Carl Icahn, Transocean is Calling You

Warren Buffett has commented in the past that as an investor you should buy a company so strong that it could be run by an idiot, since someday it will be. The management of Transocean (RIG) is busy providing evidence in support of this rule.

Their stock is already reeling from a likely large settlement related to the Gulf oil spill last year. It trades at a substantial discount to the value of its assets. Ensco (ESV) trades at 2 X tangible book value, whereas RIG (following today’s announced secondary offering) is trading at tangible book value. No doubt its unknown Macondo liability is a factor, but even a $1BN cash settlement wouldn’t be that hard for a company their size to manage. It would represent around $3 a share and is in any case approximately equal to their annual dividend. Management continues to profess confidence that all such liabilities are manageable, but the uncertainty clearly warrants a discount on the price.

On August 26 RIG agreed to pay $2.2BN buy Aker Drilling ($1.4BN in cash and $0.8BN in assumed debt), a 60% premium to its prior 30 days average price. RIG said they expected Aker to be immediately accretive to earnings. As recently as November 3 on their quarterly conference call, the company expressed confidence that they could finance this acquisition and maturing debt with cash on hand and operating cashflow. Today, a company whose management is a serial disappointer on quarterly operating performance and who has expressed an intention to return cash to shareholders, announced a secondary offering of 26 million shares (with a possible increase of 3.9 million). The purpose is to finance the acquisition of Aker and to pay down convertible debt.  So in effect they are financing the Aker acquisition by issuing more equity at what they would surely argue is a very low stock price.

Steve Newman and his corporate finance whizkids are basically diluting long-suffering stockholders at a depressed price, and rather than returning cash to stockholders they’re asking for more. Oh, and they’re helping Uncle Sam at the same time, since U.S. stockholders will receive an annual $1BN dividend taxable by the Federal government at 15% (plus state taxes for most U.S. residents) and then reinvest $1BN if they wish to retain their ownership percentage.

This is the kind of company that keeps Carl Icahn busy. Instead of making acquisitions and diluting equity holders, they ought to be selling rigs and using the cash to buy back depressed stock. Fortunately our investment in RIG is small (persistent operational mis-steps had made us cautious). We’re now waiting for more shareholder-friendly, activist investors to get involved and put things right. Steve Newman and his friends have already sent the invitations.

Disclosure: Author is Long RIG




What Investors Ask Your Blogger

Recently I’ve given presentations to a couple of investment clubs in Naples, FL. Usually I speak about midstream energy infrastructure, but I was also asked to expand on Our Darkening Fiscal Outlook, recently published on our blog,

The Q&A is always enjoyable at such events. Below are some common themes that came up.

Don’t weak natural gas prices show that Biden’s pause on approving new LNG export terminals is hurting US producers?

The White House directed the Department of Energy (DOE) to consider the overall climate impact of approving further LNG exports. They didn’t cancel existing approvals, so North American LNG export volumes are still on track to roughly double over the next four years. This includes new terminals in Canada and Mexico.

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As noted previously, the pause is unlikely to reduce emissions since Asia will simply burn more coal. Pakistan announced last year a quadrupling of coal-generated power because of high LNG prices. But it is causing uncertainty. For example, Japan’s Kyushu Electric is postponing negotiations with Energy Transfer about buying LNG from their planned Lake Charles terminal until it’s clear it will be built.

Today’s weak US natural gas prices aren’t related to the DOE pause, since it only affects the construction of new terminals which are several years out. Prices are weak because of a relatively mild winter (although I can report Naples has been unusually cold). Chesapeake recently announced they’ll be reducing natural gas production because of low prices. With natural gas well below $2 per Million BTUs, it’s clear that domestic producers and foreign buyers would both benefit from increased trade.

Will there be more mergers in the midstream sector?

Investment bankers have been busy in the energy sector over the past six months or so. The number of MLPs keeps shrinking although we expect Enterprise Products and Energy Transfer to retain their pass-through status given high insider ownership. Western Midstream Partners (WES) might be sold at some point, and that would further reduce the number of MLPs. It would also create a deferred income tax recapture event for holders if bought by a c-corp. Magellan Midstream agreed to Oneok’s acquisition last year despite the tax bill it created for long-time investors. Presumably WES holders might similarly accept a merger-induced tax bill if they felt the terms were right.

When will our dire fiscal outlook provoke a crisis?

A chart showing the stratospheric path of US indebtedness is sufficient to make the case that a debt crisis is inevitable. So why hasn’t it already happened? Thirty year bond yields of 4.5% do not reveal reluctant buyers. But then Argentina has defaulted nine times since independence in 1816 and is always able to come back for more. It’s unclear why any return-oriented investor would ever buy Argentine debt, but there are sufficient undiscerning bond buyers that in 2017 they issued 100 year bonds.

Bond underwriters know how to have fun at others’ expense. Let’s hope there were no CFA charterholders making such purchases.

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Since at least as far back as the Great Financial Crisis of 2008-09, a surplus of return-insensitive capital (central banks, sovereign wealth funds) along with inflexible mandates at others such as pension funds has kept yields low.

The Federal Reserve owns almost a fifth of our Federal debt, a portion the Congressional Budget Office expects to remain unchanged. Research suggests that quantitative easing reduced bond yields by as much as 1%. This contributes to the present conundrum whereby monetary policy is generally regarded as restrictive whereas the inverted yield curve leaves ten year treasuries at 4.3%, or 2% above expected inflation over their lifetimes.

3.3% GDP growth, 3.7% unemployment and a stock market at new highs all suggest that rates are not much of an economic headwind.

Can I trust the inflation numbers?

It’s always fun to demonstrate why inflation statistics are deceptive. See Why It’s No Longer Enough To Beat Inflation. In brief, there is no government conspiracy to understate inflation. It’s just that the economists at the Bureau of Labor Statistics measure what they can, not what you think.

“A basket of goods and services of constant utility” is what they measure. Statisticians strip out quality improvements, because they provide more utility. So consumer electronics such as iphones show up as falling in price because more features for the same cost equals a price cut in BLS-land.

What most investors want to know is the rate at which their spending capacity needs to grow so that they don’t feel any poorer. Since living standards grow, simply keeping up with CPI will leave you worse off relative to the median.

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Whenever you read “in today’s dollars” the writer isn’t giving a true picture of what it felt like to buy, say, a color TV in 1953 which cost $1,500.

That’s around $15,000 “in today’s dollars” because using CPI you need $10 today to buy what $1 did back then.

2022 median household income was $92,750, so that TV looks as if it cost about two months pay for the typical family. But in 1953 median household income was $4,242, so it really took over four months of pay to buy the TV.

The correct comparison would keep the portion of household income needed to buy the item the same as in 1953. Multiplying the $1,500 1953 TV by $92,750/$4,242, or 21.86, gives almost $33K. That’s the more meaningful representation of what a 1953 TV cost. It keeps the portion of household income needed to buy the TV the same in 2022 as in 1953.

There’s no need to mistrust the BLS. But if your purchasing power doesn’t keep up with median household income, you’ll gradually become poorer by comparison with the rest of the country.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

 




Pipeline Earnings Make Travel A Pleasure

Targa Resources provided one of several bright spots among pipeline earnings last week with a 50% increase in their dividend planned for next year. Their cashflows are increasing strongly. JPMorgan projects a Distributable Cash Flow (DCF) yield of 14% for this year, rising to 16% in 2024 and almost 18% in 2025. The new $3 per share dividend yields 3.3%. The company also bought back $132MM in stock during 3Q. Both JPMorgan and Wells Fargo see around 25% upside over the next year.

Irrational exuberance has been missing from midstream energy infrastructure for almost a decade. 25% 12 months’ upside on a stock that’s returned 32% over the past year may remind grizzled MLP veterans of 2014, when the structurally flawed Alerian MLP ETF (AMLP) peaked. It currently trades at half its value back then, missing stocks like TRGP which long ago shed the MLP structure in search of a broader investor base. The years that energy has been out of favor have served to improve the valuations of TRGP and its peers. Leverage of 3.6X Debt:EBITDA this year is projected to decline to 3.3X next year. Along with Its dividend coverage and buybacks, TRGP reflects the lower risk profile and improved shareholder returns that continue to propel the sector higher.

Energy Transfer (ET), widely owned among financial advisors we talk to, has been repaying that faith with a 26% total return YTD. 3Q23 EBITDA beat expectations handily by 7%, and they raised full year guidance (midpoint went from $13.25BN to $13.55BN). Management is still negotiating with the US Department of Energy (DoE) over a permit extension for their Lake Charles LNG project. They reported that some potential buyers have been lobbying the DoE directly to let it go ahead. It’s unclear why the DoE won’t extend an approval they previously issued. But they should. Exporting cheap US natural gas will improve energy security for our friends and allies around the world as well as offering a cleaner substitute to coal for power generation.

Cheniere expects to be at the high-end of guidance for 2023 and more importantly now expects first LNG production from Train 1 of Corpus Christi Stage 3 by the end of next year, six months ahead of prior expectations. This creates the potential for their marketing arm to sell into an elevated spot natural gas market in 2025 before contracts start.

Other good news came from MPLX which beat EBITDA expectations, Pembina who raised full year guidance by 4%, Western Gas who repurchased another 5.1 million shares from Occidental and Enlink who spent $50MM buying back shares during 3Q23.

Oneok raised 2023 guidance and expressed optimism about identifying further synergies from their recent acquisition of Magellan Midstream. Equitrans, owner of the perennially delayed Mountain Valley Pipeline (MVP), said they expect most construction to be completed by year’s end and to be in service by January.

It was another solid quarter of earnings to soothe the purchase decisions of investors committing capital to the sector.

Your blogger spent last week traveling across the southeast US seeing clients. Stops were made in Dallas, Houston, New Orleans and Miramar Beach, FL. As always, it was thoroughly enjoyable to reconnect with old friends and make some new ones. The pipeline sector’s fundamentals have been relentlessly positive. This continues to move stock prices higher which is overpowering skepticism around traditional energy.

Houston’s Red Lion British Pub serves that quintessentially English dish – Chicken Tikka Masala. Fellow Brit Geoff Lanceley and I both enjoyed it. This Indian dish is now more popular than fish and chips in the UK.

In New Orleans I saw Keith Laterrade, a long-time investor with us who in the late 1990s played professional (English) football in England. This included one game as goalkeeper for current Premier League champions Manchester City. He progressed substantially farther than me in the world’s favorite sport, and we always compare notes on the latest results before moving on to pipelines.

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Keith suggested dinner at Bayona which is owned by his long-time client Regina Keever in the French quarter just a block from Bourbon Street. It must be New Orleans dining at its best. If you can visit, you won’t be disappointed. Keith doesn’t just manage money for clients, he supports them across a wide range of financial interests. He’s currently helping Ms Keever who, after 30 years of providing a high-end dining experience is looking to sell.

If you’re interested in buying a restaurant at the top of its game, let me know and I’ll connect you with Keith.

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Miramar Beach in Florida’s panhandle is known as the Emerald Coast because of the color of the water which beautifully offsets the white sandy beaches. Long-time client Rob Coletta suggested  Bijoux for dinner. This similarly beat expectations, just like the pipeline companies that occupied our convivial dinner together.

Throughout my meetings everyone was pleased with how the fundamentals are playing out and surprised that retail buyers have not yet warmed to the sector. Although our investor base tends to vote Republican, there is an appreciation if not gratitude towards the climate extremists whose opposition to new projects has improved free cash flow, helping create the positive circumstances for today’s investors in reliable energy. My admonition to “Hug a Climate Extremist” always draws a smile.

It’s not just tongue in cheek. By investing in natural gas infrastructure, we’re supporting the source of America’s biggest success in reducing CO2 emissions by displacing coal. By investing in LNG export terminals, we’re helping provide the same opportunity to buyers around the world. Practical solutions are the best.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

 

 

 




Book Review — Going Infinite: The Rise and Fall of a New Tycoon

I listed to the audio version of Going Infinite by Michael Lewis on a recent road trip visiting clients. If you’re planning to drive from Washington DC to Columbia, SC and then on to Charleston, you’ll find that the book and travel time are nicely synchronized. It’s always better when the author does the reading. Listening to Lewis’s soft New Orleans accent is no hardship.

Michael Lewis set out to write a book about a new wunderkind making billions out of crypto while planning to give most of it away. The collapse of crypto exchange FTX and subsequent arrest of Sam Bankman-Fried (known as SBF) provided Lewis with a ringside seat as the whole edifice collapsed.

Had SBF not been arrested, he would have provided ready comparisons with Elon Musk, whose highly readable biography by Walter Isaacson was published just a month earlier. Both combine very high intellect with low emotional intelligence and have little patience for the type of human interaction most of us find normal. We’re told that greatness justifies such shortcomings. Steve Jobs, about whom Isaacson also wrote a biography, shared this trait.

Early in his career SBF worked at Jane Street, a secretive Wall Street market maker where trainees routinely bet on obscure outcomes (how many dice are in my pocket) so as to demonstrate mental acuity and probabilistic risk assessment to the senior traders. What looks like a mispriced security can be a trap set by inside information or at least factors that should have been considered. Why you’re being asked to guess the number of dice is as important as estimating the figure. Maybe I have a hundred very small ones. Markets are as much poker as chess.

I once visited Jane Street whose trading room is filled with software engineers. When I was hiring traders 25 years ago at JPMorgan we favored MBAs – I used to joke that my own resume would never have drawn an interview. Jane Street expects their traders to focus their time on research projects, discovering market relationships that can be exploited with software. The actual trading is run by algorithms and traders watch over it while doing analysis.

While at Jane Street, SBF oversaw a trade designed to profit from analyzing the presidential election results in 2016 faster than anyone else. They identified Trump’s surprising victory early and sold stocks before they dropped, only to see initial profits turn into Jane Street’s biggest ever loss as markets shrugged off the news. There was apparently little of consequence, but SBF soon left anyway to pursue crypto.

Effective altruism is a philosophy that believes your maximum benefit to society comes from selecting the career with the highest expected earnings and donating as much as possible to worthy causes. SBF initially partnered with others who shared this belief, and before long the media was attracted to this quirky young man with wild black curly hair worth tens of billions of dollars that he planned to give away.

FTX attracted some of the world’s most sophisticated investors, unperturbed by SBF’s habit of playing video games while conducting video calls with people who might expect to command his full attention. Their Bahamas campus sounds like a big fraternity with unlimited funding. They had no CFO, and apparently little sense of risk.

I’ve never found bitcoin or the rest of the crypto market to be of interest. It’s struck me as a solution to a problem we don’t have. It’s not a stable store of value and not safe from hackers stealing your coins. The authorities rarely pursue such thefts because they’re hard to trace and jurisdiction is often unclear. And yet if the authorities want to seize your stash they can, as happened when Colonial Pipeline paid a ransomware demand after being hacked. The FBI retrieved the payment. So I could never see the point. But others evidently could.

It can be no coincidence that the book’s publication coincided with SBF’s trial, since it offers a coincident recollection of events being pieced together in front of a jury.

In reading SBF’s biography you know it ends with his deportation from the Bahamas to face US criminal charges. In looking for clues along the way you’ll find none. Lewis, who is an astute observer of his subjects, draws an intimate portrait of his subject but is unable to see SBF’s world as he does. Ultimately, he was as surprised as the rest of the outsiders when FTX collapsed, and like them will be following the trial hoping for an answer to the question, Why?

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

Energy Mutual Fund

Energy ETF

Inflation Fund

 




Oneok Does A Deal Nobody Needs

Oneok Inc (OKE) surprised sell-side analysts with their Mother’s Day acquisition announcement of Magellan Midstream, LP (MMP) at a 22% premium. Anticipated synergies of $200MM aren’t that big for the $18.8BN transaction value. Management expects that to reach $400MM+ but nobody can ever tell after the fact whether it happened or not. And given the merged entity’s $60BN enterprise value, it’s insignificant.

By resetting the cost basis of MMP’s infrastructure assets, OKE expects to realize tax deferrals with an NPV of $1.5BN. Critics assert that taxes are the chief motivation with few visible benefits from synergies. Moreover, the tax benefits are coming from long-time MMP unitholders, for whom the transaction is defined as a sale of their MMP holdings.

MLP investors enjoy tax-deferred distributions, because the K-1s allow them to include their proportional share of the business’s depreciation in their tax returns. Eventually this tax has to be paid, usually when the investor decides to sell. Making a charitable donation of MLP units is one way to avoid the recapture of deferred taxes. Another is to never sell, instead leaving the investment to one’s heirs who acquire the units with a current cost basis.

The least attractive way to deal with the deferred taxes is to be forced to pay them when the company decides to sell. This is what MMP has done. Tax impacts vary by length of ownership. The longer your ownership the bigger your tax recapture. Recent MMP buyers aren’t much impacted by this.  Your blogger, a long-time MMP investor, is at the less pleasant end of this range.

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MMP is treating its investors in a similar way to Kinder Morgan when they rolled up Kinder Morgan Partners (KMP) into the parent c-corp in 2014. As well as a tax bill at a time of management’s choosing, KMP investors were also stuck with a reduced dividend. Nine years later former KMP holders remain bitter.

MMP can calculate the recapture liability for all their unitholders. On Monday’s call to discuss the deal, management noted that the $25 per MMP unit cash component was based on the aggregate tax liability of MMP unitholders. Assuming they use the cash portion of the deal to pay taxes generated by the transaction, Wells Fargo calculates that the average MMP investor will suffer a 38% distribution cut. Long-time investors will do even worse, because they’ll have a bigger than average tax liability. MLP investors are highly attuned to taxes, which is why they tolerate the K-1s. A significant percentage of MMP holders will face a tax liability in excess of the cash component. They won’t be happy.

Many investors own both companies. OKE likes the diversification provided by MMP refined products pipelines, but investors already had that as separate entities. By Tuesday’s close, the 22% premium had shrunk to 13% because OKE dropped 11% since the announcement. This increases the proportion of MMP unitholders who are net worse off from the transaction after calculating the tax recapture. An investor who holds both names in proportion to their market cap has lost more on OKE’s slump than she’s gained from MMP’s rise. And that’s before adding in the cost of the recapture of taxes deferred on prior MMP distributions. The market regards this as a value-destroying transaction. It’s not even clearly good for MMP investors alone because of the recapture.

A simple way to think of the transaction is to imagine that you owned 100% of both companies. Would you borrow $5.1BN, like OKE, to pay deferred MMP taxes in exchange for a tax shield from the stepped-up cost basis? Few of us would take on debt to pay taxes sooner rather than later. Moreover, MMP investors are there for the tax deferral and have lost it. By contrast, OKE investors care more about the increased leverage than the tax shield offered by acquiring MMP assets, as shown by the weakness in OKE since the deal was announced.

Small MLPs initially performed strongly on the news, because MLP-dedicated funds like the Alerian MLP ETF (AMLP) will have to rebalance away from MMP by investing in the ever-diminishing pool of MLPs. For example, Crestwood LP (CEQP) rose 8.5% on Monday as traders anticipated this inflow of index-constrained buying. Energy Transfer LP (ET) didn’t react the same way because it’s already at its position limit in AMLP’s index.

There’s nothing about the OKE/MMP transaction that is intrinsically bullish for CEQP or other MLPs. Traders are positioning ahead of a rebalancing. The MLP structure is out of favor compared with the more conventional c-corp because of its limited investor base. Most institutional equity investors are tax exempt and face onerous taxes if they invest in partnerships. Retail investors dislike the tax complexity of K-1s.

This leaves US taxable, K-1 tolerant buyers – wealthy individuals and taxable institutions. This includes the poorly structured AMLP, which will have to accrue for taxes once more when market appreciation turns its unrealized losses into gains. So it’s hard to interpret one more MLP going away as a reason to own a concentrated portfolio of MLPs, even though MLP-dedicated funds did receive a performance bump on Monday.

The combination looks unattractive all round. SMA managers will be explaining to clients for whom they own MMP why a strategy designed to defer taxes has instead presented an unwelcome tax bill. It tarnishes the entire MLP structure, because being a long-term investor brings increased exposure to another MMP deal with sudden tax recapture. It’s unclear why investors in either company should vote to approve. We own both OKE and MMP. That will give us two chances to vote no.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

 




The Losers From Quantitative Easing

UK Prime Minister (PM) Liz Truss has reached “in office but not in power” in record time. On September 6th she met with Queen Elizabeth II and formally became PM. Two days later the Queen died, commencing a period of mourning that ended with the monarch’s funeral on September 19th. Practically speaking, that’s when Liz Truss’s hold on power began. Four days later her government shocked markets by announcing £45BN ($50BN) in tax cuts funded with borrowing.

Sterling collapsed and by September 28th the Bank of England had abandoned its balance sheet reduction (Quantitative Tightening, or QT) in order to urgently restore financial stability. In the UK bond market pension funds were dumping thirty-year gilts, driving the yield from 3.5% to (briefly) 5%. Conservative party MPs are already discussing ways to dump their new PM.

By Friday self-preservation and market turmoil had forced her to abandon most of the plan, firing her Chancellor of the Exchequer Kwasi Kwarteng for good measure. Truss will henceforth be dodging political regicide following her disastrous start. As the Economist devastatingly observed, her shelf life is about the same as a lettuce.

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UK residents are pondering how governmental ineptitude on an epic scale has raised interest rates and made foreign trips more expensive. The rest of us are wondering if it could happen here.

Pension funds and leverage are a poor combination. The solemn trust imposed on those that manage people’s retirement savings requires ensuring market volatility never interferes. Therefore, Liability Driven Investing (LDI), the proximate cause of the turmoil, is worthy of examination. Anytime you see Value at Risk (VaR) included in marketing literature aimed at pension funds, as is the case with LDI, there’s a problem lurking.

Defined Benefit (DB) pension funds are obliged to meet certain obligations in the future, often linked to salary at retirement. Defined Contribution (DC) plans (like 401Ks) are becoming increasingly common, because employers prefer shifting the investment risk to plan participants. The UK has around 5 million people covered by DB plans with assets of £1.8TN ($2TN). For comparison, the US has $16.8TN in DB plans but $13.1TN is in Federal, state or local plans, many of which are underfunded with unclear ultimate outcomes for retirees.

DB pension funds compare their assets with the Net Present Value (NPV) of their obligations to figure out if they have a surplus or deficit. Pensions are among the longest liabilities around, and their NPV is acutely sensitive to changes in the discount rate.

Because US public pension funds follow Governmental Accounting Standards Board (GASB) rather than GAAP, they calculate the NPV of their liabilities oddly, in that they use the rate of return they think they’ll earn on their assets. It creates the perverse incentive to add risky investments since they’ll generally have a higher return, which in turn depresses the NPV of their obligations (see Through the Looking Glass into Public Pension Accounting). The average assumed return on US public pension assets, and therefore the discount rate on their liabilities, is just under 7%. Even though this has been falling, it’s still wildly optimistic.

The UK government issues guidance for DB plan discount rates – currently much lower than the US at  around 2.5% depending on the specifics of the plan.

Treasury Inflation Protected Securities (TIPs) offer a return linked to inflation and are appealing to pension funds with their long liabilities. In the UK index-linked gilts are called “linkers.”

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Real yields have been falling for years, and on US government debt have at times been negative. The UK is a more extreme version, presumably reflecting a relatively greater appetite of UK pension funds to immunize inflation risk compared to their US counterparts. The dearth of choices available to UK pension funds is apparent in the 1.5% coupon with which the now plunging 30 year gilts were issued just last year.

Investing at negative real yields guarantees reduced purchasing power. Falling long term rates have hurt UK pension funds by increasing the NPV of their liabilities. In theory equities, which represent a perpetual claim on company profits, ought to compensate. A 1% drop in a thirty year discount rate increases the NPV of a payment due in thirty years by 30% (ie the duration of a 30-year zero coupon bond equals its maturity). Unfortunately, you can’t rely on stocks going up by 30% at the same time.

UK pension plans sought advice on managing their exposure to falling rates, and it was helpfully provided by firms such as Russell Investments in the form of derivatives. Simply put, LDI is a derivatives contract that generates a profit for the pension fund when long term rates fall, the point being that falling rates will lead to a lower discount rate and therefore a bigger NPV of their pension obligations. LDI behaves like an investment in long term bonds, but without the need to spend cash to buy the bonds.

Derivatives contracts, like futures, require counterparties to post margin to one another depending on which side of the contract is in the money. The LDI models on which advice is based are naturally complex and proprietary. Pension funds probably relied on the assumption that losses on their LDI trades would be offset by a reduced NPV of their liabilities, and they could use pension contributions to provide additional margin if required. VaR analysis from their consultants would have provided reassurance.

Two things went wrong. One is that UK linker real yields fell to deeply unattractive levels, causing pension funds to explore risky alternatives. The second is that the new PM’s ill-considered fiscal expansion caught the market off-guard, driving yields up sharply. This in turn shredded VaR assumptions, requiring untimely sales of securities by pensions to cover margin calls on LDI losses. Derivatives create leverage. On one level this is another story of too much risk.

However, the underlying problem is low/negative real yields, and these are caused in large part by Quantitative Easing (QE). Society generally likes low borrowing costs, but every borrower has a lender and pension funds are clearly QE-losers. Central banks have been quicker to grow their balance sheets with QE than to shrink them with QT.

Ironically, the Bank of England provided updated guidance on QT on September 22, the day before Kwasi Kwarteng dropped his fiscal bomb. Six days later they were buying again to mop up the mess.

Buying bonds is now part of the central bank toolkit, and in the US it’s virtually certain that the next recession will be upon us before the Fed has shed its excess $TNs. Although real yields have moved up recently, there’s little reason to think their long term decline has ended. The problems of DB pensions haven’t been solved. But the UK does seem like a unique case of poor investment choices and an impetuous new PM.

Meanwhile the Fed is singularly focused on inflation which increases the odds they’ll make another mistake, upon which they’ll switch back to employment. QE will begin again, becoming a permanent form of debt monetization. 2% long term inflation is a poor bet. This FOMC shuns multi-tasking and fixates on one metric at a time. That will be Jay Powell’s legacy.




Different Audience, Different Energy Policy

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.”

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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.

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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.

 

 




Deciphering the FOMC’s Tea Leaves

Last week’s FOMC meeting for once gave the market something to ponder. The $120BN of monthly bond buying looks set to taper before the end of the year, and to be down to zero by next summer. Fed buying of mortgage-backed securities has been especially superfluous, as shown by the red-hot housing market.

The market interpreted a more hawkish message, and eurodollar futures yields rose to price in a slightly more aggressive pace of tightening. It’s true that median rate expectations of FOMC members edged up compared with June. But the range of forecasts remains very wide. This may be one of the reasons Fed chair Jay Powell continues to advise against too close a reading of the projection materials, even though we all pore over them with great care as soon as they’re released.

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To use one example – the median FOMC member’s forecast for the Fed Funds rate at the end of 2023 rose, from 0.625% to 0.875%. A 0.25% increase, even over two years out, seems significant. But as the chart shows, views within the FOMC vary widely. One member doesn’t think they’ll have raised rates at all by then (down from five who held that view three months ago). There’s still a gaping 1.5% gap between the high and low forecast. Committee discussions about the outlook must be lively, at least within the constraints of what’s plausible when discussing monetary policy.

Most FOMC members continue to expect to raise rates faster than implied by eurodollar futures, which offers an opportunity for those able to participate. The spread between Dec ‘23 and Dec ‘25 futures remains too flat – it came in briefly on Wednesday along with the twos/fives yield curve following the release of the FOMC statement but widened again the next day.

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Another interesting evolution concerned FOMC members’ “longer run” outlook for short term rates, the so called equilibrium rate. For years this has been declining, along with real rate or the premium markets demand over inflation. Chair Powell has discussed “R-star” in the past. R-star is the Fed’s assumed equilibrium real rate, or the margin over inflation they should target for neutral policy. R-star of 0.5% added to 2% inflation is how they’ve arrived at a 2.5% neutral rate, and it’s the reason today’s FOMC appears so dovish. A lower equilibrium rate means there’s less room to cut rates when needed, which makes it harder to achieve their inflation target. Hence the new policy adopted just over a year ago of allowing inflation to exceed their 2% target rather than acting pre-emptively to prevent it.

So it’s notable that FOMC members’ “longer run” forecast of short-term rates came down somewhat. Only 15 of them offered such a forecast, down from 17 in June and short of the 18 who provide annual rate forecasts through 2024. It’s unclear why an FOMC member would provide less than a complete set of forecasts, but the missing ones were probably more hawkish because all the three forecasts in June above 2.5% were gone last week.

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At the same time, inflation forecasts have edged up slightly, with core Personal Consumption Expenditures inflation (the Fed’s preferred measure) expected to run at 2.2% in 2023, up 0.1% from June. Most notably, although 2.5% is their median long run neutral policy rate, only one FOMC member expects rates to be above that level even by 2024.

What conclusions should one draw from all this numerical insight into the Fed’s thinking? Their opinions vary widely, but they expect to raise rates faster than implied by the market. But they are optimistic — even though they’ve had to constantly revise their inflation forecasts higher, they overwhelmingly expect inflation to return to their 2% target without having to raise rates above the 2.5% neutral level.

Moreover, the tone of the FOMC is very dovish, at least to this observer of 40+ years. There are no hawks in the traditional sense. The notion that monetary policy can be used to moderate income inequality, as Jay Powell has suggested in the past, has not been suggested by his predecessors. It’s easy to imagine the dilemma such a view will pose when it comes time to tighten rates. There will be a healthy debate about whether lower income Americans are hurt more by inflation or higher rates, and the consideration of income inequality along with the level of employment will cloud the right course of action.

It’s also likely that Democrat administrations will apply a monetary policy litmus test when selecting future FOMC members, in the same way that Supreme Court candidates’ past rulings are examined for signs of reliable political bias. For example, Boston Fed president Eric Rosengren, who just announced his early retirement, is an outspoken critic of the Fed’s bond buying (see The Fed’s Balance Sheet Has One Way To Go). His replacement is likely to be more dovish.

The bottom line is that, while short term rates will inevitably rise, the Fed has shifted to care more about maximizing employment than protecting savers. Investors should position accordingly.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

 




Unsettling The Climate Change Consensus

Do scientists spin the truth in order to explain complex answers simply? That is the suggestion scientist Steven Koonin makes in his new book Unsettled: What Climate Science Tells Us, What It Doesn’t, and Why It Matters 

Koonin speaks with some authority – his career includes being BP’s chief scientist 2004-09 followed by serving in the Obama administration as Under Secretary for Science 2009-11. He has a PhD from MIT in Theoretical Physics. Koonin applies his scientific background to the complex area of climate change.  

Koonin is no climate denier. He readily acknowledges that human activity is increasing CO2 emissions, warming the planet. From there, he walks the reader through two huge uncertainties – how much global warming have we caused, and how bad will it be anyway.  

The UN’s Intergovernmental Panel on Climate Change (IPCC) has issued a series of reports which led to the 2015 Paris agreement, where countries agreed that limiting global warming to 1.5 degrees Celsius above pre-industrial levels was necessary to avoid irreversible damage to the planet. Humanity’s future hinges on this binary outcome. 

In a world of soundbites, “The Paris Accord”, “Zero by 2050” and “Saving the Planet” have all become shorthand rallying cries galvanizing action by governments, corporations and investors worldwide. The implication of certainty grates with Koonin’s scientific mind which accepts degrees of uncertainty around virtually any forecast. Using computers to model the climate (as distinct from weather) taxes the powers of even today’s supercomputers.  

Global warming is likely to raise sea levels – but it turns out this has been the case since at least 1900, long before human use of fossil fuels drove CO2 levels higher. While it’s true that the 3mm rate of annual increase over the past twenty years is higher than over the past 100, the 1930s saw a similar rate.  

The media often blames extreme weather events on climate change – we’re better at measuring hurricanes, which before satellites were only recorded where they encountered people on land or at sea (assuming they survived). Nonetheless, it’s hard to see any link between the fluctuations in hurricanes and rising CO2 levels.  

None of this is intended to eliminate the likelihood that we’re warming the planet – simply to demonstrate that the consequences are hard to isolate.  

Moreover, Koonin notes that weather-related catastrophes are killing fewer people, drawing on research from Bjorn Lomborg’s book False Alarm; How Climate Change Panic Costs Us trillions, Hurts the Poor, and Fails to Fix the Planet 

Food production, which we’re warned will collapse with warmer temperatures, has risen with a warmer planet.

The UN reported record world cereal production last year. Inconveniently, rising CO2 levels are improving plant growth. The UN cites a report that satellites show a marked increase in leaf coverage for 25-50% of vegetated areas.  

The U.S. Global Change Research Program (USGCRP) is a Federal agency charged with assessing the impact of climate change. Their Fourth National Climate Assessment was published in 2018, and is full of warnings. But the economic consequences, as Koonin notes, seem insignificant.  

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The Assessment estimates the economic cost of different scenarios. Although the chart  extends as far as a 15° F temperature increase by 2100, most serious forecasts of inaction are in the 3-5° range. Assuming 2% real GDP growth, the U.S. economy will grow from $21TN to $102TN by the end of the century. If climate change makes it 2% smaller (i.e. $100TN), that would mean annual growth was 1.97% instead of 2%. The chart looks dramatic, but the plausible economic cost seems inconsequential.  

This really gets to Koonin’s point, which combines uncertain climate forecasts with unclear consequences to ask why there isn’t any cost-benefit analysis done on the world’s response to rising CO2. Bjorn Lomberg and Alex Epstein (the latter in The Moral Case for Fossil Fuels) make similar arguments. Increased energy use has improved living standards for billions of people. Koonin notes that the World Health Organization has said that indoor cooking with wood and animal waste is the most serious environmental problem in the world, affecting up to three billion people. This will not be solved with solar panels and windmills in rural areas of emerging countries.  

The science is uncertain, and the range of possible outcomes includes some very dire ones too. Prudent risk management of the only planet we have demands some steps towards mitigation. Perhaps some of the scientists who do this work, despairing of the difficulty in communicating complex uncertainty, have resorted to simplifying the message in order to promote changed behavior they sincerely believe is needed.  

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 Koonin explores this. In the USGCRP’s Fourth Assessment, they include a dramatic chart that shows more record daily high temperatures. This is why hot days cause the media, and our friends, to blame global warming. But the construction of the chart is odd. It takes the number of new record highs divided by the number of new record lows and plots this ratio. Koonin shows that what’s actually happened is that the average coolest temperature has increased, while the average hottest is about the same as in 1900. Our nights have been getting less cold – our days are not warming. The climate is getting milder.  

The chart begins in 1930, so you’d expect a lot of record highs and lows at the beginning of the sample period. This will keep the ratio of the two close to 1.0. As decades pass, the growing prior history will make new records less common, which will also cause the ratio of new highs to new lows to fluctuate more.  

Fewer record cold days with unchanged record highs has caused the ratio of the two to rise sharply. But why display the information in this way? Taking the ratio of new highs to new lows from a fixed date in the past is not at all intuitive, and it portrays a very different picture of temperatures than the actual data. At best it’s an example of sloppy work, and at worst it’s an effort to present a biased picture so as to prompt more urgent action.  

Because political discourse requires you to be for or against, critics call Koonin a climate denier, That is to ignore his thoughtful embrace of scientific uncertainty, and his advocacy for informed choices that try and balance cost/benefit. Too few climate extremists read the science, and if they truly believed humanity’s existence was threatened they’d quickly embrace natural gas power generation so as to phase out coal, and far greater use of nuclear energy.  

The obsession with solar panels and windmills belies lack of serious thought and is why global emissions keep rising – most people care until the energy transition costs them money, which it most assuredly will or we’d have already transitioned. Steven Koonin’s book is a welcome contribution to more informed debate about climate change.  

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




The Biden Put

Inflation fears are percolating. The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) had its biggest ever stretch of outflows over the past six weeks. There are plenty of warnings signs. Commodity prices are booming. This is happily driving up midstream energy infrastructure, with the American Energy Independence Index up 15% YTD, well ahead of the S&P500 at up 4%. Cyclical and value sectors are drawing renewed interest. Energy has been outperforming technology since November’s vaccine announcement.

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M2 money supply is growing at 26% year-on-year, the fastest since records began. The link between inflation and money supply broke years ago. Money velocity is down sharply, which is why inflation isn’t surging. The Fed isn’t worried. They would be happy with inflation running above their 2% target for a while. For those of us whose careers include the 1980s, when inflation and interest rates peaked, this is quite an an adjustment.

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Covid figures are collapsing, which will likely unleash pent-up spending that interminable lockdowns have stifled for a year. The CDC counts 474K deaths involving Covid, less than the 500K figure seen elsewhere because the CDC waits for official death records to be uploaded by the states. This is without doubt a tragedy.

Over the same period, 3.3 million Americans died without Covid. They spent their last months or year alive constrained by all the restrictions we know so well. To pick one cohort, 99K people aged 65-74 died with Covid, but 631K of the same group died without it. 21K aged 45-54 died with Covid, reflecting their low risk profile, but 183K in this group died from other causes, while enduring pandemic restrictions like the rest of us. Even for those 85 and older, who are almost a third of all Covid fatalities, 87% of deaths in this group were non-Covid.

A friend of mine I’ve known since elementary school died on Saturday from a heart attack, which probably caused me to consider the figures in this way. The lost final year of life for the non-Covid fatalities denied the normalcy of dinners out, companionship with friends, travel and so on is another tragic element of the pandemic, but doesn’t get much attention. Do you know anyone who isn’t ready to get out there and live once more?

Money market funds hold around $5TN, a figure that’s slowly declining but still nonetheless $1TN higher than a year ago. This has low velocity while it’s sitting there but could easily be deployed in a recovery of consumer spending. Examples of rising prices include crude oil, copper and resins used to manufacture plastics. Pipelines, which move with commodity prices and reflect ownership in physical assets, offer more protection than most sectors in this environment.

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Meanwhile, the Administration wants to spend $1.9TN on Covid relief – even if that figure is negotiated down, the vaccine rollout and falling hospitalizations suggest that the worst is behind us. A weekend article in the WSJ even suggested that the U.S. was nearing herd immunity. It’s predicated on an estimate that 0.23% of people who get infected die. Assuming that’s a reliable statistic and the 500K Covid fatalities is also accurate, it suggests 217 million Americans have been infected (500K divided by 0.23%). That’s approximately two thirds of the country. Add the growing vaccinations and you can see the country could be at 70-80%.

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It’s a controversial assessment, and friends/readers who know more than us on the topic will be moved to respond. Fauci isn’t so optimistic. Virus mutations may cause a setback. But it’s not possible to definitively reject the optimistic conclusion, only to say it’s unclear.

Once the Covid relief plan is approved and money being sent out, Biden will turn to infrastructure – another $1TN. Climate change will justify at least that in addition. There are no longer any fiscal hawks (see Modern Monetary Theory Goes Mainstream).

Although there are plenty of warning signs that inflation will rise, we’ve had almost three decades where it hasn’t. Many worried about the inflationary effects of Quantitative Easing when it was first deployed following the 2008 financial crisis. To Ben Bernanke’s credit, he knew it wouldn’t and he was right. The economists at the Fed are similarly confident today. They’re expected to keep short term rates low for at least the next couple of years.

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Betting against the Fed is usually wrong. But today, betting with them doesn’t offer much upside. The eurodollar futures curve remains extremely flat, so an investor in two year securities will do scarcely better than holding overnight deposits for the same period of time. Fed chair Powell reiterated his cautiously optimistic outlook yesterday with no need to raise rates anytime soon.

The Federal government is pouring fiscal and monetary stimulus into the economy simultaneously. And if a virulent Covid mutation sets back the current path to re-opening, more $TNs will be forthcoming.

People used to refer to the Bernanke “put”, recognizing that the Fed would respond to sharp economic weakness by easing, giving equity investors effectively a put option on their holdings. Nowadays we have both the Powell Put and the Biden Put. Bond yields are too low to properly reflect the new reality.

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