SL Advisors Talks Markets

Americans Work More Remotely

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Real estate investors are keenly attuned to the Fed’s efforts to curb inflation. The Vanguard Real Estate Index Fund (VNQ) is down 18% over the past year, lagging the S&P500 which is –6% and the American Energy Independence Index (AEITR) which is –1%.

Rising rates have cooled the hot property market that the Fed’s bond purchases caused following the pandemic. The Economist believes real estate is signaling an imminent recession. An economic slump has been forecast for months even though hiring remains strong. Last month’s unemployment showed the startling resiliency in the job market. In my experience recessions rarely arrive when expected, and don’t start with 3.4% unemployment. Acknowledging the fortunate failure so far of doomsayers, the WSJ explained “Why the Recession Is Always Six Months Away.”

But real estate companies are getting more cautious. Forward guidance for 1Q23 was negative for all 26 members of the S&P500, and 20 of them revised down their full year outlook. Property may be a good long term inflation hedge, but rising mortgage rates and a realization that hybrid work is becoming permanent are substantial headwinds.

The Wall Street Journal recently reported that US office occupancy is around 40-60% of pre-pandemic levels compared with 70-90% in Europe and the Middle East. Asia is even higher, at 80-100%. This is partly due to American homes being bigger, averaging 2.4 rooms per person compared with other rich countries that are generally below 2.0 and average 1.7 across the OECD. If you live in Hong Kong which must be close to 100% apartments, going to the office and grabbing dinner afterwards is understandably more appealing.

Two years ago we converted the formal living room of our house, rarely used and little more than a furniture showroom, into my office. My wife didn’t share my enthusiasm for more efficient use of our home, but it’s the best office I’ve ever had. You can see it in our company video.

For 25 years I endured a daily commute of 75 minutes each way (or more) from New Jersey to New York City. Transit infrastructure in many US cities is often inadequate, and inferior to other big cities around the world. Like tens of millions, I have first hand experience.

Now I walk downstairs.

It helps that America is a big country. Covid caused us to spread out. There is a lot of available space. But bigger homes mean longer commutes which is another reason Americans are happier working remotely.

Real estate may be performing poorly, but it’s not yet attractively valued. The FTSE Nareit Index which covers the US commercial real estate industry yields 4.3%, less than two year treasuries and midstream energy infrastructure. It’s close to its ten year average EV/EBITDA multiple, whereas energy infrastructure is 28% cheap. One measure of the real estate sector’s rich valuations is that its current multiple is almost 2X the pipeline sector.

Wells Fargo has estimated that around half midstream’s EBITDA is derived from pipeline contracts that have explicit inflation linkage, usually via the PPI or CPI (see Pipelines Still Linked With Inflation). For energy infrastructure investors, inflation raises the value of the real assets they own as well driving commensurate increases in tariffs. Few investments offer the potential to so readily maintain their value with inflation.

Many innumerate climate extremists assert that solar and wind are the cheapest way to generate electricity. Nonetheless, running a profitable renewables business is surprisingly difficult. Last month wind turbine manufacturer Siemens Gamesa, which calls itself “the global leader in offshore power generation,” announced a quarterly loss of $967million.

BP has moderated an earlier pledge to reduce emissions and its production of oil and gas, because that’s where the returns are highest. Along with Shell, because they’re based in Europe both companies are more vulnerable to pressure from activists. Recently the market has perceived flexibility in their energy transition goals, because traditional energy is so profitable. Their stocks have performed well as a result.

Renewable infrastructure has been an especially poor investment. The Kayne Anderson Renewable Infrastructure Index is flat since 2018 (earliest available data) compared with midstream energy infrastructure which has returned 6.9% pa over the same period. We’re biased towards natural gas infrastructure because that’s where we believe the returns are most attractive. When windmills can offer similar cash flow visibility, we’ll take a closer look.

For now, it’s increasingly clear that when it comes to hard assets, or infrastructure, traditional energy is the place to be.

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

SL Advisors Talks Markets

Climate Policies Confront Reality

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Casually following news of the energy transition can create the impression that the world is a few years away from running on solar power and windmills. The reality is that climate extremists have propagated two impractical beliefs that are impeding policies based on pragmatism. One is that solar and wind are the complete solution. The other is that emerging economies are similarly committed to reducing emissions.

Starting with electrification – the NYTimes recently acknowledged the growing delay in connecting solar and wind projects to the grid. The US has three grids — Eastern, Western and ERCOT which is approximately Texas, along with 66 balancing authorities. New sources of power supply have to negotiate access to this system, which often requires adding power infrastructure.

PJM Interconnection, a regional grid running from Illinois to New Jersey, has frozen new applications to add power until 2026 while they process the backlog. Developers often have to pay for grid upgrades. A wind farm in North Dakota was asked to pay millions of dollars to upgrade transmission lines hundreds of miles away in Nebraska and Missouri.

Across the US approvals now take on average four years. It’s estimated that less than a fifth of new solar and wind projects get connected. Climate extremists have become adept at using court challenges to vacate environmental permits issued to pipeline projects. But the same approach can also delay infrastructure to support renewables, because NIMBYs are not a coordinated political force. Permitting reform is sorely needed.

The Energy Information Administration reports that renewables were almost two thirds of investment in new power output in 2021, with natural gas 22%. There were no new coal plants. Natural gas often enables renewables by compensating for their intermittency.

Owners of Electric Vehicles (EVs) often struggle with charging. In my experience everyone loves their Tesla, but I recently took an Uber ride in Pennsylvania where the driver reported a daily one hour wait to recharge her (Uber-owned) EV. She wasn’t willing to spend the $6K required to install an EV charging outlet in her home. Most EV owners I know have a second car for long trips.

EVs will continue to gain market share, and the US is a relative laggard. Cheap gasoline, a preference for big cars and high annual mileage have slowed EV penetration outside California. Like many people, I’m going to wait until improved charging speed and availability makes buying an EV an upgrade to quality of life.

It’s also easy to think that our efforts on climate change here in America are critical to solving the global challenge of reducing CO2 emissions. We have had a lot of success over almost two decades. US CO2 energy-related emissions peaked in 2007 at 6 Billion Metric Tonnes (Gigatonnes, or GTns), and are now 18% lower. This has come about in part because coal dropped from 48% to 22% of power generation. Natural gas rose from 22% to 38%, compared with zero-carbon (which includes reliable nuclear and hydro as well as intermittent solar and wind) which rose from 28% to 39%.

This is why a sensible strategy to reduce emissions would eliminate what remaining coal we use and replace it with natural gas and nuclear. Climate extremists are purists if not practical.

Emerging countries are defining the world’s CO2 emissions, and they continue to invest in coal burning power plants. At the COP21 in Glasgow India promised to “phase down” coal, which practically speaking means its use will grow more slowly than other sources of energy. Old coal mines are being reopened, and coal executives expect their output to be required for at least another quarter century. Its fastest growing coal mine is scheduled to triple in size.

China’s coal use dwarfs the rest of the world. The Centre for Research on Energy and Clean Air (CREA) calculates that 85% of the planet’s planned new coal projects are in China.  Living standards can’t improve without increased energy use, but China’s policies render other countries’ efforts irrelevant. Or our efforts allow China to do less, depending on your perspective.

No review of climate policies would be complete without reference to that obnoxious little girl Greta Thunberg, who once preached to the rest of us from the UN (“How dare you”). Betraying her discombobulated understanding of the world’s energy needs, she recently accused Norway of “green colonialism” because of plans to build an onshore wind farm in the middle of an area where reindeer graze.

Natural gas remains the world’s best hope for serious emissions reduction, as it has been in the US in spite of sometimes incoherent opposition from climate extremists.

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

SL Advisors Talks Markets

How Tightening Impacts Our Fiscal Outlook

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For anyone in finance, the US budget deficit has always been a looming disaster but rarely a current problem. It hasn’t been a political issue since Clinton ran for office and Jim Carville quipped that the bond market intimidated everybody. For a few brief years we had a budget surplus (1998-2001), but fiscal prudence long ago lost its appeal with voters because the current costs of profligacy are inadequate to impact elections.

But tomorrow is approaching, and according to the Congressional Budget Office (CBO) sooner than we thought a year ago.

Last week the CBO updated their 10-year budget projections, with disappointing revisions compared with the prior release last May. Our Debt:GDP is at levels last seen towards the end of World War II. Back then following the end of hostilities spending fell, and artificially depressed government bond yields helped lower the country’s debt burden.

This time around, ballooning Medicare and social security spending will take us into uncharted territory.

Rising debt has increased our interest rate sensitivity. The CBO’s outlook for inflation and bond yields hasn’t shifted apart from reflecting today’s higher inflation. Compared with last year’s forecast, inflation is expected to return to the Fed’s 2% target a year later.

The impact on our finances has been dramatic. Debt will now exceed GDP next year, four years earlier than before. Interest expense over the next decade will be $159BN higher annually, bringing forward by approximately two years milestones such as $500BN, $1TN or $1.25TN in annual debt servicing cost.

The White House is unlikely to dwell on this, but the change in circumstances between the two CBO publications might represent the most rapid deterioration in America’s finances in history. The bigger the problem gets the harder it is to solve.

It would be worse without Quantitative Easing (QE). The Fed still holds $5.4TN in government bonds and another $2.6TN in MBS. Without return-insensitive buyers such as central banks (see More Than A Fiscal Agent) and others with inflexible investment mandates financing our debt would be even more costly.

The Fed follows its dual mandate by focusing on whichever of the two variables (employment or inflation) is farthest from its desired level. In the summer of 2019 at Jackson Hole, they concluded that we could tolerate a little more inflation over short periods to boost employment (see The Fed’s Balance Sheet Has One Way To Go). The timing was unfortunate, and within a couple of years a modest overshoot demanded their attention.

The Fed’s Congressional mandate doesn’t include concern about the fiscal impact of their actions, but they are becoming more impactful. QE has emasculated debt hawks by hiding the apparent cost of fiscal excess. QE’s slothful removal has impeded the Fed’s efforts to slow the economy, as seen in recent strong data such as employment and retail sales.

The current tightening cycle hasn’t been enough to raise unemployment, but it’s had a meaningful impact on our debt outlook. The Fed’s interpretation of its dual mandate now has a fiscal dimension.

The logical response is to tolerate higher inflation. There’s nothing magic about 2% – stability is more important than its level (see El-Erian, Rogoff Say It’s Too Late to Fix Too-Low Inflation Target). The numbers suggest that tolerance of 3% inflation leaves us better able to service our debt than 2%. There are few tangible benefits from the current effort to stick to the old inflation target.

Last year interest expense alone was 1.90% of GDP. Within a decade it is expected to reach 3.52%, up from a 3.254% projection in May.

The Fed’s Summary of Economic Projections has the Fed Funds rate ending this year at 5.1% and next year at 4.1%. The CBO expects Fed Funds to average 3.6% in 2024 (last year they were projecting 2.6% for 2024). If the Fed is right, the CBO’s 2024 interest rate forecast will be around 1% too low, which will result in further adverse updates to our fiscal outlook.

The CBO aligns with where interest rate futures were when they prepared their budget outlook. Since then, strong data has caused the market to shift towards the Fed’s projections.

Fed chair Powell has been clear that bringing inflation back to 2% is in everyone’s interests. While this is consistent with their Congressional mandate, it’s no longer the most desirable public policy. Our vast debt, poor fiscal outlook and heightened interest rate sensitivity make increased inflation tolerance preferable.

For now, investors should take the Fed at its word that they’ll do what it takes. But the impact on our finances of returning inflation to its 2% target is eventually going to make this a consideration. It means defining price stability as 2% inflation is becoming more costly. Maintaining the purchasing power of your assets means assuming inflation settles in higher than this target.

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

SL Advisors Talks Markets

Cost Overruns Plague Big Projects

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Earnings continue to meet or modestly beat expectations. 4Q22 EBITDA at Enbridge of $3,911MM beat expectations by $16MM, or around 0.4%. The small margins between actual and expected at many companies highlight the visibility of their earnings.

Along with TC Energy, both companies have a long history of dividend growth — 28 years at Enbridge and 23 years at TC Energy. However, the two big Canadians represent a disproportionate share of the sector’s growth capex.  Costs for TC Energy’s Coastal GasLink project continue to spiral upwards, now C$14.5BN and more than double its initial forecast. The project’s value has been written down by C$3BN, and a further writedown is expected as additional funding is provided.

Although both Canadian firms are generally well regarded, we have maintained them at below-weight positions in our portfolios because of their extensive capex programs. We estimate that their 2021-23 capex is 38% of the sector’s, ahead of their 31% share of market cap. Enbridge expects EBITDA growth this year of 2.5-6.5%, and TC Energy 5-7%.

The problems with Coastal GasLink highlight the difficulty big construction projects face in North America. Labor is tight and environmental extremists are adept at using legal challenges to impose costly delays. Kinder Morgan executives must thank their good fortune at unloading the Trans Mountain Pipeline (TMX) project to the Canadian Federal government in 2018. After delays and cost overruns it’s now scheduled to be in service next year, costing C$21.4BN versus the C$12BN estimated when Canada bought it.

Our northern neighbor has long struggled to get its oil to market. TMX became embroiled in provincial politics, with liberal British Columbia unsympathetic to land-locked Alberta’s need to move its produced crude oil to the Pacific coast. The ill-fated Keystone XL was another failed effort to solve that problem by sending crude south.

Canadian natural gas also travels great distances to reach its market, a problem TC Energy’s Coastal GasLink is trying to solve. Tourmaline sends its gas 3,000 miles via pipeline from British Columbia to Cheniere’s LNG export facility at Corpus Christi, TX where it’s loaded onto LNG tankers. From there it supplies buyers in Europe and Asia at prices 10X the Canadian spot market.

Coal to natural gas switching remains a powerful means of reducing CO2 emissions. Unfortunately, Pakistan just announced plans to quadruple coal-generated electricity and use less LNG because of high prices. Russia’s invasion of Ukraine turned Europe into a significant buyer of LNG, which has made it harder for poorer countries to use it. Pakistan is facing a balance of payments crisis and a debt default looms.

This illustrates that energy security and affordability are more important to developing nations than the energy transition. Some officials in India believe they’re more vulnerable to extreme weather events because of a warmer climate, such as the floods that destroyed neighboring Pakistan’s cotton crop last year. More likely is that these and other countries will raise living standards first and worry about emissions later, when they’re better able to absorb the higher costs of mitigation and low-carbon power. Obviously solar and wind aren’t cheaper, or Pakistan would be emphasizing them instead of coal.

In Germany a project to blend natural gas with green hydrogen in a 70/30 split has been running successfully since the fall.  Green hydrogen relies on solar or wind power to run the electrolysis that separates it from water. Utah’s Intermountain Power Project plans to supply southern California with a similar blend by 2025.

Plugging intermittent solar and wind into electrical grids creates instability, requiring battery back-up or natural gas peaker plants. Because it’s not always sunny and windy, 25-35% capacity utilization is the norm. Personally, I have no interest in weather-dependent power. But converting it into hydrogen nullifies the intermittency problem because electrolysis can run when weather permits without any disruption to customers.

Some regions still cling to the belief that everything can run on solar and wind. Eugene, OR, recently added itself to the list of unappealing places to live by banning gas hookups on new construction.

Remote work is expected to curb oil consumption by reducing commuting. Three years on from the outbreak of Covid, hybrid work is common with Fridays an especially popular day to work from home. 25 years traveling from NJ to New York City daily soon lost its appeal for me.

Goldman Sachs and JPMorgan, along with New York’s city government, all require their workers to be full-time in the office. The reality is different – JPMorgan is barely at 50% occupancy even in 383 Madison Avenue, the building they acquired when bailing out Bear Stearns in 2008 that is their de facto HQ while 270 Park Avenue is being rebuilt. JPMorgan CEO Jamie Dimon famously said, “people don’t like commuting, but so what.”

Americans are spreading out in this vast country, improving quality of life and perhaps even reducing emissions somewhat. Hybrid work is challenged to create a corporate culture and support creative teamwork, but it looks like a permanent change.

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

SL Advisors Talks Markets

Pipelines Grow Into Lower Risk

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Enterprise Products Partners’ (EPD) earnings release last week revealed that leverage (Debt:EBITDA) fell to 2.9X at the end of last year. They are now targeting 3.0X, down from 3.5X previously. This is among the lowest in the industry, and reflects a continuing trend to strengthen balance sheets, de-risking the businesses. Years ago, Kinder Morgan argued to rating agencies and investors that their diverse asset footprint justified a 5.5X debt multiple. Poor capital allocation (see Will Kinder Morgan Cover Its Cost Of Capital?) led to distribution cuts and KMI has since fallen in line.

Also cheering for investors is that higher EBITDA has been the main driver of the lower risk profile. Growth is creating stronger balance sheets.

JPMorgan estimates that average leverage at big US pipeline corporations and MLPs this year will average 3.5X. Canadians Enbridge (ENB) and TC Energy (TRP) push this figure higher. ENB’s business includes gas distribution with regulated rates and is generally perceived as less risky.

The International Energy Agency recently forecast continued demand growth for global supplies of LNG.

News from the energy patch has been uniformly good in recent weeks, led by strong earnings but supplemented by greater realism about energy security and its impact on the energy transition. Emerging economies, especially in Asia, are growing and how they provide increasing energy to their upwardly mobile populations will determine the path for CO2 emissions.

The US shift from coal to cleaner-burning natural gas for power generation is a great success story in reducing global Green House Gases (GHGs). India is providing encouraging signs of emulating this, with its biggest LNG importer looking to add an additional 12 million Metric Tonnes per year under long term contracts.

Asia-ex Japan burns vast quantities of coal for power generation. The Asia Pacific region consumes an astonishing 80% of the world’s coal output. China is in a league of its own, burning more than the rest of the world combined. India is a distant second at 12% of global demand. PM Narendra Modri  recently said he wants natural gas to provide 15% of India’s power by 2030, up from 6% today.

Poorer countries following the US lead in relying more heavily on natural gas to produce electricity offer our best chance of curbing emissions. It won’t be done with only solar and wind.

South Korea is recognizing the shortcoming of intermittent, weather dependent energy. They’re now planning for nuclear to meet a third of their power needs by 2030, up from 24% in their prior forecast. Renewables have been downgraded from 30% to under 22%. In countries with growing energy needs, reliability is a priority.

Exxon and Chevron both reported record profits recently. BP just followed suit, and now plans to increase its spending on oil and gas production although they’re still targeting a production cut of 25% by 2030 (previously 40%). This follows earlier reports that investments in renewables are delivering disappointing returns, leading to less emphasis on ESG goals. BP’s capex decisions are now guided by a long-term price target for Brent crude of $70 per barrel, up from $60 previously.

Siemens Energy is an example of the low returns in windpower, having recently announced a 4Q22 loss of €598MM due to quality issues on installed wind turbines. Siemens is planning to raise €1.5BN in additional equity to shore up its balance sheet.

ESG-driven capital allocation doesn’t assure profits.

Asian urgency around securing long term commitments of LNG supplies contrasts with Europe. Buyers are fearful that signing 20-year deals typically required by suppliers to ensure an adequate return on infrastructure investments will conflict with government regulations on hydrocarbon use. The EU is the region most willing to impose higher costs and inconvenience on their population in pursuit of reduced emissions.

Carbon capture is also growing in Europe. Denmark just approved a project that will by 2030 inject up to 8 million metric tonnes a year of CO2 into depleted oil and gas formations under the North Sea. Returning carbon in the form of CO2 underground into the formations it left as hydrocarbons has a certain logic to it. We noted a similar virtuous loop in Enlink’s plan to transport CO2 in south Texas from a petrochemical plant for eventual storage in the Eagle Ford (see Putting Carbon Back In The Ground).

Energy companies are showing they’re critical to providing secure energy with reduced emissions. It seemed improbable just three years ago, but the sector is having a good energy transition.

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