Book Review – Elon Musk by Walter Isaacson

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Book Review – Elon Musk by Walter Isaacson
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“I want to go make that happen” was twenty-one-year-old Elon Musk’s thought in 1992 on California mandating a 10% market share by 2003 for Electric Vehicles (EVs). Or rejecting a job building videogames, which he loved, because “I wanted to have more impact.” As a young man he wanted to colonize Mars to ensure human consciousness could outlive Earth and prepare for the end of fossil fuels with EVs. He’s always been a big thinker.

This becomes clear early in Walter Isaacson’s biography of Elon Musk, a gripping story that draws you to read just one more chapter (there are 95) each time you sit down with it. Those around Musk learn to live with his (self-diagnosed) Asperger’s, which makes him a harsh critic with no empathy for others. He tells those opting to remain at Twitter after three rounds of layoffs to be prepared to work “long hours at high intensity.”

Musk lives that way himself, apparently sleeping little and rarely vacationing, powering through days of problem solving with Red Bull. Somehow, he runs multiple companies that each could justify their own CEO. He demands impossible deadlines. He demands simplification in production lines and product design (“delete, delete, delete”), ignoring the warnings of engineers that his goals are impossible. Mostly, teams of employees rise to accomplish what they thought was out of reach. Sometimes they don’t, and occasionally Musk revises his opinion with new information. He instills a culture of extreme urgency, preaching that the future of humanity is at stake.

Musk embraces risk, and crises. Like many overachievers he’s never content. He’s highly analytical, yet his mood swings can trigger sharp pivots. He runs through key employees at a dizzying pace. Some burn out on the job’s demands and Musk’s mercurial temperament. Others are fired when he deems them no longer at peak productivity. There are very few who have remained, and at times he turns to close family members who are the only people he trusts. Many find it exhilarating to be around someone who is changing the world, accepting the lost family time and unpredictability as worth it.

A physically violent childhood in South Africa made Musk a fighter. His father routinely berated and belittled him. He was rarely happy and never content. He credits videogames, which he plays obsessively for a diversion during a crisis, with teaching him strategies that work in business.

An unconventional family life is part of Musk’s story. At one point he decides not to own a home, regarding possessions as unseemly for a billionaire changing the world. He enjoys good relations with nine of his ten surviving children as well as their mothers. One son transitioned to a daughter and rejects him, a source of great sadness. Odd names (one toddler is simply “X”) should surprise no-one. X is often with Musk, and learned to count backwards from ten by watching SpaceX rocket launches before he could count forward.

The acquisition of Twitter combined Musk’s restlessness and risk appetite in an impulsive gamble. As usual he threw himself into endless long days of crisis management while slashing employment by over three quarters. He slept on a couch in a conference room. Twitter the service still operates – whether it will be a financial success is less clear.

You can understand why people bet against him. Even Bill Gates shorted Tesla because he calculated there would be a surplus of EVs. His losses apparently reached $1.5BN. It’s unclear how this ultimately played out but it caused Musk to sour on Gates. “Why make money on the failure of a sustainable energy car company?” he asked.

Yet Musk routinely faces down one looming catastrophe after another. He pushes himself and others to the brink of failure, but so far has won every time. Isaacson adds up the value of the four companies Musk had founded and financed by April 2022 – Tesla ($1TN), SpaceX ($100BN), The Boring Company ($5.6BN) and Neuralink ($1BN).

Isaacson’s book presents a compelling portrait of a consequential and complex figure. Musk granted unfettered access for two years, providing rich material that is never dull. Watching Musk from afar is to see an impending train crash repeatedly averted. Somehow the world’s richest man got that way while focused on bigger goals. We should want Musk to continue pulling off miraculous victories because the changes will likely be positive.

Bill Gates said, “There is no one in our time who has done more to push the bounds of science and innovation than he has.”

There are still many more chapters in the story of Elon Musk.

Suppose The Deficit Matters

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Suppose The Deficit Matters
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For our entire careers the US budget deficit has hung over markets like the sword of Damocles. It was a political issue in 1992 when Bill Clinton beat George Bush, a victory enabled by Ross Perot siphoning off Republican voters with his warnings of fiscal catastrophe.

Under Clinton we briefly ran a budget surplus, part of an improving trend Bush had started by reneging on his pledge to not raise taxes (“Read my lips. No new taxes”). That cost Bush the election, and as the Clinton surplus melted away so did popular concern about the deficit. Today there are no fiscal hawks, because they can’t get elected. The bull market in bonds that started in 1982 lasted almost four decades. But it’s over.

When investors consider America’s ballooning debt, they shake their heads at the looming disaster and then forget about it as they select asset classes and securities. Few consider what it might mean for their portfolios.

In the 1970s bond investors suffered negative real returns as inflation rose faster than interest rates. Paul Volcker famously crushed inflation, but bond investors soon demanded higher real returns that briefly touched 10% as compensation for the risk of inflation’s return. Nominal and real yields steadily fell as inflation remained quiescent.

Yields on ten year Treasury Inflation Protected Securities (TIPs) have declined more or less continuously since their first issuance in 1982. Because investors care about returns net of inflation, the decline in real returns has affected all asset classes. The drivers are complex and the subject of much academic research. Inflation uncertainty can cause investors to demand higher returns, which is why the Fed is so focused on restoring it to 2%. Broad technological advancement can improve productivity, driving realized real returns higher, as can an increased need for capital. Central bank buying of bonds, Quantitative Easing, has depressed real returns.

There’s no accepted method for forecasting what real returns will be. But it’s clear that investors want them higher.

TIPs have provided a reasonable forecast on future returns. The third chart overlays ten year TIPs with the subsequent ten year bond return. The 1992 trailing ten year bond return was 8%. In 1982, ten year TIPs yielded 7%. The forecast reflected in this yield was within 1% of what bond buyers realized over the following decade.

It’s in this context that we should consider today’s rising TIPs yields. The downward trend is over. Real yields, which were inexplicably negative during the early stages of the pandemic in 2020, have moved up through 2% and are close to 2.5%.

Treasury Secretary Janet Yellen believes it’s because of the strong economy. US GDP rose 4.9% in 3Q23, driven by a 4% increase in consumption expenditures. Other factors could be at work. Bonds have benefited from substantial buying by the Fed and other central banks who aren’t return oriented. The Fed is now letting its balance sheet shrink. China is reducing its exposure. Perhaps they’re worried about these assets being frozen if at some point we’re at conflict over Taiwan.

The fiscal outlook could be another consideration. As non-commercial buyers are withdrawing, the return-oriented investor is the marginal buyer. Three month t-bills at 5.5% look attractive. But are thirty year bonds at 5% offering sufficient compensation for the chart at the beginning of the blog? The Fed’s commitment to 2% inflation is only as strong as the desire in Congress to support them. Taming inflation caused by the pandemic has brought forward by two years the point at which interest expense equals 3% of GDP (from 2030 to 2028). Higher rates have a deleterious effect on our fiscal outlook, because we owe so much money.

At some point over the life of the new thirty year bond the US Treasury will sell next month, the constraint posed by interest expense on discretionary spending is likely to become a topic of Congressional debate. The fealty to 2% inflation will be considered alongside other worthy goals.

Populism continues to promote deceptively simple solutions to today’s complicated problems in both political parties. We may endure another government shutdown as the new Republican speaker, whose views are right of his predecessor, pursues the facile and incorrect path of refusing to pay for what you said you’d pay for.

Populists aren’t a good credit risk.

Naturally a blog on midstream energy infrastructure will express the belief that it offers protection from the reckoning of decades of fiscal incontinence. Meaningful cash returns now will be preferable to the delayed gratification of future growth when the purchasing power of those deferred cash flows is uncertain.

Rising TIPs yields may just reflect the dawning realization of what investors already know – that our fiscal future is unlikely to be pain-free.

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

Energy Mutual Fund Energy ETF Real Assets Fund

 

 

The Magnificent Fab Four

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The Magnificent Fab Four
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Financial advisors need no reminding that performance this year has been heavily influenced by how much you invested in the Magnificent Seven (Apple, Microsoft, Meta, Amazon, Alphabet, Nvidia and Tesla). Not only have the remaining 493 stocks substantially lagged the S&P500, but the MSCI All-Country World index of nearly 3,000 companies would be down this year if not for the seven.

In other words, it’s been hard to beat the S&P500. And yet, midstream energy infrastructure continues to close in on a third successive calendar year of outperformance.

The American Energy Independence Index (AEITR) has its high flyers too. Magellan Midstream was up 45% YTD until it stopped trading following its acquisition by Oneok. We were not happy with the deal (see Oneok Does A Deal Nobody Needs). Nonetheless, we’ll grudgingly accept the profit while remaining dismayed at the recapture of deferred taxes that the transaction creates.

Equitrans (ETRN) is +43% YTD thanks to Joe Manchin insisting on the Mountain Valley Pipeline’s (MVP) inclusion in the recent legislation to raise the debt ceiling. MVP’s completion suffered another delay last week when ETRN disclosed challenges hiring workers to finish the job. It turns out that the constant risk a judge will issue a construction halt in response to one more challenge from an environmental extremist makes those jobs less appealing.

Plains All American (PAGP) is +37%. The M&A activity in energy hasn’t hurt. Exxon’s acquisition of Pioneer (see Exxon Buys More Of What The World Wants) is estimated to increase crude production out of the Permian by 350 thousand barrels per day over the next four years, which is good if, like PAGP, you own and operate crude pipelines there. Chevron’s deal with Hess is another example of capital being allocated on the premise that oil has a bright future ahead of it.

The International Energy Agency expects global crude oil demand to flatten out within the next five years before declining (see The Super Cycle Or Peak Oil?). That’s clearly not what Exxon or Chevron expect. The WSJ cheekily suggested that weakness in electric vehicle sales suggests they could peak first, before crude oil consumption (see Chevron Bets on Peak Green Energy).

Energy Transfer (ET) is +24% YTD. With a 17% 2024E Distributable Cash Flow yield (according to JPMorgan) and 7.1X Enterprise Value/EBITDA, it is the cheapest large business in the sector. It always is. ET is the most commonly owned pipeline name when we talk with financial advisors who pick individual stocks. Years ago management cemented their reputation for abusing their investors when they issued dilutive and very attractive convertible preferreds to management (see Energy Transfer: Cutting Your Payout, Not Mine from 2018 and Is Energy Transfer Quietly Fleecing its Investors? from 2016).

ET’s issuance of these offending securities led to a class action suit in Delaware which the company won. Even though they enjoyed a victory in court, they still didn’t do the right thing. Ever since, the stock has traded at what we’ll call a “Kelcy discount” (Kelcy Warren is Executive Chairman and former CEO) to its peers.

But ET knows how to run a business. Their casual relationship with fiduciary responsibility hides behind well-honed commercial instincts. When Texas suffered widespread power outages during Winter storm Uri in 2021, ET enjoyed $2.4BN in windfall gains by providing natural gas to a market that was short (see Why The Energy Transition Is Hard).  Many financial advisors are drawing some satisfaction that this long-time holding is finally rewarding their faith.

The midstream energy infrastructure sector may not have the Magnificent Seven leading the market higher. But we have these Fab Four that have all handily beaten the averages. Since we’re down to three, Enterprise Products Partners (+20% YTD) can take Magellan’s place.

The laggards this year are the Canadians. TC Energy (TRP, -10%), Enbridge (ENB, -13%) and Pembina (-11%) share the stability of utilities, a quality investors don’t value with rising rates. Their Canadian Presbyterian conservatism is being challenged. ENB is leaning against the trend in buying three utility businesses (see a comment on this in Fiscal Policy Moves Center Stage). ENB and TRP are both projected to have leverage above 5X Debt:EBITDA through the end of 2025, meaningfully higher than the 3.0-3.5X that prevails among their investment grade peers. TRP has the more pressing need to shed assets to fund their capex program, but both companies are comfortable that their debt levels are manageable.

Here I’ll switch to briefly indulge in a personal anecdote. My wife and I recently met John Cleese after watching him on stage. Americans are most familiar with Cleese through Monty Python but Fawlty Towers is among the greatest comedies of all time. Cleese plays Basil Fawlty, the irascible hotel owner constantly berating the guests whose presence is often an inconvenience or worse. Quotes from these twelve episodes have featured in our family discourse for decades. Since Cleese has been an enduring source of laughter for us, it was my great pleasure to tell him personally. True to form, he was charming and then told us to “buzz off” as there were others waiting to shake his hand.

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

Energy Mutual Fund Energy ETF Real Assets Fund

 

 

 

 

 

 

Hedging with Energy

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It’s always interesting to learn how financial advisers use our energy infrastructure investments in their portfolios. Often, it’s for income, because the 6-7% yields are well covered by cash flow, growing and supported by continued reluctance to boost growth capex. America has the pipeline network we need. New construction gets held up by court challenges from climate protesters, with the delays increasing costs. Equitrans with their Mountain Valley Pipeline project is an example. They announced a further delay because hiring is hard. Their recent 8K SEC filing noted, “multiple crews electing not to work on the project based on the history of court-related construction stops when there’s the risk of another court order stopping work.”

Canada’s federal government probably owns the record for cost over-runs, with a 4X increase since they acquired the TransMountain expansion from Kinder Morgan five years ago (see Governments And Their Energy Policies). Developments like these are dissuading growth projects, which is why pipeline sector dividends are growing. A dollar not spent on capex is a dollar coming back to shareholders, through a dividend hike or stock buyback. It’s hard not to love climate extremists.

Because of the prospect of rising payouts and buybacks, we think pipelines offer income with growth. Who says you can’t have both?

Some financial advisors like energy because it’s relatively uncorrelated with other sectors. We think this makes a lot of sense (watch Will Geopolitical Risk Effect the Energy Market?).

I was with one such investor last week who uses midstream energy as a hedge against more conventional equity exposure. He’s very happy with the results, and his business is growing strongly because of this and doubtless many other good calls for his clients.

The American Energy Independence Index (AEITR) handily beat the S&P500 for the past two years. Pipeline companies are not popularly linked with AI so have lagged the market this year. However, the gap has begun to close as Israel has responded to the shocking terrorist attack by Hamas, ratcheting up tensions across the region.

By mid-July the S&P500 was 13% ahead of the AEITR. As of Friday the gap had shrunk to 2.6%. Dividends help – the S&P500’s dividend yield is a paltry 1.6%, less than a quarter of what pipelines pay. Enbridge (ENB) yields over 8.1%. Its C$3.55 dividend has grown annually for 28 years, a record management has pledged to continue. It represents an extreme case of the contrast between energy infrastructure and the overall market. ENB still looks like a good pairs trade with a short S&P500 position. Notwithstanding your blogger’s substantial overweight to the sector, I recently put that trade on too.

Stocks had a bad week. But they still don’t look that cheap. Six months ago (see Inflation vs Regional Bank Crisis) valuations were just average compared with the past couple of decades. Since then, the S&P500 has risen 4%, 2023 forecast earnings are flat and declining, and the ten year note has risen 1.5%.

Today’s Equity Risk Premium (ERP) of 0.3 is the lowest in two decades. Even using 2024E EPS, at 0.9 it’s still unattractive. Moreover, earnings forecasts have been declining in recent weeks, with few upward revisions likely other than for the defense sector.

We’ve also included the ERP for the NASDAQ 100. This is an unconventional way to evaluate the tech sector, and your blogger long ago concluded that he felt more comfortable with value stocks. Over the years I have carefully avoided expensive investments with high growth rates, and such omissions have not always been to my advantage.

Nonetheless, it’s hard to resist publishing the Tech sector ERP chart. Rising bond yields are doubly bad here, because as well as offering a relatively stable return they mean a higher discount rate/lower NPV on those far bigger, far away profits.

Tech stocks lost three quarters of their value during the dot.com collapse. Even during the 2008 great financial crisis they were down by half. Today’s ERP for the sector is around the same level.

This blog doesn’t promise to get you into tech stocks at the low. But they don’t look cheap.

Electric vehicle (EV) sales are flattening out. Everyone I know who owns a Tesla loves it, but also has another car for long drives. But my circle of friends is not representative of America. A journalist on the NYTimes Climate desk recently reported on an EV trip he made in South Dakota that ended with his Volvo C40 being towed because it ran out of juice.

We still worry about our phone batteries going dead.

EVs seem like fun, but compared with much of the world, in the US we (1) drive farther, (2) drive bigger cars, and (3) enjoy relatively cheap gasoline. EV penetration looks as if it’ll be slower than many fans expect.

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

Energy Mutual Fund Energy ETF Real Assets Fund

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

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Book Review -- Going Infinite: The Rise and Fall of a New Tycoon
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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 Real Assets Fund

 

Exxon Buys More Of What The World Wants

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Last week the Energy Information Administration (EIA) released their 2023 International Energy Outlook. It came out on Wednesday, the same day that Exxon Mobil (XOM) confirmed their acquisition of Pioneer Natural Resources (PXD), and they’re linked in more ways than simply their announcement date.

When energy companies issue long term energy forecasts they’re well aware that environmentalists will pore over them looking for an absence of fealty to the UN’s Zero By 50 goal – that is, that emissions of greenhouse gases will be eliminated by that date in order to limit anthropogenic global warming to 1.5 degrees C above the levels of 1850.

BP concluded that publishing data and forecasts was so fraught that they handed off their Statistical Review of World Energy after seven decades to the Energy Institute. But the EIA is unburdened by such concerns, and their latest publication should have agitated climate extremists more than XOM investing $60BN in adding oil and gas production.

The EIA produces several scenarios (“cases”) incorporating high versus low global GDP growth, oil prices and zero-carbon technology, along with a Reference Case which is based on current policies. They warn that they’re making projections not forecasts, although the difference is a subtlety only meaningful to the EIA.

The headline could be, “EIA Forecasts Increase In CO2 Emissions By 2050” if their publications received such coverage. Higher living standards and population in developing countries will more than offset improving energy efficiency. When people have more disposable income, they use more energy. There is no historical precedent suggesting that can be avoided, so the EIA projects primary energy consumption will grow from 640 Quadrillion BTUs (Quads) to 856 Quads, a 1.1% annual growth rate.

The EIA includes some other dramatic changes

Their Reference Case assumes that non-fossil fuels will increase their share of primary energy and fulfill 58% of the increase in world energy consumption over that time. Increased global electricity consumption will be met primarily (italics added) by zero-carbon technologies. This is an extraordinary projection. Much of the rich world is dedicated to decarbonizing its power supply and electrifying more of its energy use – such as by shifting to Electric Vehicles (EVs) in the transportation sector. And yet, because of an increasing middle class in poorer regions such as Africa and much of Asia, electricity generation will consume more coal and gas than it does today. Perhaps most disappointingly, CO2 emissions from coal are projected to be the same in 2050 as today. The case for increased use of natural gas has never been stronger.

Aviation will more than triple.

The EIA sees EVs reaching 36% of new auto sales by 2050, which would still mean 1.4 billion internal combustion engine cars on the world’s roads. India’s energy consumption per capita will increase by 140%. China’s use of coal in iron and steel production will fall by 70%.

Other long-term forecasts typically see fossil fuel use declining over the next several decades. The International Energy Agency (IEA) in their Stated Policies Case (STEPS) expects fossil fuel consumption to peak within the decade, higher non-fossil fuel composition of primary energy and slower overall demand growth. They expect CO2 emissions to fall, but not by much.

Which brings us to XOM’s acquisition of PXD. Two years ago Engine No 1 criticized the company’s strategy, pushing it to be better prepared for the energy transition by focusing on short-cycle projects and renewables. Since then, XOM has committed $17BN to carbon capture and storage technology, biofuels and hydrogen. Nonetheless, a year ago critics such as Climate Action 100+ were complaining that 73% of their capital allocation was misaligned with the UN’s Zero By 50.

And now they’ve doubled down on the Permian basin in Texas. If production increases, Plains All American should be one of the beneficiaries. XOM also notes that they plan to accelerate PXD’s plans for zero-emission production from the wells they’re acquiring by fifteen years.

XOM’s long term outlook probably has much in common with the EIA.

The IEA’s scenario for reaching the UN’s target sees declining overall energy consumption. That only seems possible with extended slow growth in GDP and/or population.

The increase in M&A activity in the sector shows that boards are becoming comfortable making new long-term commitments to traditional energy. Oneok’s recent acquisition of Magellan Midstream, and Energy Transfer’s pending buy of Crestwood, are two more examples. They’re reaching the same conclusion as the EIA, which is that the world is going to need more of every kind of energy. America is well positioned to be part of the solution, especially with cheap natural gas.

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

Energy Mutual Fund Energy ETF Real Assets Fund

 

Terrorists Create Geopolitical Risk

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Only last week a new investor asked how the pipeline sector might respond to geopolitical risk. Conflict in any of the world’s trouble spots is bad for most sectors and the market overall. But energy is different, because the specter of supply disruption draws in buyers.

Saturday’s massive terrorist attack on Israel by Hamas is an example. Developments will render this post outdated almost as soon as it’s written, but the surprise and initial casualties suffered by the Israelis rank this up with the 1973 Yom Kippur War or even the war that immediately followed the creation of Israel in 1948.

Less than two weeks ago National Security Adviser Jake Sullivan said, “The Middle East region is quieter today than it has been in two decades.” He did add that this could easily change.

Israel hardly produces any oil, but Iran’s backing of Hamas risks broadening the conflict. Near term fluctuations in crude will be driven by events on the ground, but an enduring risk premium is likely to remain for some time. A return to the status quo ante seems unlikely, so energy exposure offers optionality to protect the rest of your portfolio against further developments.

Fertilizer stocks have risen. Israel exports 3% of the world’s fertilizer potash. Iran is a key regional producer of nitrogen derived from its supplies of natural gas.

Looking out over the next few months, the rapprochement between the US and Iran that was potentially leading to increased Iranian exports looks less certain now. Saudi Arabian supply may not change as a result of this latest war, but it’s hard to see why they’d be more likely than before to pump more to help western economies.

Energy security is once more a winner. The US is energy-independent and a stable supplier of oil and gas. For natural gas, which is expensive to transport, trade via Liquefied Natural Gas (LNG) provides greater flexibility than a pipeline. Germany’s Nordstream link to Russia will remain a lesson for many LNG buyers around the world. Pipelines represent a permanent link between buyer and seller, creating a mutual dependence that survives as long as neither sees a benefit in breaking it. Finland and Estonia are investigating a gas leak in a pipeline connecting their two countries, and sabotage is suspected.

Four years ago we considered the tinder box that is the Middle East (see Investors Look Warily at the Persian Gulf). Last year Russia pivoted from Germany to China to export its Siberian natural gas and has been negotiating a long term agreement ever since. Current circumstances make such trade mutually beneficial, but both countries will be wary of becoming too dependent on the other. Russia has few other choices and China, already the world’s biggest LNG importer, is adding additional receiving terminals (see LNG Growth Faces Few Headwinds).

There are very few pairs of countries where stable, long term relations can be sufficiently assured to justify a pipeline connection. The US and Canada is one of the few.

This is why LNG is preferable to pipelines for trade. An era of declining globalization, onshoring and shortened supply lines makes flexibility more important to buyers. US LNG exports will probably double over the rest of the decade, providing the cleanest fossil fuel reliably to meet the world’s growing desire for natural gas while also displacing coal.

The initial market response of lower bond yields, stable equity markets and higher crude oil makes midstream energy infrastructure more attractive. The rebound in stocks during the day Monday shows the sensitivity to interest rates. The Equity Risk Premium shows the market to be historically expensive (see Why Are Real Yields Rising?).

Enbridge yields over 8% and has raised its dividend for the past 28 years, as we noted on Sunday. It is in our opinion an attractive investment, even if bond yields resume their ascent.

We’re heading into earnings season, which should provide further confirmation of the sector’s continued cash flow growth, declining leverage and focus on shareholder returns via dividend hikes and buybacks. MPLX is among the names expected to benefit from inflation-linked tariff increases, an under-appreciated feature of regulated pipelines that we’ve noted in the past.

NextEra Energy (NEE) and its MLP NextEra Partners (NEP) both continue to drop, reflecting investors’ waning appetite for renewables-oriented companies. NEP has lost two thirds of its value YTD, following what should have been only mildly disappointing news that future dividend growth was being halved. With a 14.5% yield, paying dividends is a waste of NEP cash. We’ve seen this story before with other MLPs. If the stock doesn’t rebound a dividend cut will be inevitable.

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

Energy Mutual Fund Energy ETF Real Assets Fund

 

Fiscal Policy Moves Center Stage

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I traveled down the east coast last week – stopping along the way to see clients. My first stop was Washington, DC to see Robert Dove, an old friend from high school in London and a long-time client. We can both still recite the school song in Latin, an obscure skill not as highly valued by today’s younger alumni. I was privileged to join Robert at the unveiling of a stamp honoring the late Ruth Bader Ginsburg.

Additional stops were made in Virginia, South Carolina and SE Florida on my way to Naples. I always enjoy meeting our investors.

Politics came up more than usual, because of the news. The House Republicans’ defenestration of speaker Kevin McCarthy must increase the odds of a government shutdown when the brief agreement he negotiated expires next month. Indeed, it’s hard to see how any incoming speaker can avoid this without suffering their predecessor’s fate. It might even be more likely than not.

Bond yields have been rising, but inflation expectations are not. The increase in real yields has prompted articles suggesting that the market’s reckoning with our dire fiscal outlook is finally at hand. The WSJ’s Grep IP is one of several journalists linking the two. A government shutdown more clearly demonstrates the absence of any fiscal middle ground than it does a pathway to resolution.

One of the most dramatic illustrations of the problem is that Federal interest expense is now expected to reach 3% of GDP in 2028 based on the Congressional Budget Office’s June 2023 long range projections. Less than a year prior, in July 2022, the 3% threshold wasn’t expected until 2030. Fed tightening is the reason.

The June 2023 outlook assumes a real yield on the ten year treasury of 0.9% next year and 1.6% for the rest of the decade. It’s currently 2.4%. Fed tightening has worsened our fiscal outlook. The FOMC would argue that a less hawkish policy response would have allowed longer term inflation expectations to become embedded at a higher level, pushing up long term yields even more. It’s unknowable. So far the real economy has been remarkably resilient to higher rates.

Canadian pipeline stocks have been relatively weak this year, including Enbridge (ENB), the biggest midstream company in North America. The market didn’t like their acquisition of three natural gas utilities businesses from Dominion Energy for C$19BN, partly financed by issuing C$4BN in equity. The S&P Dow Jones Utility Index is down 14% YTD. ENB, which increasingly shares their characteristic of stable, regulated returns, has been dragged down with the sector.

Except ENB sports a yield over 8%, roughly 1.5X covered by distributable cash flow. It’s true their leverage will rise uncomfortably once they close on their acquisitions, but the company is confident they’re on track to get back within their prior range of 4.5-5X with a dividend payout ratio of 60-70%.

ENB has raised their dividend for the past 28 years. Canadian management teams exhibit the Scottish Presbyterian conservatism that is part of the culture. During times of market stress, we’ve mused that some American companies could do better than being run by risk-loving Texans (see Send in the Canadians!)

ENB is certainly not overlooked but compared with the S&P500 which yields 1.4%, it looks pretty attractive.

Long ENB/short SPY looks like a good trade to this blogger. If bond yields keep rising, the broader market will fall, and if nothing dramatic happens there’s over 6.5% of positive carry on the trade. If rates fall ENB will look even more attractive. And if AI stocks recommence their ascent…well, there’s always a way for a trade to lose and that is probably it.

ENB’s high and growing dividend is a decent metaphor for the entire midstream energy infrastructure sector.

RBNEnergy noted some weaknesses in the Energy Information Administration’s (EIA) long term US natural gas consumption forecasts – they’ve been consistently too low, by an average of around 3 Billion Cubic Feet per Day for several years. Part of the reason is the EIA has been overly optimistic about renewables utilization.

The past couple of years illustrate – comparing 1H22 and 1H23, solar and wind utilization both fell while natural gas rose. The problem of intermittency with weather-dependent energy remains a problem. Some states are enjoying good success with wind – notably Iowa which gets 55% of its electricity from this source. But the extended bear market in clean energy stocks and companies closely identified with renewables such as Nextera reflects a realization that it’s not an easy business. The declining utilization of existing solar and winds assets is another indication.

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

Energy Mutual Fund Energy ETF Real Assets Fund

 

Green Growth Projects Are Losing Fans

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On Sunday my daughter lamented the fact that she didn’t have a ticket for the Chiefs-Jets game that evening. Not that she’s an NFL fan – she was blissfully unaware of the injury that Aaron Rodgers sustained three weeks ago and has no experience of the perpetual heartache Jets fans stoically endure. She just wanted to see Taylor Swift waving at Travis Kelce from the VIP section. The Chiefs provided plenty to wave at.

Even the Bills 48-20 demolition of the Dolphins, coming a week after the Dolphins mauled the Broncos 70-20, couldn’t beat Taylor Swift as the opening paragraph in the WSJ’s Jason Gay NFL column on Monday. We’re simply following the trend.

Almost as important was the rebalancing of the Alerian index now that it’s lost Magellan Midstream to Oneok and will soon cede Crestwood to Energy Transfer. Vettafi, owner of the indices, opted to move beyond pipelines in its quest for more MLPs. Among the additions is USA Compression Partners which provides compression services that keep oil and gas moving through pipelines. They’re in the equipment services business, without the visible cashflows that characterize the pipeline toll model. USAC’s business is cyclical and competitive. They don’t enjoy the regulated monopolies of pipelines with PPI-linked tariff increases. High profits at USAC will draw new providers of such services. The MLP fund managers whose indices will now include USAC must choose to underweight it or accept more energy cycle risk. Investors in the Alerian MLP ETF, AMLP, will have no choice.

I remember meeting USAC’s CEO several years ago at a conference and asking him why they were still pursuing growth strategies that didn’t cover their cost of capital. He responded that if Chevron asks you whether you’ll be there for them in a new oil or gas play, you have to say yes. That’s the attitude that caused poor capital allocation at the height of the shale revolution.

Mizuno’s Gabriel Moreen, who covers the midstream sector, just downgraded USAC to underperform, saying the company, “does not possess the balance sheet flexibility to lean into growth” even if such opportunities present themselves.

Five years ago and before the pandemic, renewables stocks were starting their ascent on the belief that a fast energy transition was beginning and oil and gas assets would be stranded. Covid represented a brief setback, but the rally soon resumed. Early 2021 marked the peak in sentiment, and the deflating bubble has spread misery ever since.

Midstream energy infrastructure looks like the tortoise gaining on the clean energy hare. Five year returns are converging and on present trends it shouldn’t be too long before investors in green energy are forced to conclude pipelines were better. The enthusiasm of management teams for deploying new capital is not shared by the market.

NextEra Partners, LP (NEP), has lost almost half its value following last week’s revised guidance on distribution growth, down from a range of 12-15% to 5-8%. The market’s reaction was as if they’d slashed their payout instead of simply reducing its projected growth rate, although the current 12% yield suggests many think it will be cut anyway.

Rising interest rates have hurt companies promising high growth, including renewables. Meanwhile traditional energy companies remain content with parsimonious capex growth and high current returns.

NEP is an old-style MLP with an external General Partner (GP) in parent NextEra Energy Inc (NEE). As with the pipeline GP/MLP combinations that have disappeared, NEE sells assets to NEP who issues equity to pay for them. Pricing is supposed to be arms’ length but historically the GP has done better than the MLP, just as hedge fund managers have done better than hedge fund investors (see The Hedge Fund Mirage).

NEP tried to soften the bad news by promising no need for additional growth equity (ie secondary offerings) until 2027. However, investors were apparently unexcited about plans to “repower the majority of its wind portfolio in the coming years” which means upgrade old equipment, or the “excellent growth opportunities” from acquiring assets from the parent.

MLPs have a narrow investor base, mostly income-seeking US taxpayers willing to tolerate a K1 (ie old rich Americans) and a few energy funds. Mistreating this investor base depresses the stock price, rendering it a prohibitively expensive source of capital which in turn makes it hard for the parent to drop down assets. Former investors in Kinder Morgan Partners know what comes next (see Kinder Shows The MLP Model is Changing). The MLP gets rolled up into the parent at a low price, delivering LPs an unwelcome tax bill for deferred income recapture.

NEP CEO John Ketchum has arranged his own investments accordingly. His holdings of NEE, where he is also CEO, are more than 10X his holdings of NEP. He’s seen this movie before.

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

Energy Mutual Fund Energy ETF Real Assets Fund

 

 

Just In Time Oil

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Changes in US oil inventories sometimes cause a sharp move in the price of crude. It makes perfect sense, even if it’s hard to tease out much of a statistical relationship from the data. Oil stocks, meaning oil held in inventory, have been falling since the early days of the pandemic when the collapse in demand left traders scrambling for places to store it. The most recent weekly data showed our inventories are the lowest in almost forty years.

The US Strategic Petroleum Reserve (SPR) has also been falling. Privately held inventories move based on economics, whereas changes in the SPR are a political choice. This was most notable a year ago when high gasoline prices prompted the Administration to release oil to avoid losses in the mid-term elections. Such sales have continued (see Crude Climbs The Wall Of Supply Worries).

So for different reasons, both privately held inventories and the SPR are falling. Historically the two moved more or less independently given their differing objectives. Now, both the Federal government and commercial operators are concluding they need to hold less.

Businesses generally hold inventories of the inputs they need for production and finished goods awaiting sale. Such decisions are made to smooth production lines. Oil has the additional motivation in that speculation on higher prices may increase inventories. And the Federal government has its own, non-commercial goals.

One way to think about inventory adequacy is to measure how many days of domestic consumption could be supported if output and imports stopped. It’s well short of a perfect measure, because it assumes all the oil in storage could seamlessly move to where it’s needed and be of the correct grade to be acceptable to the refineries or other users taking delivery. So the current ratio of total oil in storage divided by average daily consumption of 57 days doesn’t mean inventories could satisfy domestic demand for that long. It’s undoubtedly far less. But it is the lowest ratio on record, going back 37 years. We’re on track to find out what inventory level is too low. Rising crude will tell us we’re there. It may already be happening.

“Just in time inventory” has made manufacturing more efficient. Delivering inputs only when needed to an automobile factory reduces the needed working capital and improves profitability. The decline in privately held oil stocks in recent years combined with stable refinery runs shows a similar improvement in operating efficiency.

Increased domestic oil production reduces our need to hold inventories for energy security. We’re less reliant on imports but because US refineries can’t use all the light shale oil we produce, two-way trade brings in the heavy crude they’re designed for and exports lighter grades. We have enormous inventory underground, accessible when needed.

Domestic production is growing, but slowly. The Baker Hughes oil rig count is at 513, down almost 20% from its peak late last year. Current output remains just shy of the 13 Million barrels per Day record of November 2019.

Exxon Mobil (XOM) is operating 17 rigs, down from 65 four years ago. Energy companies are staying disciplined, unmoved by the recent run up in prices. “If you think about capital efficiency, and you want to make sure you’re thinking long-term about your business, moving [drilling rigs] up and down a lot is not a good idea,” said Jack Williams, a senior vice president at XOM.

Pipeline operators often complain about the difficulties with construction. The experience of Equitrans with Mountain Valley Pipeline (MVP) is perhaps the most famous example of the cost that endless environmental legal challenges can impose on infrastructure projects.

But renewable energy is more urgently dependent on permitting reform because future Infrastructure projects will be concentrated there. We mostly have the oil and gas pipeline network we need, which is why midstream companies are buying back stock and raising dividends.

Wind turbines and solar panels are built in remote, sparsely populated locations. They need long-distance, high voltage transmission lines to move power to population centers. Decarbonizing our energy systems means converting more demand to electricity.

A recent WSJ report showed that more than 10,000 energy projects were awaiting permission to connect to electric grids at the end of last year, almost all wind and solar. The SunZia wind project in New Mexico filed for permits in 2006 and just received the go-ahead to begin construction. America’s system of government creates many opportunities for NIMBY opponents to file legal challenges at the local and state levels as well as federal.

Consequently, 17% of our primary energy comes from carbon-free sources. Half of that is nuclear, which given public resistance is unlikely to grow much. Switching from coal to natural gas for power generation remains our biggest source of reduced greenhouse gas emissions. Ironically, court challenges to new energy infrastructure from environmental extremists represent a significant challenge to renewables.

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

Energy Mutual Fund Energy ETF Real Assets Fund

 

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