rest of the energy business more attractive. Future supply will grow less than it would have, while demand will continue to be led higher by emerging economies in Asia and elsewhere. Oil and gas prices will likely drift higher. All the focus of climate extremists is on supply, not demand. Consumers are far less susceptible to changing their behavior in support of reduced emissions. 

Based on how all three stocks reacted, these developments were not enthusiastically received. Shifting investments away from what these companies know to new areas with very different economics isn’t a compelling way to drive higher returns. The real winners are likely to be privately-held oil and gas producers, and OPEC nations who will welcome the increased market share at higher prices that last week promises.  

XOM, CVX and RDS all finished down for the week, lagging crude oil which is usually a reliable barometer of energy sector sentiment. They were also outperformed by North American pipelines, as represented by the American Energy Independence Index (AEITR).  

In the same week Tellurian (TELL) announced a ten-year agreement to sell liquified natural gas to Gunvor, a commodities firm. It shows that demand for natural gas remains strong. Privately-held Gunvor is relatively immune to climate extremists and must regard the strategy shifts forced on the three companies as vindicating their deal. But they and TELL can also claim to be constructively lowering CO2 emissions – without the natural gas they’ll be providing to customers in Asia, it’s likely more coal would be burned to meet the region’s growing demand for electricity. Switching from coal to natural gas is the most effective way for the world to reduce emissions, as America has demonstrated for the past decade.  

As shareholder-activists and litigants force uncommercial strategies on energy companies, it is creating profitable investment opportunities elsewhere in the energy sector. If supply is constrained too far, much higher prices will cause demand destruction and improve the relative pricing of renewables. But it looks increasingly likely we are heading into a Goldilocks period – growth capex sufficiently reduced to boost free cash flow and cause higher prices, but still enough supply to stop prices from spiking ruinously. The key will be to invest where activists don’t, so as to profit from their efforts. 

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

An enduring dichotomy in the valuation of midstream energy infrastructure companies has been the sharply different outlooks implied by debt versus equity pricing. Dividend yields of 6-7% suggest equity investors don’t regard their payouts as being sustainable indefinitely. Contrast that with investors in long term bonds, who accept yields of under 4% that can only be justified by a far more optimistic outlook about asset longevity. One camp presumably thinks the energy transition will leave pipeline companies with stranded assets, and the other believes the transition will not have harmed their prospects of principal repayment over the next three decades.

Equity investors probably don’t use years of remaining useful life as an input to valuing pipeline stocks. But their collective actions do imply such a judgment. In effect, the equity prices of pipeline companies imply that bond investors will lose their seniority in the capital structure before maturity. If Free Cash Flow to Equity (FCFE) will exhaust the company’s ability to pay its owners before long term bonds mature, those bond investors will wind up owning equity. How long will this take?

It turns out there’s a neat way to estimate this. The table below shows how this works for Enterprise Products Partners (EPD). It uses dividends because they’re easily identifiable, and therefore produces a more conservative (i.e. longer) useful life than using FCFE since companies are not paying out more than their FCFE in dividends nowadays.

Equity investors who have carefully considered buying EPD before ultimately rejecting it have concluded that the dividend will not last indefinitely. Therefore, they must regard the yield on EPD’s 30-year bonds as wholly inadequate for a fixed income investment, and that ultimately bond holders will own the equity when the existing common shareholders are wiped out. Since the bond yield is what the eventual owners need as compensation for this outcome, it can be used as the discount rate on future years’ FCFE. Adding up the successive years of FCFE until its value equals the price paid (i.e. today’s equity price) reveals when equity investors by implication expect those cashflows to stop.

For EPD equity investors, discounting the company’s $1.80 annual dividend back at the 3.8% yield on its 30-year debt means that today’s stock price reflects the NPV of 19 years’ worth of dividends. The company’s 7.6% dividend yield projects that today’s equity investors will be wiped out and replaced by bond holders, who will become the new owners of EPD, at that time.

This seems to us an unreasonably pessimistic view of the remaining useful life of the company’s assets. We’re also assuming no growth in dividends or giving credit to buybacks even though EPD has a buyback program in place which is returning additional value to equity investors. The implied useful life is even less than 19 years to the extent dividend growth and buybacks occur.

EPD bond investors fully expect to be repaid in full, and don’t anticipate owning the company. EPD’s stock price implies the opposite. It would be interesting to listen to a conversation between a well-informed non-buyer of EPD’s stock and one of their bond holders.

The math produces similar results for other big pipeline companies. Kinder Morgan’s (KMI) 29 year remaining asset life is longer than the others because its dividend is more generously covered. KMI slashed its dividend in 2015 and began cautiously increasing it in 2018. It has plenty of room to grow.

Environmental extremists would likely cheer the dour outlook reflected in pipeline stock prices. Last week the International Energy Agency (IEA) published a report laying out how the world could reach net zero energy-related emissions by 2050. It relies on some bold assumptions, such as no new investment in coal, oil or gas production starting now. It also incorporates significant behavioral changes including slower speed limits on highways, warmer settings on air conditioners and a 35% reduction in the percentage of households owning at least one car compared with current trends.

As usual the media covered the report’s release favorably. The Financial Times published three articles within 24 hours (Why the IEA is ‘calling time’ on the fossil fuel industry, Energy groups must stop new oil and gas projects to reach net zero by 2050, IEA says, and The IEA has delivered an overdue message). This is how pipeline equities are priced.

More representative of the view held by bond investors was Reuters, with Asia snubs IEA’s call to stop new fossil fuel investments. Although the energy transition will continue to impact everyone, the IEA’s report is more aspirational than plausible.

Even following this year’s rally, pipeline stocks reflect an expectation of stranded assets that bond investors, and many others reject. The sector is still cheap.

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

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