The Fed’s Hobson’s Choice

The Fed has a problem with long-term yields. They are remaining stubbornly low, in willful defiance of steadily increasing short term rates. Slowing the economy so as to raise unemployment will be hard unless bond yields move high enough to impede some capital investment and debt issuance. There were signs of this in the spring when rising mortgage yields caused housing to weaken. But ten year notes soon fell back below 3%.

Today’s real yield (defined as the ten year notes minus one year trailing CPI) is –6%. Since the inflation peak of the early 1980s, slowing the economy and increasing unemployment has almost always required positive real rates. We’re not close.

Friday’s payroll report was surprisingly strong. Everybody who wants a job has one. The FOMC’s Summary of Economic Projections warns that the Fed funds rate will reach 3.8% by the end of next year. Bond investors are unfazed by this – eurodollar futures are priced for a more sanguine 3.25%, and were even more relaxed prior to Friday’s strong data. But in either scenario, the yield curve will remain inverted.

The Fed’s goal is to drive up unemployment. Their public comments rely heavily on euphemisms because it’s a heartless goal. Inflation is the scourge that harms all, so some of you will be sacrificed (ie lose your jobs) for the greater good. It’s monetary orthodoxy traditionally supported by Republicans, but there is much that could go wrong.

Given employment’s apparent resilience in response to the FOMC’s early moves, it’s possible that short term rates will need to move higher than 3.8%. Ten year treasury yields may need to reach 4% in order to add a few million unemployed, which would presumably require the Fed funds rate to reach at least 5%.

Fed chair Jay Powell will refer to the resulting budgetary problem as merely optical, but Congress may deem it more tangible. The Fed’s $8TN balance sheet has been the world’s biggest positive carry trade, allowing them to remit a $109BN operating surplus to the Treasury last year. By paying close to zero on bank reserves, most of the coupon income from the Fed’s holdings of treasuries and Mortgage Backed Securities (MBS) funded their surplus. The Federal government’s need to fund its budget deficit was lower by this amount.

Last year the Fed’s balance sheet averaged $8.06TN. They reported $126BN in interest income, so earned around 1.5% on their holdings. Maturing short term securities this year may have pushed up the average yield on the remaining portfolio slightly, but with Fed funds at 2.25-2.5% it’s likely they’re now enduring negative carry. The operating surplus will disappear, and on present trends become a deficit by next year.

The Fed shows no inclination to sell anything. Auctioning off treasuries would be tricky because they’d have to co-ordinate with the Treasury’s own auction schedule. But selling MBS would cause the rise in bond yields they need while also reducing their negative carry. However, sales would probably result in realized losses on bonds bought at higher prices. In any event, passive balance sheet reduction is their choice, which means the 2023 operating deficit will be the first one to draw Congressional attention.

Quantitative Easing (QE) followed by its proper inverse, Quantitative Tightening (QT) with selling, means buy high and sell low. Not selling simply swaps realized losses for protracted negative carry. The Fed has implemented it on a scale likely to discredit the strategy as the bill comes due. They only implement QE during a recession, when bond prices are high/yields low.

Restraining the economic rebound QE helped cause will create an operating deficit.

The difficulty in pushing up bond yields, which creates a need for even higher short-term rates, looks like a slowly developing PR disaster for the Fed. But there’s an alternative, plausible outcome. They could point to still modest long term inflation expectations in both the market for Treasury Inflation Protected Securities (TIPs) and the University of Michigan surveys. They could sidestep the struggle to push up bond yields and slow the economy. They could “declare victory and get out”, as Senator George Aiken suggested in 1966 when discussing Vietnam. The Fed could at any time look beyond the latest CPI release and declare inflation to be on a steady path lower – which based on market indicators and surveys, it is. Under such circumstances, the politics of requiring taxpayers to fund their operating deficit would be theoretical.

These two radically different paths imply substantially different rate outcomes. It’s why bonds are so volatile nowadays. Of the two, we lean towards the latter, which avoids a recession and will allow inflation to persist at 3% or higher rather than 2%. But the FOMC’s hawkish posture shows that’s not in their current thinking. Bonds still don’t offer an investment return, but at least there are some fascinating trading opportunities.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.


Earnings and Pending Legislation Good For Pipelines

The theme to pipeline earnings for 2Q22 is one of positive surprises. It reminds me of Don Layton, former vice chair at JPMorgan and more recently CEO of Freddie Mac, when I told him I’d hired a new derivatives trader with a perfect Math SAT. Don, not easily impressed, responded by recounting a class he attended at MIT where the professor asked anyone who had not achieved an 800 Math SAT to stand up. Only a handful did.

Midstream CEOs could similarly remain seated while delivering earnings reports that mostly exceeded Wall Street expectations. Anticipating this, JPMorgan had recently been raising their forecasts, and “beats” were nonetheless common.

Start with Cheniere, who beat Wall Street analysts by a wide margin, as they did in the prior quarter too. EBITDA came in at $2.529BN versus consensus at $1.9BN. The company is now guiding to full year EBITDA of $9.8BN-$10.3BN, fully $4BN above their original ‘22 forecast made last year. They also spent $540MM on buybacks, retiring 4.1 million shares. These purchases fell late in the quarter. Their 10Q revealed that their share count dropped by a further 0.6 million shares during July, so the buybacks have continued. Cheniere’s prospects, already strong, received a further boost when Russia invaded Ukraine. Global trade in Liquefied Natural Gas (LNG) is on a strong growth path. They now expect to generate $20BN in excess free cash through 2024.

Asia has historically dominated global trade in LNG, with China recently displacing Japan as the biggest buyer. Along with South Korea, India and Taiwan five Asian buyers were over 60% of global LNG volume last year. In the future we shall see European buyers figure more prominently.

This is already creating competition between the two regions. Germany and other European countries regard their desperate need for natural gas imports as a temporary diversion on their energy transition to an economy dominated by renewables. Consequently, they sometimes balk at signing the twenty year contracts that LNG exporters require to justify the enormous capital investment required. Asian buyers are more pragmatic, which has led to them signing a series of agreements with US shippers.

This tension is visible in the LNG market, where a spread is opening up between the European TTF benchmark and the Asian JKM. Ensuring adequate supplies before the northern hemisphere winter is driving global competition. We think this increased demand will endure, which will result in more commitments to buy US LNG and therefore more projects achieving a Final Investment Decision (FID) to go forward.

Energy Transfer, probably the individual stock most widely held by financial advisors who own our funds, raised 2022 EBITDA guidance from $12BN to $12.7BN (midpoint). They expect their Lake Charles LNG facility to reach FID later this year.

Williams Companies (WMB) increased their 2022 EBITDA guidance for the second time this year, now $6.25BN vs $5.8BN originally (midpoint). They expect to end the year with Debt:EBITDA of 3.6X. CEO Alan Armstrong noted that their $1.70 dividend (yield 5.3%) is covered 2.29X.

Enterprise Products Partners (EPD) beat sell-side expectations by almost 7%. The stock yields 7.3%, reflecting the MLP yield premium the market imposes to handle K1s.

The Inflation Reduction Act of 2022 now looks likely to pass. Private equity managers once again retained their indefensible carried interest tax treatment, the price Senator Kyrsten Sinema oddly insisted on to secure her vote. Independent analysis is confirming that it should reduce US CO2 emissions by 40% below 2005 levels by 2030, a significant accomplishment but so far China remains uninspired to follow our lead.

Part of the expected reduction in US emissions in the proposed legislation will rely on 45Q tax credits as high as $85 per tonne for Carbon Capture and Sequestration (CCS). Several companies commented that this was a positive development.

EPD’s Randy Fowler said, “…we believe the proposed changes to the 45Q credits could be a game changer for post combustion emitting customers.” ET’s co-CEO Mackie McCrea said, “…the new credits in this new bill would provide for a significantly higher rates of return with that tax credit going from up to the $85.”

WMB’s Chad Zamarin head of strategic corporate development said, “the 45Q credits would be very supportive of our CCUS project in the Haynesville.”

The pipeline sector was strong in July, coming close to recouping the losses of June. Recession concerns appear to be waning. Based on Friday’s unemployment report, the economy continues to expand at a rapid pace, with the unemployment rate falling to 3.5%. The Fed’s refusal to sell the mortgage backed securities they acquired during Quantitative Easing is making it difficult to slow the economy. Ten year treasury yields of 2.8% are stimulative. Bond yields are more important to capital investment and real estate than short term rates. A 3.5% neutral Fed Funds rate, the FOMC’s initial target, is unlikely to push treasury yields up much. Absent a shift to more rapid balance sheet contraction by the Fed, the economy looks robust.

With strength in pipeline sector earnings and improving growth prospects for natural gas, it’s hard to think of a more attractive sector for the long term investor.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

Liquefied Natural Gas Shows Up In More Places

To the twin certainties of death and taxes, the energy investor might add increased US exports of Liquefied Natural Gas (LNG). The outcome of Russia’s invasion of Ukraine is far from certain, but it’s hard to envisage Europe ever relying on Nord Stream 2 for natural gas. Moreover, once the flows from Nord Stream 1 stop – and at 20% of capacity they almost have – any future volumes of natural gas from Russia will not represent a critical part of Europe’s overall supply.

It’s rare for the flaws in a widely accepted public policy to be so cruelly exposed. Brexit always looked like a shot in the foot, an impulsive response to excessive immigration dressed up as a jingoistic rejection of an EU that constrained Britain’s true potential. Now UK GDP growth is 19th out of the G20, ahead of only Russia. Scotland will likely vote for independence next year, seeking their true potential unshackled from London. The reunion of the island of Ireland also looks increasingly likely within a decade or so.

Brexit will eventually undo the 1707 Act of Union that joined England with Scotland, and the Acts of 1800 that added the entire island of Ireland to Great Britain. Northern Ireland, born in 1921 out of persistent unrest and confirmed in the 1998 Good Friday agreement, rejected Brexit which means they picked Ireland inside the EU rather than England outside of it. Britain’s English rural majority imposed its Brexit will on diminutive nation-appendages as well as urban London. Once the others have left, fka Great Britain’s GDP will be closer to Canada than Germany. Like people, countries make mistakes too.

Similarly, Germany’s national security rested unsteadily on an unwavering belief that engagement with Russia through trade would ultimately lead to shared values if not a huge eastern liberal democracy. Angela Merkel, only the last in a succession of German leaders not burdened with self-doubt on the matter, faces a retirement of speeches in staunch defense – or few public speaking engagements at all.

US energy investors are the beneficiaries of Europe’s geopolitical mis-steps on energy security. Because EU policymakers also believed the world’s poorer countries would soon insist on growth via renewable energy or none at all, they pursued intermittent power to inspire others. The consequences of these twin policy failures include year-ahead power prices in France up 10X. Renewables penetration is correlated with European electricity prices. Leaders in developing countries, most obviously China, fear popular unrest at slow growth more than shame at failing to emulate hubristic Germany.

US natural gas is the opportunity to express this geopolitical analysis as an investment view.

Cheniere Energy is the obvious beneficiary. They export half of our LNG and have the lowest maintenance capex as a % of EBITDA of any midstream infrastructure company. They’re well positioned to fulfill Asian contracts that often run to two decades while growing free cash flow.

To this observer, LNG prevails over ESG nowadays in pipeline company presentations, reflecting a triumph of substance over style. To wit, in Williams Companies’ 2Q22 investor presentation, LNG appears 15 times and ESG two. One might call this a Seriousness:Frivolity ratio, or S/F, of 15:2. Kinder Morgan’s 2Q22 earnings press release S/F was 8:0. Enbridge had an S/F of 46:10 in their 2Q22 earnings presentation.

For Williams Companies, this preponderance of substance translates into nine projects to transport natural gas to LNG export facilities, with estimated in service dates all within five years. They see 1H22 LNG plus Mexican pipeline exports up over 10% year-on-year. They expect LNG exports along their Transco natural gas pipeline corridor to double by 2035.

Kinder Morgan claims to move half of US natural gas destined for export as LNG. Their growth projects include supplying Venture Global’s Plaquemines LNG facility, which just received its final investment decision in May.

Enbridge expects to almost triple its LNG exports by 2040. It’s not just in the US that it’s growing. Enbridge will supply natural gas to Woodfibre LNG, currently under development near Vancouver.

For those who find normal energy sector volatility tame, NextDecade is closing in on a final investment decision on their Rio Grande LNG export project in Brownsville, TX. They regularly issue press releases announcing new “sale and purchase agreements”, most recently with Exxon Mobil. This had an S:F ratio of 27:2, even though NextDecade’s ESG credentials are solid because they plan to capture the CO2 emitted as they convert methane into LNG.

If you possess unshakeable conviction that the abrogation of Germany’s policy of energy engagement with Russia is irreversible, NextDecade offers a pureplay bet on the consequences.

Energy as a share of the S&P500 has doubled from its 2020 low but remains well below the long-term average.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

Life Gets Complicated For The Fed

Making eurodollar futures interesting is not among Fed chair Jay Powell’s goals, but he’s achieved it nonetheless. From just after their June FOMC meeting through Thursday, the market has lopped over 0.50% off the projected rate cycle. The cycle peak has even been brought forward, from March 2023 to this coming December. The FOMC’s Statement of Economic Projections (SEP) has rates peaking at the end of next year, a forecast Powell described as “probably the best estimate of where the Committee’s thinking is still.”

Thursday’s GDP report showing a second consecutive quarter of GDP contraction further complicates matters. With the economy probably operating at beyond full employment, we’re hardly in a recession although signs of slowdown are there to see. The most important factor that will determine this rate cycle peak is the FOMC’s inflation/unemployment trade-off. The inflation figures should start improving, because old data will recede beyond twelve months, which will improve year-on-year measures of CPI.

JPMorgan’s Michael Kelly believes the Fed should be extremely patient in seeing inflation drop, suggesting that a pace of 1-2% annual reductions over several years should suffice. Conversely, the credibility argument suggests that a faster pace of falling inflation is critical to maintain expectations anchored at 2%. The rate cycle implied by these contrasting views is very different.

The range of outcomes is unusually wide. Rapid yield curve adjustments reflect heightened interest rate volatility and uncertainty. Behavioral finance teaches that overconfidence is a common mistake. Bond traders with humility are likely to be the most successful.

The current inversion in the eurodollar futures curve, mirrored in the spread between two and ten year treasuries, offers an asymmetric risk/return to this market observer. We’re already priced for substantial risk of recession. A soft payroll number or benign inflation release will quickly push the yield curve towards a more positive shape. Even by the value-less standards of today’s bond market, ten year treasury yields at 2.7% offer nothing to the discerning investor.

The Fed’s ponderous rate of balance sheet normalization omits auctioning off some of the mortgage-backed securities (MBS) they acquired through last year. When the Federal government can borrow at 6% below current inflation, that is both highly stimulative and reflective of sharply slower GDP growth. Forecasting interest rates is exceptionally hard right now.

Advice to the Fed is plentiful and not nearly as useful as figuring out what they will do. In time they may conclude that long term rates need to rise to achieve their objective. Policy remains highly stimulative, and short term rates matter less than bond yields. Auctioning MBS would slow growth more effectively. Quantitative Tightening as practised by the Fed, allowing bond holdings to passively run off, is not the analog to the active buying of bonds that was Quantitative Easing. Barry Knapp of Ironsides Macroeconomics correctly noted that Powell should have received questions on this topic during Wednesday’s press conference.

Switching to pipelines, the American Energy Independence Index (AEITR) briefly touched its pre-Ukraine level for last week. Pipeline earnings so far have been good. Although recession fears caused the sector to pull back earlier in the month, we expect to see continued evidence of strong fundamentals as other companies provide updates. The AEITR is +27% over the past year, compared with the S&P500 which is down 6%.

Putin continues to play a strong energy hand well. Natural gas flows to Germany on Nord Stream 1 are now 20% of capacity with the Russians blaming bureaucracy and western sanctions for the shortfall. By maintaining some flow of gas, Russia is maxkmizing German uncertainty around future flows and their ability to avoid rationing this winter. This continues to highlight the good long term prospects for exports of US Liquefied Natural Gas (LNG).

NextDecade announced another sale and purchase agreement, this time with Exxon Mobil to supply one million tons per annum of LNG over 20 years. The US became the world’s biggest exporter of LNG in the first half of this year, a mantle it’s unlikely to lose anytime soon. US natural gas remains a solid bet on Europe’s recently discovered need for energy security.

At the LPL conference last week several investors asked how the pipeline sector would respond if Republicans were to regain the White house in 2024, along with control of Congress which may even flip this coming November. Energy executives cheered Trump’s election in 2016, but energy investors have less fond memories of his administration. The shale bust ushered in financial discipline, augmented by Democrat policies on climate change that are unwittingly pro-investor.

Our affection for climate protesters and their ability to curb growth capex naturally causes some to wonder whether their possible loss of ascendancy might encourage more growth spending, jeopardizing divided hikes and buybacks. We think such an outcome is unlikely. Investment horizons are longer than the electoral cycle, and investors have welcomed the steady increase in distributable cash flow which provides 2X dividend coverage across the sector.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.


Bad Investment Ideas Still Flourish (Part 1)

I spent the last couple of days at LPL’s Focus event in Denver, meeting a good number of clients and prospects. Denver’s enormous conference center was teeming with LPL financial advisors. CEO Dan Arnold gave an inspiring talk. Human contact is roaring back.

On the flight out to Denver, a couple of recent conversations reminded me that Wall Street is never short of poor ideas. I’ve been around long enough to see many of them. The non-discerning and credulous regularly get drawn in. Today the list seems longer than usual. Below are a few, with a second list to follow soon.



I’ve never written about Bitcoin before. I’ve always been a skeptic but watched friends of mine make easy money owning it. I never changed my mind, but their gains inspired my humility on the topic. While it may seem easy to knock now that it’s collapsed from $70K to around $20K, many believe it will rebound and make new highs. I don’t think so, but could be wrong. I wouldn’t short it.

There may be value in stablecoins that are pegged to another currency, such as the US$, but part of the appeal of crypto derives from fiat currencies’ intangible value. Blockchain technology seems to have a promising future even if practical applications have been slow to develop.

But as an alternative currency, Bitcoin comes up short. It’s not a good store of value because it fluctuates too much. It failed as an inflation hedge. Buying products using Bitcoin incurs much greater transaction costs than with traditional currencies. If your Bitcoin account is hacked it’s often impossible to track the criminals – who do you even complain to? Bitcoin enables cybercrime.

And yet it’s not totally free of government control. Last year South Korea seized Bitcoin worth $47 million to settle a delinquent tax claim. Around the same time, the US Justice Department recovered a ransom paid by Colonial Pipeline to hackers who had compromised their system. So governments can access your Bitcoin if they want.

Bitcoin seems to be most useful when it’s going up. Otherwise there doesn’t seem much point. It may be a modern day Dutch tulip bulb craze.



Central banks have rendered fixed income devoid of any fair return. The Fed owns $8TN. China and Japan own more than 1TN each. Real returns are close to zero. Pension funds and others with inflexible investment mandates ensure that yields can never rise enough to offer a return over inflation. The point of investing is to maintain your purchasing power, so that consumption foregone today can be enjoyed in the future. Saving shouldn’t leave you worse off.

Now that central banks have discovered quantitative easing, it will be part of the toolbox whenever the economy stumbles. And if bond yields do ever rise sharply, perhaps because China decides to dump their holdings, the Fed will step in to avoid a potentially disruptive jump in mortgage rates. Under such circumstances it’s hard to envisage bonds ever being appropriate for return-oriented long term investors. Inflation persistently above the Fed’s 2% target is therefore more likely. I still don’t understand why any individual owns bonds. Hold stocks and cash. Leave bonds to those happy to lag inflation (see The Continued Sorry Math Of Bonds).


Climate Change Politics

We write about this regularly. Democrats believe the threat is sufficient that we should quit using fossil fuels. Republicans have little to say on the issue. But it should be clear that solar panels and windmills, intermittent if not opportunistic sources of energy, are a wholly inadequate replacement. Their promotion by some as THE solution has delayed any serious debate about how much more we should be willing to pay for energy to counter the risk that rising CO2 levels might disrupt the climate. The White House promises cheap energy and well paid jobs, a utopian outcome that sounds as if the free market should already be delivering it. This deflects from a serious discussion about costs and the risks of inaction.

Predicting the climate impact of higher levels of CO2 is complicated. Predictions of catastrophe have been around for decades. We’re warned that 1.5 degrees of global warming relative to pre-industrial times is the limit. The world is already 1.1 degrees warmer than 1850. Occasional heatwaves are briefly disruptive but soon forgotten. Extreme cold still kills 9X as many people as heat. Extreme weather events remain far less disruptive than making our power systems weather-dependent, in need of regular sunny and windy days. But reducing CO2 emissions is a sensible risk management response to the possibility of greater climate disruption. Phasing out coal is an obvious place to start.

China, the source of 28% of emissions and consumer of half the world’s coal, needs to be on board. China’s industrial sector is bigger than those of the US and EU combined. Substantial investments in solar and wind haven’t made a noticeable difference and are missing the big picture. Replacing coal with natural gas where possible would be a good start. Investing on the basis that renewables will be the main solution is naïve (see Russia: The Climate Change Winner?).


Emerging Markets 

The term suggests forward progress, that countries emerge to join the OECD club of rich world countries. Try naming a country that has ever done that. Wikipedia lists Israel, Poland, South Korea, Taiwan, the Czech Republic and Singapore. The typical emerging economy is a permanent member.

Moreover, high GDP growth doesn’t have to translate into high equity returns. Building a factory adds to GDP, but it only creates value for the stock investor if the company’s manufactured goods ensure a profit that exceeds their cost of capital. China offers a notoriously poor link between domestic growth and equity returns.

Investing in fast growing economies can seem appealing. But on top of the weak link between GDP growth and equity returns, investors also confront weaker disclosure standards, governance rights and higher levels of corruption. Once when I became friendly with an Indian hedge fund manager he explained how if you weren’t trading on inside information you were at a severe disadvantage.

But there’s a better way to gain exposure to emerging economies; invest in big multinationals listed in the US. Let them identify the best growth opportunities in the most attractive countries. Let them deal with local problems with uncertain property rights, corruption and regulation. If you invest in the S&P500, across all the companies they’ll collectively provide you with exposure where they think the returns justify the risk. There’s no need to buy an emerging markets fund (see Why You Should Only Buy China Through the S&P500).

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.


Why Natural Gas Affects Prices At The Pump

The other day a White House spokesman offered familiar criticism of oil companies for not reducing gasoline prices to match the recent drop in crude. It’s easy to manipulate charts to make a point, and the example used in the press briefing does that.

Gasoline prices have fallen recently, but is their relationship with crude oil changing?

It turns out that a scatterplot of crude vs gasoline over the past five years can be interpreted to support the White House claim that prices at the pump haven’t dropped as much as they should. Today’s gasoline prices are notably off the linear regression line over the past five years. It’s absurd to blame this on oil companies – it is a competitive market and there have been no serious charges of collusion. So what has changed?

One area is net trade. The US is divided into Petroleum Administration for Defense Districts (PADDs) which date back to WWII. Data on oil and refined products is mapped into these regions by the Energy Information Administration (EIA). The US generally imports gasoline into PADD One (east coast) because that’s where the ports are. It is used within the region and elsewhere across the country. We export from PADD Three (the Gulf coast) because that’s where many of our refineries are located.

We produce over 9 million barrels a day of gasoline. US refineries usually operate at >90% of capacity, and that is the case today. They’re pumping out as much as they can.

Trade flows tend to be seasonal – in the past five years we’ve been a net importer and exporter of refined products. We tend to be a net importer during the summer when domestic demand is highest. However, this summer we’re a small net exporter. Less gasoline is coming into the US than normal.

To understand why this is the case it helps to look at refinery inputs. Converting crude oil into gasoline is an energy-intensive process. Heating and vaporizing are critical steps in refining. Although some refineries produce fuel gas as an output, which then powers their processes, they also use a lot of electricity which is often generated by burning natural gas.

The global market for natural gas allows for much bigger regional variations than does crude oil, which is relatively easy to transport. Natural gas moves through pipelines or, when compressed into Liquefied Natural Gas (LNG), by specialized ship. The facilities required both to ship LNG and receive it along with their cost mean transportation expenses figure much more prominently than for crude. Russia’s invasion of Ukraine has caused big spikes in LNG prices in Europe and Asia. In energy equivalent terms, US natural gas costs around a quarter as much as a barrel of crude whereas Europe and Asian prices are around two times as much – 8X the US equivalent price.

Natural gas as an input to US refining costs up to around $2.50 per barrel of crude, so it’s not a significant cost. The global pricing described above shows that in Europe it’s substantially more – perhaps 8X as much. Refineries in Europe and elsewhere that might normally export gasoline to the US east coast are finding they’re no longer competitive – hence the typical surge in net imports that comes with the summer driving season is absent.

For more detail on why prices at the pump high remain high, check out RBN Energy’s recent blog post Bring Me Some Natural Gas – A Key Driver Behind Today’s High Refining Margins.

The president is blaming greedy oil companies, a simplistic message not supported by any evidence. He’s trying to deflect blame for gasoline prices heading into the midterms. Perhaps the solution is really too complicated – this blog post won’t easily fit into a soundbite.

But it does show how interconnected different elements of the energy complex are. In the US we’re fortunate to have relatively cheap natural gas, despite the Administration’s vilification of anything fossil fuel related. Russia’s invasion is partly to blame, although the European natural gas prices are the cause along with higher crude.

EQT Corporation, a natural gas producer, released a survey showing that nearly 70% of voters support increasing natural gas production. The support was bipartisan. EQT is hardly an unbiased observer, but politicians are learning that we want our energy to be reliable, not intermittent, and not unreasonably expensive. The White House promises “good-paying jobs and energy security.” So far there’s not an example to emulate. The truth is that transitioning to a low carbon economy will be hugely expensive and disruptive. Because it’s not sold honestly, support is thin. Inflation in food and energy is the more immediate problem facing most people, and today’s climate policies are partly to blame. Natural gas is vital to today’s energy supply and will be crucial to any thoughtful path forward.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

Russia: The Climate Change Winner?

Higher prices for traditional energy are supportive of increased use of renewables. The point of a carbon tax is to create price signals for users and producers of coal, oil and gas that reflect society’s assessed cost of the burden imposed by rising CO2 emissions. Uncertainty over long-term public policy has led to years of underinvestment in new production. The economic rebound from Covid revealed how little excess supply was available, so prices rose. Russia’s invasion of Ukraine was a further shock the world didn’t need.

But the response from policymakers has been ambiguous. President Biden would rather ask Saudi Arabia to increase oil production than remove regulatory and policy uncertainty for domestic companies. The EU wants to import natural gas from Qatar but balks at twenty year commitments, even though Asian buyers regularly agree such terms. The result is that committing capital to oil and gas production remains an uncertain proposition.

Climate extremists should cheer today’s high oil and gas prices though. It improves the competitiveness of renewables. How ironic that the pursuit of intermittent energy has led to underinvestment in traditional energy and today’s elevated prices. A US carbon tax would have re-directed some of the revenue earned by OPEC+ to the Federal government, but political support is nonexistent because people are only worried about climate change until it costs money.

Energy security, Europe’s absence of which has been so cruelly exposed by Russia, is another reason to develop domestic renewables. Keeping the windmills nearby at least means their output can’t be cut off by a political adversary.

The energy transition means increased electrification. Serious analysis is being published that highlights the challenges. In the Internation Energy Agency’s (IEA) most recent World Energy Outlook they model a Stated Policies Scenario (STEPS) which is based on current policy settings around the world, and a Sustainable Development Scenario (SDS) which aligns with the UN IPCC’s goals whereby the world reaches net zero emissions by 2070 with many countries much earlier.

RBN Energy, which produces in-depth research on the energy sector, has translated these two IEA scenarios (STEPS and SDS) into demand for minerals key to the energy transition, such as lithium, cobalt, nickel, copper and neodymium. Even on the less ambitious STEPS pathway, these minerals will represent a significantly greater share of global demand.

The time it takes to get a new mine from planning to production is longer than for oil and gas fields – a global average of sixteen years according to research from the IEA. On current trends, there will be an increasing supply shortfall for these key minerals. There’s no shortage of irony in such research. Energy (mostly oil and gas) can account for up to 40% of the total costs in mining. Although higher prices for traditional energy have a positive first order effect on renewables, they also raise the cost of obtaining the needed inputs for batteries, solar panels and windmills. The US is poorly positioned for this, dependent on imports for 100% of some 17 critical metals and minerals. Mining meets NIMBY resistance. As RBN Energy eloquently states: The simple fact is that the U.S., along with Europe, has regulated its way into far greater mineral import dependencies.

Vaclav Smil, a world-class author of books on energy, noted the mining needed for a single Electric Vehicle (EV) car battery weighing 450 kilograms (992 pounds). In How the World Really Works, Smil calculates that the lithium, cobalt, nickel, copper, graphite, steel, aluminum and plastic required for one EV would require the mining of 40 tons of ores and 225 tons of raw materials. Achieving an EV market share of 25% of the global auto fleet by 2050 would see demand for these and other inputs increasing by 15X or more.

California leads the US in embracing EVs, often cheered on by media that believes such policies will reduce the statewide fires, drought and floods they often blame on global warming. They overlook that policies in Beijing and Mumbai, where emissions are scheduled to grow for at least the rest of the decade, will determine California’s CO2 levels (and indeed everyone’s) far more than the legislature in Sacramento.

JPMorgan’s Mike Cembalest in his excellent 2021 Annual Energy Paper called out “the elephant in the room: the number one issue for China and the world is decarbonization of China’s massive industrial sector, which consumes 4x more primary energy than its transport sector and more primary energy than US and European industrial sectors combined.” In other words, widespread adoption of EVs creates great headlines but won’t make much difference.

Which brings us to the final irony. There is little to show so far for western sanctions on Russia. Their oil and gas revenues are soaring. Asian buyers freely ignore sanctions, and a humiliated Europe is slowly reducing imports so as to limit economic disruption. Russia looks likely to cut gas supplies anyway. This is Angela Merkel’s legacy.

Western policies that have discouraged investment in future oil and gas production align neatly with Russia’s vast supplies. Eight years ago NATO accused Russian intelligence agencies of covertly funding the European anti-fracking movement. It always seemed like a high return effort. But even if such charges are unproven, Russia is a top copper producer (4% of global supply, roughly equal to the US), 6% of the world’s aluminum (4X the US), and 10% of nickel (#3 in the world). Russia, one of the countries least concerned about climate change, might be one of its biggest winners.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.




Pipeline Earnings Should Be Good

Earnings season for the pipeline sector kicks off Wednesday 20th with Kinder Morgan. Crude oil prices have slid over the past several weeks, reflecting increased fears of recession and China’s ongoing efforts to eliminate Covid through regional lockdowns. Sharp moves in oil affect energy sentiment and the consequent drop in midstream energy infrastructure reflects these global macro concerns.  Fundamentals continue to look very good to us.

Europe’s sharp pivot away from Russian energy is a permanent shift, with long term benefits for the US natural gas business. The drop in crude will provide some relief at the gas pump for households. Middle income households (average income around $66K) are spending 12.3% of their income on gasoline and home energy bills, up from 9.5% in 2020. The recent drop in prices will support demand, which is good for pipeline operators.

Political developments have also been positive. The EU recently classified natural gas and nuclear power as “green”, which will enable increased use and introduce some sensible pragmatism to European energy policy. In the US, Democratic Senator Joe Manchin did us all a favor by declining to support the Democrat party’s liberal agenda on climate change at least until we see some moderation on inflation. Policies that aggressively favor solar and wind result in more expensive energy. Empirical evidence is widespread – California and Germany being two examples.

It’s increasingly clear that the science around climate change has been far more accurate in forecasting increased levels of CO2 than in predicting the resulting impact on climate. Both Vaclav Smil in his latest book How the World Really Works and Alex Epstein in Fossil Future point out numerous predictions of climate catastrophe that have been dead wrong. Smil notes four decades of shoreline change in all 101 islands in the Pacific atoll nation of Tuvalu show that the land area has increased by 3%. The Maldives, in the Indian Ocean and most of which is four feet or less above sea level, apparently faces an existential threat from climate change and nonetheless added a new airport to accommodate more tourists.

Europe is enduring a heatwave. Parts of southern England are expected to reach 100 degrees this week. The UK Met Office, which issues weather forecasts, has never before issued one so high. Having grown up in the UK I can attest that a warm summer’s day peaking around 80 degrees is thoroughly agreeable. When combined with an evening beer or three in a pub garden basking in the warm glow of a 930pm sunset, life is positively sublime. However, with residential air conditioning unknown, the country isn’t prepared for Texan weather.

Climate change will be blamed. We’ll be warned to expect more such extreme weather events. But the reality is that, as miserable as the heatwave will be, if such events occur more frequently the British will simply start installing AC. Following the policy prescriptions of climate extremists would be economically ruinous on a scale completely disproportionate to the costs of adaptation. The public has largely concluded as much, which is why global demand for fossil fuels has stayed robust. The same is true of asset markets, where no discernible “climate change discount” exists, a point memorably offered by HSBC’s former head of responsible investing, Stuart Kirk, in a wonderfully irresponsible presentation that became his swan song.

In midstream energy infrastructure, positive fundamentals are leading sell-side firms to upgrade their earnings forecasts. JPMorgan expects Kinder Morgan to revise full year guidance higher based on what they anticipate will be solid 2Q22 results. Targa Resources should have strong gathering and processing results. Williams recently provided optimistic feedback so their forecast 2Q22 EBITDA was revised modestly higher. JPMorgan has raised their 2Q22 EBITDA forecast for Enterprise Products Partners by 266MM (13%) across various segments. Energy Transfer is expected to deliver strong results from their midstream segment, with crude oil a headwind due to bad weather in the Bakken.  There should be updates on eventually getting back to a $1.22 distribution, easily covered in our opinion with distributable cash flow next year providing comfortable 1.8X coverage.

If these stocks rally it may be a case of “selling the news”. Long-time readers know better than to rely on us for short term market timing. The point is, for these companies and others, business is good.

If pipeline stocks were marketed by Walmart, their promotional ads would remind that you can “Buy midstream at pre-Ukraine war prices.” It sounds Cramer-esque.

With earnings season upon us, that might be the most accurate sales pitch.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

Hoping Russia Will Send More Gas

On Monday Nord Stream 1 was shut down for annual maintenance, cutting off the remaining Russian natural gas exports to Germany. Europe’s biggest economy continues to provide lessons to the rest of us on what a flawed energy strategy looks like. German industry anxiously waits to see whether some contrived additional repairs will extend the pipeline’s maintenance beyond its scheduled ten days. Germany is dependent for energy on a country whose soldiers are being fired at by Ukrainians using German weapons. It’s not a good place from which to negotiate.

Austrian energy company OMV said it’s receiving less than a third of the natural gas from Russia that it’s ordered.

German day ahead power is trading at €370 per Megawatt Hour. French month ahead power is over €430. Europe’s problems are being compounded by a heatwave which is forcing reduced nuclear output in France. When the river water used to cool nuclear plants rises above a certain temperature, returning water back to the river risks damaging the environment.

Right on cue, west European wind power is falling too. Hot weather tends to occur with little breeze. That’s why it’s hot. Texas is experiencing a similar drop in wind output during their current heatwave, with output running at only 8% of capacity. It is possible to want reduced CO2 emissions while valuing reliable energy over opportunistic solar and wind. Policymakers are increasingly embracing natural gas as the solution.

Global trade in Liquefied Natural Gas (LNG) rose 4.5% last year, a trend that’s likely to continue for some years now that Europe has pivoted away from Russian supplies. A recent profile of Tellurian CEO Charif Souki in the New York Times offered an unexpectedly balanced view of the benefits of natural gas. The article presented what is fast becoming orthodox thinking as policymakers confront the energy crisis:

The world may be facing energy and climate crises, he said, “but one is going to happen this month, and the other one is going to happen in 40 years.” He added: “If you tell somebody, ‘You are going to run out of electricity this month,’ and then you talk to the same person about what’s going to happen in 40 years, they will tell you, ‘What do I care about 40 years from now?’”

EU lawmakers recently approved natural gas and nuclear as “green” investments, which will make it easier for companies to obtain financing. It’s another recognition that running the world on solar panels and windmills won’t work. Nonetheless substantial incongruity remains between what rich countries want for themselves versus their policy prescriptions for non-OECD countries. For example, Nigeria exports LNG to Europe who in turn wants to see Africa by-pass fossil fuels and use more renewables. It’s leading to accusations of “green colonialism”. Egypt is hosting COP27, the UN’s annual climate change conference, and increasing poorer nations’ access to natural gas is expected to be high on the agenda, as it should be.

Further boosting domestic demand for natural gas is growing interest in Electric Vehicles (EVs), US sales of which recently crossed 5% of total auto sales. Tesla owners love their cars, but most own a conventional car too.  Inadequate charging infrastructure for EVs remains a deterrent, as does the time it takes to top up a battery. As EVs gain market share they will increase demand for electricity, the two biggest sources of which are natural gas (38%) and coal (regrettably 22%).

Recession fears continue to weigh on energy prices which is depressing the sector. The American Energy Independence Index has pulled back 19% from its recent high in early June but is still +12% YTD. The fundamentals have hardly changed. Natural gas demand remains strong over the near term and its long-term prospects seem to improve every month. Even if crude oil demand grows more slowly, it will have a minimal impact on North American pipelines.

Williams Companies has experienced an 18% pullback and yet their prospects have barely dimmed if at all. The stock yields over 5%, has a Free Cash Flow (FCF) yield of 7% and we calculate an adjusted funds from operations yield of 10%. A similarly bullish case could be made for Energy Transfer, which yields 8% and has a Distributable Cash Flow (DCF) yield of over 20%. Both companies spend no more than 10% of DCF on maintenance capex. Cheniere has a FCF yield of 17%.

Many prospective investors looked at this sector during the spring and hesitated because of the strong YTD performance. They asked whether they had already missed the move. Those same investors can invest at the prices that prevailed in February, before Russia invaded Ukraine. Back when European leaders sat atop Maslow’s pyramid with all their problems solved other than curbing CO2 emissions. A time when energy dependence on Russia passed for thoughtful engagement. A time when energy security was anachronistic. Better to watch the education from here than to live through it there.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

These Are The Good Old Days

It’s an odd recession when the economy adds 372K jobs and the unemployment rate stays at 3.6%. We seem to be talking ourselves into one. Consumer expectations are the lowest in almost a decade. High prices for energy and food are the culprit. Few are seeing their incomes keep pace with 8% inflation, so real incomes have taken a significant hit this year.

So it’s curious that the measure of how households report their present situation is well above the average since 2006. The gap between today and how people feel about the future is historically wide. A sense of foreboding is creating the type of negative outlook only seen in recessions. Collectively, we saw a brighter future at all times during the pandemic than we do today. Maybe that reflected a recognition that something so bad had to end.

A few weeks ago on Josh Brown’s show The Compound and Friends I drew skepticism when I suggested that we might look back on today as the good old days. Inflation is a problem, but jobs are plentiful. The Conference Board survey data suggests that many respondents feel the same way.

Wall Street is warning that recession odds are increasing. Citigroup puts the odds at 30% within 18 months. Former NY Fed president Bill Dudley thinks the Fed will inevitably cause one in their inflation crusade. He’s betting they’ll follow up one mistake with another. Fed chair Jay Powell says avoiding a downturn largely depends on factors outside the Fed’s control, which is a way of preparing for that second mistake.

With stocks down 20% and bonds down 10%, the classic 60/40 portfolio is down 16% YTD. Regular readers know we have shunned bonds for the entire existence of SL Advisors (see my 2013 book Bonds Are Not Forever; The Crisis Facing Fixed Income Investors). Shoddy thinking is the only explanation for why return-seeking investors still own any bonds. We have often illustrated that a barbell of stocks and cash offers a better risk/return across most scenarios (see The Continued Sorry Math Of Bonds).

The pervasive negativity among consumers, reflected in the weak stock market, is a resounding lack of confidence that the Fed will operate with a deft hand. From this blogger’s perspective over 40+ years, today’s FOMC moves as a group without strong leadership. Powell strikes me as a chair who identifies the consensus rather than creating it the way Greenspan or Volcker did. This means they’ll  be slow to shift views, because the group will need to get there together. We saw this with the FOMC’s belated recognition of surging inflation. It’s certainly premature to expect an ease of the tightening cycle, but widespread pessimism reflects a concern that a slothful FOMC shift in consensus will lead to an excessive rate cycle peak.

Inflation expectations as measured by the treasury market have fallen sharply in recent weeks. Ten year CPI inflation is priced at 2.3%. Since it’ll be well above that level for at least the next year, the market is priced for the remaining nine years to average at a level very comfortable for the FOMC.

It’s true government bond yields have been distorted for years by non-economic buying by central banks and others with inflexible mandates such as pension funds. This has kept yields lower than they would be otherwise, but presumably such buying pressure works on TIPs as well. If anything, Quantitative Easing had a bigger impact on TIPs than nominal treasuries which, by further depressing real yields would cause implied inflation to be higher. That the Fed is still tightening is a rejection of market-based measures of future inflation. Perhaps they’ve concluded that their activity and that of others have rendered the bond market an ineffective measure of investor expectations.

In recent weeks the market has recalibrated the expected path of monetary policy higher. Meanwhile, signs of a slowing economy are increasing. Most dramatically, crude oil has slumped with December Brent futures falling $20 from their level in early June. GDP projections are being revised down. Bottom-up Factset earnings forecasts are being trimmed, for this year and next.

Goldman Sachs believes the oil market has overshot, with the price drop implying a 1.1% drop in global GDP 2H22-2023. They point out that the current oil deficit remains unresolved. Energy markets have dropped on expectations of lower future demand while current demand is unchanged. Aviation demand continues to recover strongly, spurred by a rebound in international travel. They estimate June demand for crude oil was up 2% year-on-year excluding Asia.

For now it seems investors are more afraid of the future than would seem justified by the present.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.