Episode Archive - Page 23 of 32

The Fed’s Yield Curve Problem

April 10, 2022/0 Comments/in Midstream Energy Infrastructure/by Simon Lack

SL Advisors Talks Markets

The Fed’s Yield Curve Problem

00:00 / 00:06:00

What’s the best shape for the yield curve? Today’s flat verging on inverted shape isn’t optimal. It suggests the market is worried that the Fed will tighten too much, causing a recession. It also makes it hard for banks to make much money extending credit, because they typically lend for longer maturities while funding themselves at the short end. With no curve there’s no positive carry.

But a curve can be too steep as well. If the market was worried that the Fed was going to be inattentive to inflation, long term yields would rise relative to the short end. In some respects the yield curve is a measure of confidence in the Fed’s execution of its mandate. A curve that’s positive without reflecting runaway inflation – a Goldilocks curve – reflects confidence in the future. A ten year treasury yield 2-4% above the Fed Funds rate might be that ‘not too hot not too cold” happy medium. It’s occurred to me that the Fed could do worse than adopt a strategy of maintaining a Goldilocks curve – adjusting the Fed Funds rate in response to changes in long term yields. If they maintained the spread between the ten year note and Fed Funds at 2-4%, they’d be setting monetary policy based on what financial markets are recommending.

A strategy of targeting a constant slope to the yield curve is made more complicated by the presence of so many return-agnostic buyers in the US treasury market. Negative real yields distort the expectations message the bond market would otherwise transmit. As long as there are foreign central banks, sovereign wealth funds and pension funds insistent on holding assets even if they destroy value in real terms, long term treasury yields present a distorted view of the market’s outlook for inflation.

The Fed has added to this by inflating their balance sheet – former Fed chair Ben Bernanke showed the world how Quantitative Easing (QE) could be non-inflationary if practiced correctly, as it was during the 2008-09 Great Financial Crisis (GFC). Current chair Jay Powell made it part of the Fed’s toolbox when Covid caused a recession. QE was really a one-off tool to help unfreeze financial markets, but we can now assume that it will be used whenever the Fed is facing a recession.

The economy is more responsive to long term yields than the Fed Funds rate. Most residential mortgages are fixed rate. Corporate capital spending is partly financed with bond issuance. The Fed is trying to make financial conditions less accommodative, but even though their own forecast is for the Fed Funds rate to reach nearly 3% by late next year, ten year treasury yields remain stubbornly low at around 2.7%, a level that hardly translates into tight monetary conditions.

The Fed is part of the problem, because Covid QE saw their balance sheet grow to $9TN. Recognizing the importance of long term yields on economic activity, they bought bonds to push yields down. The Fed only just stopped adding to their balance sheet last month.

Having decided to operate directly in the bond market to lower yields during a recession, it’s logical for the Fed to take steps to increase bond yields when trying to slow growth – such as now.

The release of minutes last week showing the Fed intends to reduce their balance sheet by $95BN per month drew much attention. But it’s not that impactful. The Fed has $1.1TN of securities with maturities of under one year, so their planned monthly reduction simply amounts to letting these securities roll off and not reinvesting the proceeds. But even if the Fed decided to auction this $1TN in short maturity securities it would have little impact, because the Fed targets a rate for Fed Funds and buys/sells short term securities to achieve their desired rate.

A meaningful reduction in the balance sheet would involve selling long term securities, especially the $2.6TN in Mortgage Backed Securities (MBS) with maturities of ten years and longer. The minutes make clear that the FOMC is uncomfortable with the current balance sheet size and wants to reduce it faster than following the GFC without being disruptive. They also need long term rates higher to as to tighten financial conditions.

Former Federal Reserve Bank of New York President Bill Dudley says the Fed “hasn’t really accomplished much yet” with its efforts to control inflation, and will need to tighten financial conditions to push bond yields higher and stock prices lower. “If financial conditions don’t cooperate with the Fed, the Fed’s going to have to do more until financial markets do cooperate,”

The opposite of QE means selling long term bonds. It’s hard to see how the Fed could auction their holdings of US treasuries without complicating the US Treasury’s always ample schedule of new issuance. But MBS auctions would be less problematic and look inevitable; a necessary step to cool a hot housing market that the Fed’s earlier buying of MBS helped create.

Nobody wants a flat yield curve. The Fed will likely conclude a steeper curve is a necessary element of their effort to curb inflation. Mortgage rates have probably bottomed for good.

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

Energy Mutual Fund Energy ETF Inflation Fund

Please see important Legal Disclosures.

The Fed’s Aspirational Base Case

April 6, 2022/0 Comments/in Midstream Energy Infrastructure/by Simon Lack

SL Advisors Talks Markets

The Fed’s Aspirational Base Case

00:00 / 00:08:11

There were few places to hide last quarter. The S&P500 was –4.6% with nine of its eleven sectors losing. Energy sparkled at +39% and Utilities were +4.8%. Bonds were even worse, with the Bloomberg Aggregate –6.2%. Close to our hearts, pipelines (as defined by the American Energy Independence Index) were +24.5%.

Low yields have underpinned stocks for many years, so a deteriorating Equity Risk Premium (ERP) is weakening the case for “TINA” (There Is No Alternative). Although bonds remain a long way from offering a fair return, yields have risen far enough that stocks no longer look compelling. Factset bottom-up estimates for S&P500 EPS growth are 9%, putting the ERP close to its 20 year average. As a successful and now retired bond trader used to say, 3% on the ten year note is only a nine iron away. This would make stocks look decidedly neutral.

Correctly calling interest rates is of greater import to one’s equity portfolio. JPMorgan produced an interesting chart that shows bond yields and equity returns are more highly correlated when rates are low. There’s no doubt low rates have driven investors to assume greater risk. Inconveniently, most of this relationship is since the Great Financial Crisis (GFC), so it’s unclear if the correlation has risen because rates are low, or because something changed structurally following the GFC. If ten year yields move above 3.6%, JPMorgan’s chart suggests the correlation will turn negative, meaning rising rates would be good for stocks. It’s hard to imagine, but inflation is changing many things.

Larry Summers and Bill Dudley are competing via erudite blog posts for the title of most articulate Fed critic. Dudley recently said that The Fed has made a U.S. recession inevitable thanks to its slothful removal of monetary support. Jamie Dimon said in his annual letter that “the medicine (fiscal spending and QE) was probably too much and lasted too long.”

Summers warned investors, The stock market liked the Fed’s plan to raise interest rates. It’s wrong. He took issue with the recently released FOMC forecast, which presents an impossibly optimistic outlook. He notes that the Fed is expecting inflation to moderate while pushing Fed Funds barely above their neutral target, all while maintaining close to full employment. Should Jay Powell and his FOMC colleagues pull this off, they will have threaded the proverbial needle and challenged economic orthodoxy. It’s more correctly an objective, or an upside case, rather than a forecast. No business could submit a budget with such hopeful outcomes.

This makes the future path of interest rates quite wide. If inflation doesn’t moderate, will the Fed push rates high enough to cause higher unemployment? How willing will they be to risk a recession? In August 2020 chair Powell revealed a subtle but significant change in how they regard their dual mandate of maximum employment consistent with stable prices.

Decades of declining real rates and an unemployment rate that continued to fall without causing wage pressures persuaded the Fed to allow inflation more upside than in the past. Since that symposium two years ago in Jackson their policy, “emphasizes that maximum employment is a broad-based and inclusive goal.” Data shows that minorities suffer employment more quickly than the general population, so the Fed is presumably now more sensitive to minority rates of unemployment. This isn’t necessarily a bad policy, but it is a modification and comes with increased tolerance for inflation.

The Fed now assesses “shortfalls” not “deviations” from maximum employment, since “employment can run at or above real-time estimates of its maximum level without causing concern.” And most notably, “following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”

Both Dudley and Summers impose a traditional Fed policy function on today’s situation. That would regard our current inflation spike as a manifest policy error demanding a prompt response. By contrast, Powell has admitted that inflation is too high but has yet to concede a policy error. Their revised consensus statement allows for some inflation risk in pursuit of getting everyone a job, so 7.9% inflation is less of a mistake than if, say, Paul Volcker was in charge.

If the FOMC projections turn out to be correct, stocks will do very well. The risk for equities is that inflation doesn’t moderate as expected – will an FOMC stung by their error tighten too much in response? Or will they place greater importance on near term maximum employment, always waiting for another month of hopefully better data? It’s unclear, but if Larry Summers is right that the FOMC forecasts are short on “intellectual rigor and honest realism” the Fed’s fealty to their reinterpreted mandate will be tested.

Perhaps because we cover interest rates and energy markets, connections often leap out. It’s politically correct (even “woke”) to assume wildly unrealistic assumptions about renewables, because it suggests endorsement of the policies required. So JPMorgan includes a chart showing global primary energy from renewables reaching a 60% share by 2050 from under 5% today. Fossil fuel use collapses so that oil, gas and coal in aggregate are less than 20% of primary energy use in 2050 versus 78% today.

Because JPMorgan is not quite as idealistic as the chart suggests, an extensive footnote warns that it’s based on the Net Zero outlook from this year’s BP Energy Outlook. The Net Zero scenario, which isn’t BP’s central case, roughly aligns with the UN’s goals. In other words, it’s what many climate scientists believe should be happening, not necessarily what they expect. JPMorgan adds that forecasts are “not a reliable indicator of future performance.” In other words, it’s not their forecast.

Ten years ago JPMorgan published a series of charts based on work by highly regarded polymath Vaclav Smil on the slow pace of energy transitions. It took coal 60 years after reaching 5% to provide half the world’s energy. Oil and natural gas still haven’t reached that level and probably never will. The forecast that renewables will provide half the world’s energy within two decades is aspirational, and even less likely to be accurate than the Fed’s. Any serious effort to reduce emissions will use more natural gas instead of coal, increase nuclear power substantially and incorporate carbon capture. Improbable forecasts that are presented as Base Case are never good. Larry Summers would agree.

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

Energy Mutual Fund Energy ETF Inflation Fund

Please see important Legal Disclosures.

Energy Investors Unfazed By US Selling Oil

April 3, 2022/0 Comments/in Midstream Energy Infrastructure/by Simon Lack

SL Advisors Talks Markets

Energy Investors Unfazed By US Selling Oil

00:00 / 00:05:49

The Administration’s planned release of 1 million barrels of oil a day from the Strategic Petroleum Reserve (SPR) is borne of their frustration with high prices. Average crude prices have been higher under Biden than Trump, even after adjusting for the collapse during Covid (not Trump’s fault) and the jump following Russia’s invasion (not Biden’s fault).

For energy investors like us, Biden has been a huge improvement. Trump knew he wanted lots of production to keep prices low and promote American Energy Independence. Executives were emboldened by a government they perceived as supportive. The results were good for consumers but ruinous for investors.

Although the correlation between the price of crude and pipeline stocks isn’t as strong as many think, rising prices that reflect strong underlying demand have boosted returns. For the quarter just ended, the pipeline sector returned +24.6% versus –4.5% for the S&P500.

New Jersey still mandates attendants at gas stations to fill your car. It’s a trivial yet tiresome rule – people should have a choice to pump their own gas, since it’s quicker. But recently, watching the attendant as the register ticked up past $80, I nearly jumped out and gave him a high five. Clients of SL Advisors are benefiting from White House energy policies.

We hold a minority view. Presidents have less control over oil prices than voters think, although Biden could claim some credit for the energy sector’s resurgence if he wanted to.

The White House thinks US energy companies are being abstruse in failing to respond to higher prices by increasing production. They must have advisers that understand why the sector is apparently denying itself even greater profitability, but their public comments and policies don’t reflect this.

Crude oil is in backwardation, meaning that the futures strip is downward sloping. Spot oil prices get the attention because they drive what voters pay at the pump. Production decisions are based on what produced oil and gas can be sold for over the next few years. As with almost any business, capital has to be invested up front with the expectation of a future return. If the curve was upwards sloping (contango), that would allow drillers to sell forward production at prices higher than today’s, creating the additional supply the Administration wants. It’s been in backwardation for the past year, and Russia’s invasion exacerbated this – meaning the effect on prices was more pronounced on the front month futures that impact gasoline prices than it was on the rest of the strip which drives investment decisions.

Moreover, oil companies can’t suddenly turn on a spigot. The list of reasons why current output hasn’t responded to prices as much as it might have five years ago includes (1) financial discipline, (2) White House long term anti-fossil fuel policies, (3) ESG opposition, (4) an increasingly capricious regulatory and judicial process for proposed and completed infrastructure projects, and (5) service provider inflation.

If you assume an oil well could be brought online in a year and produce equal volumes over the next four years, forward production could be hedged at $80, versus the June futures price of $101. Although futures prices are poor predictors, an E&P company that produces without hedging is just speculating on future oil prices. Investors can do that themselves with crude futures, so there’s little value added for the E&P company to do so themselves.

The SPR release of 1 Million Barrels per Day (MMB/D) over six months is an understandable political reaction, but isn’t likely to alter prices much, because it’s temporary. At about 1% of global demand, it will reduce our SPR to 345 million barrels, 48% of capacity and the lowest since 1983. Reducing crude in storage will increase our vulnerability to supply shocks from a hurricane for example. And depending on the compatibility between the grades of crude released and domestic refining infrastructure, these extra barrels may wind up being exported.

Goldman Sachs thinks use of the SPR in this way exposes the market to greater turmoil in the event of a further supply disruption from Russia.

For energy investors, it’s probably net positive. The economics of investing in new production are modestly worse than before the announced SPR release. But it doesn’t represent new supply, and the brief drop in prices delays the demand destruction that many analysts believe is the only way to balance the market. CEOs understand that the White House’s desire to increase supply is ephemeral and related to the mid-terms. The Administration will regain its former hostility to traditional energy just as soon as they can get gasoline prices off the news headlines.

Concrete steps to streamline the regulatory process and eliminate much of the uncertainty around infrastructure projects could induce some companies to invest more in future production. This is the area to watch for signs that pragmatism is informing the government’s energy policies.

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

Energy Mutual Fund Energy ETF Inflation Fund

Please see important Legal Disclosures.

US Natural Gas Takes Center Stage

March 30, 2022/0 Comments/in Midstream Energy Infrastructure SL Advisors Talks Energy/by Simon Lack

SL Advisors Talks Energy

US Natural Gas Takes Center Stage

00:00 / 00:06:22

Europe’s realization that it needs a strategy to ensure energy security has provided a further boost to US natural gas stocks. Last week was especially good – NextDecade (NEXT) added another customer for their proposed Rio Grande Liquefied Natural Gas (LNG) export facility.

By coincidence we had just interviewed Matthew Mott, SVP of their Next Carbon Solutions division. President Biden also committed to increase US LNG shipments to Europe by 15 Billion Cubic Meters (BCM), equivalent to 1.45 Billion Cubic Feet per Day (BCF/D). US natural gas was already cheap, abundant and the biggest source of global CO2 emissions declines to date (see NextDecade Sees A Bright Future). Following Russia’s war on Ukraine, it is now part of Europe’s energy security too.

Biden’s commitment grabbed headlines but his advisers will know that on current trend 2022 US LNG exports to Europe will already exceed last year’s by more than 15 BCM. LNG facilities take years to build, which provides visibility into how fast our export capacity will grow. Germany has no regasification facilities at which to receive LNG, and the most optimistic forecasts are for one to be in service by the end of next year. The market for Floating Storage and Regasification Units (FSRUs) is suddenly hot because only a handful are available and they offer Germany a faster route to importing LNG. But not all will operate in the frigid waters off Germany’s north coast. Energy security went from irrelevant to critical in Europe. Getting there won’t be elegant.

Nonetheless, the German government hopes to be no longer reliant on Russian gas imports by the summer of 2024. So far it’s been in both Germany and Russia’s interests to maintain the flow of oil and gas. Germany has no near-term alternative, and Russia is enjoying the higher prices that their invasion has precipitated.

Russia is on notice that it will need to find alternative markets for the gas Germany will no longer want. That will require Russia to build new pipeline infrastructure, likely to their east coast for export as LNG. Western sanctions may impede the timely construction. Since the break in trade between the two countries is so well anticipated, Russia’s history suggests the timing will ultimately be at their choosing and not necessarily when Germany is ready to cut imports entirely.

It’s not a leap to suggest that energy security for any country requires minimizing pipeline imports, since they create dependence on a single supplier that seaborne imports avoid. LNG trade is going to keep growing. And while increased investment in renewables is a natural move to improve security, their input prices are rising too.

US LNG trade is all run by commercial entities. Although Biden’s commitment drew attention, the Federal government isn’t about to get into the natural gas business. More meaningful would be an improved regulatory process that isn’t beholden to the liberal progressive wing of the Democrat party. Hewing to their anti-fossil fuel rhetoric has jeopardized Democrat control of the House in November – gasoline prices were already rising before Russia’s invasion. There are signs the Administration is tilting (pivoting would be too strong) towards a more balanced view of the energy transition.

For example, FERC recently shelved an earlier proposal to include the emissions ultimately generated by the oil/gas passing through any proposed pipeline they were considering for approval. This could even have applied to projects already under construction. Conveniently, last week this led to certificates being approved for two natural gas pipelines (the Evangeline Pass Expansion and Columbia Gulf Transmission’s East Lateral Xpress) that link up to Venture Global’s Plaquemines LNG export facility, among others (see Baby, I Got It – Could The U.S. Alone Meet Biden’s Call For 15 Bcm More LNG To The EU?).

The stalled Mountain Valley Pipeline (MVP) project run by Equitrans is another example where the Administration could signal a more enlightened policy. While courts can rescind previously issued permits from Federal agencies that were the basis for $BNs of invested capital, energy companies will correctly assess a hostile environment for new projects. Fixing this might require legislation, but like the Keystone XL pipeline that Biden canceled immediately upon taking office, capricious policy has its costs.

The path to increased LNG exports is visible but long. Because it typically takes up to five years from Final Investment Decision (FID) to start-up, it’s possible to project out export capacity well into the future. Of 18.9 BCF/D in projects deemed “High/Medium probability” by Cowen and Company, 11.9 BCF/D are in North America. Russia’s Novatek project may struggle to complete because of western sanctions.

Of the 20 BCF/D in US projects awaiting FID, only 6 BCF/D are on the High/Medium Probability list, whereas we think most if not all of these will eventually be done.

Europe’s energy security and US LNG profitability are now more closely linked. What remains to be seen is whether Administration policy will pragmatically move from a tilt to a pivot away from its extremist liberal wing. So far US LNG has done more to reduce global emissions than anything else.

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

Energy Mutual Fund Energy ETF Inflation Fund

Please see important Legal Disclosures.

Interview with Michael Mott, SVP Next Carbon Solutions

March 25, 2022/0 Comments/in SL Advisors Talks Energy, SL Advisors Talks Markets/by Simon Lack

SL Advisors Talks Energy

Interview with Michael Mott, SVP Next Carbon Solutions

00:00 / 00:29:26

This week’s podcast is an interview with Michael Mott, SVP at Next Carbon Solutions, a division of NextDecade.

Following our podcast taping, NextDecade announced a 20 year Liquified Natural Gas (LNG) export agreement with Guangdong Energy, a Chinese utility. NextDecade stock soared as the whole US LNG sector responded positively to increasing demand, most notably from Europe. The podcast is longer than usual – around 30 minutes – but very timely.