Hydrocarbons Support The Four Pillars Of Civilization

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Hydrocarbons Support The Four Pillars Of Civilization
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Vaclav Smil is a polymath whose prolific writing on energy has produced his latest book, How the World Really Works. You read Smil slowly, taking time to digest the facts and conclusions that are his trade. He combines expertise across several disciplines to explain the technology and inputs supporting modern western lifestyles.

In Fossil Future, Alex Epstein notes the substantial improvements that traditional energy have brought to humanity and argues that we should be celebrating not vilifying the hydrocarbons that make this possible. Smil demonstrates that the world will remain dependent on fossil fuels for the foreseeable future with data-based arguments.

The first three chapters of How the World Really Works, explain how indispensable agriculture, steel, cement and plastics are to civilization. Smil reminds us that, “Modern history can be seen as an unusually rapid sequence of transitions to new energy sources, and the modern world is the cumulative result of their conversions.” He estimates that coal provided half of England’s heat by 1620, but even by 1850 only 7% of fuel energy in Europe and North America.

Shifting the transportation sector to electric vehicles and decarbonizing power generation generate media interest, but start with agriculture to understand how the world feeds its 8 billion people. In 1800 98% of the US labor force was engaged in farming. Producing a kilogram of wheat required ten minutes of labor. Today it’s two seconds – 98% lower, along with the proportion of our workers engaged in agriculture.

The entire production process has benefited from fossil fuels – tractors pull plows manufactured with steel. Combine harvesters collect and process the crop. Propane is used to dry it. Trucks transport it farther down the production line. Refrigeration reduces spoilage. Around 1920 one quarter of US farmland was dedicated to growing feed for the 25 million working horses and mules.

Nitrogen-based fertilizers have dramatically increased yields. Manure, which used to be laboriously spread on fields, contains less than 1% nitrogen whereas urea, the world’s dominant solid nitrogenous fertilizer, is 46% nitrogen. Over the last century corn yields in America have increased from two tons per hectare to 11. Natural gas is converted into ammonia, a key input into urea production. Around the world, farming efficiencies have enabled population growth.

It’s unclear how even small portions of modern food production could be migrated away from traditional energy. There is no known substitute for fertilizers derived from natural gas. Battery-powered farm vehicles are implausible. Returning agriculture to its form of a century ago would leave the world unable to support its current population. It’s not going to happen. Moreover, on current trends we’ll add a further two billion people, mostly in developing countries, by 2050. Smil concludes that, “…without the synthesis of ammonia, we could not ensure the very survival of large shares of today’s and tomorrow’s population.”

Smil refers to cement, steel, plastics and ammonia as “the four pillars of civilization”. Global production of these four “indispensable materials” requires 17% of the world’s primary energy and generates a quarter of fossil fuel CO2 emissions. Cement and steel require substantial heat, generated with coal (or coal dust) and coke. Plastic is a product of hydrocarbons such as methane (natural gas), ethane, propane or oil.

Recycled steel is almost 30% of global steel output and is 70% in the US. It can be melted in an electric arc furnace, which sounds promisingly as if it could be powered with renewables. But the energy required to reach a temperature of 1,800 degrees Celsius is enormous. Even the most efficient furnace requires the electricity of an American city of 150,000 people. Iron ore, from which steel is derived, is almost limitless. World resources are estimated at 800 billion tons, compared with annual production of 2.5 billion tons.

Smil estimates that for Electric Vehicles (EVs) to reach 25% of the global fleet by 2050, output of lithium and cobalt would need to increase by at least 15X; nickel by 28X. He estimates 40 tons of ores per EV. With global auto sales running at 100 million annually, 25 million EVs would mean mining a further 1 billion tons of ore every year.

Concrete and steel are the basis for today’s office towers, apartment complexes, bridges, dams and airports. US cement production peaked in 2005 at 128 million tons. Between 2018 and 2019 China produced 4.4 billion tons, almost as much as America during the entire 20th century.

There are no plausible, scalable methods to produce these four materials without the use of traditional energy. Fears that the energy transition would result in stranded assets of crude oil, gas and related infrastructure glossed over these vital inputs of modern civilization. Much of the growth in energy demand from emerging countries is aimed at building modern cities that emulate OECD countries.

This was always true even when ESG fervor was at its peak, inducing institutional disinvestment spurred on by that tiresome teenager Greta (“How dare you”). Energy reality is returning, rewarding those who relied more on analysis by Vaclav Smil than Climate Czar John Kerry. How appropriate that your blogger composed this on a flight to Houston.

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

Energy Mutual Fund Energy ETF Inflation Fund

Please see important Legal Disclosures.

Energy Realism Is Spreading

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Energy Realism Is Spreading
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There were three stories last week that can best be characterized as providing energy realism. The fire at Freeport’s LNG facility sent US natural gas prices skidding, with the loss of 2 Billion Cubic Feet per Day (BCF/D) of export capacity. Freeport warned it’ll be at least three weeks before operations can resume – meaning 2BCF/D of additional natural gas in the US domestic market. Dutch TTF gas futures similarly rallied on fears of reduced supply. But both markets later reversed their initial move.

Nonetheless, the spread between the two is far wider than the cost of transporting LNG across the Atlantic. The US is currently able to export around 12 BCF/D. LNG export facilities take several years to build, so there’s no near term prospect that cheap US natural gas will solve Europe’s energy security problem.

Over the next couple of years capacity will increase slightly, but within five years we should have the ability to deliver a further 10 BCF/D based on projects that have reached Final Investment Decision (FID).

Negotiations with potential buyers over the next couple of years will determine how far we go beyond that 22-24 BCF/D. If all the potential projects get funded, by the end of the decade exports could be almost 5X what they are now. Much depends on the willingness of buyers to make long term commitments. Cheniere has contracts of 20 years or more with highly rated buyers.

There’s no alternative use for a liquefaction facility, so customers have to be lined up before construction begins. US natural gas prices have been largely insulated from higher global prices because of export limitations. This will gradually change in the years to come, narrowing the gap to the benefit of US natural gas producers.

A second story worth reading concerns OPEC’s limited spare capacity. Crude oil continues to drift relentlessly higher. US motorists may complain about high prices at the pump, but they are low compared to most other countries. The current $5 per gallon would need to be $8.50 to compare with much of western Europe.

At some point demand destruction will become more apparent – but so far US states have been temporarily suspending gasoline taxes (ie New York) while the White House has resorted to ineffectually releasing oil from the Strategic Petroleum Reserve and seeking help from Saudi Arabia. Meanwhile demand continues to set new records, with global consumption expected to exceed 100 million barrels per day next year.

This is another example of the shallow support for efforts to combat climate change. Decarbonizing our energy means higher prices – obviously, or we’d already have done it. But Democrats fear a public backlash over higher prices even when they can plausibly shift at least some of the blame to Russia.

Deliberately engineering higher prices, via a carbon tax for example, is how we’d accelerate the energy transition. But there’s no support for that, so policy relies on vilifying the producers of reliable energy while claiming that solar and wind are ready to electrify everything with cheap energy and lots of union jobs.

This is why Democrats have improbably been so great for energy investors. They’re dissuading investments in new production and infrastructure, causing higher prices.

The huge weakness with solar and wind is their low, intermittent output. Solar panels and onshore windmills typically generate power around 20-25% of the time. Offshore wind is 30-40%. Combined cycle natural gas plants run at 90-95%. The result is that increased use of intermittent energy requires greater overall capacity.

Large scale battery storage adds substantial cost. A dozen large battery projects have been postponed or canceled recently, due to rising costs and difficulty in obtaining raw materials. Competition from electric vehicle manufacturers isn’t helping.

The purist view that solar and wind will solve every problem risks energy shortages in places like California. Coal to gas switching and increased use of nuclear power are the two best paths to lower CO2 emissions. US natural gas stands poised to help other countries emulate the reduced emissions we have achieved over the past decade.

In other news, I had the great pleasure of joining Josh Brown and Michael Batnick on Episode 50 of their show The Compound And Friends. We had a wide-ranging and fun discussion of markets. The episode is appropriately titled The Energy Bull Market Just Started. Josh and Mike are great hosts whose genuine interest in this guest’s opinions made being on their show utterly self-indulgent.

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

Energy Mutual Fund Energy ETF Inflation Fund

Please see important Legal Disclosures.

Even After A 30% One Year Return, Pipelines Remain Cheap

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Even After A 30% One Year Return, Pipelines Remain Cheap
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When the MLP structure dominated midstream energy infrastructure almost a decade ago, yield was a popular valuation metric. MLPs typically paid out 90% or more (sometimes over 100%) of their Distributable Cash Flow (DCF). Comparing MLP yields with the ten year treasury provided a measure of historic valuation.

By this metric, midstream isn’t cheap. The MLP spread is 0.20% narrower than 25 year average.

But much has changed for the sector in recent years. C-corps are the prevailing corporate form. Financial discipline has returned after the profligacy of a few during the Shale Revolution. Growth capex has declined, helped by opposition from climate extremists (hug one and offer a drive) whose success in stalling projects has given pipeline companies one less thing to do with their cash. It’s also increased the value of existing infrastructure. More recently, war in Europe has made energy security a political objective for the first time in living memory.

Midstream corporations tend to have lower yields than MLPs but have maintained dividends more reliably. MLP payouts have slid by almost half over the past eight years. There remains a valuation discount in retaining the MLP structure. Enterprise Products Partners, one of the best run MLPs, still yields 6.6% even though they maintained their distribution through the five year bear market that climaxed with Covid in 2020.

It’s also worth noting that, although sector indices show March 2020 was the lowest the sector has traded, c-corp yields never reached the highs of the 2008 financial crisis. We have often noted that forced selling by recklessly leveraged MLP closed end funds created the Covid low of 2020 (see MLP Closed End Funds – Masters Of Value Destruction). The chart of c-corp yields is another piece of evidence in support of our view.

Using Enterprise Value to Earnings Before Interest, Taxes, Depreciation and Amortization (EV/EBITDA), the midstream sector is substantially cheaper than its average over the past decade. It’s also worth noting that today’s 10.2X multiple is barely changed from a year ago, even though the American Energy Independence Index (AEITR) has returned 38% since May 2021. The sector’s performance has tracked EBITDA growth.

The pipeline sector is historically cheap versus utilities, often a point of comparison.

If the pipeline sector’s EV/EBITDA widens towards its ten year average of 12.5, this would trigger meaningful price appreciation. With the typical company funding about half its operations with debt, a 20% appreciation in enterprise value would translate into a 40% increase in equity. If such an adjustment took place over five years, this would imply an annual 7% capital appreciation. Add in a 5% dividend yield and you get a 12% total annual return over several years.

When investors ask us about our outlook for returns, this is the type of math we run through. The price history creates concern for some potential investors that after such a strong rally another drop is coming. But the math of valuations along with the evidence noted above that MLP closed end funds caused more trouble than they’re worth ought to assuage such worries.

The capital allocation chart should provide further comfort about the pipeline sector’s long run prospects. Wells Fargo is projecting a 2.5% growth rate for dividends, and a 4X jump in buybacks. Capex is expected to stay flat, with roughly half dedicated to maintaining existing infrastructure (“sustaining capex”) and the balance for new growth projects. US energy executives show little inclination to push up spending initiatives. They recognize how fickle public policy is.

Democrats’ concern about gasoline prices has leavened somewhat their hostility to traditional energy – but few believe it’s anything more than political tactics prior to the midterms. Multi-year capital investments in oil, gas and related infrastructure still come with a highly uncertain IRR.

The 2.5% dividend growth rate can be added to the 12% projected return derived above. This is why a mid-teens, 14-15% pa total return is a reasonable bet even after recent strong performance. The AEITR’s long term returns versus the market no longer reflect substantial underperformance. Over the past one, two and three years pipelines have beaten the market. A few good days will make that true over the past five years as well.

Meanwhile Russia’s invasion of Ukraine can never be undone. Global energy trade is transitioning to reflect geopolitical and national security objectives, not simply commercial ones. Most countries either have energy independence or have no hope of attaining it. America is exceptional, in that we achieved it. US natural gas stands poised to provide secure energy supplies that often displace coal. The sector continues to offer fine prospects.

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

Energy Mutual Fund Energy ETF Inflation Fund

Please see important Legal Disclosures.

The Hard Math Of The Energy Transition

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The Hard Math Of The Energy Transition
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Getting to zero emissions by 2050, the goal set by the UN in order to limit global warming to 1.5° C above pre-industrial times, is technically well within reach. Not with intermittent solar panels and windmills – extracting all the minerals necessary for their manufacture plus enormous battery back-up in implausible.  Kinder Morgan’s enhanced oil recovery process pumps CO2 into mature oil wells to push out additional crude. This is Carbon Capture, Use and Sequestration (CCUS). The CO2 emitted by power plants, cement and steel factories and other industrial users can also be captured for permanent burial without being used (CCS).

There is reported to be bipartisan support for a CCS tax credit of up to $150 per metric tonne (MT), a level many in the industry believe would spur investment in the necessary infrastructure. The US emits just under 5 Billion Tonnes (BT) of CO2 from fossil fuel combustion annually. As a simple example, assuming transportation went fully electric, swapping gasoline for natural gas to produce more electricity, at $150 per MT we’d spend $750BN eliminating energy-related CO2. This is just under 4% of GDP, roughly the same as our defense budget.

JPMorgan estimates that to sequester 15-20% of US CO2 emissions via CCS would require moving 1.2 billion cubic meters of CO2 – more volume than US crude oil production. This would require a lot of new infrastructure.

Direct Air Capture (DAC) removes CO2 from the air. This is another technically feasible strategy, especially if the world misses the UN’s goal and needs to remediate. Although one might think the atmosphere is swollen with CO2, it’s currently around 412 parts per million, or 0.0412%. This relatively low concentration means a lot of air needs to be processed to remove a MT of CO2. By contrast, power plant emissions range from 1-15% CO2 and chemical/industrial plant emissions are from 20-95%.

JPMorgan recently published a research paper examining prospects for DAC. There are two main technologies, one using a liquid and the other a solid which bind to the CO2 in air passed over them. Climeworks operates a prototype facility in Switzerland.  DAC uses energy. JPMorgan estimates 4.9GJ per MT of CO2 removed, or 1.37 Megawatt Hours (MwH).

To put this in perspective, if the US chose to remove the 5 BT of energy-related CO2 released annually, this would require 6.8 Terawatt Hours (TwH) of electricity. We currently generate 4.1 TwH – and if this 6.8 TwH of additional electricity wasn’t generated from 100% renewables there would be further CO2 capture required.

JPMorgan estimated a range of costs for DAC of between $191 and $454 per MT. At some scale the price could be at the low end of the range but could also exhaust availability of critical inputs, increasing costs.

The table shows the cost in terms of global GDP of removing the 35 BT of energy-related CO2 that’s emitted. None of the figures are politically acceptable in today’s environment. Even at $50 per MT it would be just under 2% of global GDP.

Note that this analysis only considers the 35BT of energy-related CO2 emitted globally. Total emissions of Global Greenhouse Gases (GHG), including methane, are estimated at 50 BT CO2 equivalent.

This also assumes the world relies fully on capturing CO2 to reach the “Zero by 50” UN goal. Increased use of renewables, coal-to-gas switching, much more nuclear power and development of hydrogen are all being pursued to varying degrees. The EU trading system for carbon permits currently prices CO2 emissions at around €90 (US$94.50) per MT. This can be thought of as the low end of the range of cost to reach Zero by 50 because current trends and policies suggest we’re not on that path. Applied globally, that is equivalent to 3.5% of GDP just to remove our energy-related CO2 emissions.

There is lots of innovation going on. For example, NextDecade estimates that they can provide CCS services at a cost of $57 per MT (before financing). Given the financial payoff for technologies that can reduce or eliminate emissions cheaply, we should expect plenty of positive surprises.

Carbon taxes, tax credits and permits provide a rough guide to the low end of the range of cost involved in transitioning to zero-emission energy. They’re generally set at a level needed to at least partially subsidize renewables, or to impose an appropriate cost on emissions, depending on your view. They need to be high enough to induce behavioral change.

Their cost reflects the ability of clean technologies to replace our current energy systems. The cost of carbon can also be thought of as incorporating the probability that we’ll achieve substantially reduced CO2 levels. A falling cost would indicate improving competitiveness of alternate energies.

That isn’t happening, at least not yet. There is no indication that the world is willing to spend anywhere close to 3.5% of GDP in fighting climate change. US gasoline prices are relatively low compared with most other countries, and yet their rise this year prompted the Administration to blame Covid, Putin and just about everything other than their own policies while symbolically releasing crude from the Strategic Petroleum Reserve.

There is little public support for paying more for energy. Which means that the most likely outcome is continued growth in the consumption of all kinds of energy; modest gains in market share for intermittent solar and wind; and learning to cope with a warmer planet.

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

Energy Mutual Fund Energy ETF Inflation Fund

Please see important Legal Disclosures.

Fossil Future

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Fossil Future
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Alex Epstein’s 100K Twitter followers have anticipated for months the publication of Fossil Future – Why Global Human Flourishing Requires More Oil, Coal, and Natural Gas – Not Less. Few authors have promoted a book more relentlessly. I awaited its publication eagerly. It is the follow up to Epstein’s 2014 book, The Moral Case for Fossil Fuels.

Epstein’s chief insight, articulated in his first book, is that the standard by which fossil fuels should be judged is whether they promote “human flourishing.” He constructs an intellectual framework based on Utilitarianism that seeks the maximum benefit for the greatest number. If his first book built a moral case defending fossil fuels, his new one unapologetically celebrates their enormous positive impact on humans all over the world.

Epstein takes the offensive against environmentalists such as Bill McKibben, the Sierra Club, and other opponents of progress (“anti-humanists”) whose philosophy logically leads to lower living standards, pain, suffering and death for millions of people around the world.

When I read The Moral Case in 2017 (see review here) I found Epstein’s defense highly compelling. The strength of Utilitarianism is that it’s hard to argue against it. Maximizing benefit for the greatest number is the ethos of any civilization – when moderated to avoid imposing undue hardship on minority groups it is the most ethical set of rules to live by. Epstein is a philosopher not a scientist, so presses his case in these terms supported by familiar statistics.

Global CO2 emissions have risen in the last century along with the human population, life expectancy and living standards. It is axiomatic that the combustion of coal, oil and gas has made this possible. Western living standards would otherwise be unrecognizable. In emerging countries cheap energy provides basic needs to ever more people. Hundreds of millions have climbed up Maslow’s Hierarchy of Needs, able to access and move beyond the basic necessities of food, water, shelter and security.

Therefore, the moral case for fossil fuels is fundamentally about allowing non-OECD countries to improve their standard of living, education, health outcomes and longevity. Rich world energy consumption is roughly flat over the past decade. Even if we engineered a draconian reduction in CO2 emissions we wouldn’t offset the increases coming from China, India and others.

Ethically there’s no case for the US, EU and other rich countries to seek lower emissions from emerging economies. Practically speaking, these countries are in any event choosing growth and offering climate pledges barely sufficient to placate. Without foreign aid on a scale never given before, CO2 emissions will rise. Net Zero is an impossible goal.

Cheap (ie fossil fuel) energy aids farming through the use of equipment and irrigation. More efficient farming frees workers to produce other goods and services. Greater specialization further raises incomes, allowing the next generation to spend more time in school.

Construction equipment allows people to move from hand-built mud huts to more permanent, secure structures, leaving them safer. By replacing wood and dung, the choice of fuel for the poorest, coal oil and gas improve indoor air quality for millions of people.

Hospitals benefit from reliable electricity, better able to support a premature baby in an incubator and provide myriad other services that keep people alive.

Cheap energy supports air conditioning, the invention of which drew internal migration to the American south after WWII. Clean water requires energy to produce it. Piping clean water to homes takes energy. The list is almost infinite.

In western countries energy consumption is stable, and we’re no longer experiencing dramatic benefits from increasing its use.

In England in the 1800s, the average family spent 80% of its income on food. On the American frontier, the typical household burned 350 pounds of wood every day to keep warm and cook. OECD countries began their energy-related great improvement in quality of life in around 1850, the start of the industrial revolution and the benchmark against which today’s global temperature is compared.

Vaclav Smil, a multi-discipliniary scientist and prolific author, recently published How the World Really Works: The Science Behind How We Got Here and Where We’re Going. Smil estimates that coal provided half of England’s household heating as early as 1620, way ahead of the rest of the world which he estimates was still 98% reliant on plant fuels (ie firewood) for heat and light in 1800. By 1900 half the world’s primary energy came from fossil fuels (mostly coal, some crude oil).

Emerging countries are following the same path, regularly crossing inflection  points that improve their citizens’ lives.

Epstein is no climate denier. He simply argues that any evaluation of fossil fuels needs to consider the enormous benefits and not just the costs. China, India and other non-OECD countries are understandably pursuing what the west already has. And they’re consuming lots more energy in the process.

Media reports of increased extreme weather omit that weather-related deaths have fallen 99% in the last hundred years. Structures are more secure, and satellite-aided weather forecasts warn of approaching hurricanes. In fact, global computing and communications consumes the equivalent of 3 billion barrels of oil per year, more than global aviation.

As regular readers of this blog know, we long ago concluded that intermittent solar and wind will never be able to replace traditional energy. Places like Germany and California that rely more heavily on sun and wind power have much higher electricity prices. Fossil fuels still provide 84% of the world’s primary energy, down from 86% in 2000.

The most strident opponents of today’s energy mix deserve the anti-humanist label Epstein gives them. They have no answer to the moral question of why poorer countries shouldn’t strive to improve their lives. McKibben, the Sierra Club and US Climate Czar John Kerry sit at the top of Maslow’s Pyramid, with all their needs solved.

Epstein coins some memorable phrases. We’re taught that impacting nature is immoral, whereas fossil fuels have allowed us to make an environmentally hostile planet habitable, via robust homes, heat and clothing. As a result, humans have perfected “climate mastery.”

Epstein regards climate extremists such a McKibben as promoting “a murderous anti-impact framework.” Their policies would consign millions to misery and death.

The IPCC’s recommendations to prevent a 1.5 degrees C temperature increase from 1850 by 2050 are really aimed at preventing a 0.4 degree increase from now, because we’ve already experienced 1.1 degrees. Epstein believes the risks from climate change are manageable, and we should deal with them as they present themselves. He cites the inaccuracy of past projections as a basis for this.

Here’s where we differ. The science is better today. Climate is complicated to model, but the uncertainty includes possible downside scenarios. Prudent risk management requires that we take steps to reduce CO2 emissions. His explanation for why the overwhelming scientific consensus recommends CO2 reductions rests weakly on the need of scientists to obtain research grants and a bias by funding organizations to promote a consensus view.

The moral case for energy use doesn’t mean ignoring the low probability catastrophic outcomes. Being ethically right doesn’t guarantee human flourishing.

But we agree that prevailing wisdom places unreasonable confidence on forecasts of climate catastrophe, without allowance for high degrees of uncertanty and humankinds’ history of climate adaptation.

Phasing out coal in favor of natural gas and increasing our use of nuclear power are both powerful options staunchly opposed by climate extremists. Solar and wind can be part of the solution, but their embrace by purists as the complete answer is sidelining pragmatic choices like natural gas.

The continued growth of emissions by most non-OECD countries shows that, while most are taking steps towards IPCC goals, Zero by Fifty is highly unlikely. China, India and others long ago embraced Epstein’s philosophy. For them it’s the rational approach.

Epstein asserts that, “Fossil fuels have taken an unnaturally dirty world and made it clean.” Elsewhere, he adds, “Fossil fuels make our world unnaturally, amazingly, increasingly livable.”

Today’s energy has made today possible. We shouldn’t be apologizing for that. And natural gas can be the world’s biggest source of reduced emissions, by displacing coal, as it has in America.

Fossil Future provides a moral underpinning for today’s investors in reliable energy.

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

Energy Mutual Fund Energy ETF Inflation Fund

Please see important Legal Disclosures.

 

Inflation Fears Moderate

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Inflation Fears Moderate
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Maybe last week’s FOMC minutes had something for everyone. Some analysts seized on the consideration the Fed gave to tighter monetary policy: “They also noted that a restrictive stance of policy may well become appropriate depending on the evolving economic outlook and the risks to the outlook.” 

On the other hand, the minutes noted that, “… the risks to the baseline projection for real activity were skewed to the downside.” They also noted upside risk to inflation. 

It is a dovish Fed, regardless of their current hawkish tone. Getting monetary policy to neutral (estimated as between 2% and 3% based on Chair Powell’s recent press conference) with inflation running at 8% is hardly slamming the brakes on. That they may move to restrictive policy reveals their bias – maximizing employment is more important than stable prices.  

Moreover, the inflation outlook is good even if the current figures are not. Ten year inflation expectations derived from the TIPs market are 2.6%. Since we know CPI over the next year will run well above this, the FOMC could conclude that long term inflation expectations remain well anchored near 2%.  

PCE inflation, the Fed’s preferred measure because unlike CPI it dynamically adjusts for actual consumption weights, is forecast by Fed staffers to be 2.5% next year and 2.1% in 2024. Although survey expectations on inflation are mixed the minutes reported that, “longer-term inflation expectations derived from surveys of households, professional forecasters, and market participants still appeared to be broadly consistent with the Committee’s longer-run inflation objective.” 

JPMorgan expects CPI to drop to 3.4% by 2H23.  

It wouldn’t be hard for the FOMC to conclude that once short term rates are at neutral, ameliorating supply constraints will restore inflation to its prior 2% level. 

There are signs of economic softness, if not yet weakness. Pending home sales on Thursday fell 3.6%. New home sales last week dropped 17%. A permanent shift to remote work has allowed Americans to spread out in this big country. But higher mortgage rates are beginning to take a toll.  

The eurodollar futures curve reflects lowered odds of a Fed-induced recession. In spite of some FOMC members’ hawkish statements, mid-2023 rates have dropped almost 0.50% from their highs in early April. A less inverted yield curve implies reduced odds of the Fed raising rates too fast and having to shift directions.  

In fact, the improving inflation outlook offers the Fed greater flexibility to respond to any economic weakness by pausing future rate hikes. Two more 0.50% increases are assured, but beyond that it’s data dependent. The FOMC would be happy to avoid moving above neutral. Therefore, the risk is that inflation doesn’t return co-operatively to its long-run 2% target.  

The FOMC core bias in favor of employment means the eurodollar yield curve is still likely to revert to a normal, positive slope. 

Pipeline companies are well positioned to benefit from higher inflation, since a substantial proportion of pipeline contracts are regulated and have built-in PPI tariff escalators. To cite one example, Magellan Midstream Partners (MMP) is about to benefit from a 6% tariff increase on July 1. They’re likely to see an even bigger jump in a year’s time, based on the likely path of PPI (running well ahead of CPI). JPMorgan recently upgraded the stock.  

In other news, Wednesday’s blog post (see ESG Has No Clothes) resonated with many readers who see ineffective hypocrisy in much of today’s virtue-signaling behavior. Adam Vaughan on Twitter noted the incongruity of G7 environment ministers opposing fossil fuel subsidies while the UK doubled tax relief for new oil and gas production. Furthering confusion, the UK government announced a “windfall tax” on energy company profits.  

Why would any energy company make long term investments when public policy is so capricious? 

JPMorgan reported that attendees at a recent conference felt energy security was displacing ESG concerns. ESG and climate change have always seemed to be concerns for those at the top of Maslov’s pyramid (see Russia Boosts US Energy Sector). If you’ve solved all your other problems, you can get to that one. This is why emerging economies are plowing ahead with increased energy consumption from all sources, including coal. They want to raise living standards. And it’s why John Kerry, Climate Czar, is so well suited to his role. He has solved all his other problems.  

Finally, for those who worry that the principals of SL Advisors afford themselves too little time for some R&R, the photo of a recent golf outing at Echo Lake Country Club should assuage such concerns. Your blogger was happy to host a convivial afternoon of golf with Bill Reilly, Director, Mutual Funds Program Manager at UBS and Rob McNeal, Head of Intermediary Distribution at Catalyst Capital Advisors. Friends of the firm are always welcome guests.  

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

Energy Mutual Fund Energy ETF Inflation Fund

Please see important Legal Disclosures.

 

 

 

ESG Has No Clothes

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ESG Has No Clothes
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Offering investments tailored to ESG (Environmental, Social and Governance) criteria is a growing source of fee income for Wall Street. Morningstar calculates that 65 US funds have been repackaged into ESG funds since the beginning of 2019. Investors are attracted by the notion of holding virtuous stocks, but companies and fund managers must also find the flexibility around what constitutes an ESG-eligible stock to be appealing too.

A year ago we looked at the then-largest ESG ETF, the iShares ESG Aware MSCI USA ETF (ESGU), which had $15BN in AUM (see Pipelines Are ESG). ESGU looks so much like the S&P500 that their returns are 0.99 correlated.

In the past year, ESGU has lagged the S&P500 by 2.5%. This underperformance has come just as the concept is coming under fire. Tesla (which is in ESGU) was dropped from S&P’s ESG index, prompting CEO Elon Musk to tweet that “ESG is a scam. It has been weaponized by phony social justice warriors.”

Musk is right that it’s a scam, although he hadn’t been a vocal critic until recently. Tesla was dropped even though its “ESG score” was stable, because its sector peers improved theirs. S&P explained that it’s not enough to be “taking fuel-powered cars off the road.”

Tesla drivers are passionate owners, but many overlook that 61% of US electricity generation is from fossil fuels, including coal (22%). It varies by state, but buyers of electric vehicles in Kentucky, West Virginia and Wyoming where coal dominates electricity production (69%, 88% and 80% respectively) are generating more harmful emissions than if they bought a conventional car.

Tesla was the biggest company to be dropped, but others included Berkshire Hathaway and Johnson and Johnson. Wells Fargo was dropped for being non-compliant with the United Nations Global Compact, which says it’s “the world’s largest corporate sustainability initiative”.

HSBC’s head of responsible investing, Stuart Kirk, may have given his swansong by accusing policymakers of overstating the financial risks of climate change. In a delightfully incongruous presentation at the FT’s Moral Money Europe Conference, he said, “there was always some nut job telling me about the end of the world.” His message was a rejection of the orthodoxy which often lapses into hyperbolic predictions that life as we know it is in its final decade.

Kirk notes that the projections of economic loss are inconsequential. The UN’s IPCC report estimates as much as a 5% loss of global GDP by 2100 due to climate change. This is a trivial impact given that even 2.5% annual growth by then will leave the economy 6.86X bigger than it is today. If it’s only 6.52X bigger instead, few will care. It’s the difference between annual growth of 2.5% and 2.433%. Global stock markets aren’t visibly affected by the jump in news articles mentioning “climate catastrophe”.

Kirk is obviously ready for a career change. He complained about the inordinate time he spends with regulators discussing HSBC’s climate exposure, when he sees much more immediate threats such as cybercrime, inflation and pandemics. He has been suspended pending an internal review. Stuart Kirk will likely become a hero to those who believe that adaptation to a warmer planet deserves more attention than it receives.

ESG is being exposed as the emperor with no clothes. The SEC is about to crack down on misleading ESG investment claims by fund managers. SEC chair Gary Gensler said “It is easy to tell if milk is fat free. It might be time to make it easier to tell whether a fund is really what they say they are.”

Gensler might care to examine the Dow Jones Sustainability North America Index, whose owners display a sense of humor by continuing to include defense contractors Lockheed Martin and Northrop Grumman as constituents.

The main problem with ESG is its infinite malleability. ESGU, which now has $23BN in AUM, includes almost the entire S&P500. If everything is ESG, then nothing is. There is no clear differentiating feature. It’s been taken over by index providers and fund managers who have identified the profit potential in creating virtue-signaling investment products. ESG’s most important quality has been in attracting fund flows, which used to cause modest outperformance until the last year or so.

Unlike Dow Jones, ESGU doesn’t regard defense contractors as promoting sustainability, one reason why it’s been lagging the S&P500. However, it does include midstream energy infrastructure companies such as Kinder Morgan and Oneok. Cheniere is an addition since our last review of ESGU a year ago, but they have inexplicably dropped Williams Companies.

The Energy Information Administration tells us that biggest driver of America’s falling CO2 emissions has been switching power generation from coal to natural gas. Pipeline companies and Cheniere are doing more to keep the planet sustainable than any other company we can think of.

Elon Musk and Stuart Kirk are only the latest to challenge groupthink that has determined orthodoxy on climate change and the definition of doing good. There should be more to come.

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

Energy Mutual Fund Energy ETF Inflation Fund

Please see important Legal Disclosures.

 

 

 

Pipeline Sector Extends Outperformance

SL Advisors Talks Markets
SL Advisors Talks Markets
Pipeline Sector Extends Outperformance
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The continued rally in the energy sector is steadily lifting past performance ahead of the S&P500 over multiple timeframes. The American Energy Independence Index (AEITR) now has a higher annual return than the S&P500 over the past one, two and three years. Even over five years the performance gap is closing. The 12.3% pa return on the S&P500 is 3.1% ahead of the AEITR. On the Covid low (3/18/20), the AEITR five year trailing return was –19.2% pa, 23.9% worse than the S&P500. It was a dark moment indeed for pipeline investors, and especially so for those focused on MLPs where the carnage was even worse. 

The subsequent recovery has produced some striking relative performance. The one and two year trailing performance figures cause some potential investors to question whether such a move will assuredly be followed by a collapse.  

The fundamentals remain very good. 1Q22 earnings generally beat expectations, in some cases (ie Cheniere) by a huge margin. Financial discipline continues to constrain growth capex, aided by pipeline protesters whose efforts further dissuade spending on new projects. Hug a protester and offer to drive them somewhere. 

The Covid recession and recovery dominate recent performance history. But it’s worth remembering that the pipeline industry had already shifted away from spending for growth in favor of increasing free cash flow before that. By late 2019, pre-Covid, we felt the sector was poised to outperform because the growth years and MLP distribution cuts of the Shale Revolution had alienated so many investors.  

Two months ago, the pre-Covid return (ie from 12/31/2019) on the AEITR moved ahead of the S&P500. As of Thursday, the AEITR is 8.3% ahead of the market. Surging inflation and Europe’s sudden desire for energy security are two important tailwinds for energy stocks. But the sharp drop and quick recovery that Covid inflicted on the pipeline sector is looking increasingly aberrant. It will always be part of the sector’s history. Becoming comfortable that it won’t repeat is a hurdle facing many potential new investors.  

Closed End Funds (CEFs) have a longer history of providing MLP exposure to retail clients than even the deeply flawed Alerian MLP ETF (AMLP, see MLP Funds Made for Uncle Sam). For example, the Cushing MLP & Infrastructure Total Return Fund (SRV) sports an inglorious fifteen year history of relentless capital destruction. It now trades at less than one tenth of its IPO price. In 2015 we were moved to note its sorry eight year performance of delivering less than a quarter of the return of its benchmark (see An Apocalyptic Fund Story). Although consistent performance has rendered its diminutive size ($70 million AUM) no longer a significant source of revenue to manager Swank Energy Income Advisers, it still serves to warn CEF investors of the damage leverage and poor management can inflict.  

CEFs were generally not a big factor in the Covid bear market, but they did play an outsized role in the MLP collapse, which hurt the entire midstream sector. Operating a single sector fund with leverage reflects an opinion that the companies in that sector should be operating with more debt than they currently do. In effect, it’s a rejection of the collective wisdom of all the CFOs and rating agencies that have arrived at the prevailing capital structure in use.  

Since the stocks within a sector will tend to be highly correlated with one another, there’s little diversification benefit which might otherwise justify the increased risk profile. Single sector closed end funds use leverage to increase the dividend they can pay. But maintaining that leverage requires them to add to their holdings in a rising market – and to reduce them in a falling one. 

When MLP prices collapsed in March of 2020, MLP CEFs had no choice but to delever, which required selling. They exacerbated the fall in prices for the pipeline sector.  

The reason investors shouldn’t expect a repeat is because the consequent value destruction left all the MLP CEFs smaller. They’re no longer managing as much money, because of locked in losses, so wouldn’t have as much to sell even if we endured a repeat of March 2020. The managers of sector-specific CEFs with leverage combine poor judgment with hubris. They include Goldman Sachs, Tortoise, First Trust and Swank.  

Many MLP CEF holders who hung on in the belief that what falls so far must surely rebound will have been disappointed. The 17 MLP CEFs listed on Nuveen’s website are on average still down 37% from their level at the end of 2019, pre-Covid. The AEITR has fully recovered its losses with an 18.5% pa positive return. 

The two lessons are: (1) don’t invest in single sector CEFs because the leverage will eventually create permanent losses, and (2) because MLP CEFs provided evidence of #1 in 2020, they can’t repeat. So prospective investors in midstream energy infrastructure can regard the worst of the March 2020 brief collapse in pipeline stocks as unlikely to repeat.  

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

Energy Mutual Fund Energy ETF Inflation Fund

Please see important Legal Disclosures.

 

Different Audience, Different Energy Policy

SL Advisors Talks Markets
SL Advisors Talks Markets
Different Audience, Different Energy Policy
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Last week’s Economist magazine included an illuminating op-ed by Nigeria’s vice-president on “the hypocrisy of rich countries’ climate policies.” Like most emerging countries, Nigeria is simultaneously pursuing two goals; improving the access of Nigerians to energy, while reducing the country’s Greenhouse Gas (GHG) emissions.

Vice-president Yemi Osinbajo’s essay neatly captures the dilemma his and other governments face. He wants to “close the global energy inequality gap.” He noted that the 48 sub-Saharan countries of Africa (excluding South Africa) are home to a billion people and use less electricity than Spain’s population of 47 million. Osinbajo wants Nigeria to achieve annual power output of at least 1,000 kilowatt hours per person. Today per capita electricity consumption in Nigeria is less than a fifth of this goal. With the country’s population of 206 million expected to double by 2050, the vice-president estimates electricity output will need to increase by 15X.

Dramatically increasing domestic power generation is a popular message designed to resonate with Nigerian voters. That part of Osinbajo’s essay is targeted at his domestic audience. Then he turns to his audience of foreign OECD governments, noting that Nigerian president Buhari has “pledged that Nigeria will reach net-zero emissions by 2060.”

ClimateActionTracker.org estimates that Nigeria’s GHG emissions will increase by 21% over the next decade. The “Almost Sufficient” grade is generous since they’re set to increase faster than ever.

Climate change is not big concern among Nigerians. Last year the Yale Program on Climate Change Communication found that Nigeria polled dead last out of 31 countries on knowledge of the topic, with only 26% responding that they knew “a lot” or “a moderate amount” about it. The US equivalent was 71%. Only 58% of Nigerians were “very or somewhat” worried, close to the US at 68% and far behind Mexico (95%). That Nigerians and Americans are similarly worried about climate change is ironic because the US, with a per capita GDP 10X Nigeria’s, is far better able to pay for mitigation.

The result is that Nigeria, like many other poor countries, offers very different messaging depending on its audience. Domestically they prioritize raising living standards, which includes access to electricity. Internationally they offer solemn pledges to reduce GHG emissions.

The COP26 meeting in Glasgow last year pledged $8.5BN to South Africa to accelerate their energy transition, although it’s still unclear how or when this will be funded. Nigeria believes it needs a green package of $10BN per year over two decades, which will cover half the capital required to meet its net-zero pledge. Plainly, Nigeria won’t reduce emissions without substantial financial support from the US and other rich world countries.

Nigeria’s power sector generates about 12 million tonnes of CO2 equivalent, less than one per cent of the US at just over 1.5 billion tonnes.  If Nigeria’s goal of adding 15X more output was done with the same energy sources, it would add what 25 million Americans generate. It sounds modest. But applied across the rest of the non-OECD world and not limited to just the power sector, growth in emerging economies could easily offset whatever reductions the rich world can achieve.

There’s a moral argument that the OECD countries who have used up most of the atmosphere’s assumed capacity for CO2 should cut their emissions aggressively while paying non-OECD countries to curb theirs. It’s a complicated issue. We’ll never subsidize China’s investments in clean energy. Moreover, western countries didn’t impose half a century of growth-impeding socialism on China or India, which they only began to shed in the 1990s. Both are making up for lost time, which is why their living standards are catching up. China is now the world’s biggest emitter, spewing out 2X the US which is number two. India is third. The world’s climate will be determined by China, India and other emerging countries.

The challenges are simple to articulate, if complex to solve. Poor countries are both more vulnerable to the negative effects of a warmer planet, and less motivated to tackle the issue without substantial OECD financial and technological help. Without a massive commitment, the world will learn to adapt to increased levels of CO2 in the atmosphere.

US climate extremists have successfully forced New England to import liquefied natural gas by, for example, blocking new pipelines from Pennsylvania. Their conviction that such efforts somehow address the non-OECD challenge outlined above betrays a misunderstanding that would be comical if it didn’t have as its objective condemning Americans to cold and darkness. It’s exacerbated by President Biden’s promise to, “…deploy clean energy for the benefit of all Americans—with lower costs for families, good-paying jobs for workers.”

US political leaders steer so far from confronting the issues, including higher costs and substantial foreign aid, that they’re encouraging wholly unrealistic and inadequate policy responses. This is why global demand for natural gas will continue to grow. Like western politicians, Nigeria’s v-p is tailoring his message to his audience.

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

Energy Mutual Fund Energy ETF Inflation Fund

Please see important Legal Disclosures.

 

 

A Good Week For The Fed

SL Advisors Talks Markets
SL Advisors Talks Markets
A Good Week For The Fed
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Financial advisors probably feel that they’re more than earning their pay recently. Market volatility is high, which means clients want to know what’s going on. Advisors have in the past confided to me that one of their most important roles is to persuade clients from selling impetuously. Their original asset allocation was made after much careful consideration and ought not to be tinkered with just because the market’s moved a bit. Friday’s rally helped, but the S&P500 is still -15% for the year. If you have energy exposure, you’ll have done better.

Global stocks registered their sixth straight weekly decline, the longest streak since 2008. This is a testing environment for financial advisors.

By contrast, Fed chair Jay Powell can look back at the ten days following the last FOMC meeting, 0.50% rate hike and press conference with some satisfaction. Investors won’t hear it said this way but engineering an orderly fall in stock prices is one of the Fed’s goals. Former NY Fed president Bill Dudley, no longer burdened by the requirement to speak responsibly as a senior Fed official, has warned that the Fed’s going to tighten financial conditions enough to push up the unemployment rate (see Criticism Of The Fed Goes Mainstream).

The Fed’s reinterpreted mandate places greater importance on achieving maximum employment. Powell hasn’t offered any warnings that unemployment needs to rise. In a fascinating excerpt from his press conference, he noted that job openings were equal to almost twice the number of unemployed, and said they were trying to reduce this imbalance. A perfect outcome for the Fed would see a drop in job openings without a commensurate increase in unemployment, making possible the vaunted “soft landing”.

When you also consider the FOMC’s Summary of Economic Projections expecting unemployment to remain at 3.6% through 2024, this is further evidence that they are prioritizing continued full employment. They’ve been criticized for this by Larry Summers among others, because it seems inconsistent with simultaneously reducing inflation to 2.3% over the same time period.

The bond market became a little more convinced that the Fed will pull this off. Although the CPI and PPI reports showed prices continue rising at a fast clip, ten year inflation expectations derived from TIPs dipped to 2.74%, having recently touched 3%. Since CPI, which is the index TIPs follow, typically runs 0.3-0.4% higher than the Fed’s preferred Personal Consumption Expenditures index, they can plausibly conclude that investors are buying the narrative that inflation will return to 2% within a couple of years.

It doesn’t look like a good bet to us. The FOMC is dovish. The disinflationary effects of globalization are petering out. And the US fiscal outlook requires higher inflation so that negative real rates can ease the burden of our growing debt.

Moderating inflation expectations have caused the twos/tens spread to widen and moderated the inversion that exists in part of the eurodollar futures curve. An inverted yield curve is a forecast from the market of a looming failure of monetary policy, implying an overshoot in tightening that would require it to be reversed.

Hoping that reduced job openings will be sufficient to cool the economy, as Powell seemed to suggest during his press conference, seems wildly optimistic with no historical precedent. Raising rates beyond the 2-3% range the FOMC believes is neutral seems certain to require a pause to assess whether prior hikes are already having an effect.

At his press conference Powell explained, “So what that really means is, to get the kind of labor market we really want to get, we really want to have a labor market that serves all Americans, especially the people in the lower income part of the distribution, especially them.” This is a laudable public policy objective, if a dubious addition to the Fed’s objectives. Monetary policy is notoriously slow and blind to the individuals it impacts. Hence the eurodollar futures curve should be priced for cautious rate hikes next year that lower the odds of requiring a reversal.

I was chatting with an investor on Friday about the increasing incidence of 1% daily moves in the S&P500. Such moves are now more likely than not based on the past 100 trading days (see Pipelines Are Less Volatile Than You Think). He found it an interesting way to think about volatility, one that’s easily intuitive. Such 100 day regimes have existed only 8% of the time over the past quarter century.

Daily moves greater than 0.5% currently occur 70% of the time. 100 day periods like this have existed less than a fifth of the time.

2% daily moves remain uncommon but are creeping up, currently 15% of the last 100 trading days (including the 3.2% drop on Monday 9th).

Even if increased volatility doesn’t lead to lower stock prices, it probably tempers exuberant economic activity. The University of Michigan’s consumer sentiment survey registered its lowest reading since 2013, with inflation cited as the biggest area of concern. Long term inflation expectations remained at 3%, slightly above the rate derived from ten year treasury securities.

In sum, lower stock prices, a steepening yield curve and falling long term inflation expectations are a positive grade on the FOMC’s report card. Investors may not feel quite as sanguine after another volatile week, but Jay Powell might permit himself a moment of quiet satisfaction.

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

Energy Mutual Fund Energy ETF Inflation Fund

Please see important Legal Disclosures.

 

 

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